THE END OF ACCOUNTING

Baruch Lev - Feng Gu

Subtitle: and the Path Forward for Investors and Managers, Wiley, 2016 pgs., index, tables, notes for each chapter

Reviewer comment - The 'end'' in this title does not mean 'end' in the sense one might assume as conclusion, finish, death, or similar. It means 'end' in the sense of purpose - the objective one seeks in a process. In this sense the authors claim, and provide much statistics and research, that public accounting as practiced by the profession today does not accomplish what it should - that is provide important and useful information about the real 'value' of businesses that would enable better investing. Each chapter in Part I builds on analysis of a particular aspect of accounting as a means for assessing 'value'. In Part II the authors present case studies in which they use their proprietary models to evaluate companies in different industries to find real 'value' relevant to making decisions about investing. In Part III they discuss how both professional investment analysts and individual investors may improve the results of their efforts to evaluate businesses.
The authors are not accountants but users of the data provided by accountants which appear in corporate documents such as profit and loss statements and balance sheets. They claim and show by statistical methods that the mass of financial information produced today is not being used as much as in the past by either investment advisors or individual investors. And they explain why in their opinions this has happened. They also discuss what are the most important variables that do have value for such evaluations and why they are not included in much of the financial reports from accountants.

Finally, note that the authors use their own company's proprietary models to demonstrate how they can do better.
As an added bonus, we have specific investments in each of the four industries the authors examine as case studies, so their detailed descriptons of what creates the most value for these is of particular interest.

The Book in a Nutshell
This is a very convenient summary, up front, of the content of the book.

"The Fading usefulness of Investors' Information"

They state their thesis, which is that the mass of financial documents provided today is highly regulated by governments but nevertheless contains less and less really valuable information that would enable investment decisions.
"Hard to believe, despite all the 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".
"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 that you should seek for substantially improved investment decisions".
"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".
The authors continue by describing what value the book holds.
"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".

"Financial Information, a Major Driver of Economic Growth" In this section the authors state that the current lack of real value of the financial information produced by current accounting methods not only prevents individual investors from maximizing their profits from decisions but also greatly inhibits the country's economic development. Faulty decisions based on faulty information have hampered the economy. |

"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".

"Unique Among Regulations"

"Accounting usefulness deserves critical examination, not only because of its central economic role, but also due to its unique, yet little known, institutional status". Accounting regulations "have, in fact, a legal status, because public companies have to follow them to the letter in generating financial information".

"What's also unique about financial reporting regulations is that they keep expanding constantly increasing the social cost burden".

Well they do indeed keep expanding, but in our society that is not unique.

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".

Chapter 1 - Corporate Reporting Then and Now: A Century of "Progress"

The authors provide a 'case study' that compares the corporate financial reports of U.S. Steel in 1902 to those of 2012. They show that these are substantially the same. They focus on the same types of information despite the drastically different positions the corporation occupied in the economy in 1903 and 2012. They analyze the full annual corporate report and rather sarcastically note what has been added by way of glossy photos and boilerplate discussions of this and that. They do give credit to the "Management Discussion and Analysis section that is required by the SEC since the 1990's but note also that this is not the accounting information. They remark about the 54 pages of footnotes as well.
"Still, we find striking that the far-reaching changes in corporate strategy and business organization over the past century didn't have any effect on the structure of corporate financial reports - especially considering that there was, for example, no outsourcing in 1902, currently rendering physical assets in many companies immaterial, nor was information technology a leading asset early in the twentieth century; alliances and joint ventures were rare; and just-in-time strategy didn't reduce the importance of inventory".

Chapter 2 - And You Thought Earnings Are the Bottom Line

This chapter is about the influence or lack thereof on actual stock markets by current products of the elaborate accounting process. It is one aspect of the authors' claim about the reduced influence of financial information for investors.

"Forecasting corporate earnings (income) is a major endeavor of financial analysts, whether working for investment banks and independent outfits or hedge funds and private equity firms". Such analysts need these reports when preparing estimates of future stock and bond values, which, in turn, influence investors' decisions.

"Undoubtedly, the prediction of corporate earnings by elaborate models and multiple inputs is a pervasive and influential investment mechanism".

But then the authors turn to corporate cash flows and demonstrate that prediction of this variable is also a valid predictor.

