Fresh out after getting my MBA, I went to work for a large management consulting firm doing forensic and litigation consulting work. With the office located in downtown Washington D.C. many of the senior leaders were former Security and Exchange Commission (SEC) employees who had moved to representing various clients in regarding SEC filings. I had a first-row seat to many of the cases that conflicted Wall Street during those many years including stock-option backdating and class action litigations. What always amazed me was the volume of information disclosed in financial reports and where that valuable information was located. The focus of regulatory scrutiny always tended to be on financial statement line items, while the true value information was always in the notes and management discussion and analysis (also called MD&A) of the SEC filed documents.
Apparently, I was not the only one that noticed this trend. Earlier this summer, two New York university accounting professors released what can be characterized as an indictment against traditional SEC-compliant financial reporting, for failing to provide sufficient performance information on companies to render an appropriate assessment and market valuation.
While shortcomings in financial reporting have been presented by a number of sources, there has never been a concerted effort to the extent as Baruch Lev and Feng Gu (“Lev and Gu”) provide in the way of statistical evidence to resoundingly demonstrate how inadequate financial statements are in valuation assessments.
“CONTAMINATED FUEL AT GAS PUMPS WOULD HAVE CAUSED A PUBLIC UPROAR AND TRIGGERED REGULATOR ACTIONS. CONTAMINATED INFORMATION, CAPITAL MARKETS’ ‘FUEL’, SHOULD LIKEWISE DRAW GENERAL CONCERN AND ACTION.” BARUCH LEV & FENG GU
THE END OF ACCOUNTING AND THE PATH FORWARD FOR INVESTORS AND MANAGERS
But Where is the Harm?
Bad, inaccurate, misleading or absent financial reporting information that is vital to properly appraising risk leads to sub-optimal market investment decisions.
- Individual and institutional investors are harmed by an inadequate assessment of risk, leading to investment losses.
- Corporate lenders risk losing both principle and interest if they grossly underestimate the risk of funding borrowers.
- Government health service programs, energy initiatives and military aerospace development projects are at risk (as are their constituents), for failing to properly establish the financial risk of selecting a chosen corporate or non-profit service provider.
- Corporate and non-profit executives also fail, if they do not sustain their strategic advantage in the markets they serve and ensure they have sufficient cash flow to protect and grow their strategic resources.
The list goes on and on….Think again if you think this should not be a priority. Over 52% of companies in the Fortune 500 in 2000 “have gone bankrupt, been acquired, or ceased to exist.”
Financial Reports Don’t Support Market Cap Projections
While reviewing financial reporting and statistical data from thousands of publically held corporations going over decades, the authors show readers that the reasons firm market valuation have become less dependent on financial statements is the marked and appreciable influence of intangibles have eclipse fixed assets, like property, plant and equipment (PP&E). This has been particularly evident in the software industry where the knowledge capital of a firm’s employees are treated as a period expense as opposed to assets that create future economic value. The assets that knowledge workers are constructing, whether it’s new biopharmaceutical drugs, predictive marketing software algorithms, big data integrations, or cultivating agreements with third party hardware manufacturing plants, it is not captured as an asset on a company’s balance sheet. This ongoing knowledge creation effort has more to advancing their company’s valuation than releasing past-focused financial reportage.
The assets that knowledge workers are constructing, whether it’s new biopharmaceutical drugs, predictive marketing software algorithms, big data integrations, or cultivating agreements with third party hardware manufacturing plants, are no longer effectively captured as an asset on a company’s balance sheet. This ongoing knowledge creation effort has more to do with advancing a company’s valuation than releasing past-focused financial reports.
Lev & Gu concede that past financial performance may provide a general tendency for where future performance may be expected, but dramatic changes in technology can result in entirely new companies replacing an industry leader. Balance Sheets and Income Statements, slicked up with photos, mission statements, and boilerplate disclaimers fail to tell the future. Furthermore, non-representation on the financial statements of the true value of intangibles owned or managed, un-documented specificity on how accounting estimates were prepared and their value, as well as extreme conservatism being reflected in one-time expense adjustments, without booking their intended future value all pointing to a financial reporting system that has outlived its useful life.
At last, the current financial reporting structure is not meant for valuation or effective information dissemination but for controls and compliance when markets were dawning during the industrial revolution. Framing the basis for future financial success in markets and valuation must be found elsewhere.
Strategic Assessment Information, Please!
Having performed a tour de force, demonstrating how no exclusive financial reporting or accounting value can help us get closer to a firm’s market valuation, the authors move on to where information on a firm’s projected future value can be assessed. This requires extracting mostly factual, non-accounting and accounting values that can be used to determine a firm’s competitive advantage in markets, as well as how they are building, leveraging and protecting their strategic resources to generate future cash flows. This takes the form of a proposed “Strategic Resources & Consequences Report”.
To add greater credence to their report, the authors then proceed to document how that report may appear, using as an example Sirus XM Inc. They review insights discovered while creating a chain of questioning that investment analysts would be expected to ask. To validate the information’s content utility to investment analysts, the authors indicate they conducted a survey to test the importance of the information in a firm’s valuation, which bore out the usefulness of their criteria.
Also provided were partial report reviews of how to treat property & casualty insurance firms (using Allstate as an example); pharmaceutics & biotech firms (using Pfizer, Giliad Sciences & Merck); and Oil & Gas firms (using Devon & Occidental Petroleum).
Where To Now?
Simply adding more work to the CFO and their team is not Lev’s & Gu’s intent. They’d like to see reciprocity on the side of the SEC to relax mid-year reporting, like financail reporting in the first and third fiscal quarters while sustaining the mid-year and year-end reports. They also invite an effort to reduce the level of financial regulations, which did not deter Enron, Worldcom, Countrywide, Lehman Brothers and Washington Mutual from collapsing. Rather than adding regulations, the authors insist on relaxing and simplifying accounting reporting regulations, while allowing room for experimentation, to more readily arrive at more widely accepted market cap valuations across industries and firms of all sizes.
They also invite an effort to reduce the level of financial regulations, which did not deter Enron, Worldcom, Countrywide, Lehman Brothers and Washington Mutual from collapsing. Rather than adding regulations, the authors insist on relaxing and simplifying accounting reporting regulations, while allowing room for experimentation, to more readily arrive at more widely accepted market cap valuations across industries and firms of all sizes.
While government bodies consider Lev’s & Gu’s proposal, those in corporate finance can start building their own unique versions of “Strategic Resources & Consequences” reports. This will help them sharpen their firm’s internal assessment of corporate strategies, measure how well they are executing their tactical programs objectives and prepare their C-suite for the next round of investor meetings and conference calls.
What types of external financial reporting do you provide to outside stakeholders besides financial statements? Please add comment below.
Really interesting article on financial reports of the company.