The End of Accounting and the Path Forward for Investors and Managers

by Baruch Lev, Feng Gu

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. 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.

Genres: Finance, Business, Accounting, Nonfiction, Economics, Management

288 pages, Hardcover

First published May 16, 2016

Reviews

[Zahwil Dossa · Rating 4 out of 5]

If you’ve ever bought shares in a public company, you may know the feeling of anticipating an earnings release, followed by the emotional surge or let down as the earnings either exceed or lag expectations (yours or those of the analysts that follow it).
The real head scratcher, though, is often the market reaction to those earnings. Sometimes the stock price surges following an earnings miss, while a consensus beat fails to rouse the market, or worse, precipitates a decline.
Do investors even read the earnings reports, you may wonder. Or, are we ensnared in another stock market bubble akin to 1999 when stock prices unhinged from reality?
What if the decoupling of stock prices from accounting earnings is due, not to the failure of investors to behave rationally, but to the failure of accounting to convey relevant, useful information?
This is precisely the hypothesis proposed, and empirically supported, by the authors Lev and Gu.
As an accountant (an admission I loathe to make), I have been taught to understand and apply the very rules and principles that underpin financial reports; yet I am as mystified as anyone by their connection, or apparent lack thereof, to stock prices.
Overall, it’s depressing news for accountants. If you believe the (largely regression based) evidence presented by the authors, the accounting machine of America provides only 5% of the information used by investors.
It’s interesting to note that their argument opposes the wisdom of finance gurus Benjamin Graham and his student Warren Buffet who have expressed that, while markets behave erratically from one day to the next, in the fullness of time the market will reflect intrinsic value.
Buffet’s yardstick for measuring intrinsic value is growth in per share book value, which he reports annually since 1965 with a side-by-side comparison to the growth in the S&P 500. And book value, as the name implies, is what’s on the books: the accounting value of a company’s assets minus its liabilities.
Lev and Gu spend most of their book chronicling how and why accounting earnings and book value as well as the ratios that employ these figures (e.g. Return on Equity and Return on Assets) are no longer relevant to investors.
So, the death knell they deliver to accounting can be extended to the entire filed of Value Investing, which is founded on the notion that investment opportunities reside among those companies that trade at low multiples of their earnings or book values.
For Lev and Gu, so called value stocks would not represent a fruitful pool of opportunities, because the accounting information is fundamentally flawed, and there is thus no reason for stock prices to align. In fact, the authors show that the correlation between earnings/book values and stock prices has significantly weakened over the last 50 years.
Why? Basically, for two reasons. The first is that accounting has failed to adapt to the modern economy. Accounting ignores the most valuable assets a company owns – it’s intangible strategic assets or those responsible for conferring that which investors care most about: enduring competitive advantage. These are assets (usually) missing from the balance sheet like human capital, information technology, R&D, patents, business platforms available for add-ons.
By expensing rather than capitalizing investments in intangible assets, a major distortion of earnings is introduced in the current period, while future periods will appear more profitable as the prior (unrecorded) assets start to generate income.
Second, accounting numbers are plagued by estimates – anything from bad debts expense to depreciation, pensions, stock options and goodwill impairment. Estimates are subject to both manipulation and error, managers do not report on the accuracy of their prior estimates, and investors have no idea how much of a company’s earnings were the result of estimates.
To fill the informational void left by accounting, investors have come to rely increasingly on non-GAAP measures such as Adjusted EBITDA and Distributable Cash as well as management guidance and quizzing management on conference calls. As the authors show, EBITDA and cash flow are easier to forecast and more highly correlated with stock prices than accounting metrics.
To remedy the many flaws of accounting, the authors introduce a new report which they call the “Strategic Resources and Consequences Report”.
This report is meant to distill in one page the business’ strategy and execution. It maps out the company’s strategic assets (i.e. those that are valuable, rare and difficult to imitate), tracks the investments that flow into these assets and describes how they are deployed in “value creation”. “Value Creation” is defined as cash flows plus investments that have been expensed, minus average capital expenditures, minus the cost of equity capital.
Their report is industry specific and they walk through four case studies to show how it can be applied to different industries.
Overall, I found the book enlightening and I admire the authors’ spirit to attempt to bring accounting into the 21st C, despite heavy resistance from entrenched interests of which they are all too aware.
I don’t hold out a lot of optimism that financial accounting will undergo any sort of dramatic change, but as an investor and manager, the book has altered my perspective on what matters.

