Problems in accounting statements
Feng Gu and Baruch Lev give more details on the problems with financial accounting in their recent piece for the Financial Analysts Journal. They argue that: “Simply put, earnings no longer reliably reflect changes in corporate value and are thus an inadequate driver of investment analysis.” (Gu and Lev, 2017, page 25). According to the authors financial accounts are not much use to investors.
They suggest that the current system of accounting was useful in accounting’s golden days, when the income statement was highly informative. Unfortunately, according to the authors, the world has changed — largely through much greater investment in intangible assets. In this time “..accounting regulators were–and still are–asleep at the wheel, treating the value-creating intangible investments as regular expenses” (Gu and Lev, 2017, page 25). This means that: “Consequently, corporate income statements now mix expenses and substantial investments, stripping earnings of their most valuable use: an indicator of value creation” (Gu and Lev, 2017, page 26)
It isn’t even wrong in a consistent manner
If financial accounting always ignored intangibles, i.e. they were always treated as expenses, in some ways that would be better. The resulting accounts would be easier to interpret and adjust to something meaningful. The accounts aren’t, however, even consistent. Some intangibles are capitalized, (recorded as assets), largely when they are purchased from a third party. This means the numbers, even though obviously biased, can’t be compared as the errors depend upon past, now likely irrelevant, corporate strategy. The financial accounts of firms are all wrong but each in their own unique ways depending upon defunct historical factors.
What to do?
Gu and Lev give their own way of valuing firms, including a simple customer valuation model. (Probably a bit too simple I’d say but it is at least interesting and practical). They suggest analysts should focus on better understanding the firm’s competitive advantage. They give a model of strategic competitive analysis. They suggest a strategic assets inventory, looking at investments in such assets, plus how the assets are protected and deployed to create value.
It is fascinating to see such views coming from respected accounting professors. What financial accountants have to do is hard, so I don’t want to be too negative. Yet I can’t help but agree with Gu and Lev that there seems to be a certain complacency in financial accounting. The current system is thought to be working if not too many disasters happen. The problem is that what is being produced isn’t necessarily useful for anything. Without a clear use it is hard to justify the amount of time and money firms devote to financial accounting. If Gu and Lev are right and investors shouldn’t bother to use financial accounts for their investment decisions it does cast a lot of doubt on the point of the whole enterprise.
Read: Feng Gu and Baruch Lev (2017) Time To Change Your Investment Model, Financial Analysts Journal: A Publication of the CFA Institute,73 (4) pages 23-33.