Journal ofBusiucss Finance &Accounting, 11(3), Autumn 1984, 0306 686X $2.50

AN ECONOMIC ANALYSIS OF VALUE TO THE OWNER: A COMMENT

F .K. WRIGHT*

In a recent contribution to this journal, Ashton (1983) presents an economic analysis of value to the owner, from which he concludes that ‘the economists’ notions of value to the owner and those of accountants differ in four out of six cases’ (1983, p.255). In this comment, it will be argued that Ashton’s inter- pretation of the concept of value to the owner is unduly narrow, and that his criticism does not invalidate the use which accounting theorists have made of that concept.

A key assumption underlying Ashton’s analysis is that a firm which owns an asset cannot in the short run obtain a replacement for that asset if deprived of it by theft or accident. This is, however, the only imperfection in the economy in which Ashton’s firm operates: it can freely substitute labour for assets in the varying proportions specified by a smooth non-linear production function, its labour supply is instantly variable at no adjustment cost, its output is not limited by demand for its products, and it always operates at its production possibility frontier. On these assumptions, Ashton shows that the maximum amount the firm would be prepared to pay in order to avoid being deprived of the asset differs from the minimum amount for which it would be prepared to let the asset go, and that both can exceed the asset’s current replacement cost.

Such a conclusion is in apparent conflict with the writings of accounting theorists who have regarded replacement cost as the upper bound of the range of possible values of an asset to the firm which owns it. It is argued in this com- ment that the two interpretations of value to the owner which Ashton offers are not the only possible ones, and that accountants have been justified in not adopting either of them.

VARIANTS OF VALUE TO THE OWNER

As the expression ‘value to the owner’ was apparently coined by J.C. Banbright, his definition is considered first. Ashton correctly quotes him as having written: ‘The value of a property to its owner is identical in amount with

The author is Fitzgerald Professor of Accounting at the University of Melbourne. (Paper received November 1983)

419

420 WRIGHT

the adverse value of the entire loss, direct and indirect, that the owner might ex- pect to suffer if he were to be deprived of the property.’ (Bonbright, 1937, p.71.) But this definition needs to be read in conjunction with an important qualification which Bonbright introduces three pages later: ‘The value of a pro- perty to its owner can be stated only by reference to the conditions under which the ownership interest shall be assumed to cease.’ It follows that there can be as many variants of value to the owner as there are different sets of conditions under which the ownership interest might cease.

Ashton considers only two variants. He distinguishes between a situation in which the firm will be deprived of the asset unless it pays up, and one in which it is asked at what price it would voluntarily relinquish the asset. Both situations envisaged by him involve immediate cessation, not only of the ownership interest, but also of the use of the asset. He does not consider the possibility that the cessation might be deferred to ‘some convenient time in the near future, after arrangements have been made to mitigate the expense or loss’ (Bonbright, 1937, p.75). This is somewhat surprising, as one of the two variants involves voluntary relinquishment of the asset, and Bonbright himself has pointed out that ‘seldom does the owner of property confront the problem of choosing between an immediate voluntary disposal of his property and its retention’ (p.75, emphasis in original).

MATCHING THE VARIANT TO THE CONTEX?‘

The existence of several variants of the concept of value to the owner might seem, at first, to be inconvenient or even confusing. It merely means, however, that anyone proposing to make use of the concept must select that variant which matches the context in which it is to be used.

One possible context, for example, is that of determining the amount of com- pensation to be paid to an owner for accidental and unforeseen loss of an asset. As Solomons (1966) points out, ‘the loss of an asset may involve its owner in incidental costs while the replacement is being obtained. Thus fire insurance cover under a home owner’s policy commonly includes not only the value of the property destroyed but also temporary living costs for the insured and his family in alternative accommodation’ (p. 124). If the context is that of compen- sating the owner of a home destroyed by fire, therefore, the appropriate variant of value to the owner will include the incidental costs mentioned by Solomons.

Quite a different context is that of a firm which is considering replacement of an existing machine in good working order with a technologically more advanced model. Here, the firm can time the disposal of the old machine so as to minimize the interval during which it is left without any equipment capable of performing the required functions. In this context, it would be plainly wrong to include, in the value to the firm of its existing machine, costs arising from in- ability to produce during the time which elapses between placement of the order for a new machine and its arrival.

AN ECONOMIC ANALYSIS OF VALUE TO THE OWNER: A COMMENT

SOME ACCOUNTING ADAPTATIONS

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Accountants making use of the concept of value to the owner have not always realized that different versions of the concept are compatible with Bonbright’s definition. Thus, Solomons (1966) follows his description of the incidental costs covered by fire insurance policies with the assertion that ‘such foreseeable in- cidental costs of being dkprived of a piece of property ought to be included in any estimate of value to the owner’ (emphasis added). It seems, however, that he found this implication rather inconvenient: for after adding that ‘subject to these in- cidental costs of deprivation, replacement cost may be said to set an upper limit on value to the owner’, he went on to develop his asset valuation rules without further reference to these incidental costs.

