Session 7: Accounting for values – Creating value in the long term
Sessions 7 and 8 focus on achieving long-term success through valuing shareholder interests. They highlight the challenges of creating long-term value, criticizing short-term profit measures as poor indicators of true value creation. The sessions also delve into the controversies surrounding financial reporting measures and the importance of appropriate value measurement in accounting.
Aims and objectives
This session will first explore how shareholder value can be created and the problems of short-term thinking for long-term value creation. It will then consider some of the problems associated with measuring values from an accounting perspective. It will next examine measurement choices in financial reporting. The session will also provide you with practical examples of the different measures of valuation based on historical cost accounting (HCA) and fair value accounting (FVA).
Learning outcomes
At the end of this session you should be able to:
explain how shareholder value is created and the different approaches to shareholder value
understand how different financial reporting measurement bases work, their reliability and their relevance
identify the arguments for and against using key measurement bases.
7.1 Shareholder value
The central issue in this section is that creating value is not the same as reporting short-term profit. Shareholder value is created when a business generates future cash flows above the cost of capital over a long enough horizon to justify its market value. That is why Rappaport argues that the real discipline of value creation is long-term, not quarterly, and why he insists that the competitive landscape, not the current shareholder register, should shape strategy. He shows that managers often betray shareholder value when they manage earnings, cut genuinely value-creating spending, or judge decisions by their immediate impact on reported earnings rather than by expected future value. Studies he cites suggest that most stock prices require more than ten years of value-creating cash flows to be justified, so short-term performance management is fundamentally misaligned with how value is actually created.
Rappaport’s core message is that companies destroy value when they chase earnings targets instead of expected value. His first principles therefore reject earnings management and earnings guidance, because both encourage managers to cut R&D, advertising, maintenance, hiring and new projects simply to hit a near-term number. His alternative is to make strategic decisions and acquisitions on the basis of expected incremental cash flows, weighted across plausible scenarios, rather than on earnings-per-share effects. This matters because EPS accretion can look favourable while actually saying very little about whether an acquisition or strategy adds long-term value. In this framework, value creation depends on disciplined capital allocation, not cosmetic accounting success.
Rappaport also pushes value thinking beyond investment appraisal into governance and incentives. If firms are serious about long-term value, they should carry only assets that maximise value, return surplus cash to shareholders when there are no credible value-creating opportunities, and design executive rewards around superior long-term returns rather than short-term stock price lifts or standard options that pay out simply because the whole market rises. Share buybacks, for example, only create value when shares are undervalued and no higher-return internal investment is available; used merely to boost EPS, they become another form of financial engineering. Senior executives, meanwhile, should bear meaningful ownership risk and be rewarded only when performance exceeds an appropriate benchmark over time.
The session then complicates the classic shareholder-value view through Bill George’s argument that companies should not think of themselves as existing solely to maximise shareholder value. His position is not anti-shareholder, but causal: the best way to serve shareholders is to create superior value for customers through mission, innovation, long-term strategy and engaged employees. On this view, shareholder value is an outcome, not the starting point. Boards and managers should therefore shape an investor base that supports the firm’s long-term strategy instead of allowing short-term activist pressure to determine decisions. This reframes the debate: long-term shareholder value and broader stakeholder value need not be opposites, because sustainable customer value is precisely what protects long-run shareholder returns.
Merchant and Sandino reinforce this by showing why accounting performance measures often fail as indicators of real value creation. Annual accounting profits explain only a small proportion of changes in shareholder returns, because value is future-oriented while accounting is largely past-oriented. Accounting measures are transaction-based, highly dependent on measurement method, conservatively biased, unable to capture many intangible investments, blind to the cost of equity capital, and generally unable to reflect changes in risk. So if a company aligns managerial behaviour purely to short-term accounting profit, it should not be surprising when it gets short-termism, gamesmanship and value destruction instead of genuine wealth creation.
