Tension is Mounting in Financial Accounting
Accounting Professors Baruch Lev and Feng Gu have written a very important book on the need to update century old accounting practices. They open their book by presenting the financial statements for U.S. Steel in 1902 and 2012. There point is that not much has changed from an accounting standpoint, but from an economic standpoint U.S. Steel’s profitability dramatically declined over the century.
Lev and Gu describe in great detail the accounting and finance literature demonstrating the 50 year decline in importance of traditional accounting data’s influence on stock prices. Although stock prices do move in the very short run in response to earnings announcements, over the intermediate term they respond far more to non-accounting data.
According to Lev and Gu the problem with current financial accounting is that it ignores intangible assets that are developed internally, for example research and development, trademarks and investments designed to improve organizational efficiency. All of those expenses are expensed. The authors would capitalize them, which is exactly what occurs when those assets are acquired in a merger or by individual purchase. Second accounting today is more about estimates rather than hard facts. These estimates would include the provision for bad debts, pension expense, stock option expense, and even revenue recognition. Finally accounting does not take into account such unrecorded events as the receipt of a patent, a new drug approval, the signing of an important contract, and the rise or fall in the number of subscribers. It is this last category that seems to matter the most to investors. For example yesterday Netflix reported better than expected earnings, but far fewer than expected new subscribers. The result the stock dropped 15% in a heartbeat.
To remedy the situation Lev and Gu would like to see corporations present a more fuller “Strategic Resources and Consequences Report.” This is really a very enhanced management discussion and analysis section that would take into account the issues raised above. The problem here is whether accountants are capable of producing such a report and whether or not management would be candid enough to put it in writing. One would hope so, because it goes to the heart of what serious analysts are interested in.
This is not an easy book for the lay reader, but for the professional investor and manager “The End of Accounting” is a most useful book.
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