Practical analysis for investment professionals
08 June 2017

Book Review: The End of Accounting and the Path Forward for Investors and Managers

The End of Accounting and the Path Forward for Investors and Managers. 2016. Baruch Lev and Feng Gu.

Flaws in generally accepted accounting principles (GAAP) severely limit the usefulness of financial reporting to security analysts. The following are examples:

  • Under GAAP, a company that laid out huge sums for brand creation shows zero value for those investments on its balance sheet. In contrast, billions of dollars of assets may appear on the balance sheet of a competitor after it acquires a company that made similar outlays. This inconsistent accounting treatment confounds investors who seek to compare companies for valuation purposes.
  • GAAP requires expensing of R&D (research and development) costs as incurred, yet studies show that investors regard these expenditures as assets that add to a company’s value. Mandatory expensing probably also depresses R&D spending.
  • GAAP violates the traditional concept of matching revenues and expenses. For example, wireless telecommunications companies must match single-year revenues with customer-acquisition expenditures that are expected to produce benefits for three to four years. Their true economic profits are consequently understated.

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In view of such serious shortcomings, should it surprise anyone that the earnings derived through traditional accounting are a second-rate influence on stock prices? The End of Accounting and the Path Forward for Investors and Managers shows that equity investors can earn far higher investment returns by correctly forecasting cash flows than by correctly forecasting GAAP earnings. Furthermore, cash flows are easier to predict than earnings, which increasingly consist of dubious GAAP-mandated accounting estimates.

The connection between GAAP and equity valuations is not only loose but loosening. During the past 60-plus years, a sharp and steady decline has occurred in the correlation between stock prices and such key accounting outputs as earnings, book value, sales, cost of sales, assets, and liabilities. Baruch Lev, professor of accounting and finance at the Stern School of Business at New York University, and Feng Gu, associate professor and chair of the Department of Accounting and Law at the University at Buffalo, attribute this decline to the transition from a primarily industrial economy to the information age.

“The major value drivers shifted from property, plant, machinery, and inventories, to patents, brands, information technology, and human resources,” write the authors. GAAP, failing to adapt to this change, continued to treat the latter four value creators as ordinary expenses. That accounting, say Lev and Gu, distorted both the balance sheets and the income statements of intellectually based companies, rendering reported financial information increasingly irrelevant.

To fix this problem, the authors audaciously propose a radical overhaul of the accounting system. Their new model addresses the fact that, by the authors’ estimate, today’s financial reporting supplies a mere 5% of the information used by investors. Lev and Gu seek to complement traditional financial statements with a “Strategic Resources & Consequences Report” focused on the items that create a sustained economic advantage. This report would present details on such things as patents, oil reserves, and information technology — all in a standardized form, rather than the haphazard disclosures already made by some public companies — to facilitate comparison of issuers within an industry.

Financial Analysts Journal Latest Issue Graphic

Lev and Gu seek, above all, to improve on GAAP’s measurement of value creation by focusing the proposed report on cash flows. In their system, companies would not only capitalize R&D but would also provide a breakdown separating research (i.e., the systematic pursuit of new knowledge) and development (i.e., the use of research to develop new products or processes). Additionally, a charge for the cost of equity capital would be deducted from cash flows. Where feasible, changes in values of major strategic assets, such as the present value of cash flows from proven oil and gas reserves, would be taken into account.

The authors recognize and deal effectively with objections to their innovations. These objections include an increased reporting burden (which they suggest might be partly offset by dispensing with quarterly reporting in favor of semiannual statements) and companies’ predictable complaint that they would be forced to divulge proprietary information to competitors. Lev and Gu prefer to have their reforms come about through demand from investors rather than by government fiat, although they would welcome the US SEC’s support of their project.

Lev and Gu differentiate their remedies from others that have been proposed, such as “key performance indicators” and the “triple bottom line,” which tracks management’s impact on people and the planet as well as on profits. Their reconstruction of financial statements does, however, bear some similarity to economic value added (EVA). Both approaches take into account the cost of equity capital, although Lev and Gu’s starting point is cash flows whereas EVA’s is earnings.

