By Stevenson Swanson
Despite the dramatic changes in the business world over the last few decades, the basic system of accounting to measure a firm’s profitability and prospects has remained largely unchanged since double-entry bookkeeping was devised some 500 years ago during the Renaissance.
That fact led two accounting professors, Baruch Lev and Feng Gu, to ask a provocative question: are earnings statements still relevant?
The two recently spoke on Fordham’s Rose Hill campus about their surprising findings, which are contained in their new book, The End of Accounting and the Path Forward for Investors and Managers (Wiley, 2016). Their talk was part of the Gabelli Center for Global Security Analysis lecture series.
“We discovered that earnings reports no longer move the market the way they used to,” said Gu, an associate professor at the University of Buffalo. “They contribute only about five or six percent of the total information used by investors.”
This declining relevance stems in part from the fact that reported earnings are less reliable as indicators of future earnings, he said. For one thing, a firm’s tangible assets—for example, its land and buildings—are becoming less important to its bottom line than intangibles such as its brand names and ideas. It’s hard to pin a value on such assets, leading to a dramatic rise in the use of estimates. By their very nature, estimates are less reliable than hard numbers.
Examining a sample of financial reports from large corporations, the two professors found that words or terms indicating the use of estimates had increased from an average of 30 estimate-related terms in 1995 statements to 150 in statements for 2013.
Less reliable earnings statements lead to poor investment decisions and misallocation of resources, said Lev, a professor at New York University’s Stern School of Business. To counter that, he and Gu propose a number of reforms and innovations, including less reliance on estimates, the development of a new accounting report that would focus on a company’s strategic resources—such as the new drugs a pharmaceutical company has in its pipeline—and changing how intangibles are treated.
They should be viewed as assets, not expenses, Lev said. Studies have shown that simple change leads to an increase of research and development investment in those intangibles, which can turn into profitable products.
“That’s a very important message for you accounting students,” he told the audience. “Accounting affects corporate behavior.”