33,99 €
Mehr erfahren.
- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Wiley Finance Editions
- Sprache: Englisch
An innovative new valuation framework with truly useful economic indicators
The End of Accounting and the Path Forward for Investors and Managers shows how the ubiquitous financial reports have become useless in capital market decisions and lays out an actionable alternative. Based on a comprehensive, large-sample empirical analysis, this book reports financial documents' continuous deterioration in relevance to investors' decisions. An enlightening discussion details the reasons why accounting is losing relevance in today's market, backed by numerous examples with real-world impact. Beyond simply identifying the problem, this report offers a solution—the Value Creation Report—and demonstrates its utility in key industries. New indicators focus on strategy and execution to identify and evaluate a company's true value-creating resources for a more up-to-date approach to critical investment decision-making.
While entire industries have come to rely on financial reports for vital information, these documents are flawed and insufficient when it comes to the way investors and lenders work in the current economic climate. This book demonstrates an alternative, giving you a new framework for more informed decision making.
- Discover a new, comprehensive system of economic indicators
- Focus on strategic, value-creating resources in company valuation
- Learn how traditional financial documents are quickly losing their utility
- Find a path forward with actionable, up-to-date information
Major corporate decisions, such as restructuring and M&A, are predicated on financial indicators of profitability and asset/liabilities values. These documents move mountains, so what happens if they're based on faulty indicators that fail to show the true value of the company? The End of Accounting and the Path Forward for Investors and Managers shows you the reality and offers a new blueprint for more accurate valuation.
Sie lesen das E-Book in den Legimi-Apps auf:
Seitenzahl: 451
Veröffentlichungsjahr: 2016
Ähnliche
Table of Contents
Title Page
Copyright
Dedication
Acknowledgments
The Book in a Nutshell
The Fading Usefulness of Investors' Information
Who Cares?
Not Only for Investors
Financial Information, a Major Driver of Economic Growth
Unique among Regulations
About Us and Our Approach
Notes
Prologue
Chapter 1: Corporate Reporting Then and Now: A Century of “Progress”
Spot the Differences
Differences Spotted
Real Improvements Spotted?
A Devil's Advocate
Takeaway
Notes
Chapter 2: And You Thought Earnings Are the Bottom Line
The Lucrative Earnings Prediction
Curb Your Enthusiasm
Earnings Had Its Days of Glory
But Wait, What about the Earnings Consensus?
Takeaway
Notes
Part One: Matter of Fact
Chapter 3: The Widening Chasm between Financial Information and Stock Prices
How to Measure the Usefulness of Financial Information
Honey, I Shrunk Accounting
Some Useful Details
And Now for Some Intuition
Who's the Culprit—Earnings or Book Values?
Are We Fair to Accounting?
How Can This Be?
Takeaway
Notes
Chapter 4: Worse Than at First Sight
When Is a Message Informative?
A Preempted Announcement
Measuring Financial Report Timeliness
Roll the Tape
Aren't We Trivializing Accounting's Contribution?
Takeaway
Notes
Chapter 5: Investors' Fault or Accounting's?
Irrational Investors?
Eyes to the Future
Predicting Corporate Earnings
And the Results Are…
Reasons, Please
Investors Alert: An Accounting Loss Isn't What It Used to Be
Takeaway
Notes
Chapter 6: Finally, For the Still Unconvinced
“But Accounting Is Complicated”
Experts at Work
Vague Information and Disagreement
Quantifying Disagreement
Takeaway
Notes
Chapter 7: The Meaning of It All
To Recap
Should Investors Really Care?
A Last-Ditch Defense of Accounting
The Decreasing Volatility of Businesses
Takeaway
Notes
Part Two: Why Is the Relevance Lost?
Note
Chapter 8: The Rise of Intangibles and Fall of Accounting
The Intangibles Surge
Accounting for Intangibles, Inconsistent and Opaque
Worst Yet—Misleading Information
More Bad News
More, Not Less Information Is Needed
Intangibles and the Accounting Relevance Lost
Not in Their Best Interest
Takeaway
Notes
Chapter 9: Accounting: Facts or Fiction?
“GE Brings Good Things to Life,” But Not to Accounting
How Did Estimates Come to Dominate Accounting?
Away with Historical Values
Roll the Tape
Clinching the Deal
Takeaway
Notes
Chapter 10: Sins of Omission and Commission
The Missing Accounting Link
Accounting and Nonaccounting Events
Did We Forget Causation?
On Conservative Accountants
Takeaway
Notes
Part Three: So, What's to Be Done?
Notes
Chapter 11: What Really Matters to Investors (and Managers)
The Corporate Mission
Digging a Bit Deeper
Strategic Resources
Mapping Investments to Resources
Preserving and Renewing the Strategic Resources
Strategic Asset Deployment and Operation
Measuring the Value Created
The Proposed Strategic Resources & Consequences Report
Takeaway
Notes
Chapter 12: Strategic Resources & Consequences Report: Case No. I—Media and Entertainment
Sector Synopsis
Sirius XM: Resources & Consequences Report
Subscribers Growth
It's the Strategy, Stupid
Disruption Threat
Value Created
A Reality Check
But Is This Really What Investors Need?
Finally, a Report for the Sector
Notes
Chapter 13: Strategic Resources & Consequences Report: Case No. 2—Property and Casualty Insurance
Sector Synopsis
It All Starts with Strategic Assets
The Resources & Consequences Report: Customers
New Products—Innovation
Agents—Still Important
Operations—Resource Deployment
Penetrating the Costs Black Box
Resource Preservation
Value Created
Notes
Chapter 14: Strategic Resources & Consequences Report: Case No. 3—Pharmaceutics and Biotech
Strategy and Strategic Resources
Investing in Innovation
The Resources & Consequences Report: Resource Investments
Innovation
Strategic Resources
Resource Preservation
Resource Deployment-Operations
Value Created
Notes
Chapter 15: Strategic Resources & Consequences Report: Case No. 4—Oil and Gas Companies
Accounting Limitations
Resource Investments
Strategic Resources
Resources Threats
Resource Deployment—Operations
Value Created
Notes
Part Four: Practical Matters
Chapter 16: Implementation
How to Elicit the Proposed Information
Pfizer Responds to Analysts' Pipeline Questions
Why the Pipeline Expos?
