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When: 18 December 2017

Where: ICAEW's Information for Better Markets event, London, UK

Nick Anderson delivered a 'practitioner view' response to a speech by Professor Baruch Lev with the title 'Financial reporting for Investors—do the financial statements give them what they need?' at ICAEW's Information for Better Markets event for academics in London on 18 December 2017. As a former buy-side investor, he shares his views on the important role financial statements continue to have in enabling investors to make investment decisions. 

Response to Professor Lev

I would like to thank Professor Lev for his thought-provoking presentation, and the Institute of Chartered Accountants in England and Wales (ICAEW) for inviting me to respond. (Before I start, let me be clear that the views expressed here are my own and not necessarily those of the International Accounting Standards Board (Board) or the IFRS Foundation.)

I joined the Board in September, 31 years to the day after I started my career as a buy-side investor. For me, analysing reports and accounts has always been a critical element when making investment decisions. So, on a personal level, I find Professor Lev’s thesis curious. While he asserts that the relevance of financial reporting has declined, and although I would admit that sometimes one has to work a little harder when using some aspects of a company’s accounts, my stock-picking seemed to improve with time! Perhaps the wisdom of years?

But let me take a more considered approach to the arguments put forward by Professor Lev.

Growth of intangibles

 As Professor Lev noted, the growth in intangible assets—and their importance in generating value—is indisputable. Intangible assets, of course, come in many different guises—from, for example, software, research and development (R&D), patents, brands, and customer relationships through to workforce and corporate culture. There is a spectrum from the more tangible intangibles to the more intangible intangibles.

It’s interesting to note that some investors are seeking to analyse corporate culture within a more systematic framework. In my experience, a strong culture embedded across an organisation can transform a good business into an outstanding one. But, equally, culture can be a liability; one only needs to think of the misselling of financial products or the scandals around car emissions.

Measuring the impact of financial reporting

The central tenet of Professor Lev’s proposition is that financial reporting fails to recognise many intangible assets and, as a consequence, the relevance of financial reporting has significantly declined. He chooses to calibrate this decline through share-price reactions at the time companies report their results. This perspective of both ‘financial reporting’ and ‘relevance’ is, however, a narrow one.

Financial reporting in its entirety provides a much richer set of information than the data points available on the day a company reports its results. Perhaps sell-side analysts are frustrated by fewer ‘actionable’ price movements. Yet, as a buy-side investor, irrespective of whether I start analysing a new company in March or November, the first document I reach for continues to be the report and accounts.

Professor Lev seeks to augment his case by looking at other measures, such as the dispersion of analyst forecasts. But taken together, these arguments appear inconsistent. According to his research, financial reports are said to ‘provide only about 5% of the information used by investors’. However, when seeking to explain the increased dispersion in forecasts, the same reports are described as the ‘analysts’ main information source’ and ‘at least partly’ to blame for increased dispersion.

The proliferation of non-GAAP metrics is also flagged as an indicator of discontent with the current financial-reporting model; more of this later.

New sources of information

While financial reporting has remained central to the investment process and relevant in an absolute sense, new and valued sources of information have continued to develop.

Companies have lifted their game through the increased professionalism of investor relations and regular events such as capital markets days. Technology has been a major factor. The internet has become both a delivery mechanism and a data source in its own right. Drones flying over car parks to assess retail activity is an example of more recent innovation.

Consider how much more we know about executive compensation than we did 20 or 30 years ago together with the recent explosion of environmental, social and governance data. Given the development of new and valued information sources, we should not expect financial reporting to have maintained its relevance on a relative basis. Still, for many buy-side investors, audited financial reports remain an essential element of the investment process.

A buy-side perspective

Managing ever-increasing flows of information is a challenge for investors. Within the standard-setting community, the perception is that the appetite of users of financial information for more disclosure is insatiable. However, a key issue for buy-side investors is the need to focus on the information and issues that really matter. Significant information from a number of sources is weaved together to build an investment case. Words such as ‘jigsaw’, ‘mosaic’ and ‘holistic’ are often used to describe the process.

Most investors will spend time thinking about the nature and motivation of management, for instance. As part of my research process, I sought to understand where a specific company sat on the spectrum from—at one end—being a management-remuneration vehicle to—at the other end—being focused on generating sustainable economic and shareholder value. Information from a number of sources, including financial reports, MD&A reports, management meetings, sell-side conversations and compensation reports, is drawn together to form a judgement. But the foundation of the process, and the basis for looking forward, remains the financial-reporting framework. Not only is there an interdependency between information sources, but audited financial reports remain a pivotal element.

The role of standard-setters

Professor Lev asserts that standard-setters are responsible for the apparent demise of financial reporting that he seeks to portray. Standard-setters are charged with the ‘abandonment of the traditional income model in favour of asset valuation’. He asserts that the ‘two boards [in other words, our Board and the Financial Accounting Standards Board] pursued vigorously the balance-sheet approach in standard-setting.’

