Five building blocks of radically improved external reports
In recent decades, voluminous and increasingly complex quarterly and annual reports have lost much of their relevance for their primary users: investors. In their book, The End of Accounting, Baruch Lev and Feng Gu empirically prove that the relevance of accounting information is indeed lost, and go on to explain why this happened. Then they introduce new ways to make the reports relevant again.
By Jeppe Kleyngeld
In their book, Baruch Lev and Feng Gu demonstrate that corporate reports have lost most of their usefulness in doing what they are supposed to do: provide investors with information that they can use to make optimal investment decisions. Their shocking conclusion is that the very pricey financial report only provides five percent of the information that investors base their decisions on. Lev and Gu propose a new method called the 'Resources & Consequences Report'. The focus of the 'Resources & Consequences Report' is on the strategic, value-enhancing resources (assets) of modern enterprises, like patents, brands, technology, natural resources, operating licences, customers, business platforms available for add-ons, and unique enterprise relationships, rather than on the commoditised plant, machines or inventory, which are now prominently displayed on corporate balance sheets.
Why the usefulness of accounting information is strongly reduced
No economy can grow and prosper without an active and deep capital market that channels the savings of individuals and business organisations to the most productive investment uses by the private sector. The 'fuel' running this sophisticated capital accumulation and allocation 'machine' is information: the information available to investors and lenders on the prospects of business enterprises, translated to expected risks and returns on investments.
While business models of organisations have radically changed during the past 100 years, the financial reports of companies have hardly changed at all. Therefore, the current reports are fit for companies from the industrial age, not the current information age in which intangible, intellectual assets largely determine the success of businesses.
Pictured: Baruch Lev
One of the major issues is that complex regulations (IFRS/US GAAP) demand uniformity, while optimal reporting is sector specific and can only arise through trial and error. The consequences of the standstill of developments in corporate reporting is that the relevance of reports has enormously declined during the past half century. For investors, the publication of quarterly and annual reports is now usually a non-event from which they learn nothing new.
The most important reasons for the decline in usefulness of financial reports by investors are:
- The ignoring of intangible assets by the accounting system while these are increasingly important for gaining a competitive advantage.
- The ignoring of important business events like increases in customer 'churn rates' (termination) of telecom companies, by accounting. Only transactional information is being reported.
- The notion that accounting is becoming less and less fact-based. The figures are increasingly based on the subjective estimates of corporate managers.
No wonder that privately held companies, which are not affected by investors' decisions based on low quality information, invest considerably more and grow faster than publicly held companies.
An information system that does work
Now that Lev and Gu have explained and empirically proven that current financial reports have lost most of their value to investors, they show the way forward for financial managers. Their 'Resources & Consequences Report' consists of five important attributes that show how the company is creating sustainable value for customers and shareholders. These are strategic resources, mapping investments to resources, preserving and renewing the strategic resources, strategic asset deployment and operation, and measuring the value created. Each will be discussed in turn.
1. Strategic resources
Strategic resources, which are currently hardly mentioned in financial reports, are what give companies their competitive advantage. They share the attributes of being valuable, rare, and difficult to imitate. Enterprises owning and operating such strategic assets efficiently are able to consistently implement value-creating strategies that their present or potential competitors cannot put into effect and thereby gain a sustained competitive advantage. Examples are the algorithms that Netflix uses to make recommendations, the exclusive rights to content (movies, TV series, sport programmes) that the company owns, and unique collaborations. Customers and human capital also fall under strategic resources.
2. Mapping investments to resources
Strategic resources are not free. Instead, they are generated by targeted corporate investments, such as R&D, brand enhancement or acquired technology. Therefore, a quarterly and annual report should inform investors with specificity how the company invests in building the enterprise's strategic assets. For instance, a pharmaceutical company could spend considerable R&D funds developing a drug, or alternatively, acquire a small biotech company that is already developing it. The two routes will obviously have different costs and time to market. Explaining why and how the choices are made is very important for investors evaluating the firm's efficiency in creating and acquiring strategic assets.
Since customers are also strategic assets, the acquiring costs of new customers or costs to keep existing customers satisfied also belong to this reporting category.
3. Preserving and renewing the strategic resources
Since their strategic resources are their means to create customer value, companies should be deeply concerned about competitors infringing on their assets. But infringement by rivals is not their only concern. Disruption is, too. Digital photography replacing chemical photography, Wikipedia replacing traditional encyclopaedias - disruption is an even greater threat to owners of strategic assets. Given the serious and continuous threats of infringement and disruption of strategic assets, and consequently the harm to the enterprise's business model, investors and other constituents should be regularly informed of those threats and the measures taken by the enterprise to safeguard and preserve strategic assets.
Such measures should fall under the risk management function of the company, which is a major component of its internal controls. Included in the preservation of strategic assets are efforts to slow down the obsolescence of these assets. Brands decay (lose their price advantage) without continuous maintenance by advertising and promotion; customers drift away absent company attention and communication; media content, like TV series, wither without sequels; and certain patent lives can be extended by modification of the invention.
The battle against resource obsolescence should be a continuous part of the business model of the enterprise. As such, its essentials should be shared with investors.
4. Strategic asset deployment and operation
How a company actually deploys strategic assets determines the creation of value. Broadband capacity may be fully utilised or only partially used. Big data on the firm's customers can be extensively mined to enhance sales, or this resource can waste away on the firm's servers. Patents can just lie dormant, or they can be developed into profitable products and services, or alternatively, licenced out.
Currently, financial reports only give insight in the outcome of the use of strategic assets, but nothing is written on how this outcome was accomplished. And the choices made can make a big difference in how investors evaluate the long-term outlook of companies. For the sustainability of the revenue, for instance, it would matter if the company made money via streaming content or the rental of DVD, or if products were sold to customers directly through online channels or via external brokers. Understanding which roads were chosen enables investors to understand how a company actually implements its strategy.
Pictured: Feng Gu
5. Measuring the value created
The value created from the chain of resource creation-preservation-deployment is the fifth and final building block of the proposed information system. It involves quantifying and reporting the consequences of managers' efforts to create value with the company's strategic assets. The focus in this chapter should be mainly on the cash that was generated. Revenues and earnings usually contain a lot of estimates and noise and thus will not give a clear view.
Many financial managers are already aware of the shortcomings of current financial information, and are therefore open to making serious improvements. The strong incentives to reduce investors' uncertainty, thereby increasing share prices and reducing the cost of capital, will undoubtedly contribute to managers' willingness to adopt this proposal.