The Fading Usefulness of Investors' Information

Corporate financial reports—balance sheets, income and cash flow statements, as well as the numerous explanatory footnotes in quarterly and annual reports and IPO prospectuses—form the most ubiquitous source of information for investment and credit decisions. Many stocks and bonds investors, individuals and institutions, as well as lenders to business enterprises look for financial report information to guide them where and when to invest or lend. Major corporate decisions, such as business restructuring or mergers & acquisitions, are also predicated on financial report indicators of profitability and solvency. Responding to such widespread demand, the supply of corporate financial information, tightly regulated all over the world, keeps expanding in scope and complexity. Who would have imagined, for example, that the accounting rules determining when a sale of a product should be recorded as revenue in the income statement would extend over 700 (!) pages?¹ Eat your heart out, IRS. Its complexity notwithstanding, financial information is widely believed to move markets and businesses. But does it?

Like a Consumer Reports evaluation, we examine in the first part of this book the usefulness of financial (accounting) information to investors and, regrettably, provide an unsatisfactory report, to put it mildly. Based on a comprehensive, large-sample empirical analysis, spanning the past half century, we document a fast and continuous deterioration in the usefulness and relevance of financial information to investors' decisions. Moreover, the pace of this usefulness deterioration has accelerated in the past two decades. Hard to believe, despite all of regulators' efforts to improve accounting and corporate transparency, financial information no longer reflects the factors—so important to investors—that create corporate value and confer on businesses the vaunted sustained competitive advantage. In fact, our analysis (Chapter 4) indicates that today's financial reports provide a trifling 5 percent of the information relevant to investors.

To avoid undue reader suspense, Part II of the book identifies, again with full empirical support, the three major reasons for the surprising accounting fade, thereby laying the foundation for the main part of the book: our new disclosure proposal outlined in Part III, which directs investors with specificity to the information they should seek for substantially improved investment decisions. Our proposed disclosure to investors is primarily based on nonaccounting information, focusing on the enterprise's strategy (business model) and its execution, and highlighting fundamental indicators, such as the number of new customers and churn rate of Internet and telecom enterprises, accidents' frequency and severity—as well as policy renewal rates—of car insurers, clinical trial results of pharma and biotech companies, changes in proven reserves of oil and gas firms, or the book-to-bill (order backlog) ratio of high-tech companies, to name a few fundamental indicators that are more relevant and forward-looking inputs to investment decisions than the traditional accounting information, like earnings and asset values, conveyed by corporate financial reports. Such reports, moreover, are outright misleading for important sectors of the economy, such as fast-growing technology and science-based companies, often portraying innovative and high-potential enterprises as losing, asset-starved business failures.

In short, based on our evidence, we grade the ubiquitous corporate financial report information as largely unfit for twenty-first-century investment and lending decisions, identify the major causes for this accounting fade, and provide a remedy for investors. But wait.

Who Cares?

So what if financial (accounting) information lost much of its relevance to investors in recent decades? Who besides accountants, and accounting educators like us, should care about that? With modern information technologies, the proliferation of data vendors (Bloomberg, FactSet), and the ubiquity of financial social media sites, investors can surely supplement the relevance-challenged accounting data with more pertinent and timely information. So, why bother about the fading usefulness of financial information? Why this book?

For the simple and compelling reason that there aren't and never will be good substitutes for corporate-issued information, since corporate managers are always substantially better informed about their business than outsiders. Managers are privy, for example, to recent sales and cost trends, the progress of drugs or software products under development, customer defection rate (churn), new contracts signed, and emerging markets penetration rate, among many other important business developments. No information vendor, Internet chat room, or even a sophisticated analyst can provide investors such “inside” information. No advances in information technology and investors' processing capacity (Edgar, XBRL) can overcome the fundamental information asymmetry—managers know more than investors—inherent to capital markets. You might not like it, but that's how it is and will be.

In fact, in subsequent chapters we provide empirical evidence suggesting that the quality of the overall information used by investors continuously deteriorates and share prices reveal less of companies' value and future prospects. Not the buzz, hype, and financial Internet chatter, which are surely deafening; rather the hard, fundamental data so crucial for investors' decisions. So who cares? Investors, policy makers, and even corporate managers should be highly concerned with our findings of the fast-diminishing relevance of financial (accounting) information.

