[07/11/21] The Sad State of Accounting

The Wall Street Journal reported (July 1, 2021) that the International Accounting Standards Board (IASB), the accounting body that sets the financial reporting rules of public companies in more than 140 jurisdictionsbut not in the U.S.got a new chief: Mr. Andreas Barckow, who until now served in a similar role in Germany. Congratulations Mr. Barckow!

Setting uniform accounting and reporting standards for most of the world is a pretty important job, particularly given the poor quality and low relevance of corporate financial statements. How do I know? A study of mine showed that even if you could predict all the companies that will meet, or beat analysts’ consensus earnings estimatesan impossible feat, of courseyou wouldn’t make real money. That’s how useless earnings numbers are. Another study, conducted a few years ago by top finance researchers, examined the number of downloads of U.S. annual reports from the EDGAR system. All U.S. public companies have to file electronically their quarterly and annual reports with the Securities and Exchange Commission (SEC) through the EDGAR system, and the SEC makes these reports publicly available upon receipt. So EDGAR, with advanced search capabilities is a major go to source for investors interested in accounting data. The researchers’ interest in how many times are annual reports downloaded is, therefore, understandable. The results of the study are beyond surprising: An annual report of a public company is downloaded, on average, less than 30 times (28.4 to be precise), in the day of, and the day after it’s made publicly available! Hard to believe that this is the level of interest of millions of investors in newly released accounting information. (And we all know that a download doesn’t mean that the report is actually read and analyzed.) So, accounting standard-setters have their work cut out for them.

Given this sad state of accounting affairs, you would expect that the worldwide accounting standard-setting body under a new leadership will set a bold and imaginative work agenda. How disappointed I was to read in the Journal (July 1, 2021) that the new agenda issues (not yet fully determined) “could include accounting for cryptocurrencies, climate risks, income taxes, government grants and inflation…” The article continued: “One project in particular will test Mr. Barckow’s skills… [the rule] which forces companies to remeasure their estimates of future cash flows form insurance contracts.”

No kidding, the accounting for estimates of future cash flows from insurance contracts is the major problem with corporate financial reports? Is insurance accounting, or the accounting for income taxes or government grants the reason why so few investors are interested in just-released financial reports? It seems that the accounting standard-setters aren’t even aware of the real challenges facing their work product. Here are a few suggestions for a meaningful new agenda for accounting regulators.

1. Accounting for the industrial era. The past quarter century has witnessed a revolutionary, world-wide change in the business models of economic enterprises. From the industrial-era reliance on physical assetsplant, machinery, structures, inventoryto create value, businesses have switched to compete and grow by intangible assets: R&D, software, brands, and unique business processes, like AI and customer recommendation algorithms. The level of U.S. annual investment in intangibles (about $2.5 trillion) is currently twice that of the investment in physical assets. Physical assets are, at best, enablers of intangibles. And yet, accountants are inexplicably stuck in the industrial-era, physical assets environment.

         If you invest today in plant or machinery, these assets are recognized as such on the balance sheet and book value, but if you invest in drug development (R&D) or AI, the costs will be expensed in the income statement, dragging down reported earnings and book values. In 2019, the last pre-Covid boom year, a full half of U.S. public companies, and 70% of high tech and healthcare (including drug) companies reported annual losses. Half of these “losers” would have reported profits without the intangibles expensing. This is not a reliable accounting system.

         So, if I were the new chief of the International Accounting Standards Board (IASB), I wouldn’t waste my time on trivialities, like the estimated cash flows from insurance contracts, or income tax accounting. Rather, I would focus on dragging accounting to the 21st century by recognizing as assets the main value-creators of businesses: internally-generated intangibles.

2. Facts, not guesses. Accounting regulators in the past 30-40 years moved steadily away from reporting facts to relying on managerial estimates and guesses, all in the name of the illusory “fair value accounting” principle. Financial reports are currently floating on a sea of estimates, often manipulated by managers: assets write-offs (to current values), goodwill impairment, revenues allocated to future services (software contracts), etc. Current balance sheets are an odd, and rather useless mixture of assets reported at historical (irrelevant) purchase costs, observable current values (traded securities), and guesswork (impaired assets and goodwill). The total of this hodge podge of valuation bases serves to measure profitability: return on assets (ROA).

            A serious IASB chief would focus on reigning-in the constant proliferation of financial report managerial estimates, thereby enhancing the credibility and usefulness of accounting data.

3. Hopelessly behind events. People used to joke about the U.S. “leading from behind.” With accounting, this is not a joke. New accounting standards, like the recently enacted revenue recognition and leases standards, took 10-15 years to enact. Newly-emerging information needs of investors are just being ignored by accountants.

            Consider, for example, the current rush of investors to ESG-intensive companies. Whatever you think of ESG (and I have my doubts about it), a reliable information system which will report on corporate investment in ESG, and particularly on tradeoffs (e.g., how much profits were sacrificed to achieve carbon emission reduction) is currently of great importance to investors. The various rankings of companies by ESG promulgated by various vendors are notoriously unreliable.

            Since ESG doesn’t seem like a passing fad, if I were the new IASB chief, I would start working on a system reporting corporate ESG costs and consequences, but definitely not by initiating a 10-15 years project.

Am I hopeful that my suggestions for an IASB (or FASB) agenda will be adopted? No. But I will be remiss not making my opinion on such an important matter publicly available and open to debate.


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