[Heiko Daniel · Rating 2 out of 5]

This is an equally easy read for accountants and non-accountants alike, fairly untechnical and written in an engaging style. It also adopts a thought-provoking perspective where it references long-term empirical studies and compares financial statements side-by-side for the same company (U.S. Steel Corporation) for the years 1902 and 2012.

Having said that, I struggle to agree with most of the important conclusions in the book. After reading the empirical evidence cited in their support, I admit that I'm even more sceptical than if I had simply been told the authors’ opinions without the data. In my view, in almost all cases, the analysis either conflates matters that should be analysed separately or there are alternative explanations available that seem equally or more plausible to me and lead to different, generally less dramatic, conclusions. The evidence presented in the book does not suggest that we have reached the “end of accounting”, or anything like it.

Chapter 2, p. 18 – an analysis titled “Earnings Had Its Day of Glory” – lays much of the groundwork the book’s central message, i.e. that accounting (or financial reporting – an important difference) has become less relevant. It would be very good to see the continuation of the analysis since 2013. The one year that shows clear above-market return differences of trading on cash flows to earnings is 2009, a year of the financial crisis, and the same year that the authors state that they omit in other analyses in the book. Even if this is a trend, to consider this as evidence of the “end of accounting” is over the top.

It also seems to me that the conclusions in Chapters 4 and 5 that reported financial information is becoming less significant relative to analysts’ forecasts and nonaccounting SEC filings conflate the matter of timeliness of financial reporting and the usefulness of the information itself that is reported. Even if it’s true that analysts’ forecasts and other information increasingly replace the importance of reported earnings, consider what it is these analysts forecast – EPS, that’s (accounting) earnings per share. What if what’s really happening here is that, over time, the importance of earnings included in financial reporting has been replaced, to some extent, by analysts’ estimates of these earnings (with guidance from the company the analysts cover)? This explanation seems plausible and leads to less dramatic conclusions. Again, to consider any of this evidence for the end of accounting appears overblown.

It is true that, on the surface, the format and appearance of financial reporting have not changed much over a period of more than a hundred years, as the authors demonstrate with a very useful side-by-side comparison of U.S. Steel Corporation’s financial statements for 1902 and 2012. That's not surprising. The way accounting information is presented in the financial statements (in principle) had been developed over many years prior to 1902. The way I think about it is that financial statements may not have changed very much – but neither have the decimal numbers system or the letters of the alphabet. So what. All are just conveyors of information that used to do and still do their job. Indeed, this is what the side-by-side comparison of U.S. Steel's financials suggests: While the authors say “Seriously, a struggling enterprise, like the 2012 US Steel, providing the same information as the booming 1902 company?” (p. 4), one might point to the fact that the 2012 income statement shows a net loss – correctly, it seems, representing the economic reality of the business for the year. On the other hand, the 1902 income statement shows a profit – again, apparently correctly capturing that period’s economic reality. Doesn’t this support just the opposite of the claim in the book, i.e. that the accounting worked well in both 1902 and 2012, at least in respect of this particular company?

The authors make a valid argument (which has been made before) that much value can be omitted from a balance sheet prepared under GAAP, especially in relation to internally developed intangible assets. It may be true that the fraction of value that is not captured in GAAP balance sheets has increased over time. In a technology-driven, service-oriented economy, that is what one would expect (though I have learned that mismatching of revenues and expensed R&D conveys information about risk). The question, of course, is what to do about this, in accounting terms. The problem is this: valuing intangibles requires a multitude of estimates. This brings more speculation into financial statements (Benjamin Graham called it "water"). Imagine an accountant for the Wright Brothers capitalising an intangible knowledge asset titled “Flight Technology” or similar in 1903, at the dawn of aviation – do we really want accountants to put a value on these and similar assets? The issue is not one of value that doesn't exist, but that it is exceedingly difficult to measure (even with the benefit of almost 120 years of hindsight since 1903); and this opens the floodgates to speculation. Everyone is, of course, free to speculate about the value of knowledge and similar assets, but it is important, in my view, to keep that speculation out of the financial statements. Despite many years of considering the problem of accounting for intangibles, which I've followed at least since the dot-com bubble, I don't see that anybody has come up with a credible alternative to what's being done today. (This has not kept corporates who’d like greater discretion for inflating earnings from advocating these kinds of positions).
Here is another problem: The authors don't like many accrual accounting items that involve accounting estimates. They argue that many of the estimates involved in assets and liabilities valuations make these items similar to “fiction”. A sentence like “Accounting isn’t about facts anymore” (p. 78) is, however, over the top, in my view.