Their conclusion: "We examined in this chapter the two most prevalent uses of reported corporate earnings: generating earnings forecasts to guide investment decisions and assessing corporate performance by earnings surprises. In both cases, we found that the relevance of reported earnings to investors faded".

Part One - Matter of Fact

"In this part of the book, we provide comprehensive, large-sample - but very intuitive - evidence on the fast-diminishing usefulness to investors of accounting and financial report information".

Chapter 3 - The Widening Chasm between Financial Information and Stock Prices In this chapter the authors use statistical methods to perform correlations between the publication of various accounting created financial predictions used by investors and subsequent changes in actual market values of stocks.

"It is, therefore, appropriate that our tests of the usefulness of financial information will mainly consider the role of this information in investors' decisions".

Their conclusion: "The usefulness of financial (accounting) information to investors is reflected in the association between key financial variables and companies' stock prices. We have provided in this chapter comprehensive evidence that this association deteriorated markedly over the past half century, a clear sign of the loss of accounting's relevance".

Chapter 4 - Worse Than at First Sight

In this chapter the authors claim to employ 'more sophisticated research methodology to examine the contribution of financial information to investors"...

Their conclusion: "The research methodology we use in this chapter allows us to focus on the unique information contribution of financial reports - to new, decision-triggering content of their message - relative to competing information sources". The result was a decline in the value of the accounting product.

Chapter 5 - Investor's Fault of Accounting?

In this chapter the authors examine to possible alternative consideration - that the decline in relevance and results is not due to a decline in accounting products' value but rather has been due to investors themselves. They have become less 'sophisticated' or more 'irrational' in their stock selection decisions. After displaying their statistical model results in various graphs they conclude: "The tests provided in this chapter lay this belief to rest". The culprit they identify is the "increasing mass of accounting regulations that contaminate the earnings with multiple nonrecurring, transitory items".

Chapter 6 - Finally For the Still Unconvinced

In this chapter the authors bring out their heavy artillery. "We show that measures of financial analysts' uncertainty, or ambiguity about the future prospects of the companies they follow have been trending up during the past three decades".

To demonstrate this the authors proceed to statistical analysis of the spread between numbers of professional analysts who provide buy and sell recommendations on the same stock at the same time. The 'dispersion' (standard deviation) of analyst predictions around a consensus estimate has been growing. Their point is that if the body of 'expert' analysts cannot reach consensus in their conclusions, how can investors hope to use financial information to make worthwhile buy or sell decisions.

Comes the kicker: "We'll conclude with an important lesson for investors and managers: The increasing analysts' disagreement and bewilderment reflected by Figure 6.1 (the diagram) suggest that you shouldn't take analysts' earnings forecasts too seriously".

"Bewilderment" indeed.

Chapter 7 - The Meaning of It All

In this brief chapter the authors seek to demonstrate or at least convince investors that it is important, nay critical, for them (and for their professional advisors) to get with it and employ better analytical tools and accounting procedures to enable better stock picking.

Part Two Why is the Relevance Lost?

Now we arrive at examination of the 'causes' of this travesty in accounting. And we find the authors identify several actually well known developments in the business world itself.

"1. The inexplicable accounting treatment of intangible assets - the dominant creators of corporate value". OK, we read very frequently in the press about how critical such variables as patents, brand, IT, and many others are now in producing 'value' for an organization. The authors inform us that required accounting regulations still focus on the old (tangible) things like physical plan and inventory.

"Corporate investment in intangible capital now surpasses investment in physical assets by a wide margin, and the gap keeps growing".

(President Trump for years has complained to Forbes that they are undervaluing his real net worth - [around 3 billion when he claims 10 billion] because they are not giving credit for his 'brand' namely his name, which appears on everything.)

"2. Accounting isn't about facts any more". This, they claim, is because so much 'estimates' from management have entered the process.
"3. Unrecorded events increasingly affect corporate value". By this they mean that official events that enter accounting are external generators of debits and credits. But nontransactional business events such as activities in IT or product development, do not.

Chapter 8 - The Rise of Intangibles and Fall of Accounting

In this chapter the authors examine the first issue - "the surge of intangible assets - to become the prime value creators of businesses". The authors's evidence about this is extensive and frequently mentioned in the general press.

Their conclusion: "Intangibles' rise to prominence among value-creating corporate resources is he most profound business development of the past quarter century. This change affected -every facet of the business world - except accounting".