An Important Role for the SEC
Industry Associations Could Help, Too
But, of Course, Managers' Cooperation Is Indispensable
Competition and Litigation Concerns
For Consideration: Lighten the Regulatory Burden
Takeaway
Notes
Chapter 17: So, What to Do with Accounting? A Reform Agenda
Revitalizing Accounting
I. Treat Intangibles as Assets
II. Reverse the Proliferation of Accounting Estimates
III. Mitigate Accounting Complexity
Takeaway
Notes
Chapter 18: Investors' Operating Instructions
Analysis Focused on Strategic Assets
Assessing Enterprise Performance and Competitive Edge: The New Approach
First Step: Taking an Inventory of Strategic Resources
Second Step: Creating and Maintaining Strategic Assets
Third Step: Successful Deployment of Strategic Assets
Takeaway
Notes
Epilogue: Advocacy Needed
Author Index
Subject Index
End User License Agreement
Pages
ii
iii
v
xi
xiii
xiv
xv
xvi
xvii
xviii
xix
xx
xxi
xxii
xxiii
xxv
1
2
3
4
5
6
7
8
9
10
11
12
13
15
16
17
18
19
20
21
22
23
24
25
26
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
146
147
148
149
150
151
152
153
154
155
156
157
158
159
160
161
162
163
164
165
166
167
168
169
170
171
172
173
174
175
176
177
178
179
180
181
182
183
184
185
186
187
188
189
190
191
192
193
194
195
199
200
201
202
203
204
205
206
207
208
209
210
211
212
213
214
215
216
217
218
219
220
221
222
223
224
225
226
227
228
229
230
231
232
233
234
235
236
237
238
239
241
243
244
245
247
248
249
250
251
252
253
254
255
256
257
258
259
260
Guide
Table of Contents
Begin Reading
List of Illustrations
Chapter 2: And You Thought Earnings Are the Bottom Line
Figure 2.1 Predicting Companies' Earnings—A “Winning” Strategy
Figure 2.2 Pitting Earnings Against Cash Flow Strategies
Figure 2.3 The Consequences of Missing or Beating the Consensus Earnings Estimate
Figure 2A.1 Cash Flows Are Increasingly More Accurate to Predict than Earnings
Figure 2A.2 Analysts Predict Cash Flows More Accurately than Earnings
Chapter 3: The Widening Chasm between Financial Information and Stock Prices
Figure 3.1 Share of Corporate Market Value Attributed to Earnings and Book Value
Figure 3.2 Share of Corporate Market Value Attributed to Earnings
Figure 3.3 Share of Corporate Market Value Attributed to Book Value
Figure 3.4 Share of Corporate Market Value Attributed to Multiple Financial Indicators
Chapter 4: Worse Than at First Sight
Figure 4.1 The Unique Contribution to Investors' Information: Financial Reports, Analysts' Forecasts, and Nonaccounting SEC Filings
Chapter 5: Investors' Fault or Accounting's?
Figure 5.1 Declining Ability of Reported Earnings to Predict Future Earnings
Figure 5.2 Increasing Impact on Earnings of Transitory Items
Chapter 6: Finally, For the Still Unconvinced
Figure 6.1 Analysts' Ambiguity on the Rise
Chapter 7: The Meaning of It All
Figure 7.1 Decreasing Volatility of Corporate Sales over Time
Chapter 8: The Rise of Intangibles and Fall of Accounting
Figure 8.1 The Intangibles Revolution
Figure 8.2 Decreasing Accounting Relevance by Vintage Year of Public Companies
Chapter 9: Accounting: Facts or Fiction?
Figure 9.1 Increasing Frequency of Estimate-related Terms in Financial Reports
Figure 9.2 Increasing Amount of Extraordinary and Special Items Relative to Net Income, All Companies, 1950–2013
Figure 9.3 ROE Prediction Errors Are Higher for Companies with Above-Median Number of Estimates
Chapter 10: Sins of Omission and Commission
Figure 10.1 Increasing Frequency (Left Axis) and Impact (Right Axis) of Nonaccounting Events in 8-K Filings, 1994–2013
Figure 10.2 Nonaccounting Events Leading to Higher Earnings Prediction Error
Chapter 11: What Really Matters to Investors (and Managers)
Figure 11.1 The Strategic Resources & Consequences Report
Chapter 12: Strategic Resources & Consequences Report: Case No. I—Media and Entertainment
Figure 12.1 SIRIUS XM Inc.: Resources & Consequences Report
Figure 12.2 Media and Entertainment: A Strategic Resources & Consequences Report
Chapter 13: Strategic Resources & Consequences Report: Case No. 2—Property and Casualty Insurance
Figure 13.1 Customers' Box
Figure 13.2 Insurance Company Operations
Figure 13.3 Property & Casualty Insurance: A Strategic Resources & Consequences Report
Chapter 14: Strategic Resources & Consequences Report: Case No. 3—Pharmaceutics and Biotech
Figure 14.1 Pharmaceutical and Biotech Companies: A Strategic Resources & Consequences Report
Figure 14.2 Pipeline Product Candidates
Chapter 15: Strategic Resources & Consequences Report: Case No. 4—Oil and Gas Companies
Figure 15.1 Resource Investments
Figure 15.2 Strategic Resources
Figure 15.3 Resource Deployment—Operations
Figure 15.4 Strategic Resources & Consequences Report: Case 4—Oil and Gas Companies*
Chapter 16: Implementation
Figure 16.1 Number and Percentage of Product Pipeline-Related Questions Raised by Analysts During Pfizer's 2001–2015 Earnings Conference Calls
Chapter 18: Investors' Operating Instructions
Figure 18.1 Residual Cash Flows Measure Outperforms Conventional Ones
List of Tables
Chapter 1: Corporate Reporting Then and Now: A Century of “Progress”
Table 1.1 United States Steel Corporation Consolidated Income Statement
Table 1.2 United States Steel Corporation Consolidated Balance Sheet
Chapter 16: Implementation
Table 16A Major Enhancements in Pfizer's 10-K Disclosure About Its Product Pipeline, 1994–2014
The End of Accounting and The Path Forward for Investors and Managers
BARUCH LEVFENG GU
The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more. For a list of available titles, visit our website at www.WileyFinance.com.
Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding.
Copyright © 2016 by Baruch Lev and Feng Gu. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.
For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.
Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.
Library of Congress Cataloging-in-Publication Data:
Names: Lev, Baruch, author. | Gu, Feng, 1968- author.
Title: The end of accounting and the path forward for investors and managers / Baruch Lev, Feng Gu.
Description: Hoboken, New Jersey : John Wiley & Sons, Inc., 2016. | Series: Wiley finance series | Includes index.
Identifiers: LCCN 2016007850 (print) | LCCN 2016015075 (ebook) | ISBN 9781119191094 (hardback) | ISBN 9781119190998 (pdf) | ISBN 9781119191087 (epub)
Subjects: LCSH: Financial statements. | Investments—Decision making. | Finance. | BISAC: BUSINESS & ECONOMICS / Finance.
Classification: LCC HG4028.B2 L49 2016 (print) | LCC HG4028.B2 (ebook) | DDC 332.63/2042—dc23
LC record available at http://lccn.loc.gov/2016007850
Cover Design: Wiley
Cover Image: © Sergey Nivens/Shutterstock
To Ilana, Eli, and RacheliRui, Elizabeth, and Isabella
Acknowledgments
In recent decades, corporate financial information, conveyed by those voluminous and increasingly complex quarterly and annual reports, has lost most of its usefulness to investors—the major intended users—and is urgently in need of revitalization and restructuring. In this book, we empirically prove the former (information relevance lost) and perform the latter: propose a new and actionable information paradigm for twenty-first century investors.
In this we were very ably assisted by various colleagues and experts to whom we express our deep gratitude. Gene Epstein, Barron's economics editor, provided important guidance and insight (though was disappointed that we didn't change the book title to The Death of Accounting). Our colleague, Stephen Ryan, provided numerous comments and suggestions on accounting and statistical issues. Win Murray, Director of Research, Harris Associates; Philip Ryan, Chairman, Swiss Re Americas; and Allister Wilson, Global Audit Partner at Ernst & Young, all provided valuable comments on parts of the book. Zvika Zelikovitch, a superb artist, and Ayala Lev, creative and loving, furnished useful ideas for the book cover. Our colleagues Mary Billings, Massimiliano Bonacchi, Matthew Cedergren, Jing Chen, Justin Deng, Ilia Dichev, Dan Gode, William Greene, John Hand, Doron Nissim, Suresh Radhakrishnan, and Paul Zarowin enlightened us with numerous suggestions and insights.
Our trusted assistant, Shevon Estwick, highly professional and dedicated, provided invaluable administrative support in handling the manuscript. Nancy Kleinrock, not only edited the book very skillfully, but offered numerous constructive comments and suggestions. Jessica Neville, Executive Director of Communications at NYU's Stern School of Business, provided valuable marketing advice, and Wiley Finance Editor, William Falloon, accepted the book almost at face value and guided it smoothly and efficiently through the long production process, providing important advice. He was ably assisted by his Wiley editorial and production team.
We are deeply indebted to all, and to our families, of course.
The Book in a Nutshell
The Fading Usefulness of Investors' Information
Corporate financial reports—balance sheets, income and cash flow statements, as well as the numerous explanatory footnotes in quarterly and annual reports and IPO prospectuses—form the most ubiquitous source of information for investment and credit decisions. Many stocks and bonds investors, individuals and institutions, as well as lenders to business enterprises look for financial report information to guide them where and when to invest or lend. Major corporate decisions, such as business restructuring or mergers & acquisitions, are also predicated on financial report indicators of profitability and solvency. Responding to such widespread demand, the supply of corporate financial information, tightly regulated all over the world, keeps expanding in scope and complexity. Who would have imagined, for example, that the accounting rules determining when a sale of a product should be recorded as revenue in the income statement would extend over 700 (!) pages?1 Eat your heart out, IRS. Its complexity notwithstanding, financial information is widely believed to move markets and businesses. But does it?
Like a Consumer Reports evaluation, we examine in the first part of this book the usefulness of financial (accounting) information to investors and, regrettably, provide an unsatisfactory report, to put it mildly. Based on a comprehensive, large-sample empirical analysis, spanning the past half century, we document a fast and continuous deterioration in the usefulness and relevance of financial information to investors' decisions. Moreover, the pace of this usefulness deterioration has accelerated in the past two decades. Hard to believe, despite all of regulators' efforts to improve accounting and corporate transparency, financial information no longer reflects the factors—so important to investors—that create corporate value and confer on businesses the vaunted sustained competitive advantage. In fact, our analysis (Chapter 4) indicates that today's financial reports provide a trifling 5 percent of the information relevant to investors.
To avoid undue reader suspense, Part II of the book identifies, again with full empirical support, the three major reasons for the surprising accounting fade, thereby laying the foundation for the main part of the book: our new disclosure proposal outlined in Part III, which directs investors with specificity to the information they should seek for substantially improved investment decisions. Our proposed disclosure to investors is primarily based on nonaccounting information, focusing on the enterprise's strategy (business model) and its execution, and highlighting fundamental indicators, such as the number of new customers and churn rate of Internet and telecom enterprises, accidents' frequency and severity—as well as policy renewal rates—of car insurers, clinical trial results of pharma and biotech companies, changes in proven reserves of oil and gas firms, or the book-to-bill (order backlog) ratio of high-tech companies, to name a few fundamental indicators that are more relevant and forward-looking inputs to investment decisions than the traditional accounting information, like earnings and asset values, conveyed by corporate financial reports. Such reports, moreover, are outright misleading for important sectors of the economy, such as fast-growing technology and science-based companies, often portraying innovative and high-potential enterprises as losing, asset-starved business failures.
