That sounds reasonable, but there is an important subtlety. If a firm buys inventory that it can sell tomorrow with high probability, it books it as an asset on the balance sheet, If a firm builds a plant to produce inventory that it can sell with high probability, it books the plant to the balance sheet. But if a firm invests in R&D that has produced no product of revenue as yet…and it might not be successful…should the investment be booked to the balance sheet? There is a lower probability of payoff, so should an asset be booked with the pretense that it provides collateral? We are told that 85% of R&D investment is unsuccessful.

The investor is interested in the payoff to investment, and th ecutting edge here is the probability of payoff. That is the criterion for capitalizing assets in the balance sheet under FASB and IFRS accounting standards. For the accounting for R&D under FASB Statement No. 2, the FASB requires the investment to be expensed due to the “uncertainty of future benefits.”  In IAS 38, the IASB applies the criterion of “probable future economic benefits” to distinguish between “research” (which is expensed) and “development” (which is capitalized in the balance sheet and amortized). Even IAS 16 on property, plant, and equipment requires benefits to be “probable” for the asset to be booked.

Reporting R&D just says an expenditure has been made, nothing about the likely payoff. So the criterion for booking any asset to the balance sheet is the probability of future benefits. That suits the investor who is concerned about the risk to payoffs. Indeed, we will see in chapter 8 on risk to value that the expensing of intangible assets to the income statement conveys important risk information to the investor. The accounting authorities might not have the precise calibration as yet, but the investor is warned: Buying a firm with R&D with relatively low probability of payoff (an R&D startup, for example) is risky. And that applies to other intangible assets. For expenditures on advertising or brand building, it is uncertain whether the customers will be hooked. For investment in human capital, the outcome is uncertain; the employees may leave and go to a competitor. And so for investment to develop supply chains and distribution systems, customer loyalty programs, software development, merger costs, start-up and organization costs, and more.

For more on this, see

Barker, R., A. Lennard, S. Penman, and A. Teixeira. 2021.Accounting for Intangible Assets: Suggested Solutions.” Accounting and Business Research Vol. 52 No. 6, 601-630

Penman, S. 2023. Accounting for Intangible Assets: Thinking it Through. Australian Accounting Review Vol. 33 No. 1, 5-13.

Penman, S. 2024. Empirical Research on Capitalizing Intangible Assets is Logically Incoherent. At https://ssrn.com/abstract=4982366.

RNOA₁ can be high because assets are missing from its denominator, NOA₀. That results in a higher residual income. But correspondingly, the book value term in the valuation, NOA₀ is lower. Indeed, it exactly offsets the higher RNOA₁, leaving  unaffected. See the illustration with Coca Cola in chapter 6. Carry the Balance Sheet with You.

The same point applies to RNOA₁ generated by accounting manipulation. The mischievous accountant can increase next year’s operating income and RNOA₁ by writing off assets. But that reduces NOA₀. Carry the balance sheet with you to protect against such mischief.

A solution is proportional consolidation: Consolidate the subsidiary into the parent company’s accounts as with the accounting when the interest is over 50%. Then you get the information. That, of course, can only be done if there are published financial statements for the subsidiary. That is the case in the EU and UK where private company accounts are available. But in the U.S. accounts are available only for public companies whose shares are listed for public trading, though also for companies where their stock is not listed but their debt is.

In July 2024, a judge ruled against the firm, requiring a $6.0 billion payment, refundable if Coke won on appeal. Coke appealed the decision but still maintained its “more likely than not” stance that it would not have to pay, the standard for recognizing a contingent liability. The judgment covered years 2007-2009 with other years yet to be litigated.

To finance the $6.0 billion, Coke issued debt. Contingent debt (not recognized on the balance sheet) became actual debt (recognized).

At the end of 2023, Eastman Kodak Corporstion (KODK) reported pension liabilities of $2,974 million against the value of pension plan assets of $4,074 million (at fair value). That’s $1,110 million in overfunding. The value of the pension assets had increased significantly with a strong performance from its stock portfolio. That is value added for Kodak for it is backing for the pension liability. Shareholders will not have to make cash contributions to the pension fund as the pension liability grows.

But can shareholders realize the funding surplus? It’s for employees, not shareholders. Well, there are ways around it provided employees are not damaged. Kodak converted some pension obligations to employees by giving them a value-equivalent annuity that pays out on retirement. With the liability removed, the firm was then free to cash out the part of the pension fund no longer needed to cover the liability. The firm was expected to book a gain of $535 million with the maneuver. That compares with the $75 million from the firm’s core operations in 2023. Unlocking value, it is called.

But beware. The escalation of risk with credit default swaps (CDS) in 2007-2008, also a device to spread the risk around, had unhappy consequences. In 2008 AIG could not honor CDS claims and collapsed, with the defaulting cascading to other firms now without the CDS insurance on the debt of other defaulting firms: Contagion. For these firms, risk was off balance sheet but came back to hit them. A CRT is a little different from a CDS, but the same worry remains: The default by a firm buying the instrument could spread to other firms. Firms taking on the risk are usually not as informed about the risk as (say) banks making loans to their customers, so are in a less favorable position to manage the risk. And, though there is usually no recourse with these instruments, they can come back and hit a bank if the third party is leveraging with loans from the bank when buying them. And, if banks make more risky loans because of freed-up regulatory capital, the cascading could magnify. Another historical event also brings warnings: In 2005-2007, banks sold off loans to third parties who then packaged them into mortgage-backed securities with little ability to monitor or manage the risk. You know what happened in 2008 and to banks…

The value investor has a mantra: When you see complicated transactions and instruments, beware. They can have long tentacles.

