Editors’ Note: Published this past June, Baruch Lev and Fang Gu’s The End of Accounting and the Path Forward for Investors and Managers (Wiley) has generated a great deal of controversy within the profession. The CPA Journal presents two contrasting perspectives on this thought-provoking book: Arthur J. Radin questions whether the authors are right about the conclusions they draw from the data, and Thomas I. Selling agrees with some of their recommendations but disagrees about the linkages to value creation.
A Mountain or a Molehill?
Review by Arthur J. Radin
The book is certainly interesting and thought provoking. Lev and Gu claim that financial reporting as we know it today, and pretty much for the last century, is no longer giving investors useful financial information, or, to use their term, “decision-relevant information.” They support their position with many charts and analyses based on disclosures made by public companies and the effect on their share prices over a period of time. Their conclusion is that the financial statements now being issued are not relevant to investors, if they ever were.
The authors also believe that information that would be useful to investors is not presented in financial statements. The first 10 chapters of the book try to show that current reports are not productive; the remaining 10 explain what the authors believe is important to investors and how such information should be presented, as well as suggesting broad changes in U.S. GAAP. The authors buttress their argument by indicating that non-GAAP disclosures are becoming more and more prevalent in financial reports.
The State of GAAP
I share some of the authors’ criticisms of GAAP; however, the main thrust of the book is to seek a new basis, far away from GAAP. The authors devote the first chapter to describing a U.S. Steel 1902 financial statement and comparing it to a current one. Their position is that after 113 years, the standard can no longer be appropriate. I suggest that the lack of change is evidence of the validity of our time-tested financial statement concepts.
The authors’ mathematical statistical support is well defined, can be followed by one who has not taken statistics since college, and appears to be statistically appropriate. I disagree, however, with their analysis of the information. Their positions are based on the following:
- The issuance of corporate quarterly and annual financial statements does not move the markets. Prices are more responsive to non-financial reports.
- The ratios of total market value of companies to their earnings and their net worth to their total market value have declined over the last 65 years.
- Markets move more in relation to changes in cash flow than GAAP.
- The function of financial statements is to be predictive of future results.
- The determination that few analysts ask about the financial results, instead focusing on other developments.
For each of the above analyses, there is an alternative explanation that does not undercut the utility of financial statements:
- With the improvements in current reporting, the information that moves a market should not be in the quarterly financial reports. The SEC Form 8-K requires disclosure of any material event within four business days of the event. The later publication of the financial results merely confirms what is already in the news and should not have an immediate effect on the stock price.
- The world has changed over the last 50 years; certainly most companies are not evaluated primarily on book value. The authors’ analysis of the effect of reported earnings on values appears to be simply an analysis of price/earnings ratios and how they have moved over the years. I do not believe that such an analysis denigrates GAAP.
- Academia is more supportive of cash flow than GAAP. In view of all of the weaknesses of cash flow (the lack of accruals, delay in recording revenues, management’s ability to time receipts and disbursements), I do not believe it is a useful measure. Furthermore, since the cash flow statements are part of all financial statements, I do not understand why it is an issue.
- The purpose of financial statements is not to predict the future, but rather to show the present or recent past. Accounting is history; the financial statements are the beginning points from which predictions should be made.
- The job of analysts is to look beyond the financial statements. Media stories about reported results are written after the issuance of financial statements. At the time of the analyst calls, these are old news, and the analysts assume the reported results and look for something else.
The authors appear to have done a good job in computing the correlations indicated above, but have jumped to their conclusions while many others are possible—and, I believe, more probable. Correlation is not causation, nor is there only one reason for correlation.
The authors also point out items such as the appropriateness of expensing the costs of an acquisition, expensing research and development (R&D) costs, and the use of estimates. I agree that the widely used non-GAAP earnings disclosures are evidence that GAAP needs revisions, although not the ones they propose. In general, however, I think their case is weak and not supported. They also object to all estimating. Somehow, cash flow statements without accruals make no sense to me.
The authors wish to separate research from development and capitalize it all, subject to impairment testing. I am old enough to remember accounting before FASB Statement of Financial Accounting Standards (SFAS) 2, Accounting for Research and Development Costs, which was issued more than 40 years ago. At that time, those items that should or should not be capitalized could not be determined, and the conclusion was therefore to expense it all and eliminate the evaluation but disclose the total. I believe that the disclosure of the amount spent enables a careful reader to obtain almost all the information that the authors suggest. Furthermore, I do not believe that a split between research and development is realistic, having had to do it for software. Finally, the original SFAS 2 gives a wonderful explanation (paras. 37–59) of why expensing all costs is preferable to other alternatives. These paragraphs were dropped when GAAP was codified.
The book then addresses what investors really need from financial reporting. The book defines new reporting information as “Strategic Resources and Consequences Reports” and describes these reports for four industries: media, insurance, pharmaceuticals, and oil and gas. For each of these industries, the authors give a blueprint as to what financial disclosures should be made. The suggested disclosures are listed under five topics: resource development, strategic resources, resource preservation, resources deployment, and value created. For each of the four industrial examples, the authors list relevant information related to the particular industry. I agree with the suggested additional information; however, I also have the following criticisms:
- For each industry, the factors are considerably different. To prescribe their reporting, a template for each industry would have to be created.
- The authors eschew the use of regulation to require this disclosure. They seem to believe that there should, or will, develop a grassroots movement for such information. I sincerely doubt this.
- To compensate for the additional work in such a report, the authors suggest eliminating the three- and nine-month Form 10-Q reports. I am not sure there is a logical quid pro quo for eliminating two quarterly reports for their reports.
