Reviewed by Martin Fridson, CFA
The End of Accounting and the Path Forward for Investors and Managers. 2016. Baruch Lev and Feng Gu.
Flaws in generally accepted accounting principles (GAAP) severely limit the usefulness of financial reporting to security analysts. The following are examples:
- Under GAAP, a company that laid out huge sums for brand creation shows zero value for those investments on its balance sheet. In contrast, billions of dollars of assets may appear on the balance sheet of a competitor after it acquires a company that made similar outlays. This inconsistent accounting treatment confounds investors who seek to compare companies for valuation purposes.
- GAAP requires expensing of R&D (research and development) costs as incurred, yet studies show that investors regard these expenditures as assets that add to a company's value. Mandatory expensing probably also depresses R&D spending.
- GAAP violates the traditional concept of matching revenues and expenses. For example, wireless telecommunications companies must match single-year revenues with customer-acquisition expenditures that are expected to produce benefits for three to four years. Their true economic profits are consequently understated.
In view of such serious shortcomings, should it surprise anyone that the earnings derived through traditional accounting are a second-rate influence on stock prices? The End of Accounting and the Path Forward for Investors and Managers shows that equity investors can earn far higher investment returns by correctly forecasting cash flows than by correctly forecasting GAAP earnings. Furthermore, cash flows are easier to predict than earnings, which increasingly consist of dubious GAAP-mandated accounting estimates.
The connection between GAAP and equity valuations is not only loose but loosening. During the past 60-plus years, a sharp and steady decline has occurred in the correlation between stock prices and such key accounting outputs as earnings, book value, sales, cost of sales, assets, and liabilities. Baruch Lev, professor of accounting and finance at the Stern School of Business at New York University, and Feng Gu, associate professor and chair of the Department of Accounting and Law at the University at Buffalo, attribute this decline to the transition from a primarily industrial economy to the information age.
"The major value drivers shifted from property, plant, machinery, and inventories, to patents, brands, information technology, and human resources," write the authors. GAAP, failing to adapt to this change, continued to treat the latter four value creators as ordinary expenses. That accounting, say Lev and Gu, distorted both the balance sheets and the income statements of intellectually based companies, rendering reported financial information increasingly irrelevant.
To fix this problem, the authors audaciously propose a radical overhaul of the accounting system. Their new model addresses the fact that, by the authors' estimate, today's financial reporting supplies a mere 5% of the information used by investors. Lev and Gu seek to complement traditional financial statements with a "Strategic Resources & Consequences Report" focused on the items that create a sustained economic advantage. This report would present details on such things as patents, oil reserves, and information technology - all in a standardized form, rather than the haphazard disclosures already made by some public companies - to facilitate comparison of issuers within an industry.
Lev and Gu seek, above all, to improve on GAAP's measurement of value creation by focusing the proposed report on cash flows. In their system, companies would not only capitalize R&D but would also provide a breakdown separating research (i.e., the systematic pursuit of new knowledge) and development (i.e., the use of research to develop new products or processes). Additionally, a charge for the cost of equity capital would be deducted from cash flows. Where feasible, changes in values of major strategic assets, such as the present value of cash flows from proven oil and gas reserves, would be taken into account.
The authors recognize and deal effectively with objections to their innovations. These objections include an increased reporting burden (which they suggest might be partly offset by dispensing with quarterly reporting in favor of semiannual statements) and companies' predictable complaint that they would be forced to divulge proprietary information to competitors. Lev and Gu prefer to have their reforms come about through demand from investors rather than by government fiat, although they would welcome the US SEC's support of their project.
Lev and Gu differentiate their remedies from others that have been proposed, such as "key performance indicators" and the "triple bottom line," which tracks management's impact on people and the planet as well as on profits. Their reconstruction of financial statements does, however, bear some similarity to economic value added (EVA). Both approaches take into account the cost of equity capital, although Lev and Gu's starting point is cash flows whereas EVA's is earnings.
The End of Accounting makes a powerful case for redirecting security analysis away from GAAP accounting. Already, the authors note, between 2003 and 2013, the proportion of public companies reporting non-GAAP ("pro forma") earnings doubled from 20% to 40%. How can this phenomenon be explained, they ask, other than as a function of company managers' awareness of the rapidly diminishing usefulness of financial information to investors? Actually, there is an alternative narrative - namely, that corporate executives benefit when their bonuses are calculated on the basis of non-GAAP rather than (lower) GAAP earnings.
Fact-checking produces a few other quibbles with the book. The authors state that Ford Motor Company's (NYSE:F) first car, the Model A, was available "in any color as long as it's black." In reality, company founder Henry Ford made the comment, probably in jest, about the later Model T, which was, in fact, offered in a variety of colors, including fire-engine red and hunter green. Lev and Gu also attribute to "a critic" a comment on the music of Richard Wagner: "It's not as bad as it sounds." American humorist Edgar Wilson Nye (1850-1896) was the actual source of a slightly different version of this remark, which Mark Twain cited in his autobiography. The critic to whom it is frequently misattributed is the playwright George Bernard Shaw.
None of these criticisms diminishes the authors' achievement. They have put forth a serious challenge to the established accounting regime and the entire structure of security analysis built upon it - all in a delightfully irreverent tone. The ball is now in the accounting regulators' court either to adapt to the 21st-century economy or, what appears more difficult, to demonstrate that Lev and Gu's manifesto is somehow misconceived.
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