David M. Katz
Although the title of the new book Baruch Lev has co-authored, “The End of Accounting,” provocatively suggests the finale of financial reporting as we know it, he cautions that he really isn’t calling for its absolute elimination.
“We don’t recommend getting rid of financial reports. Financial reports as an historical document will always be important. You need to have some kind of an historical perspective of the business,” Lev, a professor of accounting and finance at New York University’s Stern School of Business, acknowledged.
“There is some importance in knowing the past,” he adds. “I don’t completely disregard it. But it doesn’t give you linear information about what will happen in the future.”
“What we are saying is that current financial reports don’t provide a clear guide with respect to the future. And that’s what we set out to change,” says Lev, referring to the book he wrote with Feng Gu, a professor of law and accounting at the University of Buffalo.
In their book, published by Wiley, the authors contend and attempt to prove that “those voluminous and increasingly complex quarterly and annual reports… [have] lost most of [their] usefulness to investors….” They cite the Financial Accounting Standards Board’s 700-plus-page 2014 revenue recognition standard as an example of such length and complexity.
Further, corporate managers should be worried about “the deteriorating usefulness of financial information” because it increases investors’ risk, according to Gu and Lev. In turn, that hikes companies’ cost of capital and slashes their share values.
Besides diagnosing the problems posed by the abundance of outdated and wordy rules, the authors propose that companies file a brief disclosure document they dub the “Strategic Resources and Consequences Report.”
Based mainly on non-accounting information, the report would focus on a company’s business model and execution of it. The document would highlight such “fundamental indicators” as Internet and telecom companies’ new-customer and churn rates; car insurers’ accident severity and frequency and policy-renewal rates; biotech and pharmaceutical company clinical trial results; and energy companies’ proven oil and gas reserves.
These indicators “are more relevant and forward-looking inputs than … traditional accounting information” like earnings and asset values, according to the book.
At least since the accounting scandals of the early 2000s, Lev has been a well-known advocate for more extensive corporate reporting of intangible assets. Following are edited excerpts from an interview with the financial reporting luminary.
What does your title, “The End of Accounting,” actually mean?
The end of accounting in the current way it is conducted, meaning the constantly increasing, extremely complex regulations that fewer and fewer people understand. This, in our opinion, should come to an end.
How practical would it be to put your system in place?
Very practical. We demonstrate our disclosure paradigm on four specific industries: media and entertainment, oil and gas, pharma and biotech, and insurance. The Strategic Resources and Consequences Report is not another 60- or 70-page report on top of the financial statements. It’s a one-page or, at most, two-page report which focuses on all the things which are missing from the financial statements.
These are what economists call “strategic assets,” or assets that create value. In this economy and in other developed economies value, is not created by factories, machines, and inventory. All your competitors have those in roughly equal measure. Value is created by unique strategic assets like franchises, patterns, brands, specific business processes, and customer-recommendation algorithms. And all these assets are completely missing from the financial report.
Just to be clear, we are not calling for putting values of intangibles in the financial statements. This would be difficult, if not impossible. We are calling on companies to recognize them as assets just as machines and buildings and inventory are recognized as assets, which is much, much easier in that it doesn’t require any valuation.
Your remedy seems to focus mostly on technology and science companies, which have lots of intangibles. But what about industrial companies or those heavily weighted toward tangible assets? How would your plan improve the accuracy of their financials?
It really is not limited to technology and science companies, because in today’s economy you cannot succeed without innovation. And innovation is achieved by intangibles. For this reason, we have insurance as one of our four industries. It’s an example of an industry that’s definitely not high-tech and not science.
What gives an insurance company an advantage over others? Specific client services, which are reflected, for example, in the company’s policy renewals. So if people are dissatisfied with the company you will have a low policy-renewal rate. And policy renewals are not a GAAP indicator.
Insurance companies also engage in innovation, such as developing the plug-in-the-car device, which tracks your driving behavior. Some people don’t want others to know about their driving behavior, of course. But insurance companies claim that when they can track driving behavior, then they can be more specific about the insurance rates. This is a very interesting innovation. It’s R&D, since some companies have patents on these devices. So in practically every industry, high-tech and low-tech, there are innovations, and those are really not reflected in the financial reports. That’s what we are focusing on.
But doesn’t changing the indicators into something more industry-specific, more unique, threaten the comparability of the standards?
I’ve been an academic and practitioner for a very long time, and I’ve never believed in uniformity across industries. When you look, for example, at financial analysts who analyze companies, they all specialize in industries: pharma, software, oil and gas. The fact is that the business models of companies differ significantly across industries. And you cannot have a good information system that is uniform across industries. You can refer to the balance sheet, but banks’ balance sheets are entirely different from those of retailers.
You seem to be saying that GAAP is built on a false premise: that uniform standards should apply to all kinds of industries.
Yes, and FASB has recognized it, because you have specific GAAP rules for oil and gas companies, for insurance companies, for banks, for software producers. But I wouldn’t call what we’re proposing clearly industry-specific. It focuses on the strategy, on the business model of the company, and because of that, it must be industry specific.
What’s your overall message to CFOs?
I’m in contact with many CFOs. Many of them already sense that there is a serious problem with the relevance of the information in financial reports. I gave an early version of our book to a CFO to read, and his comment was, “Baruch, I’m going to disappoint you. We know this.”
Another way I know they already sense this is that there is a significant increase in non-GAAP information. And I don’t speak here about non-GAAP earnings. I know that’s very controversial. Instead, for example, all pharmaceutical and biotech companies voluntarily provide extensive information on their project pipelines. All media, entertainment, and insurance companies provide extensive information on their customers. This is not required.
So they already sense serious problems with information, and they try to overcome it by providing additional information, particularly around the earnings calls. They provide extensive tables and graphs, and disclose lots of information in the calls, particularly in answering questions.
Now the only problem with this voluntary, non-GAAP disclosure is that it is not uniform. Some companies provide this information, other companies provide that information. And it’s not even consistent over time: some provide it in one year and then stop in the next year and move to other things. Despite the good intentions, this information is of very limited use to investors.
But non-GAAP metrics give rise to lots of skepticism because they can appear to be self-serving and manipulative.
You’re right. There’s also great skepticism about GAAP reports, by the way, which easily can be manipulated and massaged. How do you get the phenomenon that 70% of all companies beat analysts’ consensus? It’s impossible without some companies somehow slightly massaging the data. But there may be more skepticism with respect to something which is not standardized.
We hope that our suggestions, if they’re adopted, will be become standardized. I don’t see, for example, any skepticism with respect to reporting the product pipeline of pharmaceutical companies. It is provided in a very responsible, consistent way, and, just judging from analysts’ comments, it’s incredibly useful. There is skepticism with respect to non-GAAP earnings because some companies are just playing with the numbers. They are deleting all kinds of regular expenses that really should not be deleted.