There is another feature to add to the tracking: The accounting for the no-growth component of the market price. Based on anchoring information, this is an accounting without speculation about growth. If the no-growth valuation is maintained over time, but the market’s pricing of growth declines, that is worth investigating. On the other hand, if the market’s pricing of growth increases but the no-growth valuation declines, that waves a red flag. Referring to the building block diagram, the ratio of the no-growth component to market’s growth component is a metric that can be employed.

There are four financial statements produced by the accounting: A balance sheet at the beginning and end of a period, the income statement, the cash flow statement, and the statement of changes in common shareholders’ equity (CSE). The shareholders’ equity statement is often not mentioned but you can see in the diagram it lies at the center of things for it explains the change in shareholders’ equity from the beginning balance sheet to the ending balance sheet. The change in shareholders’ equity is explained by

CSE_t-1+ CI_t – Net Payout to Shareholders_t = CSE_t

That is, equity in increased by adding all income, comprehensive income (CI), and reduced by Net Payout to Shareholders which is Dividends + Share Repurchases – Share Issues. This equation is known as the Clean Surplus Equation, clean surplus because all sources of income, comprehensive income, must be included. (GAAP and IFRS typically have two statements for income, the Income Statement and the Other Comprehensive Income Statement totaling to Comprehensive Income, CI).

The diagram then displays the (comprehensive) income statement as giving more detail on how the income was generated:

Revenue_t ‒ Expenses_t

The cash flow statement explains the net payments to shareholders as the remainder from free cash flow generated by the business after paying off the other claimants, usually net debt holders:

Net Payout to Shareholders_t = Free Cash Flow_t – Cash to Other Non-equity investors

The balance sheet reports the resulting shareholders’ equity but explains it with assets and liabilities:

CSE_t = Assets_t – Liabilities_t

That, of course, is the balance sheet equation.

Note that GAAP and IFRS do not present some of these statements in the same format, something we will have to iron out as we proceed.

Behind all of this, double-entry accounting is working. By increasing shareholders’ equity with income, assets and liabilities must also be affected (double entry) otherwise the balance sheet equation will not hold. An example: In recording revenue (a credit in accounting parlance), an asset, cash or accounts receivable must also be recorded (a debit). These effects of double entry are important when taking accounting to valuation, as later chapters show.

The shareholders for a government entity are the taxpayers who will be called upon to deal with an accumulated deficit by paying more taxes or by reducing expenditures on services to them. Yet there is no formal accounting for what we, the taxpayers, are up for. True, observers do keep track on paper, with the U.S. government accumulated deficit a horrifying $34 trillion in 2024 and projected to growth more. That calculation just goes into the bottom draw (so to speak). Without the formal accounting, politicians are not held to account, even ignoring the accumulated deficit as both candidates in the 2024 U.S. presidential campaign did. Indeed, they proposed lower taxes and higher expenditures to get votes.

An accumulated cash deficit, even if calculated, is not the whole picture. An accrual balance sheet would give a more complete picture, and so would an accrual income statement. National governments spend much on defense equipment for the security of their citizens in the future…aircraft carriers, submarines, missiles, and much more…but this expenditure goes into the current deficit under the cash accounting. No: these are assets to go on an accrual balance sheet. If accrual accounting were implemented, the reported deficit for the period would be lower. And there are other assets: national parks, government buildings, infrastructure, and more. There is no record of these assets, nor for the depreciation (of infrastructure), so it comes as a surprise that suddenly it is realized that bridges and airports must be replaced or upgraded at significant cost, again reporting cash deficits.

Perhaps the most pernicious problem is failing to keep track of debt on a balance sheet. Many politicians don’t think about it. Some even see debt as revenue! It’s cash coming in! Regular publication of a government balance sheet sent to the shareholders, the taxpayers, might get the thinking straight. Perhaps even an annual meeting…a virtual town hall…where politicians present their (accrual) accounts to shareholder-taxpayers just like the accounts are presented to shareholders at an annual meeting for corporations. That might also bring more sense to voters who now understand what they are up for.

It is a serious matter. The crises that arise from government indebtedness give rise to political extremes. Civilizations fall under the weight of debt. Accrual accounting, please.

Look at the Wikipedia entry on accrual accounting for governments:

https://en.wikipedia.org/wiki/Accrual_accounting_in_the_public_sector#:~:text=Accrual%20accounting%20in%20the%20public%20sector%20is%20a%20method%20to,associated%20cash%20payments%20are%20made.

That book records business activities with double entry: There are two pieces of language given to each business transaction; a sale of a product is recorded as revenue and as an accounts receivable. Speaking out of both sides of the mouth? Double entry gives the accounting book properties which enhance the ability to draw value implications from business activities. You’ll see these coming strikingly to bear as the accounting book is developed as you proceed through chapters.

The importance of double-entry accounting has long been recognized. The quote from Goethe is pertinent:

“What advantages does he derive from the system of book-keeping by double entry? It is among the finest inventions of the human mind.”

… Goethe, Wilhelm Meister’s Apprentice, Book One (1795)

The merchants of Venice saw how the double-entry accounting system was so important to their trade. See the following for more:

https://dergipark.org.tr/tr/download/article-file/2661341

https://apcz.umk.pl/CJFA/article/view/45203

https://www.jstor.org/stable/43610885

https://sociology.northwestern.edu/documents/faculty-docs/faculty-research-article/Carruthers-Accounting.pdf

https://byuaccounting.net/mediawiki/index.php?title=Accounting_Quotes

https://blogs.harvard.edu/vrm/2014/09/30/why-bookkeeping-is-actually-cool/