Generally accepted accounting principles (GAAP) have been the standard in financial reporting for decades. But has the business world evolved so much that GAAP rules have outlived their usefulness? At least one critic thinks so.
That would be Baruch Lev, the Philip Bardes Professor of Accounting and Finance at New York University Stern School of Business. Professor Lev has been with NYU for 20 years (formerly at Berkeley), and in his current position, he teaches courses in accounting, financial analysis, and investor relations. He co-authored the book, The End of Accounting and the Path Forward for Investors and Managers, with Feng Gu in 2016.
I recently spoke to Lev, and he told me that the GAAP standards have lost much of their relevance over the last 40 years, primarily because the industrial economy has been supplanted by a new economy - one that is driven by intangible assets.
"GAAP was quite useful for many years, because it established a uniform business language. The problem is that around the mid-80s, there was a revolution in the business models of companies that completely bypassed the traditional accounting system that was rooted in hard assets," he explained. "The problem is that most companies' investments in value-creating assets today - like patents, information technology, unique business franchises, and powerful brands -are treated as regular expenses, misstating both assets and earnings. In addition, GAAP's focus on fair values increased exponentially the number of managerial estimates in financial reports over the last 20-30 years. Right now, accounting is not about facts - it's about estimates and views."
It's true that physical assets aren't the most accurate barometer of a company's performance anymore, and to prove that point, Lev looked no further than two of top-performing stocks as prime examples of the failure of the current model: Tesla and Amazon.
The two, who are arguably two of the best examples of disruptive business models in modern American business, show years of operating losses under GAAP accounting, while their market values kept growing. Same with many biotechnology, Internet, and healthcare companies.
Now many business owners around the country may be reading this and expressing a collective shrug. After all, accounting issues are often pretty dry, and GAAP is no exception. But it turns out that there's a very important takeaway in all of this for businesses both large and small.
"This outdated accounting model puts corporate leaders at a huge disadvantage, because they are unable to tell the full story of the company with the financial report," Lev explained. "Amazon, for example, missed Wall Street analysts' consensus earnings estimates six of the last 12 quarters. So is Amazon a failing company or a success story? Gilead's recent earnings decrease was partially due to a large R&D increase. Was this then a decrease in real earnings? Company leaders are really unable to convey the full story using GAAP, and as a result, you've seen a surge in non-GAAP reporting.
The problem is even more serious, since "what companies report externally is, to a large extent, the basis of management decisions inside a company." GAAP does not require any information on alliances and joint ventures, for example, and as a result, senior leadership often doesn't have this information at their fingertips. Though it may sound counterintuitive, "external reporting has a big effect on decision making inside the company."
What's the alternative? Lev recommends a report on the strategic (value-creating) assets of enterprises--the Strategic Resources & Consequences Report--and a different value creation measure called "residual cash flow," which he thinks could provide a clearer picture of companies' true financial performance. In this model, he would aim to reflect investment in intangible assets that simply aren't measured properly under GAAP.
But even as he outlined some of his guidelines for how this system would work - such as specifically-calculated charges for equity capital usage depending on how stable a specific industry is - Lev does admit that there are significant hurdles to overcome - from the role of regulators to the very nature of trying to accurately report something that's always changing.
"Regulators have a vested interest in maintaining the status quo, because they are 100 percent convinced they know what's good for us and that they're doing the right thing," he explained. "And while the SEC and FASB has made genuine attempts to improve financial reporting, it hasn't been enough. GAAP is the only regulation that is constantly growing, expanding, and becoming more and more complicated, yet the usefulness of financial information keeps falling. I have to admit that there will always be important aspects of a company's financial health that just cannot be reflected in their reporting, even if they were to adopt every single idea that I propose."
So while Lev may not have all the answers, he knows that more people need to ask questions if we're ever going to get the real story behind modern American businesses.