- Such reports would be filled with estimates. The authors seem to object to estimates.
- The authors appear to have chosen industries that best illustrate their point. But do these parameters apply to others, like retailers?
In summary, this area of the book is not accounting, but rather investment information suggestions. While the proposed reports would be interesting, and maybe even helpful from an investing point of view, they are in no way a replacement for traditional financial reporting.
An Insufficient Conclusion
After 10 chapters on the ineffectiveness of GAAP, Chapter 17, “So What Do You Do with Accounting? A Reform Agenda,” is a letdown. The authors suggest only the following: 1) capitalize internal intangible costs, subjecting such costs to amortization and impairment testing; 2) make better disclosure relating to intangibles primarily as to patents; 3) reduce estimates, including where there are estimates subsequent to reporting as to differences; and 4) reduce complexity. I note that the authors do not give the reasons why these suggestions have not previously been adopted. None of these suggestions is new or unreasonable. After ten chapters on the uselessness of accounting, however, I feel that the authors produced a molehill instead of a mountain. Interestingly, there is enough information in GAAP financial statements for a reader to make his own adjustments and arrive at the information the authors are requesting. Such adjustments are frequently the topic for the non-GAAP adjustments one sees in annual reports.
The authors also generally ignore uses of financial statements outside of their usefulness in predicting future stock prices. Users of financial statements also need them for such functions as reporting on stewardship, evaluating the use of resources, evaluating financial resources, and ascertaining the ability to weather a downturn.
The authors write in a fairly informal style that is not always well suited to the topic. They also like to use broad statements that are not supportable and sometimes wrong; for example, “Intangibles’ rise to prominence among value-creating corporate resources is the most profound business development of the past century.” They may believe that statement, but it is not supported.
In summary, while I feel that the authors have raised interesting questions, there are too many alternative explanations to justify the book’s title or thesis.
Accounting or Reporting?
Review by Thomas I. Selling
Like many accounting professionals, I share the desire to have a conversation about the diminishing quality of GAAP, and Lev and Gu contribute to the case for urgency. I also agree with some of their recommendations to improve financial reporting, but strongly disagree with their renewed emphasis on capitalization of historic costs, with matching of revenues and expenses.
Accounting and Share Prices
The authors’ recommendations are founded on evidence of weakening correlations between broad financial statement metrics and share prices. Share prices are the more reliable indicator of shareholder value creation, but the power of accounting is realized through a process of deconstructing a broad indicator of performance (e.g., return on equity) into components that have the potential to explain actual economic effects.
Especially in light of the 2008 financial crisis, I do not consider this type of analysis to be the final word on the relevance of accounting. Among other things, accounting supports regulators charged with ensuring the safety and soundness of financial institutions. For this purpose, measurement of capital adequacy would supersede measurement of value creation. Similarly, the public has a stake in corporate governance. Accounting should not be an artifice of management for misappropriating shareholder wealth.
Moreover, it need not be the case that correlation with share prices must increase in order for accounting to gain in decision usefulness. For example, I support the authors’ call for greater detail in key areas, including the presentation of expenses by nature as well as by function. And if they are correct that reported cash flow from operations is a valuable performance metric, more detail would also be called for, which would be presented by the direct format.
In fact—although the authors do not point this out—FASB proposed just these sorts of changes seven years ago, along with detailed roll-forwards of balance sheet accounts. Yet FASB has, shamefully in my opinion, acceded to pushback from issuers. Evidently, “revealed preferences”—an economic concept the authors invoke to describe how relevant disclosures can evolve without regulation—is a double-edged sword.
I also support the authors’ call to provide standardized disclosures of operating statistics and to bring these disclosures within the scope of the auditor’s report (as appropriate). In the spirit of its own rules, and consistent with the examples cited by Lev and Gu, the SEC has recognized that financial statements in isolation can be misleading. Requirements to disclose key performance indicators for more industries, along with the accounting enhancements described above, would be most welcome. This would prevent GAAP from being misleading in the ways that the authors describe, and it would also ratchet up the quality of MD&A without changing its principles-based requirements.
If accounting is at its “end,” a few common-sense changes could bring forth a renaissance; however, none of these changes would affect the correlation between broad accounting metrics and share prices, a recurring theme of this book.
Accounting versus Financial Reporting
Differences of opinion as to the future of accounting could also arise because of a distinction that should be made between “accounting” and “financial reporting.” Like no doubt many accountants, I hew to the view of accounting in the historic sense as related by Jacob Soll in The Reckoning: Financial Accountability and the Rise and Fall of Nations (Basic Books, 2014). If done well, it is a clear-eyed assessment of a subset of an entity’s assets and liabilities, along with how these have changed over time. Accounting is an important component of financial reporting, but linkages from accounting to value creation are purposefully limited in this view.
From a distinction between accounting and financial reporting, it is understandable that we would differ on what accounting should measure, how it should be measured, and who should do the measuring. The accounting for R&D as a deferred cost is a prime example of the “what” issues. R&D is now expensed under GAAP because the discretion to capitalize was abused by issuers; too much of the R&D that should have been expensed was capitalized, and vice versa.
I have already commented on the “how” and “who” of measurement at length in the CPA Journal (“On the Coexistence of Professionalism and Commercialism in CPA Firms: A Path Forward,” May 2015). In brief, there is no law of nature dictating that management must produce the estimates that go into financial statements and by extension their own compensation; there are only auditing standards. If independent appraisers were to produce estimates of current costs of assets, then accounting rules could be much simpler, and management would not—to the great detriment of the investing public—be calling their own balls and strikes.