In short, based on our evidence, we grade the ubiquitous corporate financial report information as largely unfit for twenty-first-century investment and lending decisions, identify the major causes for this accounting fade, and provide a remedy for investors. But wait.
Who Cares?
So what if financial (accounting) information lost much of its relevance to investors in recent decades? Who besides accountants, and accounting educators like us, should care about that? With modern information technologies, the proliferation of data vendors (Bloomberg, FactSet), and the ubiquity of financial social media sites, investors can surely supplement the relevance-challenged accounting data with more pertinent and timely information. So, why bother about the fading usefulness of financial information? Why this book?
For the simple and compelling reason that there aren't and never will be good substitutes for corporate-issued information, since corporate managers are always substantially better informed about their business than outsiders. Managers are privy, for example, to recent sales and cost trends, the progress of drugs or software products under development, customer defection rate (churn), new contracts signed, and emerging markets penetration rate, among many other important business developments. No information vendor, Internet chat room, or even a sophisticated analyst can provide investors such “inside” information. No advances in information technology and investors' processing capacity (Edgar, XBRL) can overcome the fundamental information asymmetry—managers know more than investors—inherent to capital markets. You might not like it, but that's how it is and will be.
In fact, in subsequent chapters we provide empirical evidence suggesting that the quality of the overall information used by investors continuously deteriorates and share prices reveal less of companies' value and future prospects. Not the buzz, hype, and financial Internet chatter, which are surely deafening; rather the hard, fundamental data so crucial for investors' decisions. So who cares? Investors, policy makers, and even corporate managers should be highly concerned with our findings of the fast-diminishing relevance of financial (accounting) information.
But our book doesn't end with this downer. Far from it. In Part III of the book—its main part—we propose a new, comprehensive information paradigm for twenty-first-century investors: the Strategic Resources & Consequences Report. For clarity, we demonstrate this information system on four key economic sectors: media and entertainment, insurance, pharmaceutics and biotech, and oil and gas. The focus of this Resources & Consequences Report is on the strategic, value-enhancing resources (assets) of modern enterprises, like patents, brands, technology, natural resources, operating licenses, customers, business platforms available for add-ons, and unique enterprise relationships, rather than on the commoditized plant, machines, or inventory, which are prominently displayed on corporate balance sheets. The main purpose of the proposed information system is to provide investors and lenders (and managers, too) with actionable, up-to-date information required for today's investment decisions. It directs every investor and lender to seek from companies the information that really matters, rather than the information regulators believe is good for you. So, what you get in this book is a package deal: comprehensive evidence that the information you used to rely on lost much of its usefulness, along with the reasons for this relevance lost, and a clear articulation of the information you should seek and use to assess the performance of business enterprises and chart their future potential. The book concludes with three important chapters: How exactly can our radical change proposals be implemented (Chapter 16); how should the current accounting and reporting systems be restructured to advance them to the twenty-first century (Chapter 17); and how should investors and analysts transform their investment routines in light of this book's message (Chapter 18).
In short, this is an operating instructions book for investors, directing them with specificity to the information leading to successful investment and lending decisions, as well as guiding corporate managers, many of whom intuitively realize the serious shortcomings of financial information, how to enhance their information disclosure. Importantly, while this book deals with highly complex, often confusing financial information, and is fully backed by large-sample empirical evidence, you don't have to be an accountant or a statistician to fully comprehend it. In contrast with typical academic courses, there are no prerequisites for this book. Common sense, intuition, and a strong desire to improve your investment performance are all that is required for reaping the benefits of this book. Open admission, so to speak (except for diehard accountants whose peace of mind might not endure this book's message).
Not Only for Investors
While the intended readers of this book are mainly investors and lenders, alerted here to the hazards of using outdated, inadequate financial report information in making investment and lending decisions, the implications of our findings are far reaching and of considerable interest to wider audiences: corporate managers, accountants, and capital market regulatory agencies. These widespread implications stem from the unique role of the corporate accounting and reporting systems in the economy.2 To fully grasp this role, and the implications of our findings, we have to briefly consider the impact of financial information on economic growth and the perplexing uniqueness of accounting regulation. Bear with us, you don't get this in business school.
Financial Information, a Major Driver of Economic Growth
While you surely heard, and perhaps even personally experienced, that accounting is outright boring, it's nevertheless vitally important. Here is why. No economy can grow and prosper without an active and deep capital market that channels the savings of individuals and business organizations to the most productive investment uses by the private sector.3 Promising biotech companies, software producers, energy startups, and healthcare enterprises rely on the stock and bond markets to raise the much-needed funds to finance their capital investment and R&D, and attract talent by offering shares and stock options. In capital markets, investors' funds chase corporate growth opportunities and, vice versa, desert failing businesses. The “fuel” running this sophisticated capital accumulation and allocation “machine” is information: the information available to investors and lenders on the prospects of business enterprises, translated to expected risks and returns on investments, directing investors' capital to its most productive uses. Poor information, in contrast, seriously distorts investors' decisions by misdirecting their capital to failed enterprises, while starving worthy ones. The economic “growth machine” falters with the contaminated fuel of low-quality information.
