Abstract
Despite the interest caused by financial scandals such as Enron and the attempts by bankers and others to blame accountants for the financial crisis, accounting still has a rather sober public image as a necessary but unexciting ‘bean counting’ routine. It may therefore seem remarkable to non-accountants that its students and practitioners display such passion in debating their methodology and its limitations, but the passion may be justified by the important economic consequences of the issues. This book is an example: an impassioned polemic asserting that financial accounting has lost its relevance to investors and proposing a ‘Path Forward’ to remedy this situation. The authors are both distinguished academic researchers, known particularly in recent years for work related to the reporting of intangible assets, an issue which features prominently in their proposed path forward.
The intended audience includes practitioners, particularly investors, so the book is written in a racy style, which sometimes reads like the transcript of a motivational talk, including copious summaries and ‘takeaways’, occasionally facetious asides (often in mid-sentence) and some short ‘sentences’ that lack verbs. However, the argument is clear and forcefully presented and supported by a substantial volume of empirical evidence, with tables, footnotes and references in the style of an academic paper. It is to be hoped that practitioners are not deterred by this important supporting material: debates on accounting policy are too often conducted without resort to evidence. Equally, academics should not mistake the informal style for lack of substance, although they are unlikely to agree with all of the authors’ super-confident conclusions.
The argument of the book runs as follows.
First, in two introductory chapters and Part 1 (chapters 3–7), it is argued (with supporting empirical evidence) that during the past half-century, financial accounts have lost much of their relevance to investors (characterised as ‘the end of accounting’). Both the strong investor orientation and the evidence reflect particularly the experience of the United States, but it seems likely that the case has wider relevance to listed companies worldwide, particularly those that apply International Financial Reporting Standards.
Second (Part 2, chapters 7–10), the authors give their diagnosis of the reasons for this loss of relevance. They identify three factors: the increasing importance of intangible assets (particularly those of the ‘know-how’ variety, which are difficult to report within the traditional framework), the increasing extent of subjective estimates in accounts (such as ‘level 3’ fair values, based on models rather than market prices) and the biased reporting of important value relevant events (such as the results of clinical trials for pharmaceutical companies, which are not reported at all, or the initiation of restructuring programmes, which is reported only when they give rise to impairments rather than gains).
Third (Part 3, chapters 11–15), the authors propose their solution to these ailments of financial accounts. Their main proposal is a Strategic Resources and Consequences Report, which would combine both quantitative (both financial and non-financial) and qualitative data to provide a holistic picture of the firm’s strategic resources and how they have been managed. This type of proposal can be easier to advocate than to implement, but the authors demonstrate their commitment by providing four case studies of firms from different industries, although the information (gathered from publicly available sources) is necessarily incomplete.
Finally (Part 4, chapters 16–18), a practical programme of reform is proposed. It is framed specifically in the institutional context of the United States. Perhaps optimistically, the authors suggest that the new strategic review could be adopted voluntarily, without prescription by the regulator. However, they do suggest that regulatory endorsement (rather than requirement) would be helpful and that managers would be more likely to comply if they were relieved of the existing requirements for quarterly reports. Apart from introducing the strategic review, they suggest three improvements to existing reporting (generally accepted accounting principles (GAAP)): capitalise all expenditure of intangible assets (but do not measure them at current values, unless reliable market prices are available); reduce the extent of subjective managerial estimates in financial reports (notably fair values based on models rather than direct observation of market prices); and reduce complexity, particularly by eliminating detailed requirements for transactions that are industry specific or rare. The section, and the book, concludes with ‘investors’ operating instructions’, urging investors to focus on the strategic assets of the business and their management, rather than traditional short-term accounting measures such as earnings.
In summary, this is a book that will inform and challenge the reader but is best read critically because its central claims are contentious.
First, with regard to the ‘End of Accounting’, the earlier sections of the book do provide some fascinating evidence that the use of financial accounts has changed over the past half-century or so, but this change of use does not necessarily imply such a dystopian conclusion. The authors confine themselves to investment decisions and the role of accounts as a basis for predicting future returns. They do not address the traditional role of accounting as part of accountability, or stewardship, which requires accounting data as a means of confirmation rather than prediction. Given that there are incentives for managers to misrepresent their past performance and future prospects, accounts that report past transactions and events can be an essential check on management, improving behaviour through the prospect of being found out and enhancing investors’ confidence in the more timely but subjective data provided by management.
Even if the stewardship function is ignored, the empirical evidence presented suggests that accounting for investors has a changing role but not necessarily a reduced one (although the rising amount of non-accounting information may reduce the role of accounting information as a proportion of the total). If we accept the authors’ view that accountants should not be valuers but rather providers of useful information to investors who do their own valuations, then it is good news that simplistic summary measures such as accounting earnings or net asset values have a declining role in determining stock market prices. However, this does not mean that the accounts are not providing useful detailed inputs to investors’ more sophisticated decisions. As the electronic availability of data increases, these decisions are likely to use a wider set of economic and financial information than in the past because of its increased volume and timeliness, but such information should complement rather than substitute entity-specific accounts. If we really are approaching the End of Accounting, it is surprising that more than 100 countries have adopted International Financial Reporting Standards since their inception in 2001 and that securities market regulators and investors have been active supporters of the process.
Second, with regard to the authors’ agenda for reform (the Path Forward), in the later sections of the book, there are some useful suggestions and interesting ideas, but hardly the radical proposals that the reader has been led to expect. The centrepiece is the proposed Strategic Resources and Consequences Report. This bears a similarity of purpose to the Management Discussion and Analysis, currently required in the United States, which has counterparts elsewhere. The authors’ proposal is for a more thorough and holistic statement, but this is really an injunction to try harder with existing policies rather than a call for revolution. The content of this statement, and of a number of other proposed reforms, would rely heavily on management being committed to transparency and objectivity (telling it the way it is). Unfortunately, this has not always been the case in practice, as the authors admit by their advocacy of reducing the extent of management estimates in the accounts. Notably, they do not consider the challenge to auditors that their proposals would create. Hence, the authors’ emphasis on voluntary adoption may be naive. Equally, the proposals for better disclosure about intangible assets are hardly revolutionary: they are more a call to systematise and extend the best, rather than the worst, of current practice. For example, the importance to pharmaceutical companies of the product pipeline is already well known, subject to keen attention from analysts and the reason for many disclosures at present.
Overall, this book is a very stimulating and provocative read, which accountants and academics will enjoy even if they disagree with the conclusions. The polemical style of writing encourages criticism, and the critical reader will find plenty of scope for disagreement.