The solutions proposed in part 3 of the book involve adding certain industry-specific KPIs to corporate reporting. Maybe these things are useful. I admit I couldn’t get through this part. These ideas seem neither fundamentally new (even though the specific metrics may well be), nor is there anything that stops corporates from disclosing these things already, or standard setters from requiring additional disclosures. What’s clear is that these solutions aren’t going to replace double entry accounting or do much to reform accounting, and I'm pretty certain that we have not reached the "end of accounting”.

[Pedro Ceneme · Rating 4 out of 5]

This book is good in summarizing the main three shortcomings of accounting in reflecting reality of the modern business, namely:

I – increasing relevance of intangibles as a source of competitive advantage and investment focus of companies

II – Increasing usage of subjective estimates and valuation of key metrics by managers and accountants

III – Increasing relevance of facts that don’t immediately impact accounting values (patents, long-term contracts, failed tests, M&A, etc)

Mr. Lev argues that these three factors reduced greatly the relevance of earnings as a tool for making predictions about the quality and sustainability of a business, which I largely agree. The author writes in plain language and gives lots of examples. Segments II and III are the real highlights of the book, where Mr. Lev shows the main shortcomings of modern accounting, suggests a framework to better assess the strength of businesses and provides some examples of more informative metrics. Segment III puts all this together through four case studies. He also highlights how the incentives are somewhat skewed against better disclosures by several market participants, which contributes to reinforce the current status quo. Pair this book with Financial Shanenigans from Howard Schilit and you will have a great starting point to better interpret financial statements.

Nonetheless, I’ve found that the book could be more straightforward in some segments, with a lot of repetition. I also wasn’t completely convinced by the first segment of the book in which he tries to quantitively assess the amount (or lack of) explanatory power of earnings for stock price movement. The fourth segment is also somewhat dull because he spends a substantial amount of time detailing possible solutions for improving companies’ disclosures, which is interesting but maybe would be better suited to another audience.

[Ronald J. · Rating 5 out of 5]

Excellent empirical look at why accounting has lost its relevance to the community it believes it serves: investors. The authors are accounting professors and they are basically arguing that accounting is less relevant than ever in our knowledge economy. I couldn't agree more, and wrote as much in my own book, Mind Over Matter. If you're an accountant, this is essential reading to understand the number one issue facing the profession--relevancy!

[InvestingByTheBooks.com · Rating 3 out of 5]

There is something wrong with the accounting. It doesn’t appear to serve its purpose anymore. Baruch Lev and Feng Gu, two accounting professors at NY Stern and the University of Buffalo respectively, in a legible way explain why this is and what to do about it. This is not a book for those who want to understand the intricacies of today’s accounting, it’s a book that argues for a total overhaul of the way we practice accounting. The aim is to mobilize investors to lobby for a change towards a better accounting methodology.

In the main sections of the text the authors first try to convince the reader of their thesis that the usefulness of accounting numbers is in decline, then they give their main reasons for this and finally present a reform package in a section of the book that also contains a number of case studies from various industries.

So, what are the issues that Lev and Gu single out as indicators of a quality problem? They show how even having the gift of perfect foresight in forecasting quarterly EPS numbers has yielded gradually less outperformance since the 1990s. With a start in the late 1980s they show a declining correlation between historical sales, profits and book values and future ones rendering historic numbers less practical when making forecasts, with regards to what moves share prices new accounting data now contribute 5% of the movements compared to 10% two decades ago. This leads to higher estimate errors and increased estimate dispersion from analysts while the volatility of the underlying businesses has dropped. All this is, in the authors’ view, indications of the declining relevance of accounting numbers with regards to their key target group of analysts and investors. Although they present a convincing case this part of the book is a bit too agitating for my taste.

A large part of the explanation for the declining efficiency is that while the core principles of accounting haven’t changed for at least a century there has been a big shift in the structure of businesses. The center of gravity of the business world is gradually moving towards what’s called asset light companies. The thing is that even those companies have assets; they’re just not accounted for. In the 1970s the unaccounted intangible assets were estimated to equal half of the tangible ones on the balance sheet. Today, the ratio is the reverse. Thus, the number of non-accounting events that affect the value of a company has gone up. Further, the amount of subjective managerial decisions in deciding on values in the accounts has increased dramatically. Lev and Gu count estimate-related terms in financial reports (“expected”, “estimated” etc.) and show that they have increased 400% in just two decades and further that this change correlates well in time with the growing difficulty of using historic numbers to forecast future ones.

