[07/11/21] The Sad State of Accounting – Lev End Of Accounting Blog

         If you invest today in plant or machinery, these assets are recognized as such on the balance sheet and book value, but if you invest in drug development (R&D) or AI, the costs will be expensed in the income statement, dragging down reported earnings and book values. In 2019, the last pre-Covid boom year, a full half of U.S. public companies, and 70% of high tech and healthcare (including drug) companies reported annual losses. Half of these “losers” would have reported profits without the intangibles expensing. This is not a reliable accounting system.

         So, if I were the new chief of the International Accounting Standards Board (IASB), I wouldn’t waste my time on trivialities, like the estimated cash flows from insurance contracts, or income tax accounting. Rather, I would focus on dragging accounting to the 21st century by recognizing as assets the main value-creators of businesses: internally-generated intangibles.

2. Facts, not guesses. Accounting regulators in the past 30-40 years moved steadily away from reporting facts to relying on managerial estimates and guesses, all in the name of the illusory “fair value accounting” principle. Financial reports are currently floating on a sea of estimates, often manipulated by managers: assets write-offs (to current values), goodwill impairment, revenues allocated to future services (software contracts), etc. Current balance sheets are an odd, and rather useless mixture of assets reported at historical (irrelevant) purchase costs, observable current values (traded securities), and guesswork (impaired assets and goodwill). The total of this hodge podge of valuation bases serves to measure profitability: return on assets (ROA).

            A serious IASB chief would focus on reigning-in the constant proliferation of financial report managerial estimates, thereby enhancing the credibility and usefulness of accounting data.

3. Hopelessly behind events. People used to joke about the U.S. “leading from behind.” With accounting, this is not a joke. New accounting standards, like the recently enacted revenue recognition and leases standards, took 10-15 years to enact. Newly-emerging information needs of investors are just being ignored by accountants.

            Consider, for example, the current rush of investors to ESG-intensive companies. Whatever you think of ESG (and I have my doubts about it), a reliable information system which will report on corporate investment in ESG, and particularly on tradeoffs (e.g., how much profits were sacrificed to achieve carbon emission reduction) is currently of great importance to investors. The various rankings of companies by ESG promulgated by various vendors are notoriously unreliable.

            Since ESG doesn’t seem like a passing fad, if I were the new IASB chief, I would start working on a system reporting corporate ESG costs and consequences, but definitely not by initiating a 10-15 years project.

Am I hopeful that my suggestions for an IASB (or FASB) agenda will be adopted? No. But I will be remiss not making my opinion on such an important matter publicly available and open to debate.