Earlier this year, the Financial Accounting Standards Board voted to require companies to add to their balance sheet most of the leases they use. This rule, one among hundreds, could swell balance sheets by as much as $2 trillion and make companies, such as airlines that lease planes and retail or restaurant chains that lease real estate, look far more leveraged than they do now.
The new rule capitalizes leases on the balance sheet, when current footnote disclosure on future lease payments provides essentially the same information. According to FASB, putting leases on the balance sheet is expected to make it easier for the average investor to see the effect they have on a company’s finances. But is that really true?
We recently conducted a comprehensive study of almost all the standards issued by FASB. The results were surprising. Of the estimated 150 standards issued from FASB’s inception in 1973 through 2009, 75 percent had zero effect on the shares of the impacted companies. What’s more, 13 percent of the standards actually detracted from shareholder value and only 12 percent of the standards improved investors’ lot.
Other evidence shows that over the past 20 to 25 years, the usefulness of financial information to investors diminished markedly, and a growing void has opened between share prices and corporate financial information. Even the dreaded consensus earnings miss of between one and three cents a share isn’t what it used to be: It will get you, on average, a paltry 1.5 percent drop in price — a routine daily change these days.
Many executives in our survey reflect a growing frustration over the increasing complexity and obscurity of financial reporting regulations. Take FASB’s recent revenue recognition standard: The 607-page tome is so complex that its implementation had to be postponed soon after enactment.
No wonder that several CFOs in a survey we conducted complained that financial reporting has become a compliance exercise, abiding by the ever-more complex accounting rules, rather than an effort to inform investors. How did we get to this sorry state where what used to be the backbone of investors’ information — corporate financial reports — no longer matter much?
Financial reports lost their relevance because FASB generates increasingly complex rules on issues that largely don’t matter to most investors, such as the fair values of nontraded assets and liabilities for non-financial firms. It also insists on ignoring the value of patents, brands, IT or unique business processes. These intangible assets are now the major value creators of businesses.
The corporate investment rate in intangible assets is now twice the investment in physical assets, and yet corporate balance sheets still proudly exhibit plant, machinery and inventory. So what’s to be done?
First, FASB must change the accounting regulatory process to deal with issues that matter to investors, like the strategy of the enterprise, the major assets that drive this strategy, such as the customer franchise, patents, brands, IT and unique talent — all missing in financial reports — and the efficiency of deploying these assets (customer churn rate, patents developed or licensed out vs. lying dormant, utilization rate of call centers or insurance agencies, etc.). Our analysis of hundreds of earnings conference calls reveals that most questions focus on strategic issues and business model execution, rather than on traditional accounting items.
Second, FASB must drastically reduce the complexity of accounting rules by moving to principles-based accounting: focusing on the major postulates of accounting for revenues and expenses, as well as assets and liabilities, and leaving the multitude of situation-specific cases to managers’ discretion, under full disclosure and audit. Our evidence shows that stock prices react more favorably to enactment of principles-based accounting standards than to rules-based standards.
Finally, FASB must hit the pause button on issuing new standards. Uninformative or confusing financial statements enhance share price noise and investor uncertainty. Then, FASB must seriously assess the mounting evidence on the ineffectiveness of current accounting and reporting regulations. Both investors and executives will appreciate a fresh direction.
Should we care about the increasing irrelevance of accounting and financial reports? We absolutely should care because there are no substitutes for reliable and relevant company-sourced information. Corporate managers will always know more about their business than investors, and meaningful information improves investors’ decisions.
Baruch Lev is the Philip Bardes Professor of Accounting and Finance at the New York University Stern School of Business and Shiva Rajgopal is the Roy Bernard Kester and T.W. Byrnes Professor of Accounting and Auditing at Columbia Business School.