The role of accounting in the twenty-first century firm

^†Presented at the ICAEW Conference on Information for Better Markets series ‘Capital: reporting, regulation and resource allocation’ (December 2014).

Abstract

I explore the evolving role of accounting information in allocating capital. Accounting arose to control conflicts of interest in organizations (stewardship role). The industrial revolution spawned capital-intensive firms and public capital markets with dispersed shareholders to finance these firms. The regulation of these public capital markets shifted the role of accounting toward providing investors with information for making informed investment decisions (valuation role). With the advent of the semiconductor and global competition, emerging and public firms today differ from their predecessors in fundamental ways. Exploiting the information technologies created by the semiconductor, twenty-first century firms are now more knowledge based, have more intangible assets, are more reliant on their employees’ human capital, confront increased competition, and face diverse conflicts of interests and hence different challenges accessing capital than their forerunners. Responding to the demands of twenty-first century firms, private-equity (PE) markets provide a bundled service – capital and governance. To supply this bundle, PE firms require accounting information to control the conflicts of interest both within the PE firm (between the general and limited partners) and within their investees. Controlling these conflicts shifts the role of accounting back toward its original stewardship roots. The valuation role remains important, but there is little to value unless the conflicts of interest are first mitigated.

Keywords:

• stewardship
• venture capital
• private equity
• knowledge-based firms
• valuation
• GAAP
• private company GAAP

Acknowledgement

I gratefully acknowledge the comments from an anonymous reviewer, Sanjai Bhagat, Mary Barth, James Brickley, Don Chew, Jeff Collins, Annita Florou, Sudarshan Jayaraman, Jaewoo Kim, Cheryl McWatters, Sugata Roychowdhury, Bryce Schonberger, Brian Singleton-Green, Anup Srivastava, Steven Zeff, and Mark Zupan.

Disclosure statement

No potential conflict of interest was reported by the author.

Funding

I gratefully acknowledge the financial support provided by the University of Rochester Simon School.

Notes

^† Presented at the ICAEW Conference on Information for Better Markets series ‘Capital: reporting, regulation and resource allocation’ (December 2014).

1. See Kothari et al. (2010) and Lambert (2010).

2. Also see Toms and Wright (2002).

3. IBM, the quintessential example, shed most of its manufacturing to become a services and software firm. Less than 40% of its 2013 revenue is from hardware sales.

4. Prior to the rise of public capital markets, capital markets were private. Investors in the early fourteenth-century trading ventures utilized private contracts between the various parties. The rise of public capital markets appears to have eclipsed private investing. But this is in part illusory as data on total private investments are unavailable. Friends and family providing seed money for new ventures goes largely unreported, as does some individual angel investments.

5. ‘Venture Impact: The Economic Importance of Venture Backed Companies to the U.S. Economy’, National Venture Capital Association (2009).

6. https://www.preqin.com/docs/newsletters/pe/Preqin-Private-Equity-Spotlight-October-2014.pdf [Accessed 25 February 2015].

7. Several studies document public companies fleeing US exchanges following the passage of the Sarbanes-Oxley Act of 2002. See Gao (2011), Hostak et al. (2013), Piotroski and Srinivasan (2008), Li (2104), and Leuz et al. (2008).

8. The regulation of UK capital markets increased the financial regulation and investor protection in the middle of the twentieth century. See Franks et al. (2003).

9. PE includes a variety of specialized financial intermediaries including VC funds, angel investors, PE pools, and other organizations that raise private capital and invest in early and later stage start-ups, private companies seeking capital, and public firms looking to exit the public markets (Gilligan and Wright 2014). VCs and PEs have fundamentally different investment strategies. VCs invest in start-ups and young high-growth companies, whereas many PEs invest in mature companies with stable cash flows and few growth options.

10. http://www.ifrs.org/IFRS-for-SMEs/Pages/IFRS-for-SMEs.aspx and http://www.fasb.org/pcc [both accessed 25 February 2015].

11. Accounting, especially managerial accounting, has always played a very important role internally for performance measurement, cost control, and responsibility accounting (i.e. stewardship). What I am arguing is that the relative importance of the information role will decline.

12. Hand (2005) finds that financial statement data (cash, debt, revenues, expenses, etc.) are value relevant in VC markets, but that the value relevance of this data increases as the firm matures and has more assets in place.

13. British and European accounting policy-makers traditionally have ascribed stewardship a larger role for financial reporting than American policy-makers. However, the International Accounting Standards Board (IASB) has deemphasized stewardship and has moved more towards the US position (Zeff 2013). Also, see Whittington (2008).

14. Gjesdal (1981) also defines the stewardship accounting arising from the ‘demand for information about the actions that are taken for the purpose of controlling them’.

15. Shivakumar (2013) was presented at the 2012 ICAEW Conference on Better Capital Markets.

16. While the valuation and stewardship roles are distinct, the same information can be useful for both. For example, valuations that guide managers’ decisions can also be used to evaluate past decisions by managers (Lambert 2010).

17. Much of this section draws from Zingales (2000).

18. See Gilligan (1997) for a history of UK law and how the collective interests of the City of London protected their regulatory autonomy over several hundred years.