The End of Accounting makes a powerful case for redirecting security analysis away from GAAP accounting. Already, the authors note, between 2003 and 2013, the proportion of public companies reporting non-GAAP (“pro forma”) earnings doubled from 20% to 40%. How can this phenomenon be explained, they ask, other than as a function of company managers’ awareness of the rapidly diminishing usefulness of financial information to investors? Actually, there is an alternative narrative — namely, that corporate executives benefit when their bonuses are calculated on the basis of non-GAAP rather than (lower) GAAP earnings.

Tile for Equity Valuation: Science, Art, or Craft?

Fact-checking produces a few other quibbles with the book. The authors state that Ford Motor Company’s first car, the Model A, was available “in any color as long as it’s black.” In reality, company founder Henry Ford made the comment, probably in jest, about the later Model T, which was, in fact, offered in a variety of colors, including fire-engine red and hunter green. Lev and Gu also attribute to “a critic” a comment on the music of Richard Wagner: “It’s not as bad as it sounds.” American humorist Edgar Wilson Nye (1850–1896) was the actual source of a slightly different version of this remark, which Mark Twain cited in his autobiography. The critic to whom it is frequently misattributed is the playwright George Bernard Shaw.

None of these criticisms diminishes the authors’ achievement. They have put forth a serious challenge to the established accounting regime and the entire structure of security analysis built upon it — all in a delightfully irreverent tone. The ball is now in the accounting regulators’ court either to adapt to the 21st-century economy or, what appears more difficult, to demonstrate that Lev and Gu’s manifesto is somehow misconceived.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.


About the Author(s)
Martin Fridson, CFA

Martin Fridson, CFA, is, according to the New York Times, “one of Wall Street’s most thoughtful and perceptive analysts.” The Financial Management Association International named him its Financial Executive of the Year in 2002. In 2000, Fridson became the youngest person ever inducted into the Fixed Income Analysts Society Hall of Fame. He has been a guest lecturer at the graduate business schools of Babson, Columbia, Dartmouth, Duke, Fordham, Georgetown, Harvard, MIT, New York University, Notre Dame, Rutgers, and Wharton, as well as the Amsterdam Institute of Finance. Fridson's writings have been praised widely for their humor, rigor, and utility. He holds a BA in history from Harvard College and an MBA from Harvard Business School.

1 thought on “Book Review: The End of Accounting and the Path Forward for Investors and Managers”

  1. Mr. Fridson does great justice to Lev and Gu’s book, and his review inspired me to purchase a copy. While I agree with Mr. Fridson’s assessment of the book’s fine content and sound conclusions, I also believe the authors missed an opportunity to explore environmental, social and governance (ESG) issues.

    E and S issues in particular form important financial and non-financial links between corporate profits and our surrounding environment and society. First, there is a growing demand for material information on ESG issues. In their introductory remarks Lev and Gu dismiss these issues as too broad and not predicated on the sound research results that come from surveys or from data-mined analyst call manuscripts, but the Sustainable Accounting Standards Board was formed more than five years earlier (shareholder oriented SASB isn’t even mentioned in their book), and the stakeholder oriented Global Reporting Initiative (GRI) was founded in 1997.

    The advent of both GRI and SASB belie Lev and Gu’s too easy dismissal of ESG issues, and while it doesn’t detract from their fine book, it is a missed opportunity. In addition to the granular issue of how to identify, define and codify material ESG issues (the core of both GRI and SASB, though of course through their respective stakeholder and shareholder lenses), there is a philosophical question that goes beyond calculating financial returns to determining the cost of externalities such as excess carbon emissions, lost biodiversity, and poor social conditions. Some of the same data that informs the valuation of corporations is also used by regulators, policy makers, and law setters.

    It would have been nice if Lev and Gu had provided more detail on ESG issues, and expanded their scope to allow consideration of the corporation’s role in society. As it is, their assumption is that it is solely a vehicle to greater growth and profit. “Even major environmental disasters, like the Exxon Valdez spill (March 1989), were, in retrospect, just a hiccup in the relentless growth path of the company.” There are many who would find fault with their observation about Exxon, not because it isn’t true, but because it is. Updated accounting rules offer the promise of more than just more accurate valuations; they also offer potential for greater accountability for externalities and other costs offloaded to society and the planet.

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