For that reason, Merchant and Sandino outline four broad responses. Firms can look at market measures of value, improve accounting measures through non-GAAP metrics such as free cash flow, EBITDA or economic profit, lengthen the measurement window so performance is judged over several years rather than one, and combine financial measures with more forward-looking indicators such as customer satisfaction, product quality, innovation output or market penetration. None is perfect, but each tries to move performance management closer to the economics of value creation rather than the mechanics of short-term reporting.
7.2 Measuring issues
The second section shifts from creating value to measuring it. The key point is that accounting measurement sounds objective, but it is not objective in the same way as measuring weight or temperature. In financial reporting, “value” can mean different things depending on the measurement basis chosen. Measurement matters because financial statements are meant to be decision-useful and to provide a basis for assessing management stewardship. If the measurement basis is weak, the information may mislead users about both the firm’s position and management’s performance.
Merchant and Sandino’s article helps explain why measurement is so important. If managers are judged on flawed measures, they may optimise the wrong things. If investors rely on flawed measures, they may make poor capital allocation decisions. Because accounting numbers only partially capture economic value, the choice of what to measure and how to measure it becomes central. This is why the session emphasises not just accounting outputs, but the logic behind measurement itself.
The controversy in modern accounting is especially visible in the shift from historical cost accounting toward fair value accounting. Historical cost has long dominated because it is simple, documentable and relatively conservative. Fair value has expanded because users increasingly want current information that reflects what assets and liabilities are worth now, not merely what they cost in the past. The tension between these two approaches reflects a broader accounting dilemma: should reporting prioritise reliability and verifiability, or relevance and current economic meaning? The answer is not straightforward, because a measure can be highly reliable yet stale, or highly relevant yet subjective.
7.3 Measurement choices
Measurement in accounting means deciding the monetary amount at which assets, liabilities, income and expenses are included in the financial statements. The three key bases explored here are historical cost, deprival value and fair value. Each gives a different answer to the question, “What is this item worth?” and each rests on a different conception of value.
Historical cost accounting records assets at the amount paid to acquire them and liabilities at the amount received or expected to be paid in settlement. Its defining feature is that gains are usually not recognised until realised. If an asset rises in market value, that increase is ignored until sale. This makes historical cost conservative and relatively objective because it is grounded in actual transactions and documentary evidence. It is also simpler and cheaper to operate, and it can protect creditors and investors from the premature distribution of unrealised gains. But it excludes many internally generated intangibles and can become increasingly detached from economic reality as time passes.
Deprival value, or value to the business, asks how much worse off the firm would be if it were deprived of an asset. This is not simply market value. If the asset can be replaced economically, replacement cost matters. If it cannot, the relevant amount becomes its recoverable value, defined as the higher of net realisable value and value in use. In other words, the measure depends on what the rational business would lose: the cost of replacing the asset’s service potential, the cash from selling it, or the value generated by continuing to use it. Deprival value is therefore more entity-specific than fair value and tries to capture the economic significance of an asset to the business itself, not just to the market. It can be especially useful when considering whether a business is maintaining its operating capability or when assessing the real economic cost of continuing operations.
Fair value accounting measures assets and liabilities at current value, defined in IFRS 13 as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It is based on an exit-price notion and uses a hierarchy of inputs: Level 1 quoted prices in active markets, Level 2 observable inputs other than direct quoted prices, and Level 3 unobservable inputs when markets are thin or absent. Fair value therefore aims to improve consistency and comparability while recognising that some valuations are far more observable than others. It brings current market information into the accounts, can recognise changes in value as they arise rather than when realised, and may better capture the opportunity cost of holding assets. But its strength depends heavily on whether robust market evidence exists.
These three approaches reveal that accounting is not merely a neutral recording exercise. Historical cost looks backward to actual transactions. Fair value looks outward to current market exchange values. Deprival value looks inward to the value of an asset to the particular business. Each can be defended as logical, yet each embodies a different answer to what financial reporting is for.
7.4 The problem with historical cost accounting
Although historical cost remains deeply embedded in practice, this section shows why it is controversial. Its biggest weakness is that past prices can lose relevance over time, especially under inflation or when asset values change sharply. Historical cost assumes a stable monetary unit, but inflation means that old money and current money are not directly comparable. A building purchased decades ago may still be carried at a nominal historic amount that says very little about its current economic significance. This weakens both balance sheet meaning and profit measurement.