For years, Enron's and WorldCom's glowing—yet misleading—financial reports masked the operational failures of these companies and drove investors to plow billions of dollars into them, only to see their fortunes go down the drain, and, more seriously, depriving other worthy investments of much-needed capital.4 But note, it's not only fraudulent information that impedes investment and growth; it's mainly the poor quality of “honest” financial reports, legitimately disclosed under the current, universally used accounting system, that seriously harms the capital allocation system and economic growth. Consider:
Biotech companies developing promising drugs and medical instruments, as well as high-tech and Internet startups, often report heavy losses because their investments in R&D, brands, and customer acquisition are treated by accountants as regular, income-reducing expenses, rather than assets generating future benefits. Many such enterprises encounter difficulties in raising money by going public, or, once public, in getting additional funds in the capital or debt markets because promising investments are erroneously perceived by investors as enterprises awash in red ink.5 For established enterprises, important business events—like increases in customers' “churn rate” (termination) of telecom, Internet, and insurance companies, which is a leading indicator of serious operating problems—aren't reported to investors. Nor is there full and timely disclosure to investors of the success or failure of clinical trials for drugs under development by pharma companies. As for the information conveyed by corporate reports, it's often subject to serious biases, like reflecting the costs of restructuring without its benefits (conservatism, in the accounting parlance), and uncertainty due to heavy reliance on managerial forecasts and estimates that are subjective and sometimes unreliable. These, and other reporting shortcomings are detailed in Part II. All in all, a largely deficient source of information for investors. No wonder that privately held companies, which are not affected by investors' decisions based on low-quality information, invest considerably more and grow faster than publicly held companies.6
Given the crucial role of financial (accounting) information in fostering prosperity and growth of business enterprises and the economy at large, the serious deficiencies of this information, documented in the following chapters, should be of great concern not only to investors—the primary users of the information—but also to managers, accountants, and policy makers. Corporate managers, in particular, should be concerned with the deteriorating usefulness of financial information, since the consequent increasing opaqueness of companies elevates investors' risk and companies' cost of capital, and reduces share values.7 Contaminated fuel at gas pumps would have caused a public uproar and triggered regulatory actions. Contaminated information, capital markets' “fuel,” should likewise draw general concern and action.
Unique among Regulations
Accounting's usefulness deserves critical examination, not only because of its central economic role, but also due to its unique, yet little known, institutional status. Did you know that those, rather obscure, accounting rules and procedures underlying financial information are like the law of the land? They have, in fact, a legal status, because public companies have to follow them to the letter in generating financial information.8 But what makes accounting regulation unique and imposes a heavy burden on the economy is that, unlike any other regulation, it is mandatory for all public companies, uniform throughout the world, and constantly expanding.
Start with uniformity: Financial reporting regulations are by and large identical throughout the world. In practically every free-market economy, public companies must periodically disclose to the public balance sheets, income, and often cash flow statements of essentially identical structure, form, and content.9 Furthermore, the financial statements of all public companies must be audited by external auditors (certified public accountants—CPAs) and are closely monitored by national regulators, like the SEC in the United States. We are not familiar with any other law or regulation that is similarly uniform throughout all free-market economies. Different cultures, economic institutions, and developmental histories exert strong effects on national laws (genetically modified food products are generally banned in Europe but not in the United States; capital punishment is legal in some countries, but not others). Accounting and financial reporting regulations defy diversity.10
That's a good thing, you say: The global uniformity of accounting—one business language throughout the world—saves information generation and processing costs to multinational firms, but the unintended consequences of this uniformity are serious. In particular, uniformity deprives accounting of a major force for innovation and rejuvenation—the vital experimentation and evolution that come with diversity. Regulatory development is generally a trial-and-error process, as in the regulations prohibiting tobacco smoking in public places that emerged slowly and sporadically (Minnesota in 1975 was the first US state to ban smoking in most public places), gaining worldwide adoption only after extensive experimentation. Even now, countries differ in the extent of smoking bans. Same with environmental regulations, where cross-country differences are legion. In contrast, the stagnation of the accounting system and the consequent loss of relevance—documented in this book—can be, in part, attributed to the absence of any experimentation with new information structures or modes of disclosure, which comes from diversity of reporting across countries or regions. This is most evident by the fact that accounting regulations keep piling up and ineffective ones are rarely abolished: no trial, no error—just more of the same.
Often, regulatory competition among states in the United States, or stock exchanges around the world, leads to regulatory and institutional improvements (the evolution of gas fracking regulation in the United States, for instance), but there has never been competition on accounting and financial disclosure systems. Even the small differences between certain specific accounting procedures mandated in the United States (GAAP) and those in Europe and certain other countries (IFRS) could soon disappear due to the pressure to converge (harmonize) these systems. Continued fading relevance will be the consequence of such convergence. In contrast, our proposals, set forth in Part III, call for extensive innovation and experimentation in corporate disclosure to investors.
What's also unique about financial reporting regulations is that they keep expanding, constantly increasing the social cost burden. Each wave of corporate scandals and financial failures brings in its wake new accounting and reporting rules aimed at rectifying past failures, and new economic and business developments trigger further changes to accounting regulations. But, old, dysfunctional accounting rules, like the expensing of R&D, rarely die, nor fade away (unlike General MacArthur's memorable old soldiers), they just proliferate. The only regulations that are similar to financial reporting in scope, cost, and constant expansion are environmental laws, with one crucial difference: Environmental regulations are constantly, often heatedly debated and challenged in the public arena. The current controversies in the United States about carbon tax, subsidies for alternative energy sources, and gas fracking, are but a few examples. And not just in the States: In July 2014, Australia scrapped its unpopular national carbon tax, instituted just two years earlier. Such close public scrutiny significantly improves the quality of environmental regulations and mitigates their cost. In contrast, we aren't aware of a serious, change-leading public scrutiny of corporate financial reporting, not even after repeated, demonstrated failures, such as the 2007–2008 financial crisis, which made clear that the financial reports of the troubled institutions—Citibank, AIG, Merrill Lynch, Lehman Bros., Countrywide Financial—didn't alert investors and regulators to the excessive risk-taking and the poor quality of bank assets that caused the failures.11
The absence of experimentation and serious public scrutiny, and the constantly rising social costs of accounting regulations set the stage for a comprehensive examination of mission accomplished: the usefulness of corporate financial information to investors, on which we embark in this book.