But our book doesn't end with this downer. Far from it. In Part III of the book—its main part—we propose a new, comprehensive information paradigm for twenty-first-century investors: the Strategic Resources & Consequences Report. For clarity, we demonstrate this information system on four key economic sectors: media and entertainment, insurance, pharmaceutics and biotech, and oil and gas. The focus of this Resources & Consequences Report is on the strategic, value-enhancing resources (assets) of modern enterprises, like patents, brands, technology, natural resources, operating licenses, customers, business platforms available for add-ons, and unique enterprise relationships, rather than on the commoditized plant, machines, or inventory, which are prominently displayed on corporate balance sheets. The main purpose of the proposed information system is to provide investors and lenders (and managers, too) with actionable, up-to-date information required for today's investment decisions. It directs every investor and lender to seek from companies the information that really matters, rather than the information regulators believe is good for you. So, what you get in this book is a package deal: comprehensive evidence that the information you used to rely on lost much of its usefulness, along with the reasons for this relevance lost, and a clear articulation of the information you should seek and use to assess the performance of business enterprises and chart their future potential. The book concludes with three important chapters: How exactly can our radical change proposals be implemented (Chapter 16); how should the current accounting and reporting systems be restructured to advance them to the twenty-first century (Chapter 17); and how should investors and analysts transform their investment routines in light of this book's message (Chapter 18).

In short, this is an operating instructions book for investors, directing them with specificity to the information leading to successful investment and lending decisions, as well as guiding corporate managers, many of whom intuitively realize the serious shortcomings of financial information, how to enhance their information disclosure. Importantly, while this book deals with highly complex, often confusing financial information, and is fully backed by large-sample empirical evidence, you don't have to be an accountant or a statistician to fully comprehend it. In contrast with typical academic courses, there are no prerequisites for this book. Common sense, intuition, and a strong desire to improve your investment performance are all that is required for reaping the benefits of this book. Open admission, so to speak (except for diehard accountants whose peace of mind might not endure this book's message).

Not Only for Investors

While the intended readers of this book are mainly investors and lenders, alerted here to the hazards of using outdated, inadequate financial report information in making investment and lending decisions, the implications of our findings are far reaching and of considerable interest to wider audiences: corporate managers, accountants, and capital market regulatory agencies. These widespread implications stem from the unique role of the corporate accounting and reporting systems in the economy.² To fully grasp this role, and the implications of our findings, we have to briefly consider the impact of financial information on economic growth and the perplexing uniqueness of accounting regulation. Bear with us, you don't get this in business school.

Financial Information, a Major Driver of Economic Growth

While you surely heard, and perhaps even personally experienced, that accounting is outright boring, it's nevertheless vitally important. Here is why. No economy can grow and prosper without an active and deep capital market that channels the savings of individuals and business organizations to the most productive investment uses by the private sector.³ Promising biotech companies, software producers, energy startups, and healthcare enterprises rely on the stock and bond markets to raise the much-needed funds to finance their capital investment and R&D, and attract talent by offering shares and stock options. In capital markets, investors' funds chase corporate growth opportunities and, vice versa, desert failing businesses. 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, directing investors' capital to its most productive uses. Poor information, in contrast, seriously distorts investors' decisions by misdirecting their capital to failed enterprises, while starving worthy ones. The economic “growth machine” falters with the contaminated fuel of low-quality information.

For years, Enron's and WorldCom's glowing—yet misleading—financial reports masked the operational failures of these companies and drove investors to plow billions of dollars into them, only to see their fortunes go down the drain, and, more seriously, depriving other worthy investments of much-needed capital.⁴ But note, it's not only fraudulent information that impedes investment and growth; it's mainly the poor quality of “honest” financial reports, legitimately disclosed under the current, universally used accounting system, that seriously harms the capital allocation system and economic growth. Consider:

Biotech companies developing promising drugs and medical instruments, as well as high-tech and Internet startups, often report heavy losses because their investments in R&D, brands, and customer acquisition are treated by accountants as regular, income-reducing expenses, rather than assets generating future benefits. Many such enterprises encounter difficulties in raising money by going public, or, once public, in getting additional funds in the capital or debt markets because promising investments are erroneously perceived by investors as enterprises awash in red ink.⁵ For established enterprises, important business events—like increases in customers' “churn rate” (termination) of telecom, Internet, and insurance companies, which is a leading indicator of serious operating problems—aren't reported to investors. Nor is there full and timely disclosure to investors of the success or failure of clinical trials for drugs under development by pharma companies. As for the information conveyed by corporate reports, it's often subject to serious biases, like reflecting the costs of restructuring without its benefits (conservatism, in the accounting parlance), and uncertainty due to heavy reliance on managerial forecasts and estimates that are subjective and sometimes unreliable. These, and other reporting shortcomings are detailed in Part II. All in all, a largely deficient source of information for investors. 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.⁶

