My colleague, Dan Morris, CPA, recently asked Barry Melancon, president and CEO of the American Institute of CPAs, what kept him up at night. He replied, “My biggest worry is the relevancy of our core products.”

In that case, The End of Accounting, by Professor Baruch Lev and Feng Gu, should contribute many sleepless nights to the entire accounting profession.

 

MORE RULES, LESS INNOVATION

A lot of rules have been added since the Venetian monk Luca Pacioli published the first accounting textbook in 1494, introducing double-entry bookkeeping. It was a creation for future accountants that was as big as the invention of zero for mathematicians.

Unfortunately, one could also make the argument that it was the last revolutionary idea to come from the accounting profession. The balance sheet dates from 1868; the income statement from before World War II. GAAP fits an industrial enterprise, not an intellectual one.

Despite the fact that, according to the World Bank, 80 percent of the developed world’s wealth resides in human capital, you will look in vain to find it in the traditional GAAP financial statements.

 

PART 1: RELEVANCE LOST

Enter Lev’s and Gu’s book, The End of Accounting. It’s divided into four parts:

  • 1. Relevance Lost.
  • 2. Why Is Relevance Lost?
  • 3. So, What’s to Be Done?
  • 4. Implementation.

Like a Consumer Reports evaluation, they provide an unsatisfactory report:

“Based on a comprehensive, large-sample empirical analysis, spanning the past half century, we document a fast and continuous deterioration in the usefulness and relevance of financial information to investors’ decisions. The pace of this usefulness deterioration has accelerated in the past two decades.”

“Our analysis indicates that today’s financial reports provide a trifling 5-6 percent of the information relevant to, and used by, investors.”

One illustration they use in the book is to compare United States Steel Corp.’s 1902 and 2012 financial statements. The former is 40 pages; the latter is 174 pages. Yet they focus on the same information. Uniformity has lead to less experimentation and innovation as the world moved from an industrial/service economy to a knowledge economy.

In another indictment that what the accounting profession is peddling is the Edsel of our day, pro forma (non-GAAP) earnings disclosures have doubled from 2003 to 2013, and now are over 40 percent.

As The Economist stated: “The real Enron scandal is that so much of what Enron did conformed with GAAP.”

How much of stock prices is attributable to earnings and book values? It was roughly 80 to 90 percent in the 1950s and 1960s; the authors say it’s 50 percent today.

 

PART 2: WHY IS IT LOST?

The authors document three major reasons for why financial reports have lost relevance:

1. The inexplicable treatment of intangible assets — the dominant creators of corporate value. Intellectual capital — such as brand development, human capital, R&D, etc. — are all expensed by current accounting standards.

2. Accounting isn’t about facts anymore but more and more about managers’ subjective judgments, estimates and projections.

3. Unrecorded business events increasingly affect corporate value (competitor moves, regulatory changes, alliances, etc.).

Just one example: The prevalence of mark-to-market rules is a clear case of asking GAAP to do something it is constitutionally incapable of doing — projecting value into the future, because accounting is not a theory, it’s an identity equation. GAAP can only record value once a transaction has taken place.

This is why the “goodwill” of a business is booked after it has been sold. It is why our late colleague, Paul O’Byrne, FCA, used to say that goodwill is the name accountants give to their ignorance.

Warren Buffett remarked, “This is not marked-to-market, rather marked-to-myth.” As the authors point out, Enron was marking-to-market 30-year gas contracts in which they were the main market-maker.

Much of this is due to the Financial Accounting Standard Board’s obsession with the “balance-sheet approach,” adopted in the 1980s, with the prime objective to value assets and liabilities at fair (current) values. These adjustments spill over into the income statement, making it less relevant. If the balance sheet is flawed, so is the income statement.

 

PART 3: SO, WHAT’S TO BE DONE?

There have been initiatives to supplement the traditional financial statement report, such as with key performance indicators, the value reporting revolution, intellectual capital reports, the Enhanced Business Reporting Model, integrated reporting and so forth.

They haven’t amounted to much, and they are not grounded in solid economic theory. Lev and Gu propose adding “The Strategic Resources & Consequences Report” to the financial statements. As they explain:

“The focus of this ... Report is on the strategic, value-enhancing resources (assets) of modern enterprises, like patents, brands, technology, natural resources, operating licenses, customers, business platforms available for add-ons, and unique enterprise relationships, rather than on the commoditized plant, machines, or inventory, which are prominently displayed on corporate balance sheets.”

“Our proposed disclosure to investors is primarily based on non-accounting information, focusing on the enterprise’s strategy ... and its execution, and highlighting fundamental indicators … more relevant and forward-looking inputs to investment decisions than the traditional accounting information, we grade the ubiquitous corporate financial report information as largely unfit for twenty-first-century investment and lending decisions, identify the major causes for this accounting fade, and provide a remedy for investors.”

It’s an innovative and empirical approach, as the authors studied investor calls, earnings disclosures, etc., to learn what educated investors were asking to help them peer into the future potential of companies.

This is an enlightened way to develop key predictive indicators — that is, theories that can be used to peer into the future, rather than merely looking backward with data that compose most key performance indicators.

 

PART FOUR: IMPLEMENTATION

The authors are not fans of more regulation. In fact, they advocate lessening the disclosure rules. They believe their proposals could be voluntarily adopted, perhaps with a “nudge” by industry trade associations and the SEC.

The authors also advocate eliminating quarterly reporting, since frequency and reporting quality are substitutes, making it semi-annual, as in the U.K. and Australia, among other countries. They would still require quarterly reporting of sales, cost of goods sold, and gross margin. Finally, they propose three reforms to GAAP:

1. Treat intangibles as assets (at cost) and improve disclosures (such as separating research from development).

2. Reverse the proliferation of accounting estimates — such as marking-to-market, leaving fair market value to investors since accountants have no expertise in valuation. Compare the top five to seven key managerial estimates and projections to actual.

3. Mitigate accounting complexity — regulatory complexity now exceeds business complexity. It’s futile to have a rule for every scenario. We need more principles and professional judgment, and fewer rules.

 

A DETERIORATING PARADIGM

The accounting model is suffering from what philosophers call a deteriorating paradigm — the theory gets more and more complex to account for its lack of explanatory power.

I am very curious to see the profession’s response to this book going forward. My guess is, for the most part, it will be ignored, which would be tragic, and a missed opportunity.

The No. 1 issue facing the accounting profession is loss of relevance. Does anyone doubt that using financial statements to run — or invest in — a modern-day intellectual capital organization is the equivalent of timing your cookies with your smoke alarm?

It’s time for the profession to step up its game, and stop being historians with bad memories. One of the canons of a profession is a spirit of service — to put society’s interests above our own.

How can we claim to be doing that when the return on investment is so low — and I would argue negative — on our core products? The deadweight loss to the economy from financial statement reporting, auditing, regulatory compliance, etc., is appalling. It’s a disservice to those we purport to serve — investors, and the public at large.

It’s past time to bring some innovative disruption to auditing, such as having the stock markets select and pay the auditors of listed companies, once and for all tackling the sham that is “auditor independence.” How can you be independent when you’re paid by the very company you are auditing? I only wish the authors had dealt with this issue.

The End of Accounting is the most important book that has been written on the irrelevance of accounting in recent times. The profession had better pay attention to its diagnosis and its prescriptions, or it deserves all of the irrelevance and loss of value it will surely suffer.

Ron Baker is the founder of the VeraSage Institute.