About Us and Our Approach
We, the writers of this book, are veteran accounting and finance researchers and educators, and one of us has extensive experience in public accounting, business, and consulting. For years we have documented in academic journals the failure of the accounting and financial reporting system to adjust to the revolutionary changes in the business models of modern corporations, from the traditional industrial, heavy asset-based model to information-intensive, intangibles-based business processes underlying modern companies, as well as documenting other accounting shortcomings. While not alone in this endeavor, our impact on accounting and financial reporting regulations has regrettably been so far very limited. But we now sense an opportunity for a significant change, motivating this book. The deterioration in the usefulness of financial information has been so marked, that it can no longer be glossed over. Corporate managers, realizing the diminished usefulness of financial information, respond by continuously expanding the voluntary disclosure to investors of non-GAAP (accounting) information. Thus, for example, the frequency of releasing proforma (non-GAAP) earnings doubled from 2003 to 2013, standing now at over 40 percent.12 Researchers, too, sense a serious problem: A recent study by leading accounting researchers examined the impact on investors of all the accounting and reporting rules and standards issued by the Financial Accounting Standards Board (FASB) from its inception (1973) through 2009—a staggering number of 147 standards—and found that 75 percent of these complex and costly rules didn't have any effect on the shareholders of the impacted companies (improved information generally enhances shareholder value), and, hard to believe, 13 percent of the standards actually detracted from shareholder value. Only 12 percent of the standards benefited investors. Thus, 35 years of accounting regulation came to naught.13 The SEC is concerned, too:
Consider, for example, the current initiative of the US Securities and Exchange Commission (SEC)—Disclosure Effectiveness—aimed at “… considering ways to improve the disclosure regime for the benefit of both companies and investors.”14 The SEC invited input and comments to this initiative, and indeed, a Google search reveals scores of mostly extensive comments and submissions by business institutions, accounting firms, and individuals. Reviewing some of these submissions, we are struck by the following common threads, which sadly remind us of previous futile attempts to enhance financial reporting effectiveness: Commentators generally presume to know what information investors need without articulating how they gained this knowledge (research, surveys), and proceed with improvement recommendations that often boil down to generalities, like reduce information overload, focus on material information, or streamline and increase reliability of information, without identifying how exactly this should be done.15 The exceptions are suggestions with a specific agenda, calling for environmental, social, or sustainability disclosures that are bound, we suspect, to antagonize most information suppliers (i.e., corporate managers).16 Finally, most suggestions cut across all industries—a straightjacket approach, typical to current financial disclosure. Thus, despite the good intentions, we are skeptical that the current SEC's effort will fare better than its predecessors' in leading to real improvements in disclosure effectiveness, bringing to mind the famous remark: “Everybody complains about the weather, but nobody does anything about it.”17
We approached our mission in this book—to alert investors to the information they should seek and use for successful investment and lending decisions, and in the process enhance disclosure effectiveness and improve capital markets efficiency—differently:
First, rather than
assume
that financial disclosure lost its effectiveness, we document comprehensively, on large samples of companies, the fast diminishing relevance of this information to investors, and proceed to identify, again, evidence-based, the major reasons for this information fade (Parts I and II). This identification of failure drivers guided our choice of the information modes that will improve investors' decisions.
Second, rather than
presume
to know what information investors need, we conducted a detailed examination of hundreds of quarterly earnings conference calls and investor meetings in four major economic sectors, distilling from analysts' questions the specific information items crucial for investment decisions. This, we backed up with lessons from economic theory to construct new
industry-specific
information paradigms—the Strategic Resources & Consequences Reports—proposed in
Part III
.
Third, again, in the tradition of research, we don't just
claim
that our proposed information is required by investors—we prove it. We show that selected nonaccounting information items we propose, like insurance companies' data on the frequency and severity of claims, are correlated with companies' stock prices and future earnings, hence their relevance to investors.
Last, our only book agenda is to outline to investors and lenders the information needed for assessing the performance and potential of twenty-first-century business enterprises, thereby improving investment decisions and enhancing the functioning of capital markets. Corporate financial reporting will benefit, too.
Enough said.
Notes
1
The Financial Accounting Standards Board (FASB) issued this new standard on “revenue recognition” in May 2014, classified as ASC 606.
2
See Jacob Soll,
The Reckoning
(New York: Basic Books, 2014), for a historical perspective of the centrality of accounting to economies and nations.
3
Abundant economic research substantiates the crucial role of capital markets in fostering corporate and national growth. For example, Anne Krueger, “Financial Markets and Economic Growth,” International Monetary Fund, 2006.
4
If you are of the post-Enron and WorldCom generation, here are more recent accounting scandals, courtesy Japan: Olympus's (cameras, optics) multibillion-dollar accounting scandal concealed investment losses and missing assets, revealed in 2011, and Toshiba's (computers, machinery) also multibillion-dollar accounting scandal, disclosed in 2015.
5
At the very early stage of such enterprises, capital is usually provided by venture capitalists who rarely rely on financial reports. Subsequent to IPO, though, most early investors cash out, and the company is left to raise funds from regular investors whose decisions are often based on financial information, such as earnings and asset values, and on intermediaries (financial analysts), who also rely on financial report information.
6
See John Asker, Joan Farre-Mensa, and Alexander Ljungqvist, “Corporate Investment and Stock Market Listing: A Puzzle?”
Review of Financial Studies
, 28(2) (2015): 342–390.
7
Evidence that decreased transparency increases companies' cost of capital is provided in, for example, Mary Barth, Yaniv Konchitchki, and Wayne Landsman, “Cost of Capital and Earnings Transparency,”
Journal of Accounting and Economics
, 55 (2013): 206–224.
8
Deviations from accounting principles (GAAP) lead auditors to qualify their audit report, and often trigger SEC actions and shareholders' lawsuits against managers and directors.