The inflation problem creates several distortions. First, it can overstate profits by matching old costs against current revenues. A firm may appear more profitable simply because replacement costs have risen, not because it has created real economic surplus. Second, it can threaten capital maintenance: if inflated nominal profits are distributed as dividends, the firm may not retain enough resources to replace the assets or inventories needed to maintain its operating capacity. Third, it can distort comparisons across firms and across time, because older assets produce lower depreciation charges and apparently higher returns than newer but otherwise identical assets. Historical cost may therefore reward age of asset base rather than true efficiency.
A further weakness is that historical cost is less objective than its defenders sometimes claim. The purchase price itself may be objective, but subsequent accounting still requires judgement: depreciation methods, useful lives, impairment decisions and timing of realisation all involve discretion. Management can exploit this by timing disposals to crystallise gains when convenient, boosting reported profit without any genuine improvement in the business. So while historical cost is more auditable than many alternatives, it is not immune to manipulation.
Even so, historical cost retains strong defences. It is based on actual transactions, usually supported by contracts and documentation, which gives it a clear audit trail. It is comparatively simple, understandable and less volatile than fair value. For long-lived assets held to maturity or for ongoing operational use, many users may prefer not to see accounts swing with every market movement. It also avoids recognising unrealised gains that may later reverse. These qualities explain its staying power: even critics acknowledge that it offers a practical, disciplined basis for recording past transactions.
The arguments in favour of historical cost therefore centre on objectivity, verifiability, simplicity, consistency and prudence. The arguments against it centre on relevance, inflation distortion, weak representation of current value, inability to capture some internally generated or donated assets, and the discretion embedded in depreciation and realisation. The debate is really about whether accounting should privilege faithful recording of past transactions or more timely representation of present economic conditions.
Fair value presents the mirror-image case. Its main strength is relevance to current decision making. When active market prices exist, fair value can be highly informative and objective, because it reflects what the asset or liability could currently be exchanged for. It is particularly useful where assets are separable, marketable and capable of generating independent cash flows, such as many financial instruments or investment properties. It also avoids the historical cost problem of earnings management through selective realisation, since gains and losses are recognised as values change rather than only on disposal.
But fair value also attracts serious criticism. Where no active market exists, estimates become subjective, especially at Level 3 of the hierarchy. That reduces reliability and opens the door to model risk and managerial discretion. Fair value’s exit-price logic can also sit uneasily with the going-concern assumption, because firms are valued as if assets were being sold even when the business intends to keep using them. Finally, market prices can be volatile, cyclical or temporarily distorted, creating fluctuations in accounts that may obscure rather than clarify underlying performance. The criticisms made during the 2008 financial crisis exemplify this concern: fair value gains in rising markets boosted income and, in some cases, executive rewards, while later markdowns were blamed for intensifying the downturn.
Session summary
The main thread across the whole session is that long-term value creation and accounting measurement are related but not identical. Businesses create value through long-horizon strategic decisions, customer value, disciplined capital allocation and appropriate incentives. Accounting then attempts to represent that value, but every measurement basis captures some aspects better than others. Short-term profits are often a poor proxy for long-term value, which is why both Rappaport and Merchant and Sandino warn against organising management around quarterly accounting outcomes alone.
The larger lesson is that accounting numbers are not raw facts waiting to be read off reality. They are constructed through measurement choices. Historical cost, deprival value and fair value each reflect different priorities: prudence and verifiability, business-specific economic loss, or current market relevance. Because different bases produce different results, accounting is unavoidably judgemental. That is why debates over measurement continue, and why the “best” basis depends on what kind of decision the financial statements are meant to support.
LO 1: Shareholder Value
Shareholder value arises from expected future cash flows exceeding cost of capital.
Value creation is long-term; quarterly earnings pressure promotes short-termism.
Earnings management distorts strategy through underinvestment in innovation, marketing and capability.
EPS growth and accounting profit are unreliable indicators of economic value.
Financial engineering can inflate metrics without increasing real value.