Chapter 9 - Accounting: Facts or Fiction?

This chapter examines the second point above - whether accounting is providing real facts or fiction.

The problem: "Accounting items - like revenues, expenses, and assets - are increasingly based on managers' subjective estimates and projections, which sometimes amount to sheer guesses".

Their conclusion after much display of statistics: "We have documented a steep increase during the past two-to-three decades in the number of subjective managerial estimates and projections underlying financial (accounting) information, and directly linked this rise in estimates to the deterioration of financial information usefulness".

Chapter 10 - Sins of Omission and Commission

In this chapter the authors offer yet another causal factor. "This is the disturbing fact that despite accounting's aura of exactitude and comprehensiveness, there is an increasing number of important, value-changing business events that escape the accounting net or that are reported in a systematically biased manner".

Wow

The authors' summarize in concluding: "Having provided in Part I of the book comprehensive evidence on the fast-deteriorating usefulness of financial information to investors, we turned in Part II to investigate the main causes of this highly disturbing finding. we identified three major causes: a wholly deficient accounting treatment of intangible assets - the increasingly dominate creators of corporate value; the growing prevalence of subjective managerial estimates and projections underlying financial information that decrease its reliability; and, in this chapter, the delayed, or biased recognition of important business events".

Part III So, What's to be Done?

The authors comment that there have been many complaints published already but little has been done. They believe the proposed remedies have not been 'comprehensive' or 'workable'. They cite several examples, for instance with respect to Netflix and Exxon. They propose a more comprenensive solution described in the following chapters.

Chapter 11 - What Really Matters to Investors (and Managers)

In this chapter the authors propose their own system named - The Strategic Resources & Consequences Report. In developing this they derived five criteria for information usefulness.
"Usefulness attribute no. 1 - Inform investors about the strategic resources of the enterprise".
"Usefulness attribute no. 2: Inform investors with specificity about the investments made in the process of building the enterprise's strategic assets".
"Usefulness attribute no 3: Quantify and report the consequences - value creation - of managers' activities in increasing, preserving, and deploying strategic assets".

They create and display a form in which this "Strategic Resources & Consequences Report" shown. They note that the relevant information to be included in this form and report will be different for each kind of industry. This itself will be an improvement because so much of standard accounting today is presented in uniform fashion which ignored such differences between types of industry. They assert also that the content gathered and presented in this format eliminates that causal deficiencies they have identified in previous chapters.

Chapter 12 - Strategic Resources & Consequences Report: Case No. 1 - Media and Entertainment

In this chapter they create their report in a format and with content relevant to the media and entertainment industry. For this industry "its customers are the most important strategic asset". The industry is very competitive, has low entry barriers and has significant vulnerabilities. They use Sirius XM as a sample to demonstrate how variables relevant to this industry should be assembled and evaluated.

Chapter 13 - Strategic Resources & Consequences Report- Case No. 2 - Property and Casualty Insurance

This obviously is quite a different industry. In this chapter the authors first note that there are three different segments - property and casualty - like and health - and reinsurance - They demonstrate only with relevance to the property and casualty industry. This too is a highly competitive industry with high risk relative to other insurance segments. Its most important strategic asset is its customer franchise. They discuss AARP, Allstate and Geico. As a bonus this chapter contains an interesting analysis of this industry.

Chapter 14 -Strategic Resources & Consequences Report- Chase No 3 - Pharmaceutics and Biotech

The chapter now focuses on a really specialized industry with its own unique problems. One of this industry's key activities is research and development (R&D), much more significant for these than for the previous two industries. Currently they do not provide much investment useful information on their R&D programs.

"The major strategic resources of drug and biotech companies are in-line products and their underlying patents, the product development pipeline, trademarks and other intellectual property and key human resources".

The authors note that, "As in the preceding case study of insurance companies, practically everyone is a customer of drug or biotech companies". But few of these are happy about results. The authors use Pfizer for a case study. The authors compile their report with different content.

Chapter 15 - Strategic Resources & Consequences Report - Case No 4 - Oil and Gas Companies

Again, we find a very different kind of industry used for the case study on what to include in the report. This industry encounters extreme external volatility from geopolitical events and environmental issues. It is subject to significant political pressures and manipulations.
As the authors note: "Oil and gas resources are exposed to a higher level of threats and risk than the resources of most other companies". Their operations require great levels of capital and labor so cost containment and operating efficiency are critical.

