Do financial statements remain a valuable source of information for investors when making investment decisions? The answer to that question has generated some serious debate among US and Australian accounting experts.
For investors in the social media giant Facebook Inc., the events besetting the company in March 2018 were tangible in every sense of the word.
Revelations that a now-defunct British political consulting firm, Cambridge Analytica, had been secretly mining the personal data of tens of millions of Facebook users around the world saw almost US$100 billion wiped off Facebook’s US$500 billion market value in just a week, as its shares plunged 18 per cent.
Yet, for investors brave enough to hang on over the following month, and those lucky enough to have bought in at the bottom, there was a silver lining.
Facebook shares rebounded 9 per cent in one day, on 25 April 2018, as the company reported a 63 per cent surge in March quarter net income to US$4.99 billion.
On the surface, using the recent Facebook crisis as a case study, one could readily conclude that there is a definite correlation between company financial statements and share price behaviour.
“The earnings don’t measure changes of values as they used to. To focus on earnings as many financial analysts are still doing, with all the spreadsheets that they have, which are basically aimed at predicting future earnings, is just a futile exercise.” Baruch Lev, Stern School of Business
Yet, in the accounting world, it seems there’s a divergence of views on just how useful and accurate financial earnings and balance sheets really are in helping individuals to make informed investment decisions.
At the sharp end of this debate is Professor Baruch Lev, head of accounting and finance at New York University’s esteemed Stern School of Business, and co-author of the controversial book The End of Accounting and the Path Forward for Investors and Managers.
Lev and his co-author and fellow US academic, assistant professor Feng Gu at the College of Staten Island, have conducted extensive research, comparing over 60 years of market values of US companies, based on their annual earnings and year-end book values.
What they found “was a continuous and sharp decrease of correlation” between financial results and share price, which Lev says indicates that earnings and book values (net assets) are playing a fast-decreasing role in investor valuations.
“We show that even if you predicted all American companies that would either exactly meet or beat the analysts’ forecasts of earnings, while you would have made huge amounts of money in the ’80s and early ’90s, today it basically is almost zero,” Lev says.
The earnings don’t measure changes of values as they used to. To focus on earnings as many financial analysts are still doing, with all the spreadsheets that they have, which are basically aimed at predicting future earnings, is just a futile exercise.”
An alternative view
But what holds true in the US isn’t universal, and a team of researchers in Australia, funded by CPA Australia, has found that company earnings and balance sheets here do have a stronger correlation with market values.
The Australian team includes Professor Michael Davern, chair of accounting and business information systems in the Department of Accounting at the University of Melbourne, the department’s Melbourne enterprise fellow Nikole Gyles and Monash University senior lecturer in accounting, Dean Hanlon.
The team has conducted an archival data analysis of Australian companies, examining the relationship between share prices, and the earnings and book values published in annual financial statements. It also has undertaken a series of interviews with professional investors, regulators, and other practitioners to understand the processes that equity investors go through in making investment decisions.
“At a simple level, the question we’re trying to answer is whether financial statements are useful for investors in making investment decisions and whether we see any earnings as many change in that over time,” Gyles says.
“What we found in Australia over, I think financial analysts it’s 25 years of regression analysis, is that basically the usefulness remains constant. If you put net income and book value together, our research says that explains with all the 64 per cent of the companies’ share prices, which is much, much higher than the US spreadsheets that evidence was suggesting.”
Why the US and Australia differ
Why is there a discrepancy between the US and Australian findings?
Lev attributes the financial information/share price mismatch in the US to a dramatic increase in corporate investment in intangible assets as their US counterparts, because the R&D spending intensity of Australian companies is on average one-tenth of the R&D spend of American companies. Lev says the problem in the US is the accounting treatment of intangible assets.
Facebook, for example, has $US1.9 billion in intangible assets, including what it calls acquired users, acquired technology, patents and trademarks.
“It’s not the intangible assets themselves, but the clumsy treatment by accountants of intangibles, the mindless expensing of all internally-generated intangibles, and the capitalisation of singular acquired intangibles,” Lev says.