I can only speak as one member of the Board but I strongly refute this argument. It simply doesn’t stack up against any reasonable assessment of the facts. The May 2015 Exposure Draft of the Board’s forthcoming update to its Conceptual Framework clearly states that ‘General purpose financial reports are not designed to show the value of a reporting entity; but they provide information to help existing and potential investors, lenders and other creditors to estimate the value of the reporting entity.’ The Conceptual Framework also acknowledges that the objective of financial reporting ‘is likely to result in the selection of different measurement bases for different assets, liabilities and items of income and expense.’ Information about income and expenses is ‘just as important as the information provided by assets and liabilities.’

The Board has been careful—deliberately so—not to express a preference for either historical cost or current measurement, but rather to consider the specific nature of the economic activities that are to be portrayed. The role of the relevant business model, for instance, is considered when determining the measurement of financial instruments within IFRS 9. If the business model in question is to hold assets to collect contractual cash flows, then measurement is amortised cost; whereas, for a business model where financial assets are for trading, measurement is fair value through the profit or loss.

Furthermore, most users acknowledge that current values have a role to play in financial reporting in combination with the use of a traditional accruals-based approach. Accounting for pension liabilities and stock-based compensation are two examples where investors appreciate that current values better portray the underlying economics.

Moving forward

While I profoundly disagree with Professor Lev’s diagnosis, needless to say, there remains room for improvement in financial reporting. Professor Lev proposes two accounting changes to, in his words, ‘restore the income statement matching.’

Capitalise selected intangibles

Professor Lev’s first proposal is to capitalise and amortise expenditure on identifiable long-term investments such as R&D, IT and customer-acquisition costs. Under existing IFRS Standards, development and software costs can, of course, be capitalised.

The new Standard for insurance contracts, IFRS 17, issued by the IASB in May 2017, requires a company to capture in its measurement of insurance contract liabilities all fulfilment cash flows, including directly attributable customer-acquisition costs. So, although not recognised separately, customer-acquisition costs are effectively capitalised.

Are there other categories of intangible assets that might be better capitalised than expensed? Here the balance to be struck is between decision-usefulness, practicalities and cost. For some of the most defining intangibles, such as culture, I suspect that Professor Lev and I would agree that they are beyond the scope of financial reporting.

In relation to intangibles, Professor Lev is right to flag the inconsistent treatment of acquired intangible assets, such as brands and customer lists, and those developed organically. Of course, this inconsistency can be resolved in one of two possible ways. It is also interesting to note that there is little evidence to suggest that investors have found recognition of these assets useful.

Treatment of ‘one-off’ costs

The second change proposed by the Professor is to characterise what are described as ‘numerous one-off items like goodwill write-offs and restructuring expenses’ as other comprehensive income (OCI) rather than profit or loss. He cites the growth in non-GAAP performance measures as an indicator of discontent with GAAP accounting.

The proposal to post restructuring costs through OCI troubles me. Restructuring costs have grown in frequency over recent years and in most cases these are cash costs. Putting these through OCI would be like giving companies a blank cheque. (It would certainly encourage investors to pay greater attention to OCI!)

It’s also interesting to note that the recent trend among US companies has been for fewer of them to adjust for stock-option expenses in non-GAAP metrics. The IASB is considering measures of management performance as part of its Primary Financial Statement project, including the issue of persistency.

Finally, I would like to comment on two other suggestions that Professor Lev makes in his book The End of Accounting, which I read with interest.

Focus on residual cash flows

Investors are advised to focus on cash flows, specifically residual cash flows, rather than reported earnings. In this respect, it’s worth distinguishing between sell-side analysts, focused on earnings, and those on the buy-side, where the importance of cash flows and reinvestment opportunities has been well understood for many years. In response to feedback from users of financial information, the Board has introduced a requirement for companies to reconcile the movement in debt from one year to the next. This will help analysts ensure that they capture changes in cash and debt and provide a stronger foundation to forecast cash flow.

Analyse strategic assets

The second piece of advice in Professor Lev’s book is for investors to focus on the strategic assets of a business and for companies to develop a new report on their strategic resources. This would seem to be a key element to any fundamental assessment of a company’s prospects; the development of something akin to a strategic-resources report by more companies would be welcome. Indeed, the greater prevalence of intangible assets was one of the reasons why the Board agreed to add a project to update its Management Commentary Practice Statement.

The Professor recognises that producing a strategic-resources report would be an additional reporting burden for most companies and suggests that we should do away with quarterly reporting as a quid pro quo. While I miss some aspects of managing money, it’s fair to say that quarterly reporting isn’t one of them. It’s a joy no longer to be subject to the tyranny of the quarterly reporting cycle—and this is one change that many buy-side investors would welcome.

Summary

Financial reporting remains a fundamental element in the investment process. Over my last five years managing money, working with my co-manager, our fund delivered top-quartile returns. Could we have achieved these returns without access to financial reports that we knew we could trust? I don’t think that would have been very likely. Of course, that’s not to say that today’s reporting is perfect. There will always be room for improvement and the Board remains committed to its mission to develop standards that bring transparency, accountability and efficiency to financial markets.

Once again, let me thank ICAEW and Professor Lev for stimulating the debate. Although we have some different views, discussing these issues is important, especially given that we share the same objective: to improve the effectiveness of financial reporting. Thank you.