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Q&A With Baruch Lev: The End of Accounting?

We recently spoke with Baruch Lev, the Philip Bardes Professor of AccountingSharon Merrill Associates Investor Relations and Finance at New York University Stern School of Business. In “The End of Accounting and the Path Forward for Investors and Managers,” Prof. Lev and Feng Gu, associate professor at the University of Buffalo, propose a new system to improve transparency of corporate accounting.  This system aims to make public accounting disclosures more useful to investors. They encourage investor relations professionals to begin discussions with management to increase the usefulness and relevance of company disclosures for investors.

Q: Thanks for joining us. Let’s start with a basic question. You call your book “The End of Accounting.” What do you mean by that?

A: I definitely don’t mean the end of traditional accounting, which involves accounts receivable and accounts payable and revenue and expenses. These factual items will always be useful. What I meant by “the end of accounting” is that the usefulness of current financial reports to investors has decreased substantially in the past 20 to 25 years. We measure this by the variance around the consensus of individual analyst forecasts, which reflects investors’ ambiguity. We show that this average variance constantly increases. We also show that financial information is increasingly detached from stock prices. You would think that with all the efforts of FASB and the SEC, investors would be less bewildered. The fact is, they are more bewildered, because the information is less and less useful.

One reason for this lack of usefulness is that although companies now create value with patents, brands and information systems, these intangible assets are not recognized in accounting and financial reports. Another reason is the huge increase in the number of subjective managerial estimates in financial reports. They get farther and farther from facts, into the realm of guesses and sometimes even manipulation.

Based on the things that really interest investors and on our evidence, we designed the Strategic Resources and Consequences Report. My coauthor and I spent a year analyzing very carefully hundreds of earnings conference calls in four major industries. Our proposed new report reflects these investors’ information needs.

Q: What advice do you have for investor relations officers and chief financial officers who want to take your work and make a real difference in how they communicate to the investment community? What’s the first step they should take?

A: They should evaluate empirically the usefulness of their communication with investors. I’ve spoken to many investor relations executives and CFOs. All of them tell me, “Our conference calls are very, very useful. We speak with investors, and they say they are useful.” This is really not a satisfactory answer. Analysts are not going to tell you to your face that you wasted their time. They’re going to be polite, and they want to have a good relationship with you, so of course, they tell you it was useful! For example, you can look at the volume of trading in your shares on the date of the conference call, relative to normal volume on dates without conference calls. If there is a substantial increase in volume, it means the conference call had an impact or created a buzz. Look also at how many analysts favorably changed their estimates after the call.

IR executives should obtain a quantitative assessment for the usefulness of their other communications to investors, such as investors day and earning releases. Some investor relations people tell me they don’t have a seat at the table. I tell them that you get a seat at the table when you add information to the other people at the table. This kind of communication effectiveness study would be very important information that you can bring to the table.

Next, I would look at the non-required information your company provides. With GAAP information, there are no degrees of freedom, and we know that it’s not very useful, anyway. But companies should provide information about intangible assets and other items that don’t appear in the financial statements. For example, many pharmaceutical companies provide extensive information on their product pipeline. Subscription-based companies provide extensive information on new customers, churn rate and customer acquisition costs, which are not required by GAAP. Look for this type of information and try to make it relevant to investors in a responsible way.

Q: What do you see for the future of accounting? Do you think things are changing? What do we need to do to have better, more effective disclosure?

A: Accounting regulators are sheltered from public opinion. They continue to go on the wrong track, making financial reports more and more complicated, more and more obscure, and less and less useful. For example, look at the new revenue recognition rule, which is 706 pages long. After 15 years of working on this project – 15 years – they came up with this monster last year, and it was so complicated, no one could apply it, so the FASB had to postpone the application.

It’s very difficult to change within such an environment. We hope we’ve started a discussion about the inadequacy of all of this. We believe there will be increased pressure from investors to get more and more relevant information, but it’s going to be very slow going, no doubt about it.

Q: This has been very helpful. Any final thoughts?

A: CFOs, CEOs and board members are quite complacent about financial reporting. It’s basically a compliance exercise, rather than an effort to inform investors. You should have a discussion on how to increase the usefulness, the relevance, of information to investors, I believe for investor relations people, it’s going to enhance their stature, their standing within companies. In some companies, of course, the response will be, “No, we shouldn’t do anything beyond GAAP.” But the fact is that lots of companies provide non-GAAP information. And investor relations people can play a major role in this ongoing debate within companies. It should be seen by them as a great opportunity.

Prof. Lev discusses current investments and accounting issues on his blog at https://levtheendofaccountingblog.wordpress.com/For more information or to purchase “The End of Accounting and the Path Forward for Investors and Managers (Wiley Finance)” please visit http://amzn.to/2jLZeYs.

Disclosure, Investor Relations, Public Accounting, accounting regulations, IR Recommendations

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