They continue: "The unusual oil and gas business challenges and complexities tax the limits of the accounting and financial reporting system. The balance sheets and income statements of oil and gas companies fall short of articulating the underlying and crucial constant strategic repositioning of these enterprises - dynamic portfolio management - where resources are frequently bought and sold to enhance the quality and productivity of the asset portfolios". .. "The most important activity of oil and gas companies, and the most difficult for investors to comprehend is the continuous repositioning of the resources portfolio". The authors conducted detailed examination of the earnings conference calls and investor day presentations of the 10 oil and gas companies, large and small, that they studied. From this they compiled data on what the investing public was asking about - what is most important to investors. "Very few questions were aimed at information items disclosed in financial reports". "Accordingly, the proposed oil and gas Strategic Resources & Consequences Report aims to get a clear handle of the company's strategy and its execution, piercing the thick veil of complexity of oil and gas operations and enabling investors to assess the performance of companies and their ability to maintain long-term competitive edge".

Part Four - Practical Matters

The following chapters will address three practical issues.
Implementation. How can the disclosure paradigm be implemented?
Accounting. How should the accounting and reporting system be restructured?
Investors' operating instructions. How should investors' financial and securities analyses be changed to best utilize the proposed strategic information for improved performance?

Chapter 16 - Implementation

In this chapter the authors describe how the Strategic Resources & Consequences Report could be implemented by companies. This will require that the missing information be collected. This would add to the burden on corporate management. They use Pfizer as an example of a company has begun to provide important information, but this took over a decade to accomplish. The authors propose that the SEC require more disclosure. And corporate managers should be educated about how important this is so that they would be less reluctant to respond. At the same time the regulators should reduce the volume of currently required reports that have no or small value. For instance standard reports now required quarterly could be cut to only semi-annual reports. But it will be up to analysts and investors to agitate for more of this reporting.

Chapter 17 - So, What to Do with Accounting? A Reform Agenda

In this chapter the authors propose major changes to the accounting and reporting system. A gradual 'fine tuning' approach has not and will not be sufficient.
They propose:
1 Treat Intangibles as Assets and Improve the Disclosure of Intangibles
2. Reverse the Proliferation of Accounting Estimates - Leave Valuation to Investors but Enable the Verification of the Remaining Managerial Estimates and Forecasts
3. Mitigate Accounting Complexity - They have coined their own Lev-Gu law on the dynamics of regulation. "Regulatory systems strive to be even more complex than the structures or institutions they are charged to regulate". "The numbing complexity of the statutory corporate financial information system constantly on the rise, is a major contributor to its deteriorating usefulness".

Of course this is an attribute of all aspects of bureaucracy in all civilizations as Toynbee documented over 60 years ago. And Joseph Tainter has described it recently in his excellent study - The Collapse of Complex Societies.

The authors propose several specific changes:
Adapt accounting to the revolutionary change in the value-creating resources of business enterprises.
Avoid the valuation in financial reports of assets and liabilities that are not traded in active markets.
Reduce accounting complexity, primarily by avoiding ruling on industry specific infrequent transactions.

Chapter 18 - Investors' Operating Instructions In this chapter the authors summarize the main lessons that investors should learn. "It is up to investors to change their approach to analyzing the performance and long-term competitive position of twenty-first century business enterprises". They should focus on analysis of strategic assets.

They comment: "Traditional securities analysis focuses on symptoms, like sales, earnings, profitability and solvency. But these are backward -looking consequences of past deployment of strategic assets".
They propose a new method: "Assessing Enterprise Performance and Competitive Edge: The New Approach"

"First Step: Taking an Inventory of Strategic Resources" Some examples include: The customer franchise - the Product pipeline - Brands of consumer goods - Unique talent - Patents .
"Second Step: Creating and Maintaining Strategic Assets" "Strategic assets have to be constantly maintained, adapted, or replaced".
"Third Step: Successful Deployment of Strategic Assets" "Success is shown by value creation: Primarily organic sales growth and positive residual cash flows".
They throughout are strong advocates for focus on residual cash flow.

Epilogue: Advocacy Needed This is a one page pitch urging the readers to overcome inertia - not mainly their own, but that of the industry and its regulators. Those recognizing that change is critical must organize and agitate. They kindly offer to assist.