Given the crucial role of financial (accounting) information in fostering prosperity and growth of business enterprises and the economy at large, the serious deficiencies of this information, documented in the following chapters, should be of great concern not only to investors—the primary users of the information—but also to managers, accountants, and policy makers. Corporate managers, in particular, should be concerned with the deteriorating usefulness of financial information, since the consequent increasing opaqueness of companies elevates investors' risk and companies' cost of capital, and reduces share values.⁷ Contaminated fuel at gas pumps would have caused a public uproar and triggered regulatory actions. Contaminated information, capital markets' “fuel,” should likewise draw general concern and action.

Unique among Regulations

Accounting's usefulness deserves critical examination, not only because of its central economic role, but also due to its unique, yet little known, institutional status. Did you know that those, rather obscure, accounting rules and procedures underlying financial information are like the law of the land? They have, in fact, a legal status, because public companies have to follow them to the letter in generating financial information.⁸ But what makes accounting regulation unique and imposes a heavy burden on the economy is that, unlike any other regulation, it is mandatory for all public companies, uniform throughout the world, and constantly expanding.

Start with uniformity: Financial reporting regulations are by and large identical throughout the world. In practically every free-market economy, public companies must periodically disclose to the public balance sheets, income, and often cash flow statements of essentially identical structure, form, and content.⁹ Furthermore, the financial statements of all public companies must be audited by external auditors (certified public accountants—CPAs) and are closely monitored by national regulators, like the SEC in the United States. We are not familiar with any other law or regulation that is similarly uniform throughout all free-market economies. Different cultures, economic institutions, and developmental histories exert strong effects on national laws (genetically modified food products are generally banned in Europe but not in the United States; capital punishment is legal in some countries, but not others). Accounting and financial reporting regulations defy diversity.¹⁰

That's a good thing, you say: The global uniformity of accounting—one business language throughout the world—saves information generation and processing costs to multinational firms, but the unintended consequences of this uniformity are serious. In particular, uniformity deprives accounting of a major force for innovation and rejuvenation—the vital experimentation and evolution that come with diversity. Regulatory development is generally a trial-and-error process, as in the regulations prohibiting tobacco smoking in public places that emerged slowly and sporadically (Minnesota in 1975 was the first US state to ban smoking in most public places), gaining worldwide adoption only after extensive experimentation. Even now, countries differ in the extent of smoking bans. Same with environmental regulations, where cross-country differences are legion. In contrast, the stagnation of the accounting system and the consequent loss of relevance—documented in this book—can be, in part, attributed to the absence of any experimentation with new information structures or modes of disclosure, which comes from diversity of reporting across countries or regions. This is most evident by the fact that accounting regulations keep piling up and ineffective ones are rarely abolished: no trial, no error—just more of the same.

Often, regulatory competition among states in the United States, or stock exchanges around the world, leads to regulatory and institutional improvements (the evolution of gas fracking regulation in the United States, for instance), but there has never been competition on accounting and financial disclosure systems. Even the small differences between certain specific accounting procedures mandated in the United States (GAAP) and those in Europe and certain other countries (IFRS) could soon disappear due to the pressure to converge (harmonize) these systems. Continued fading relevance will be the consequence of such convergence. In contrast, our proposals, set forth in Part III, call for extensive innovation and experimentation in corporate disclosure to investors.

What's also unique about financial reporting regulations is that they keep expanding, constantly increasing the social cost burden. Each wave of corporate scandals and financial failures brings in its wake new accounting and reporting rules aimed at rectifying past failures, and new economic and business developments trigger further changes to accounting regulations. But, old, dysfunctional accounting rules, like the expensing of R&D, rarely die, nor fade away (unlike General MacArthur's memorable old soldiers), they just proliferate. The only regulations that are similar to financial reporting in scope, cost, and constant expansion are environmental laws, with one crucial difference: Environmental regulations are constantly, often heatedly debated and challenged in the public arena. The current controversies in the United States about carbon tax, subsidies for alternative energy sources, and gas fracking, are but a few examples. And not just in the States: In July 2014, Australia scrapped its unpopular national carbon tax, instituted just two years earlier. Such close public scrutiny significantly improves the quality of environmental regulations and mitigates their cost. In contrast, we aren't aware of a serious, change-leading public scrutiny of corporate financial reporting, not even after repeated, demonstrated failures, such as the 2007–2008 financial crisis, which made clear that the financial reports of the troubled institutions—Citibank, AIG, Merrill Lynch, Lehman Bros., Countrywide Financial—didn't alert investors and regulators to the excessive risk-taking and the poor quality of bank assets that caused the failures.¹¹

The absence of experimentation and serious public scrutiny, and the constantly rising social costs of accounting regulations set the stage for a comprehensive examination of mission accomplished: the usefulness of corporate financial information to investors, on which we embark in this book.