Preparing annual financial statements. This course is designed to help you understand the process of compiling a set of financial statements and develop an awareness of some of the disclosures required, including those relating to the primary statements and those stand-alone disclosures.
He notes that 70 per cent of all high-tech and science-based companies in the US report losses, even though the economy is doing very well and most of these companies have large valuations in the market.
“The reason they report losses is because of this expensing of intangibles. Half of this 70 per cent of the companies that report losses, if they didn’t expense intangibles, they would have reported profits. “For me, I’m satisfied with just capitalising those intangibles. You capitalise investment in a building, why shouldn’t you capitalise investment in a patent?
“All I’m saying is, treat not all intangibles but identifiable intangibles as assets. Capitalise the cost, put it on the balance sheet, and if, for example, in three, four years, nothing comes out of it, then write it off.”
However, Davern says the findings from the Australian team run counter to Lev and Gu's intangibles argument.
“We did an industry-based analysis to see whether there were any differences in the sort of relationships we were observing based on the industry sector: technology, telecom, utilities, health care, and so on. If we compare 2000 to 2015 and to the 10 years prior to that, we’ve actually seen a stronger relationship since that time.”
Differences in reporting standards
A mandated requirement under US GAAP standards is that companies must report quarterly. In Australia, however, under IFRS accounting, most companies report half-yearly.
Davern says the Australian research team's current working hypothesis is that one of the key reasons for the different correlations between earnings and valuations in the US and Australia is reporting frequency.
“In the US, you have mandated quarterly reporting, so they are getting more frequent information. That means that when you get to the end, annual financial statements, you have actually already seen three quarters of that revealed during the year, which is not the case in Australia.
“When you sit there and say, 'Well, there’s not a strong relationship with the annual financial statements and the share price' of course there isn't, because you’ve seen three quarters of the earnings in the quarterly releases that have gone through.
“It's not that the accounting information is more relevant here and less relevant in the US. Our working hypothesis is that accounting information has been released to the market in a regulated form more often in the US, so when you look at any one release of information, that single release is less informative because there’s less news in it.”
The team has presented its initial findings to the Australian Accounting Standards Board research forum, and has also done a presentation to the Accounting Standards Advisory Forum in London.
What should investors do?
The common ground between the US and the Australian researchers is that all investors should do their financial homework by assessing a company’s fundamentals.
Lev says investors have to focus on the real value drivers of the company, and this differs from industry to industry.
“If you are considering the whole range of what is called subscription-based companies, which are all internet companies, telecom companies, media companies and software companies, then the customer franchise is your focus.
“How many new customers were added last quarter, or last year? Is it on the rise? These are the things to look for. If this percentage goes down, I don’t care about the earnings of this company. Sooner or later they will run into serious trouble.
“How much do they spend on what’s called customer acquisition costs? Is it on the rise, or decreasing? You should see it going down as the company grows. If it goes up, this company is in trouble.”
He says this applies from industry to industry.
“It’s not complicated. It’s more involved: you have to work harder in order to understand the strategy, to understand the value drivers, and see how they are operating. That’s my suggestion to investors.”
In a similar vein, Davern says that the starting point for investors is trying to understand what a company’s future performance will be.
“The starting point for that process is very much the annual financial statements, because they’re the most credible and reliable source of information that investors can get,” he says.
“Everything else is potentially biased, estimated in various ways. Here’s the starting point, so it’s the foundation of that investment decision-making that they’re doing.
“It’s back to the fundamentals. [From] both the statistical analysis we’ve done, and our discussions with the professional investors, the annual financial statements are the foundation.
If it doesn’t look good there, it’s not going to get better elsewhere.”
Professor Feng Gu will speak at CPA Congress 2018 in Melbourne, Brisbane, Perth and Adelaide. Find out more at cpaaustralia.com.au/congress
The End of Accounting and the Path Forward for Investors and Managers, Baruch Lev and Feng Gu, Wiley, A$70.95