Gu Feng - The End of Accounting and the Path Forward for Investors and Managers

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Copyright 2016 by Baruch Lev and Feng Gu. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Names: Lev, Baruch, author. | Gu, Feng, 1968- author.

Title: The end of accounting and the path forward for investors and managers / Baruch Lev, Feng Gu.

Description: Hoboken, New Jersey : John Wiley & Sons, Inc., 2016. | Series: Wiley finance series | Includes index.

Identifiers: LCCN 2016007850 (print) | LCCN 2016015075 (ebook) | ISBN 9781119191094 (hardback) | ISBN 9781119190998 (pdf) | ISBN 9781119191087 (epub)

Subjects: LCSH: Financial statements. | InvestmentsDecision making. | Finance. | BISAC: BUSINESS & ECONOMICS / Finance.

Classification: LCC HG4028.B2 L49 2016 (print) | LCC HG4028.B2 (ebook) | DDC 332.63/2042dc23

LC record available at http://lccn.loc.gov/2016007850

Cover Design: Wiley

Cover Image: Sergey Nivens/Shutterstock

To Ilana, Eli, and Racheli
Rui, Elizabeth, and Isabella

In recent decades, corporate financial information, conveyed by those voluminous and increasingly complex quarterly and annual reports, has lost most of its usefulness to investorsthe major intended usersand is urgently in need of revitalization and restructuring. In this book, we empirically prove the former (information relevance lost) and perform the latter: propose a new and actionable information paradigm for twenty-first century investors.

In this we were very ably assisted by various colleagues and experts to whom we express our deep gratitude. Gene Epstein, Barron's economics editor, provided important guidance and insight (though was disappointed that we didn't change the book title to The Death of Accounting). Our colleague, Stephen Ryan, provided numerous comments and suggestions on accounting and statistical issues. Win Murray, Director of Research, Harris Associates; Philip Ryan, Chairman, Swiss Re Americas; and Allister Wilson, Global Audit Partner at Ernst & Young, all provided valuable comments on parts of the book. Zvika Zelikovitch, a superb artist, and Ayala Lev, creative and loving, furnished useful ideas for the book cover. Our colleagues Mary Billings, Massimiliano Bonacchi, Matthew Cedergren, Jing Chen, Justin Deng, Ilia Dichev, Dan Gode, William Greene, John Hand, Doron Nissim, Suresh Radhakrishnan, and Paul Zarowin enlightened us with numerous suggestions and insights.

Our trusted assistant, Shevon Estwick, highly professional and dedicated, provided invaluable administrative support in handling the manuscript. Nancy Kleinrock, not only edited the book very skillfully, but offered numerous constructive comments and suggestions. Jessica Neville, Executive Director of Communications at NYU's Stern School of Business, provided valuable marketing advice, and Wiley Finance Editor, William Falloon, accepted the book almost at face value and guided it smoothly and efficiently through the long production process, providing important advice. He was ably assisted by his Wiley editorial and production team.

We are deeply indebted to all, and to our families, of course.

Corporate financial reportsbalance sheets, income and cash flow statements, as well as the numerous explanatory footnotes in quarterly and annual reports and IPO prospectusesform 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? 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 factorsso important to investorsthat create corporate value and confer on businesses the vaunted sustained competitive advantage. In fact, our analysis () indicates that today's financial reports provide a trifling 5 percent of the information relevant to investors.