Wright (1967) did not explicitly refer to Bonbright’s concept when he intro- duced the expression ‘opportunity value’ with the following definition: ‘The opportunity value to a firm of an asset owned by it is the cost, loss or sacrifice which the firm would have to incur if it did not already own that asset; it is measured by the least costly of the alternatives avoided through owning the asset. ’ (p.76.) Subsequently, however, he sought to reconcile opportunity value with Bonbright’s concept (Wright, 1969).

Warrell(l974) was clearly troubled by what he believed to be a need to in- clude incidental costs of deprivation in any estimate of value to the owner. He avoided the perceived difficulty by suggesting the adoption for accounting pur- poses of a more malleable concept which he termed ‘enterprise value’.

ASSET VALUES FOR INCOME MEASUREMENT

The concept of asset value which is relevant for income measurement was analyzed by Wright (1969) in the following passage:

AS accountants, we wish to measure the success of the recent activities of an enterprise by determining how much better off it is as a result of those activities. It is for this purpose that we find it necessary to assess the residual values of the firm’s assets: we need to know how much better off the firm is because it has them. In order to discover this, we need to specify some rele- vant alternative with which the firm’s actual situation as owner of the assets might be compared.

We can hardly imagine the firm in the position of not having any of its assets: it would no longer be the same firm. It is somewhat easier to imagine the firm in possession of all its assets but one, though even this may sometimes be hard to visualize. Suppose that the asset is one which the firm, as at present constituted, could not do without. We would then need to ask how the firm came to place itself in such a predicament. It is perhaps just conceivable that the firm might have undertaken all the commitments it now

42 2 WRIGHT

has, and yet failed to take the necessary steps to acquire one particular asset service which is essential to fulfilment of those commitments; but this would represent utterly foolish behavior. Comparison of the firm’s actual position with this imaginary alternative would merely show that the firm is much better off than it would be if it had done something very stupid. But that is not the kind of information accountants are employed to provide, and the value imputed by such a comparison is thus irrelevant to the purpose for which going-concern values are required.

A much more useful concept of value emerges if a slight modification is made to the conditions of this thought experiment. Suppose that the firm is warned that it will be deprived of the services of one of the assets, and that it is given ample time to make alternative arrangements. If the firm behaves rationally, it will choose ‘the least costly of the alternatives (hitherto) avoided through owning the services’ (Wright 1964). This yields a measure of opportunity vkue which is relevant to accounting, since it indicates how much better off the firm is as a result of its past decisions to acquire and re- tain the asset in question, without implicitly postulating stupid or irrational behavior as part of the alternative to those decisions.

CONCLUSION

An asset valuation concept relevant to accounting is consistent with Bonbright’s concept of value to the owner, if ‘the conditions under which the ownership interest shall be assumed to cease’ are that ample warning of the im- pending deprivation is given to the firm, thus allowing it to make the best possi- ble alternative arrangements.

Accounting theorists making use of the concept of value to the owner have at least implicitly adopted this interpretation of the concept when they assert that replacement cost sets an upper limit to the value of an asset to its owner. The justification for excluding incidental costs of deprivation when measuring values for accounting purposes is that accountants seek to measure ‘going- concern values’, and these are incompatible with the notion that the firm might be deprived of assets suddenly and without warning.

REFERENCES

Ashton, R.K. (1983), ‘An Economic Analysis ofvalue to the Owner’,JournalofBusinessFinancennd

Bonbright, J.C. (1937), The Valuation ~JProperp, Vol. I (h4cGraw-Hill, 1937). Solomons, D. (1966), ‘Economic and Accounting Concepts of Cost and Value’, in Modern

Accounting Thv, ed. Morton Backer (Prentice-Hall, 1966), pp.117- 140.

Accounting (Summer 1983), pp.251-256.

AN ECONOMIC ANALYSIS OF VALUE TO THE OWNER: A COMMENT 423

Warrell, C.J. (1974), ‘The Enterprise Value Concept of Asset Valuation’, Accounting and Business

Wright, F.K. (1964), ‘Towards a General Theory of Depreciation’,Jouml ofAccounting Reseurch

- (1967), ‘Adaptation and the Asset Measurement Problem’, Abacus

__ (1969), ‘On the Linear Programming Approach to Asset Valuation:

Research (Summer 1974), pp.220- 226.

(Spring 1964), pp.80-90.

(August 1967), pp.74-79.

A Reply’, Journul ofAccounting Research (Autumn 1969), pp. 183- 187.