The end of accounting in the US?
In their new book, 'The End of Accounting and the Path Forward for Investors and Managers', Baruch Lev and Feng Gu discuss the usefulness of financial reports is eroding. Andrea Murad reports.
Providing a valuation for a company has challenges, particularly for those companies that don’t have tangible assets. While business models have changed, financial reports haven’t changed to address how companies operate today.
Baruch Lev, Philip Bardes Professor of Accounting and Finance at New York University’s Stern School of Business, and SUNY Buffalo accounting professor Feng Gu co-authored, “The End of Accounting and the Path Forward for Investors and Managers”, to address the differences between accounting reports and business models.
Their book is an organising principle. “We basically say to CEOs and CFOs that we know you want to provide some useful information, here is what investors are interested in and a good way to organize this information,” says Baruch.
The book provides an analysis of how valuations are completed and a proposal for how to enhance information in a standard report.
While a partner at a consulting firm about 25 years ago in Berkeley California, Baruch worked on valuations for new economy companies that included cell phone, biotech and Internet companies.
He always started with financial reports, but these reports didn’t highlight the value drivers of these companies — the projects that biotech companies focused on and the speed of penetration into the area and customer acquisition costs for cell phone companies were more telling.
“All of these things weren’t mentioned in the reports, and I had to use other non-accounting, non-GAAP measures for valuations,” says Baruch. “This was the first time that I vividly saw the failure of financial reports to provide the needs of investors.”
This data came from outside the accounting system and instead from materials that companies provide to investors and in earnings conference calls, or from the company itself.
What’s the problem?
“Accounting is no longer based on facts,” says Baruch. “When you look at the income statement, every item in the income statement is an estimate.”
Accounting standards have not adjusted for the huge change in how businesses operate and create value, and valuations rely more and more on estimates that decrease the usefulness of financial reports.
The co-authors provide evidence based on samples of 5,000 companies that show a very fast decrease in the usefulness of information to investors.
“In one of the chapters, we are able statistically to quantify the information that investors get from financial reports, and it’s about 5 to 6% of all the information they are using,” says Baruch.
“This gives you an idea of the extent of the fall from grace of information and particularly of the earnings of the income statement, which is the centre of attention of investors.”
Most of the information comes from other sources, but the financial information is the reason for the issues.
That’s because of the dramatic change in company business models and how they create value, and this isn’t just a problem in the US.
“This dramatic change is the move from investment in physical investments, like plants, machinery and inventory, structures, tangible assets, to intangible assets,” says Baruch. “That’s where value’s created today — from patents, brands, and information systems, from all kinds of business processes that companies are using.”
Today, many companies don’t have machines or factories that produce products as a significant portion of their value lies in their brand. Putting a figure on what that brand is worth is where the challenge lies when having to do a valuation. Investments in intangibles are expensed just like salaries and interest.
“You don’t see them and can’t evaluate how much the company invests in it, and it really drives this usefulness of financial information,” says Baruch.
“Don’t you want to know the performance of the company and future growth of the company, whether they invest in human resources and how much they spend on human training, whether this investment goes up or down?
"Isn’t this as important as how much you pay for machines 10 years ago? This is one of the reasons for the decrease in usefulness.”
During this time, regulators were churning accounting rules, but most of these accounting rules require estimates that, in many cases, are just guesses with respect to the future.
The fair value of assets, which are not traded in markets, for example, don’t have a fair value and someone can use any number that they want. “This increased significantly the uncertainty of the earnings of companies,” says Baruch. “They are mainly based on estimates and focused by management rather than by facts.”
Some estimates are more reliable than others, but they’re still pretty much guesses.
The book includes a detailed proposal, the Strategic Resources and Consequences Report, that’s demonstrated on four major industries: media and entertainment, oil and gas, insurance companies, and pharmaceutical and biotech companies.
“We chose the most important sectors in the economy and demonstrated our new report,” says Baruch.
“We shift the focus of the information to what investors really need, and this is a report on the business model of the company, on what is called the strategic assets of the companies that create value, like patents for pharma, oil and gas reserves, the customers for media.”
The report highlights how management deploys strategic assets to create value, and Baruch is working with a Big Four accounting firm to hopefully create an industry standard and with investors who are interested in a new way of investing with companies and perceiving real value.
Many organisations are looking at the usefulness of financial reports as well, but many don’t provide the evidence of the extent of the decrease in usefulness — they just assume. “We provide a very specific solution to this problem, which is our new report,” says Baruch.
This report was constructed by analysing the quarterly conference calls that companies have with investors and analysts that include a Q&A between investors and analysts, and management.
The co-authors analysed thousands of these questions asked during calls for companies in different industries and scenarios, and most questions were about a company’s strategic assets and how much that company invests in these assets. “We constructed our report empirically, not because we think that’s what investors need, but because these are the question they ask,” says Baruch.
There is a resistance to change from all directions. People within the industry do recognize that the information has become less useful, which translates into a decrease in the usefulness of audit services. Regulators are the ones that need to make changes within the industry though.
“Companies are somehow used to the way they do it for decades and decades,” says Baruch. “Any change of regulation is a long-term project, but as I said, I can see the initial signs of interest and traction.”