Accounting for Owners’ Capital

Well-designed financial accounting aligns the desire of a firm’s owners to maximize dividends, and thus equity value, with the efficient usage of the firm’s resources and the protection of outside financiers’ interests. In the presence of information asymmetry between owners and outsiders, these goals are met if and only if (i) investment that maximizes firm value also maximizes earnings (goal congruence); (ii) obligations to outside financiers never exceed firm value (solvency); and (iii) expected future dividends exhaust the excess of firm value over liabilities (full property rights). Generally, these conditions can only obtain when net book value is understated relative to market value. The understatement increases in the lag between investment expenditures and the associated revenues. There exist multiple optimal accounting systems but none of them can correlate earnings perfectly with firm value. Separation of ownership from management, with managers incentivized to maximize earnings, permits more accelerated earnings recognition and thus higher leverage and more liquid equity markets.