Capital allocation discipline determines sustainable shareholder returns.
Surplus cash should be returned when reinvestment cannot exceed cost of capital.
Executive incentives determine managerial time horizons.
Long-term equity exposure aligns managers with shareholder risk.
Customer value creation is the primary driver of durable shareholder returns.
Stakeholder value functions as the causal mechanism of long-term shareholder wealth.
Activist investors often prioritise short-term extraction over strategic development.
Boards must protect long-term strategy from market expectation pressure.
Accounting performance explains only a limited portion of shareholder returns.
Complementary measures include market valuation, adjusted financial metrics, multi-year horizons and non-financial indicators.
LO 2: Different financial reporting measurement bases
HCA — Historical Cost Accounting
Assets recorded at original purchase price.
Value based on actual past transaction.
Gains recognised only when asset is sold.
Unrealised gains excluded from profit.
Strong audit trail from transaction documentation.
High reliability and objectivity.
Conservative profit measurement.
DVA — Deprival Value Accounting
Measures economic loss if the business loses the asset.
Focuses on value of the asset to the business.
Upper limit of value set by replacement cost.
If replacement not rational, use recoverable value.
Recoverable value = higher of value in use or net realisable value.
Entity-specific valuation rather than market valuation.
FVA — Fair Value Accounting
Assets and liabilities measured at current market exit price.
Value reflects price received to sell or paid to transfer.
Recognises gains and losses as market values change.
Uses fair value hierarchy for valuation inputs.
Level 1: quoted market prices.
Level 2: observable market proxies.
Level 3: model-based estimates when markets absent.
Prioritises current economic relevance over transaction reliability.
LO 3: Using key measurement bases - pros and cons
HCA — Historical Cost Accounting
Assets recorded at original transaction price.
Gains recognised only when realised through sale.
Measurement based on past transactions rather than current market values.
Transaction evidence provides strong verifiability and auditability.
High reliability due to objective documentation.
Conservative measurement excludes unrealised gains.
Relevance declines as asset values change over time.
HCA - Pros
Objective measurement based on actual transactions.
Clear documentary audit trail.
Simple and inexpensive measurement system.
Conservative profit recognition protects creditors.
Stable valuations reduce earnings volatility.
Transaction-based reporting constrains managerial discretion.
HCA - Cons
Values become outdated over time.
Inflation weakens comparability between historical costs and current revenues.
Older assets distort profitability and return comparisons.
Nominal profits may represent inflation rather than real value creation.
Capital maintenance risk when inflated profits are distributed.
Depreciation estimates introduce judgement and inconsistency.
Timing of asset disposals enables strategic profit recognition.
FVA — Fair Value Accounting
Assets and liabilities measured at current market exit price.
Measurement reflects price received to sell or paid to transfer.
Unrealised gains and losses recognised as values change.
Fair value hierarchy ranks valuation inputs by observability.
Level 1 uses quoted market prices.
Level 2 uses observable proxies and comparable prices.
Level 3 uses model-based estimates where markets are absent.
High relevance due to current market valuation.
Reliability varies depending on availability of observable market inputs.
Pros
Current market values improve decision usefulness.
Market prices reveal opportunity cost of holding assets.
Active markets generate externally determined objective valuations.
Cons
Valuation becomes subjective when active markets do not exist.
Exit-price logic conflicts with the going-concern assumption.
Market volatility can distort reported performance.
DVA — Deprival Value Accounting
Measures economic loss if the firm were deprived of an asset.
Value to the business determined by replacement cost or recoverable value.
Recoverable value equals higher of value in use or net realisable value.
Measurement reflects asset importance to the specific business.
Focus on operational capability rather than market exchange value.
Integrates replacement cost, resale value and expected income streams.
Relevance derived from entity-specific economic context.
Pros
Captures economic value of assets to the business.
Considers replacement cost and operational capability.
Combines multiple valuation perspectives for relevance.
Cons
Complex framework requiring multiple valuation estimates.
Heavy reliance on managerial judgement for cash flows and replacement costs.
Limited practical adoption reduces comparability across firms.
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