We’re about to enter “earnings season,” when publicly traded companies release a quarterly snapshot of their financial performance.
Feng Gu, associate professor and chair of the accounting and law department at the University at Buffalo’s School of Management, says the information companies share doesn’t tell investors what they truly want – and need – to know. He and Baruch Lev, a New York University professor, made their case in a book they co-authored, with a bold title: “The End of Accounting and the Path Forward for Investors and Managers.”
“We’re not calling for the complete stop of the current (financial) reporting system,” Gu said. “We’re basically interested in getting people to think about important ways to improve the system, and provide proposals.”
Gu and Lev spent lots of time conducting research and reviewing transcripts of more than 200 earnings conference calls, when corporate executives and financial analysts engage in a give-and-take about quarterly results. The most eye-catching conclusion the co-authors reached: Traditional accounting figures, like earnings per share, don’t move the market the way they once did.
Gu shed light on what he and Lev learned and suggested changes to the system to benefit investors in a recent interview.
Q: What led you and your co-author to write this book?
A: We have seen a lot of research evidence – not just from ourselves, also from other people – showing the relevance of accounting information has been declining since the ’80s. We have been talking about 30 years of declining accounting usefulness, which is not something very trivial, because most people agree with the point that accounting information is very important.
We talk about the unique importance of accounting by saying accounting numbers move the market. I think most people who are familiar with the idea of accounting could not disagree with that. This evidence of declining accounting usefulness is enough to make us as researchers pause and think, “Wait a minute, this is supposed to be very important. How come the importance has been declining over time?”
Q: You read lots of companies’ conference call transcripts. What were the analysts curious about?
A: Financial analysts are widely regarded as the most sophisticated investors. They spend their whole life and career tracking the performance of publicly traded companies. Their main job is to help investors understand the performance and the changing risk of each company, so this way investors can make decisions about whether or not they want to invest in a given company.
It turned out the majority of analysts’ questions and interests are not along the line of traditional financial reports. So for example, when a company like Sirius XM comes out with its quarterly earnings, the CEO or CFO starts with a quick mention of the earnings per share, which is really one of the key numbers that is included in companies’ financial reports. Quickly, everybody forgets about earnings per share and they talk about something else that is not required by the system financial reporting, that is not included in the standard financial reports. … After reading 200, 300 such examples, we got a very clear sense that investors are not interested in what is included in the standard financial reports. They are interested in something more important, something that is not being reported by companies today.
Q: Such as?
A: For example, with pharmaceutical companies, [analysts] don’t care too much about the current quarter earnings or sales. They’re more interested in what projects, what products each company is currently working on, the so-called product pipeline. What is [already] out there is providing the current sales and earnings, and the investor already knows a lot. What is going to come in the future is going to be powered by the products that are currently under development. So that’s certainly something the current financial reporting system does not require companies to share. Many companies are indeed sharing this kind of information on a completely voluntary basis.
Our conclusion is, the current framework of financial reporting is not really what investors want. Instead, they want to have information about each company’s strategic assets. These are the kind of assets that provide a company with a long-term sustained competitive advantage, something that is difficult for competitors to imitate. ... They want to know what assets are providing strategic value to each company, what steps are being taken by the company to protect the value of these assets, because if you don’t protect it, competitors can infringe on your key patents, they can try to follow what you’re doing. … And finally, what kind of value is being created by strategic assets?
Q: Your book contends accounting information used to influence the market more. What changed?
A: If you go back to the early ’50s, accounting numbers were extremely powerful in moving the market. Starting from the mid ’80s, things have become quite different. Accounting numbers have lost more than half of their relevance, compared to the golden days of the ’50s. What we think has happened and contributed to this change was the arrival of the Information Age, the knowledge-based economy. ... There are several key turning points. The first one is the mid ’80s. That is when the [personal computer] revolution started. Microsoft became a publicly traded company. ... Roughly 10 years later, the internet revolution started. Netscape goes public. ... In these two turning points, you clearly see the trend.
Q: Where should things go from here?
A: I think in our book, we made a point very clear that regulators have to require companies to treat investment in their strategic assets as investment for accounting purposes. ... Most of the investment in strategic assets like R&D, advertising, branding and so on, are not being treated as an asset on the balance sheet of the company. They’re being treated as just a one-time expense. … This is the least that regulators can do to correct the information problem that we have documented and other people have documented.
Q: Do you think the changes proposed in the book will happen?
A: We have actually received a lot of calls from practitioners, financial analysts, corporations, even auditors, to talk about possible approaches to help them improve their current practices. I think changes will probably start from the bottom, instead of starting from the top.