America’s antiquated accounting rules are dangerously distorting the real performance of the knowledge economy.
At least that’s the theme of a compelling new book called ominously entitled “The End of Accounting,” by professors Baruch Lev of New York University’s Stern School of Business and Feng Gu of the University of Buffalo School of Management. According to the authors, corporate earnings and the other standard benchmarks reported in quarterly and annual reports have severed most of their connection to stock prices, and hence basically lost their relevance to investors. “Financial information doesn’t move markets,” they conclude. “Reported earnings are largely detached from reality, and no longer reflect the factors that create corporate value.”
Lev and Gu want to replace today’s outdated rules with an entirely new regime designed around what Alan Greenspan calls the “conceptual industries” that dominate today’s economy, where it’s patents, trademarks, brands and tradition-shattering new ideas, rather than plants and inventories, that power an Apple or Amazon. Their manifesto calls for rewriting the rules to make the money that funds those intellectual products count as what they really are, assets that generate future benefits, and limit managers’ freedom to muddy real results by using highly subjective estimates to value, say, what a leased electric car will be worth four years from now, or the “price” of exotic securities that aren’t traded.
The authors summon lots of data showing that the connection between market value and accounting performance is rapidly fading. From the 1950s until around 1980, reported earnings explained 80% to 90% of gains and losses in equities. Today, the figure is as low as 40%. The reason: Starting in the early 1980s, the U.S. economy made a tectonic shift from hard assets used in manufacturing to knowledge, or intangible, assets. Increasingly, factories, warehouses and the like were viewed as commodities available to all competitors. Gaining competitive advantage meant summoning research and training dollars to build FedEx’s reliable distribution system, Southwest’s customer service, Microsoft’s software portfolio, Facebook’s customer outreach, and Gilead’s revolutionary therapies in biotech, not to mention burnishing of great brands such as Coca-Cola and Walt Disney. “Yet the regulations were set forty years ago for for the Industrial Age, and America left them behind by moving into the Information Age,” Lev told Fortune.
It’s those fusty rules, severely mismatched to the New Economy, that caused the radical disconnect between GAAP earnings and what matters to investor: whether those reported profits truly justify share prices and market values.
In the past forty years, U.S. companies lowered investment in hard assets 30%, and raised their spending on intangibles by 60%. While spending on new plants and the like is classified as capital investment, and correctly capitalized on the balance sheet as assets that generate earnings for years to come, the research and development dollars that design new airline reservation systems or create breakthrough cancer drugs get an entirely different treatment. More than anything else, it’s the wrongheaded treatment of R&D that’s responsible for the declining usefulness of accounting.
The GAAP rules require that all R&D spending be lumped into costs in the year the money is spent. Hence, America’s top moneymaking innovations ranging from the Apple’s iPhone to Amazon’s customer recommendation algorithms aren’t treated as assets at all. As the authors note, at least R&D is listed as a single number in the income statement. A lot of other spending that enhances future earnings, such as advertising to build brands, development of information technology, training of sales staff, or marketing to burnish trademarks is buried in salaries and overhead, so investors have no idea how much companies are spending on them, or how much they’re making on those “investments.”
To make matters worse, GAAP isn’t even consistent. The “expense immediately” rules apply to all R&D dollars a company spends to nurture products or technologies on its own. When a company purchases individual patents or customer lists, or buys a rival with a portfolio of intellectual property, it’s required to add those items to its balance sheet as assets, assigning a portion of the purchase price to each product. As the authors stress, startups that develop technologies internally can look like losers under GAAP because they’re forced to book all those expenses right away, when they’re really laying the groundwork for the future. The disastrous-looking official earnings numbers in the early days for Google and Amazon gave no inkling of the their future success. As a result, analysts often applaud tech players that grow through acquisitions instead, because the buying strategy makes their profits look stronger, even though the “make it internally” approach may be better from creating shareholder value, especially since so many acquisitions fail to generate decent returns on the money spent.
Lev and Gu contrast how GAAP makes Lockheed Martin appear more profitable than its competitor Boeing. mainly through an accounting illusion. Boeing develops most of its technology internally, while Lockheed Martin does so primarily through acquisitions. As a result, Boeing’s earnings are understated because of its heavy spending on R&D, so that it’s return on assets––a crucial measure––is a lot lower. “Is Boeing’s real profitability lower than Lockheed Martin’s?” they ask. “Highly unlikely. The arbitrary accounting treatment of different innovation strategies of the companies––internal generation vs. acquisitions––had a large effect on the ROA difference, distorting any meaningful comparison of profitability.”
The authors are also highly critical of the proliferation of multiple, subjective managerial projections that account for a larger and larger portion of reported earnings. They argue that GAAP profits, even for highly respected companies such as GE, “are based layers over layers of subjective managerial estimates, projections, and sometimes sheer guesses.” A regime that was supposed to be based on “counting,” they say, is now largely about fiction. Companies, for example, can assign arbitrary values to spending on products in the development stage, when they make acquisitions. By heavily writing down that “in-process R&D,” they can lower the dollar value of the assets they’re adding to their balance sheets, and inflate future return on assets and equity to make their results appear a lot better than they really are.
So what’s their solution? Naturally, Lev and Gu advocate re-categorizing all R&D spending not as expenses–the “R” is for hatching new technologies, and the “D” for tweaking existing ones––but as intangible assets added to the balance sheet.
But their reform agenda goes much further. The authors would require that companies file an annual Strategic Resources & Consequences Report that lists every major corporate initiative, and tracks its success or failure in generating profits. Many of those programs are utterly hidden to investors, including brand advertising, sales force training, customer list development, and enhancement of supply chains. For example, pharma companies provide little detail on the amounts spent, and the potential success in clinical trials, of their therapies. Nor do they inform shareholders of the dangers posed by competing drugs introduced by competitors. The authors would also like to see far more detail from insurance and internet companies on the now opaque “customer churn” rates that show whether their gaining or losing customers in total.
As the authors acknowledge, managers won’t take kindly to their recommendations, since they’d rather maintain their freedom to bend the accounting rules to burnish their reported results. But Lev and Gu are on the side of the accounting angels. Polishing official earnings and ratios doesn’t fool shareholders. They’re interested in the fundamentals that the companies often don’t want to discuss, and that the accounting rules don’t reflect. So let’s revolutionize the rules to fit the Knowledge Economy. And let’s force managers to reveal a lot more about where all the big expenditures are going, what they’re supposed to accomplish, and whether that spending, and the executives who mandate it, are really delivering on their promises. That’s the disclosure investors really want, and richly deserve.