19. See Nobes (forthcoming) for a history of the development of concept of ‘distributable income’.

20. http://www.sec.gov/about/laws.shtml [Accessed 25 February 2015]. The UK has a similar information perspective:

The FRC's mission is to promote high quality corporate governance and reporting to foster investment. … Our functions contribute to the effective functioning of the capital markets. We help ensure that investors have what they need to place their money with reasonable confidence that any risk is taken on an informed basis and managed as well as it can be. (Financial Reporting Council 2014)

21. The 1934 US Securities Act created the Securities and Exchange Commission (SEC) and gave it the power to set accounting standards and periodic reporting for public companies.

22. Firms seek to protect their ‘software’, or intellectual property, via patents, trademarks, and non-compete-employment agreements with key personnel. However, the high cost of using the legal system to protect a firm's intellectual property limits the effectiveness of these protections.

23. www.forbes.com/sites/danschawbel/2013/09/09/why-companies-want-you-to-become-an-intrapreneur/ [Accessed 25 February 2015].

24. EVCA European PE Activity Data, 2007–2013.

25. The California Public Employees’ Retirement System, the largest US public pension fund, provides retirement, health and related financial programs and benefits to more than 1.6 million public employees. It manages $300 billion with $30 billion invested in various PE funds. See www.calpers.ca.gov/index.jsp?bc=/investments/assets/mvs.xml [Accessed 25 February 2015].

26. Some PE funds with poor performance do not liquidate in the allotted time because their investments have soured. These so-called zombie funds, estimated at close to $500 billion in 2013, allow fund managers to continue to earn fees because their fund agreements gave management too much power. But most of these zombie funds have not been able to raise capital for new funds. See Thomas (2013).

27. All financial firms are excluded.

28. Figure 2 is drawn from data in Srivastava (2014, Table 1).

29. Averages are computed using all firm-year observations for the firms in each listing cohort. For example, for all firms listed prior to 1970, the average SG&A to total expenses includes all firm-year observations from when the firm was listed through 2009, if the firm survived through 2009.

30. Volatilities are computed as the standard deviation of the last four years of the variable deflated by average total assets.

31. For firms listed before 1970, a 10% increase in SG&A to total assets generated a 10.5% increase in revenues to total assets. Firms listed in the 2000s, a 10% increase in SG&A to total assets generated a 1% increase in revenues to total assets.

32. Earnings relevance is measured using the adjusted R-square from regressions of annual stock returns on levels of, and changes in, annual earnings.

33. Core et al. (2003) report mixed findings that the relation between equity value and traditional financial variables differs between firms trading after the mid-1990s from those trading in previous periods. However, Core et al. (2003) do not specifically examine the relation between equity value and traditional financial variables for successive cohorts of firms listed by decade. Also, see Kothari and Shanken (2003) and Hand (2005).

34. Srivastava (2014) rules out changes in GAAP as the primary cause of the observed changes in reported accounting numbers for two reasons. First, GAAP has required immediate expensing of in-house intangible investments since the early 1970s. Second, he replicates all of his findings using the cash components of revenues, expenses, and earnings, which should be less affected by changes in GAAP.

35. Jensen (1989) argues that public corporations with free cash flows in excess of their growth prospects should be private so that active investors can control the opportunistic behavior of managers to retain excess cash invested in unprofitable projects.

36. Economist (2012). In 2013, the number of publicly traded US firms rose by 92 companies. See Strumpf (2014).

37. Mathematically, the number of permutations of n distinct innovations is the product of all positive integers less than or equal to n, which increases at an increasing rate in the number of distinct innovations.

38. Restatements will increase due to increased product-market competition creating cost containment pressures, including cutting accounting staff, leading to more financial reporting errors.

39. This is consistent with the analysis in Fama and Jensen (1983). They argue that it is very difficult to design hierarchical structures to control behavior of managers in complex organizations where information relevant to decisions is dispersed throughout the firm. In such complex firms, ownership will be more concentrated.

40. Zeff (2013, p. 51) argues ‘At the very least, one concludes that the USA seems to be an environment which is not hospitable to genuine innovation in financial reporting.'

41. http://www.ifrs.org/IFRS-for-SMEs/Pages/IFRS-for-SMEs.aspx [Accessed 25 February 2015].

42. http://www.ifrs.org/IFRS-for-SMEs/Documents/Fact-Sheet/IFRS-for-SMEs-Factsheet-August-2014.pdf [Accessed 25 February 2015].

43. FASB (2010, p. 1)

44. ‘However, management has the ability to access additional financial information, and consequently, general purpose financial reporting need not be directed explicitly to management' (FASB 2010, p. 10). The IASB in its Conceptual Framework reaches the same conclusion (see IASB 2010, OB9).

45. Berland and Boyns (2002) document that budgeting was a common practice in many British and French firms by the 1930s, and some firms had budgets as early as 1900.

46. See Shroff (2014) for references.

47. Not all standard setters agree that the objective of accounting should focus primarily on valuation. In fact, there was substantial debate surrounding the IASB's conceptual framework project, and several IASB members objected to de-emphasizing the stewardship role (Whittington 2008).

48. One might argue that more complex GAAP also yield benefits to the firm. But if the benefits exceeded the costs, firms had incentives to adopt the GAAP voluntarily.

49. Limited data on private US firms exist. See Sageworks.com, PrivCo.com, Hoovers.com, and dnb.com.