Consider this idea: perhaps GAAP-based accounting numbers aren’t giving stock investors all the information they need.
What is wrong with this picture?
In April, Netflix announced their earnings fell short of analysts’ expectations. Usually that would drop the stock price. What happened?
Nexflix stock jumped 18%.
What could cause that? The market supposedly has incorporated the consensus into the price. Missing the expectation should drop the price.
Consider this: At the same time, Netflix announced their new-subscribers were 4.9 million instead of the expectation of 4.0M.
That means they will have stronger earnings for the next several quarters than was expected the day before the announcement. Thus, the stock price rose.
Investors looked at the new subscriber tally as a better indicator of future earnings and thus future stock price than this quarter’s GAAP net income. New subscribers is more important than EPS.
If you wonder are wondering why GAAP EPS isn’t the driving force in that story, here is a brain stretcher for you:
“The End of Accounting”
Professors Baruch Lev and Feng Gu point to The End of Accounting and the Path Forward for Investors and Managers in their June 21 Wall Street Journal article.
You can find the book at Amazon here. It is a bit steep, $32 in hardback and $26 in Kindle format, which is really high for an e-book. I already have a copy on my e-reader. Started reading it yesterday.
The professors suggest that reported earnings under GAAP are losing relevance for investors as we move further and further away from an industrial economy. When know-how, processes, patents, using the internet, and other intangibles are the source of income, GAAP doesn’t report useful information for figuring out future earnings.
By the way, keep in mind that providing historical information to readers of the financial statements to allow them to make estimates of future earnings and cash flows of the company is, like, sorta’, kinda’, the purpose of GAAP financial statements.
The problem with GAAP
Some drawbacks in looking at GAAP numbers, according to the professors:
- Things that create value, such as IT, patents, and brands, are expensed. The balance sheet has no indication of the future value, or whether the intangibles are going up or down. Are companies building for the future or giving up the future to add a few cents to EPS?
- Long term items creating growth in the future are mixed together with one-time adjustments on the income statement.
- Assets that have no market, such as untraded bonds, are carried at some sort of fair value measurement.
- Lots of factors are subjective estimates vulnerable to managing the number. Consider depreciation, allowance for bad debts, pension liabilities.
Don’t even start discussing the issue of when to impair goodwill.
I’ll add to the discussion California’s state pension plan; the assumed long-term earnings rate is 7%, or so I hear. Only in a fantasy world is that a good assumption. What happens to the liability if 6% or 4% is used?
UPDATE: Okay, I’ll get started on the California pension fiasco. On the mess in the CalPERS retirement plan that GAAP reporting hides, The American Interest explains The California Pension Bomb Just Got More Explosive. Current assumed long-term rate of return is 7.5%. Dropping that to 5% would add a trillion dollars to the pension deficit. Actual return for the 6/30/16 fiscal year was 0.61% on top of a 2.4% for 2015. State budget for FY 17 is $123 billion. The increased shortfall from dropping the assumed return from 7.5% to 5% would be offset if the state did not spend one dollar for the next 8 years. Those GAAP numbers are cool because the CalPERS management said so. Do you suppose it might just be material to voters that their state taxes will need to double for the next ten years or so just to cover the gap between 7.5% and 5%, to say nothing of how many decades it will take to cover the full shortfall?
All those factors and others make backward looking GAAP numbers of
little shrinking use to investors, according to the professors.
What are investors looking for? We’re not talking about taking the GAAP numbers and splitting them out in some creative way, backing out some components you don’t like along the way.
The professors suggest the following might be what investors want:
… metrics like customer growth and churn rate, test results of products under development, policy renewal and cancellation rates of insurers, or capacity utilization of transportation companies, that reflect the business strategy and its execution, rather than reported assets, liabilities or profits.
The professors suggest there are sector specific indicators that would tell far more about the future of a company than GAAP numbers.
How would the reported financial statements look if the following information was included in the required disclosures?
customer acquisition costs,
additions and churn rate for internet, telecom and media companies;
the progress and risk diversification of the product pipeline of pharma and biotech firms;
capacity utilization and route changes (coverage) of transportation enterprises; or
frequency and severity of claims for insurance companies.
They also suggest:
- Same-store sales.
- Book-to-bill ratio. That would be order backlog. I don’t spend any time in the world of stock analysis, but seems to be the backlog number would be a superb proxy for top line revenue of Boeing or SpaceX for the next year or two.
- Replacement ratio. Portion of oil reserves replaced compared to amount drilled for petroleum industry. Seems to me that is a good indicator whether a Big Oil company is building or draining future value.
I’ll make a wild guess there are two or three such KPI in every sector of every industry. Such indicators would tell a good tale of how a company is doing and their prospects for the future.
The professors suggest developing
…industry-specific, coherent and uniform strategic information frameworks that focus on the strategy of the company and the success of its execution and value creation by managers.
CPAs have the tools to provide assurance on those new indicators
I’ve heard and realized for a long time that financial statements are loosing relevance to investors.
How many mutual fund investors look at financial statements? I’ll bet most are like me; your broker’s web site has all the info needed to select mutual funds with the audited financial statements available at a link, if you really, really want to see them. I’ll guess the audited financials are irrelevant to the overwhelmingly vast majority of mutual fund investors.
That should be of concern to auditors.
In the first chapter of the book, the authors say the learning offered in the book is available to anyone:
Common sense, intuition, and a strong desire to improve your investment performance are all that is required for reaping the benefits of this book.
Anyone can join the party. Open admission to the class offered by the profs.
Open admission, so to speak (except for diehard accountants whose peace of mind might not endure this book’s message.)
It isn’t just CPAs and company accountants who will struggle with maintaining their peace of mind after reading the points in this book. I’m a CPA and that is my audience. And yeah, the message might be hard to hear for those of us who take the description ‘diehard accountant’ as a high compliment.
The funny thing? CPAs could audit that information. Tools already exist. The auditing standards will apply directly to some parts of the professors’ suggested reporting framework. For all the other parts, the attestation standards we have on the shelf today could be used to put an accountant’s report around those pieces of information.
I think we CPAs have tools on the shelf that would allow us to support this kind of transition. What a radical idea, huh? Perhaps we could show some creativity, responsiveness to the market, and an ability to reinvent ourselves.
Interview with authors
Accounting Today has an interview with the professors: Is This the “End of Accounting”? Maybe So.
Authors point out there is a growing disconnect between share prices and GAAP reporting.
This is one factor why companies are providing non-GAAP measures: Investors need and are asking for something more. The downside pointed out by the authors is that each company develops its own measures. The expected result is lack of consistency from company to company and likely lack of consistency from year to year for a company.
Another downside, it seems to me (based on watching casually from a distance), it that non-GAAP metrics is use today typically consist of taking GAAP numbers, pulling them apart, then putting them back together in a desired structure. The result is some scrambled-egg version of the GAAP numbers.
Standard, industry-wide metrics would be more helpful and provide consistency between companies and across time.
Again, I think CPAs familiar with all the tools on our tool shelf could jump into providing assurance on such a reporting framework as soon as the framework was approved.
So, how is that for your brain stretcher for the day?