9
There are, of course, certain differences in reporting regulations across countries, but they are few and relate to details, like R&D, which has to be expensed in the United States vs. partially capitalized under strict circumstances in countries—mainly European—following the international accounting rules (IFRS). But these are details. The general structure and content of accounting and financial reporting is practically uniform throughout free-market economies.
10
For systematic, cross-country differences in regulatory approaches, see David Vogel, Michael Toffel, Diahanna Post, and Nazli Uludere Aragon, “Environmental Federalism in the European Union and the United States,” in
A Handbook of Globalization and Environmental Policy
, F. Wijen, K. Zoeteman, J. Pieters, and P. Seters, eds. (Cheltenham, UK: Edward Elgar, 2005).
11
A study on the recent financial crisis concluded that: “However, transparency of information associated with measurement and recognition of accounting amounts…were insufficient for investors to assess properly the values and riskiness of the affected bank assets and liabilities.” Mary Barth and Wayne Landsman, “How did financial reporting contribute to the financial crisis?” working paper (Stanford University, 2010), 3.
12
See Jeremiah Bentley, Theodore Christensen, Kurt Gee, and Benjamine Whipple,
Who Makes the non-GAAP Kool-Aid? How Do Managers and Analysts Influence non-GAAP Reporting Policy?
working paper (Salt Lake City: Marriott School of Management, Brigham Young University, 2014).
13
Urooj Khan, Bin Li, Shivaram Rajgopal, and Mohan Venkatachalam,
Do the FASB Standards Add (Shareholder) Value?
working paper (New York: Columbia University Business School, 2015).
14
US Securities and Exchange Commission,
Disclosure Effectiveness
, 2015.
15
Here and there, we found exceptions. For example, the accounting firm Ernst & Young proposes a report on critical estimates underlying financial information and their realizations. We also advance this important suggestion in
Chapter 17
.
16
We don't mean to denigrate agenda proposals. In fact, there are several research studies documenting an association between sustainability policies and improved corporate performance. For example Robert Eccles, Ioannis Ioannou, and George Serafeim, “The Impact of Corporate Sustainability on Organizational Process and Performance,”
Management Science
, 60 (11) (2014): 2835–2857.
17
Generally attributed to Mark Twain, although some claim it originated with Charles Dudley Warner (1829-1900), an author and a friend of Twain.
Prologue
This book is loaded with surprises, not the least of which is that, in recent decades, corporate financial reports—the backbone of investors' information—lost most of their usefulness to investors, despite efforts by worldwide regulators to improve this information. But before delving into the evidence of accounting's relevance lost and what investors should do about it, we wish to share with you, as a preamble, two important findings that surprised even us. These will help to ease your way into the rest of the book:
First, while accounting and financial reporting appear to be constantly changing to keep up with the times, you will be surprised to learn that the fundamental structure of corporate reporting to shareholders—balance sheets, income and cash flow statements, as well as their specific line items—is, in fact, frozen in time, having stagnated over the past 110 years. Would you believe that?
Second, in recent years, basing investment decisions on the prediction of corporate earning—a time-honored and lucrative practice by analysts and investors—lost its edge over simpler investment techniques. It is time to look for new approaches to investment analysis.
The reason we open the book with these intriguing, yet fascinating findings is that they chart the path for the rest of the book: an unconventional and uncompromising look at the current state of investors' information, and an innovative approach at providing the information investors really need.
Chapter 1Corporate Reporting Then and Now: A Century of “Progress”
In which we show, using US Steel’s financial reports from 1902 (yes, 1902) and 2012, that the structure and content of corporate financial reports—balance sheets, income and cash flow statements—haven’t changed over the past 110 years, despite dramatic increases in investors’ sophistication, information processing ability, and complexity of business operation. Surprised? We don’t blame you.
Spot the Differences
The year is 1903. Theodore Roosevelt is in his third year of presidency, the Ford Motor Co. produces its first car—the Model A (available, as Henry Ford said, in any color as long as it's black)—and the first World Series is played: Boston Americans (soon the Boston Red Sox) versus the Pittsburgh Pirates. No surprise, Boston wins with Cy Young pitching. Alas, there is no television to watch the game, nor is there air transportation, or shopping malls. Not even the Internet—no Facebook or Twitter. But steel is produced, and the largest steel producer in the world—United States Steel Corporation (US Steel)—publishes its first annual report to shareholders. The main components of this report, the balance sheet and the income (profit or loss) statement for the previous year, 1902, are recast below, alongside with—fast-forward 110 years—their 2012 counterparts. (The original 1902 US Steel statements are reproduced in the Appendix.)
Recall your early childhood when you likely played the popular game Spot the Differences. Examining two seemingly identical pictures, you were challenged to identify minute, hidden differences. We challenge you to do the same with the two US Steel balance sheets and income statements, spanning 110 years, displayed below and in the next page. The purpose of the exercise: a first glimpse at the progress, or rather, lack thereof, of accounting and financial reporting over the past century plus decade.
Amazingly, you'll find that there are absolutely no differences in the structure and information items provided to investors by the two financial reports. Same layout of the income statement (Table 1.1) and balance sheet (Table 1.2), and identical information items disclosed in the two reports: assets, liabilities and equity in the balance sheet; and revenues minus an array of expenses in the income statement—as if investors' information needs and tools of financial analysis and securities valuation were frozen over the past 110 years, and no advances had been made in information processing and data display. Imagine if the report that people get today following a comprehensive physical checkup were identical to what patients received from their doctors 110 years ago. Yet, the corporate annual checkup report is frozen in time. Don't be misled by the “low” sales in 1902—$560 million. Converting this 1902 figure to 2012 values with the help of the Consumer Price Index (CPI) yields $16,324 million, pretty close to the actual 2012 sales of $19,328 million. So, US Steel was already a sizable enterprise 110 years ago, worthy of comparison with today's company.