About Us and Our Approach

We, the writers of this book, are veteran accounting and finance researchers and educators, and one of us has extensive experience in public accounting, business, and consulting. For years we have documented in academic journals the failure of the accounting and financial reporting system to adjust to the revolutionary changes in the business models of modern corporations, from the traditional industrial, heavy asset-based model to information-intensive, intangibles-based business processes underlying modern companies, as well as documenting other accounting shortcomings. While not alone in this endeavor, our impact on accounting and financial reporting regulations has regrettably been so far very limited. But we now sense an opportunity for a significant change, motivating this book. The deterioration in the usefulness of financial information has been so marked, that it can no longer be glossed over. Corporate managers, realizing the diminished usefulness of financial information, respond by continuously expanding the voluntary disclosure to investors of non-GAAP (accounting) information. Thus, for example, the frequency of releasing proforma (non-GAAP) earnings doubled from 2003 to 2013, standing now at over 40 percent.¹² Researchers, too, sense a serious problem: A recent study by leading accounting researchers examined the impact on investors of all the accounting and reporting rules and standards issued by the Financial Accounting Standards Board (FASB) from its inception (1973) through 2009—a staggering number of 147 standards—and found that 75 percent of these complex and costly rules didn't have any effect on the shareholders of the impacted companies (improved information generally enhances shareholder value), and, hard to believe, 13 percent of the standards actually detracted from shareholder value. Only 12 percent of the standards benefited investors. Thus, 35 years of accounting regulation came to naught.¹³ The SEC is concerned, too:

Consider, for example, the current initiative of the US Securities and Exchange Commission (SEC)—Disclosure Effectiveness—aimed at “… considering ways to improve the disclosure regime for the benefit of both companies and investors.”¹⁴ The SEC invited input and comments to this initiative, and indeed, a Google search reveals scores of mostly extensive comments and submissions by business institutions, accounting firms, and individuals. Reviewing some of these submissions, we are struck by the following common threads, which sadly remind us of previous futile attempts to enhance financial reporting effectiveness: Commentators generally presume to know what information investors need without articulating how they gained this knowledge (research, surveys), and proceed with improvement recommendations that often boil down to generalities, like reduce information overload, focus on material information, or streamline and increase reliability of information, without identifying how exactly this should be done.¹⁵ The exceptions are suggestions with a specific agenda, calling for environmental, social, or sustainability disclosures that are bound, we suspect, to antagonize most information suppliers (i.e., corporate managers).¹⁶ Finally, most suggestions cut across all industries—a straightjacket approach, typical to current financial disclosure. Thus, despite the good intentions, we are skeptical that the current SEC's effort will fare better than its predecessors' in leading to real improvements in disclosure effectiveness, bringing to mind the famous remark: “Everybody complains about the weather, but nobody does anything about it.”¹⁷

We approached our mission in this book—to alert investors to the information they should seek and use for successful investment and lending decisions, and in the process enhance disclosure effectiveness and improve capital markets efficiency—differently:

• First, rather than assume that financial disclosure lost its effectiveness, we document comprehensively, on large samples of companies, the fast diminishing relevance of this information to investors, and proceed to identify, again, evidence-based, the major reasons for this information fade (Parts I and II). This identification of failure drivers guided our choice of the information modes that will improve investors' decisions.
• Second, rather than presume to know what information investors need, we conducted a detailed examination of hundreds of quarterly earnings conference calls and investor meetings in four major economic sectors, distilling from analysts' questions the specific information items crucial for investment decisions. This, we backed up with lessons from economic theory to construct new industry-specific information paradigms—the Strategic Resources & Consequences Reports—proposed in Part III.
• Third, again, in the tradition of research, we don't just claim that our proposed information is required by investors—we prove it. We show that selected nonaccounting information items we propose, like insurance companies' data on the frequency and severity of claims, are correlated with companies' stock prices and future earnings, hence their relevance to investors.
• Last, our only book agenda is to outline to investors and lenders the information needed for assessing the performance and potential of twenty-first-century business enterprises, thereby improving investment decisions and enhancing the functioning of capital markets. Corporate financial reporting will benefit, too.

Enough said.