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  • The End of Accounting Book Review – Part One

    Posted by Carl from Chicago on January 8th, 2017 (All posts by )

    Recently I read an excellent book called “The End of Accounting and the Path Forward for Investors and Managers” by Baruch Lev and Feng Gu. I highly recommend this book for investors, analysts, accountants, and those with a general interest in business. The book is very well written and researched in that it:

    1. Describes the current situation in depth
    2. Aligns the situation across an historical context and with relevant research
    3. Makes specific recommendations about how to improve the situation

    If you’d like to read more about this topic on your own (will help to frame out these posts), here is an excellent Wall Street Journal article titled “The End of Accounting” (if the link doesn’t work because you don’t have a subscription you can probably find it elsewhere on the internet). Here is a link from Accounting Today and an interview with the author from CFO magazine.

    The first post in this series is going to be my personal insights and journey in the area of accounting information, financial and investor relations analysts. This context is relevant because I, too, have seen the problems that the authors outline in the series and come up with my own “hacks” to attempt to gain better information and insights.

    I started out my career as an accountant, and I used to help create the footnotes that you see at the end of the financial reports. This wasn’t creative work per se – you would start with last year’s footnote as a template and insert new numbers, unless it was a new requirement, in which case it was a lot of work and we would turn to specialists. At that time (20+ years ago) there were only a few footnotes and the financial statements themselves weren’t that long; you would be able to read from the Chairman and CEO’s letter all the way through to the last footnote in a couple of hours.

    This was also before the internet; we would go into the company library and look at microfiche sometimes to do research or you’d pull up the hard (printed) copy from the files. At that point an annual report was also somewhat of a marketing document; companies put a lot of thought into the cover, for instance.

    At various points in the history of accounting there has been a focus on the balance sheet (assets and liabilities), the income statement (earnings per share and price / earnings ratio) and on cash flows (cash generated from the business). Each of these views are important and have their merits and their drawbacks. The statements were generally the “GAAP” view which focused on financial statement presentation and used taxes at official rates (many companies pay almost nothing in taxes in actuality by deferring them indefinitely) and held assets at historical costs. Both of these assumptions made the financial statements less useful for certain types of companies and industries.

    When the “Management’s Discussion and Analysis” of financial statements came out, this was a big improvement. Rather than just having numbers in a table, management would be able to shed some light on what they actually viewed as driving the underlying business rather than the ending financial numbers in GAAP format. After a while, however, this section devolved into more boilerplate analysis and the statements became bloated with endless footnotes, each more obscure than the last.

    Also useless are the boilerplate warnings to investors that take up several pages in each earnings statement. Instead of putting risks in context including likelihood and how the company would respond if they occurred (to accept the risk or to mitigate the risk), that section is likely used only by trial lawyers seeking to sue a company when a stock price decline occurs in that a particular risk was not previously disclosed.

    Finally it came down to the point that almost no one really read the financial statements from end to end except for a few masochists. While accountants toiled for months on obscure footnotes and new accounting requirements, the “real” information is up on the company web site under presentations – every quarter almost every company puts out a press release describing how the company did that quarter financially (with obviously the most favorable outlook highlighted).

    Another source of valuable information is the conference call, where analysts get to ask questions to company executives after the executives have completed their prepared statements. In these questions, the analysts often probe for the reasons behind the numbers and the company responds to either clarify the situation or to say that they won’t provide that information for one reason or another. These conference calls are available at sites such as “Seeking Alpha” almost immediately after the call – it is usually easier to read the transcripts than to actually sit through the call in the first place.

    As an investor, I am much more inclined to view the company presentations, to read the conference call transcripts, and perhaps the CEO and Chairman’s letter from the annual report than to slog through all the numbers in the financial statements and the endless footnotes. And this situation – where companies and accounting standards boards toil endlessly with arcane rules and regulations and disclosures and spend a lot of money to generate these documents – which in turn are ignored by many / most investors – is the key topic that Lev is attempting to tackle with this book.

    Cross posted at LITGM

     

    3 Responses to “The End of Accounting Book Review – Part One”

    1. Mrs. Davis Says:

      I blame SarBox, Dodd Frank, the reduction of the Big Eight to the Big Three, wholly owned subsidiaries of USG and the intrusion of the SEC into accounting rule making. Statement of Cash Flows is still King.

    2. Carl from Chicago Says:

      It is still the big four (not the Big Three) – PriceWaterhouseCoopers (PWC), KPMG, E&Y and Deloitte. They each have large accounting / tax functions. I do remember the Big Eight which makes me old.

    3. DirtyJobsGuy Says:

      As the owner of a small multinational you see the continued corruption of management accounting at the hands of income tax accounting. If companies were freed of the incentive of managing income for tax purposes (or if the tax rate was small enough to make it less important) corporate financial statements could be more representative of the health of the business as an enterprise. A key thing is to better understand the factors underlying software services like Google or Facebook. The IP of these are often fragile or not well understood.