Table 1.1 United States Steel Corporation Consolidated Income Statement
(in $ Millions)
Year 1902
Year 2012
Sales
$ 560
$19,328
Cost of sales
(411)
(18,291)
Gross profit
149
1,037
Minus Expenses:
Selling & general expenses
(13)
(654)
Other gains/(losses)
5
(136)
Interest income
3
7
Interest expense
(9)
(247)
Income tax
(2)
(131)
Net income (loss)
133
(124)
Table 1.2 United States Steel Corporation Consolidated Balance Sheet
(in $ Millions)
Year 1902
Year 2012
Assets
Current Assets
Cash & equivalents
$56
$570
Net receivables
49
2,090
Inventories
104
2,503
Other current assets
5
211
Total current assets
214
5,374
Investments
4
609
Property, Plant & Equipment
1,325
6,408
Intangibles
—
253
Goodwill
—
1,822
Other noncurrent assets
4
751
Total assets
$1,547
$15,217
Liabilities
Current Liabilities
Accounts payable
$19
$1,800
Payroll payable
4
977
Accrued taxes
1
146
Other current liabilities
26
67
Total current liabilities
50
2,990
Long-term debt
371
3,936
Employee benefits
—
4,416
Other noncurrent liabilities
30
397
Total liabilities
451
11,739
Stockholders' Equity
Common stock
1,018
3,282
Retained earnings
78
196
Total shareholders' equity
1,096
3,478
Total Liabilities and Equity
$1,547
$15,217
There is an important difference, however, between the 1902 and 2012 US Steels: While the company generated in 1902 a healthy profit of $133.3 million (equivalent to $3.9 billion in 2012 dollars)—amounting to a 13 percent return-on-equity (ROE)—US Steel's operations in 2012 resulted in a loss of $124 million.1 Many things have changed, of course, over the years, but perhaps a clue to the stark difference in operations lies in the board of directors. In 1902, US Steel had on its board the likes of John D. Rockefeller, J. Pierpont Morgan, Charles M. Schwab (also president of the company), Marshall Field, and Henry C. Frick (of the New York museum fame), among other business titans. Who says directors don't matter?
Seriously, a struggling enterprise, like the 2012 US Steel, providing the same information as the booming 1902 company? Shouldn't today's investors be told what aspects of the business model failed in 2012 or before? Informed about manufacturing setbacks? Specific marketing challenges? And told, backed by data, about the remedial steps taken by management? Shouldn't a twenty-first-century corporation reporting about its operations and economic condition systematically convey such strategic information, rather than report what it paid years ago for buildings and machinery or questionable assets like goodwill? And not just investors, whose money is at stake, should be better informed. The public at large, asked frequently by steel companies to support protective measures against foreign producers, should fully understand the challenges faced by the current US Steel. Really informative financial reports, rather than those frozen in time, are essential to investors and the public at large.
Differences Spotted
Examining the US Steel financial reports line by line, it is evident that the two income statements are identical in terms of the items presented: sales, cost of sales, income tax expense, and so on. Thus, the 1902 and 2012 investors, different folks to be sure—the latter, with vastly more powerful analyzing capabilities, access to alternative investments and investment tools (multiple hedging mechanisms, short sales, programmed trading)—received similar information from the two profit and loss statements. As for the balance sheets, the only items on the 2012 report absent in 1902 are goodwill and intangibles, the result of certain mergers and acquisitions conducted by the “modern” US Steel. The company founders apparently believed that growth should be internally generated by innovation and investment, rather than acquired externally by hunting for bargains. Recent research, showing that most mergers and acquisitions disappoint due to overpayment and/or acquiring strategic misfits, proves the founders right.2 Thus, with the exception of goodwill, readers of the two balance sheets were also equally informed. Finally, while in 1902, a cash flow statement—the third major component of a financial report—was not mandatory as it is now, US Steel provided one anyway (see Appendix).
But, you surely say, there is more to an annual report than an income statement, a balance sheet, and a cash flow statement. Today's supplementary information is much more extensive than a century ago. True. The sheer sizes of the two reports attest to this: The 1902 US Steel report is a slim 40-page document, whereas its 2012 counterpart is, in the best accounting tradition of mounting complexity and obfuscation, a hefty 174-page tome. A real forest killer.
But what does the latter report have on the former in terms of useful information? In 2012 there are, of course, the obligatory glossy pictures of smiling employees, executives, and customers, all absent in 1902. Come to think of it, we don't recall ever seeing smiling pictures of J. P. Morgan or J. D. Rockefeller. Those poor chaps really worked for a living; today, it's all about having fun. Lots of colorful graphs and exhibits of financial data adorn the 2012 report, as well as the soup du jour—a lengthy discussion of environmental issues. And not to be ignored—the 2012 report has a 12-page (!) boiler plate list of risk factors facing US Steel and its shareholders. Who would have guessed, for example, that the steel industry is cyclical, that steel production involves environmental compliance risk, that raw materials prices may fluctuate, or that an employer of some 45,000 workers faces litigation exposure? The 2012 risk factors statement tells you all this and more. Seriously, we have yet to meet a financial analyst or investor who learned anything valuable from, or based a decision on, the risk-factors boilerplate or the glossy graphs in financial reports. These are widely ignored, as are the smiling pictures.
In contrast, the 1902 report's discussion of risk, litigation, and environmental issues is much briefer, since legal and regulatory issues were not on top of managers' minds during those happy days. Back then, managers could focus on the business, rather than spend so much valuable time with lawyers and lobbyists; yet another reason for the vastly different 1902 versus 2012 operating performance of US Steel.3
Real Improvements Spotted?
Potentially more informative is the 2012 Management Discussion and Analysis (MD&A) section, mandated by the SEC in the early 1990s, in which managers discuss the main factors affecting the most recent financial results and economic situation of the company, compared with the previous two years. Such a managerial discussion was not required in 1902, and is in any case beyond the confines of the accounting system on which we focus.
In terms of accounting, the
