If the total surplus is negative the firm is infeasible; redesign the contracts or shut down
If the total surplus is zero, there is a unique distribution in which everyone gets zero surplus
If the total surplus is positive, there are multiple feasible allocations. There is no basis for choosing one allocation over another. Therefore, the distribution of surplus among participants is determined through bargaining
3. Income/Value of the Firm to Various Participants
Few investors hold equity securities till maturity
Suppose, I plan to sell the security in two years. How should I value it?
My value is the NPV of cash flows for two years + the estimated market value at the end of two years
Estimated market value depends on what I expect others to expect the cash flows to be
Therefore, for a short horizon investor, value of the security to an investor is not his fundamental value; it depends on his expectations of others’ expectations
When we extend the same argument to the second and third generation of investors, valuation of the firm using the NPV becomes almost impossible (Hirota and Sunder 2005) because we must do backward induction from the future to the present through the higher order cash flow expectations of many layers of investors
Impossibility of Valuation through Backward Induction
The NPV model of fundamental valuation breaks down in a world without common knowledge and with short term investors
How are the investors to form expectations of the future cash flows?
6. Role of accounting in valuation: past as anchor for assessing the future
This is where accounting plays a key role
Being anchored in the verified events of the past, accounting provides an anchor that investors can use to make estimates of the future
This does not mean that the past cash flows can be or should be mechanical projected into the future
Accounting provides the historical record that can be exploited by investor who is willing to make projections on the basis of any relationships between the past and the future
If, on the other hand, accountants try to provide estimates of the future on their own, it is not clear that they serve the investors’ interests
7. Consequences of ignoring value creation in favor of valuation
By being rooted in reporting verified events of the past, accounting helps serve both objectives
It helps creation of value for the participants by making sure that the contracts of the firm are implemented
It also helps provide data from the past that the investors can combine with their model of the link between the past and the future, to make personal projections about the future
If accountants were to provide their own future projections, they would fail to serve both the value creation as well as valuation functions of accounting
Shyam Sunder, Theory of Accounting and Control , Cincinnati: SouthWestern College Publishing (1997). Korean translation: Kim Gab-Ryong, Hwekewa Tongjae, Seoul: Dae Young Publishing Company, 1999. ISBN 89-7163-090-6.
Shyam Sunder, "Management Controls, Expectations, Common Knowledge and Culture," Journal of Management Accounting Research , 14, (2002), pp. 173-187.
Shyam Sunder, " Knowing What Others Know: Common Knowledge, Accounting, and Capital Markets," Accounting Horizons , 16:4, (December 2002), pp. 305-318.
Shyam Sunder, "Value of the Firm: Who Gets the Goodies?"," September 2001.
Shinichi Hirota and Shyam Sunder, " Price Bubbles sans Dividend Anchors: Evidence from Laboratory Stock Markets,” Revised October 2004.