Strange; there are very few accounting papers examining the informativeness of financial reports and the effectiveness of standard-setters in providing useful information to investors and other stakeholders. Even fewer dare to propose changes to the current accounting system. The exception was a spate of studies subsequent to the adoption of IFRS, examining the improvement of information. But not much after that. We generally prefer to work on other issues, like corporate governance, debt contracting, analysts forecasts, or earnings management than on our “bread and butter”—the effectiveness of financial report information and regulation, and changing the system.
The few exceptions to the above generated very interesting and sobering findings. For example, Dichev and Tang (“Matching and the changing properties of accounting earnings over the last 40 years,” The Accounting Review, 2008) report that as a result of the increasingly poor matching between revenues and expenses in the income statement, due to the FASB and IASB adoption of the balance sheet model, earnings volatility continuously increases and earnings persistence (predictability) decreases. Obviously, the usefulness of reported earnings to investors deteriorates. Khan, Li, Rajgopal and Venkatachalam (“Do the FASB’s standards add shareholder value?” working paper, 2016), examine comprehensively the impact on investors of all the FASB standards issued from 1973 to 2009 and report that 75% of the standards had absolutely no impact on investors; 13% of the standards decreased shareholder wealth; while only 12% of the standards increased value. The overall impact of all the standards was negative. Standards requiring managerial estimates—practically all the major FASB rules issued in the past quarter century—were the most value decreasing. Amazing. Such intriguing findings seem to call for additional research, but not much of this regulatory, effectiveness research is in the works.
Three years ago Feng Gu and I embarked on a comprehensive empirical examination of the usefulness of U.S. financial information to investors. This work culminated in our book: The End of Accounting and the Path Forward for Investors and Managers (Wiley, 2016). We do three things in this book: (1) We assess the usefulness of financial information to investors over the past 60 years, using a battery of tests (going well beyond the conventional regressions of market values on financial information). Our conclusion from all those tests: There has been a continuous deterioration of usefulness and use of financial information, particularly from the mid-1980s (more on this below).
(2) We empirically explore the reasons for this “relevance lost” and identify three major reasons: (a) The dramatic increase from the mid-1980s in the role of intangible assets in corporate business models—the rate of investment in intangibles in the U.S. is now double the rate of investment in tangible assets. The accounting glaring deficiencies and inconsistencies in recording and reporting on intangibles are well known and contribute to the information relevance lost. (b) The constant increase in influential managerial estimates underlying financial information (marking-to-market of nontraded assets/liabilities, impairment of assets and goodwill, etc.). All these estimates, many of which are essentially guesses, increase information noise and decrease its reliability. (c) More and more events (in contrast to transactions), like clinical test failures of pharma and biotech companies, or reserves changes of oil and gas companies, impact significantly corporate value but are not reflected in a timely manner by the accounting system.
(3) The third, the longest part of our book is devoted to the development of a new report—the Strategic Resources and Consequences Report—which addresses investors’ concerns. How do we know about investors’ concerns? We spend a considerable amount of time analyzing hundreds of quarterly conference calls between managers and investors/analysts in four major sectors (media & entertainment, oil & gas, pharma and biotech, insurance) to clearly understand the information needs of investors. We structured our proposed report to fulfill those needs, namely focus on the value-creating strategic assets of enterprises and their deployment to create values. We demonstrate the report in detail for the four industries.
I don’t know about you, but having taught accounting for many years in major universities I am frankly embarrassed to devote whole classes to topics like inventory (discussing the exciting issues of LIFO and FIFO), fixed assets (elaborating on various depreciation methods), accounts receivable, etc., etc. In today’s business environment, where the five largest companies in the world by capitalization are Google (Alphabet), Amazon, Apple, Facebook, and Microsoft, to devote considerable time to property, plant & equipment, inventory, accounts payable and accounts receivable, or to the fair values of machines and buildings doesn’t excite my students, and this is an understatement.
In contrast, to deal with the measurement and reporting of firms’ strategic assets—the real value drivers—like R&D, patents, brands, streaming content, or major business processes (Amazon’s and Netflix’s recommendation algorithms), is much more relevant to 21st century students, and frankly, much more fun. To discuss how corporate information can track the strategies of companies and their execution is more exciting and relevant than tax accounting. To analyze how can financial reports reflect the value and performance of the fast-growing “platform companies” (Uber, Airbnb)—companies without traditional assets—is truly intellectually challenging. To try to understand what is missing from the balance sheets of Google, Amazon, Apple, Facebook and Microsoft, with an average market-to-book ratio of 9.0, is fascinating. To explore how can we account and report for “data,” the world’s new and “most valuable resource,” according to the Economist (May 6, 2017) will really stretch your students’ imagination. I would rather do that in class, rather than continue teaching accounting the same way that I have been taught decades ago.
Why do I say all this? Because our book, The End of Accounting…, lays out the foundation for such a new approach to effective financial information use and improved accounting education. Our shift of focus from traditional accounting and reporting to what currently and in the future will concern financial information users should, I believe, be of interest to all accounting educators. And this is not only for teaching: the research opportunities in this pace are truly exciting. But, on this, in a forthcoming post. I welcome discussion of these issues in this blog, or on my own blog - https://levtheendofaccountingblog.wordpress.com/ - on which I regularly post related topics.