Does Net Value Equal Shareholders' Equity?

Companies typically use their balance sheets to express their financial condition. These balance sheets are divided into three main parts: assets, liabilities and shareholders' equity. We can use the identity “assets = liabilities + shareholders' equity” to express the relationship between these three. One way to interpret this identity is to say that the assets an enterprise possesses come from two sources, one of which is liabilities. These are assets that the enterprise has not acquired from its owners (the shareholders). The other source is shareholders' equity. These assets, representing the shareholders' own investment, plus historical operating income, should in theory be entirely for shareholders to enjoy.

We normally divide “total shareholder equity” (that is, net equity value) by "total shares outstanding" to get "net value per share", and divide "current net income" by "total shares outstanding" to get "earnings per share". In simple terms, net value per share represents how much net asset value there should be for each share held by shareholders, while earnings per share is the profit due to each share, and which the company should be able to distribute to the shareholders in the future. Earnings per share and net value per share are most commonly used as reference points in investment valuations, but under actual conditions, it sometimes happens that not all shareholder equity can be enjoyed by shareholders, and earnings per share does not represent the dividend that the shareholder will be able to get for each share of stock. This divergence between appearance and reality arises in part because real world application of accounting principles entails the use of certain conventions and assumptions intended to reduce the scope for factitious judgments and manipulation. This places constraints on the information in financial statements that make "asset" entries unable to express the true value of assets. Another reason for the discrepancy is that some non-shareholders can enjoy shareholder equity.

To see why "asset" accounting items do not truly represent the value of assets, consider the following examples:

• In accounting, assets are required to be accounted for at their actual acquisition cost and expressed in given currency units. This makes it impossible to show in the statements certain assets that, while valuable to the operation of the business, lack objective measurement standards. This would include things such as management's ability to run the business.

• The historical cost principle makes it impossible for many assets to reflect their true value, even after revaluation (increase in value). Moreover, the prerogative to initiate a revaluation rests with management (or else a majority shareholder or the board of directors). Also, depreciation of fixed assets using the straight line method does not really reflect how much of the asset's utility has been consumed.

• No matter how many principles and conventions are applied in practice, accounting will not be unable to completely root out factitious judgments and manipulation in areas such as losses due to market price declines, bad debts or inventory obsolescence.

• Preferred shares: The manner in which surpluses and earnings are distributed to holders of preferred shares directly affects the equity of common stock shareholders, so the latter should pay particularly close attention to the clauses specifying how such shares are to be issued.

• Employee stock options are given in order to reward employees' hard work towards the profitability of their company. Since option exercise prices and market prices are different, shareholder equity is affected.

• Bonds (or preferred shares) that can be converted to common stock are like employee stock options: Bond (or preferred share) issue clauses usually leave the decision to convert up to the holder, and holders naturally seek to convert them when it is advantageous to them.

• Earnings distributions: A company's articles of incorporation must be read carefully to see how distributions of earnings are to be handled. In addition, one must also note the percentages that may be distributed to employees and board members, as well as whether employees and board members could take part in earnings distributions in previous years. If employee bonuses are in cash, the effect is limited, but if they are in company shares, then the effect will be large, especially if the share price is high.