By decoding a vast amount of conference call Q&A transcripts from when companies report their quarterly earnings the authors try to reverse engineer what investors truly focus on. They conclude that companies should report 1) what the strategic resources of the company are that will help them get a sustainable competitive advantage, 2) how they invest in these resources, 3) what the risks are towards the resources value creating ability and what management is doing to mitigate them, 4) outline the strategies with regards to how the resources are deployed and 5) measuring and reporting the resulting value creation through a cash flow based economic profit measure that deducts the full cost of the capital used. This would create a relevant, industry- and company specific reporting. To not just add more things for companies to report they further suggest full semi-annual reports instead of quarterly and the abolishment of much of fair value accounting going back to cost based numbers to leave the valuation to investors.

After a, in my view, too sensationalist first half the authors actually present an unconventional and interesting solution on how to reform accounting.

[Oussema El · Rating 4 out of 5]

There are very few books on accounting that are exciting and innovative. Innovation has not been big in accounting, and that's in fact one of the points made by the authors in this book. However, I think the authors make claims that are too bold for the empirical results that they present in the first part of the book, and also in the later parts that attempt to convince the reader of the effectiveness of their innovative financial analysis method and disclosures. I suspect the authors did so to not be too technical and scare away readers not too familiar with modern causal inference. This however, makes those who are familiar with such tool skeptical of the argument made in the first part, or at least the degree to which those claims hold. Still, I found myself convinced of the authors final points and suggestions for how to make accounting reports matter.

[Alicia 🌻 · Rating 2 out of 5]

This was for school. I thought the ideas the authors had to say were very intriguing. As a student, you never think of what could change in the accounting world, you think of it as what it is. I think the authors were too sarcastic and depend too much on the readers to take the action they want. They may have had more success had they pushed this themselves and spoken to FASB and SEC and whomever else.

[Taylor · Rating 3 out of 5]

A very thought provoking book about how financial reporting can change to be more relevant for investors (and also surprisingly readable). I enjoyed the book, and liked many of the proposals made, but I don’t see the implementation happening as soon as the authors would like. That being said, once the point of the book was made clear, it was hard to pick up and be excited about.

[Rossana Peña Rivera · Rating 4 out of 5]

Un planteamiento atrevido pero convincente. Aunque creo que esta tesis esta un poco débil, es porque aun esta en panales. Sin embargo estoy de acuerdo con los autores de que hace falta unos cambios al sistema.

[Basili · Rating 1 out of 5]

Skimmed it. Not worth the time.

[Guilherme Dantas · Rating 3 out of 5]

Dava pra ter lido só o último terço

[Matthew Critchley · Rating 3 out of 5]

This has a brilliant discussion about intangible assets hidden accounting speak. Anyone interested in growth should read it.

[Aldwin Susantio · Rating 3 out of 5]

The authors argue that the usefulness of accounting has been diminishing. There are several evidence that back this arguments. First, the rise of intangible (patents, programs) that are not recorded as assets, even though those are valuable assets to generate revenue. Second, too many estimates in financial statement that make the end number doesn't reflect the true situation. Third, defects in accounting procedure itself. For example, when a company restructure itself, the cost of restructuring is recorded as expense, therefore substract company's profit. As the result, when the financial statement is released, there would be sell-off of the company's stock because investors doubt of the company prospect. The reality is the opposite, restructuring usually is followed by improving company performance, not the other way around. This evidence show that company's net income is not reliable to be used as investing consideration. There are some other scenarios that further support the argument just now in the book.

How should we face this situation? The author suggested that we fix current accounting system. The ideas proposed by this book are : Record intangibles as asset and demand the company to disclose information regarding its intangible; let investors do their own estimate of uncertain numbers or perform verification of the estimation to improve its reliability; and reduce accounting complexity to accomodate everchanging businesses.

This review is just the outer layer of the book. Read the book for more comprehensive-technical explanation.

[Nick Clark · Rating 5 out of 5]

Exciting books on accounting are few and far between - but here is one. An exceptionally clear exposition of the damage of currently US and IRFS GAAP including expensing of R&D, non-tangible assets, non-disclosure of key strategic industry metrics and significant overregulation which has manifested itself in a gradual decrease in financial statements ability to predict stock prices.