Hey, financial statements – this thing between us just isn’t working out!

How helpful are financial statements in the new economy?

A recent blog post took off from the following premise:

  • With only 20% of companies’ market value found in the tangible assets in the financial statements, it is no wonder companies around the world are increasingly using the International <IR> Framework to support integrated thinking and help understanding of the 80% of their market value that is created by ‘pre-financial’ factors, such as intellectual capital, relationships and human capital.

A recent article in the Harvard Business Review – Why Financial Statements don’t work for Digital Companies – provides a good reason to return to this broad line of thinking (the authors are Vijay Govindarajan, Shivaram Rajgopal and Anup Srivastava). If you think the 20% relevance measure cited above was a bit meagre, how about the even grimmer finding that “earnings explains only 2.4% of variation in stock returns for a 21st century company — which means that almost 98% of the variation in companies’ annual stock returns are not explained by their annual earnings.” Of course, we wouldn’t expect much correlation between the two, given the morass of forward-looking factors that impact on stock prices, but 2.4%…well, that’s not much.

Much of the HBR article covers territory we’ve mentioned before, for example the increasing strain placed on the relevance of balance sheets by their failure to reflect internally-generated intangible assets:

  • Our research has found that intangible investments have surpassed property, plant, and equipment as the main avenue of capital creation for U.S. companies – which further suggests that the balance sheets has become an artifact of regulatory compliance, with little or no utility to investors. The balance sheet has also become less useful for banks’ lending decisions because banks rely on asset coverage to calculate their security. Curiously, companies are allowed to report purchased brands and intangibles as assets on balance sheet, creating distortions between earnings and assets of digital companies that rely on organic growth versus acquisitions.

The article also notes though that no matter how much we can amass evidence for the accumulating irrelevance of financial statements, they still count for something:

  • If earnings are so meaningless, then why do investors react positively to rumors concerning a digital company turning profitable? For example, when Twitter reported its first profits, its share prices jumped 20%. The same thing happened to Yelp. One plausible reason could be that this news has an important signaling effect – that the company might have crossed its initial investment phase, that it might now break even, or that it might catapult into a trajectory where it can reap winner-takes-all rewards. This conjecture challenges our overall argument that earnings have no information; another challenge could be that initial losses of digital firms convey risks involved in purchasing their stocks.

As an aside, those Twitter and Yelp instances were both specifically based on attaining GAAP-based profits rather than some measure of adjusted profit, confirming that non-GAAP measures haven’t won the reporting war yet. I imagine the authors’ conjectures are broadly on point, that when an entity attains profits, it can be regarded as moving into a more stable, annuity-generating phase. Of course, there are several caveats to that. For one, the entity might attain stability at a lower level of profits than the valuations during the start-up phase implicitly foresaw; for another, it would be foolhardy to react solely to a profit report, given that whatever positivity that number embodies might be far outweighed by other negativities.

Any considerations of these issues are likely to come back to the same broad point, that companies have to actively consider what forms of supplementary reporting will best compensate for the deficiencies of the financial statements. The HBR article notes that “investors look for certain cues about the success of a company’s business model, such as acquisition of major customers, introduction of new products and services, technology, marketing, and distribution alliances, new subscriber counts, revenue per subscriber numbers, customer dropouts, and geographical distribution of customers,” and that this can all be disclosed in the MD&A. It goes on:

  • Any significant, value-relevant development must be immediately disclosed rather than waiting for the annual report. We have demonstrated in other research that disclosures on network advantages, such as web traffic and strategic alliances, are considered highly value-relevant by investors. When combined with these nonfinancial indicators, financial performance measures become more value relevant. In addition, companies can provide detailed information on intangible investments made by the company – even if that information is not vetted by the auditors – by reporting these investments in three categories: customer relationship and marketing, information technology and databases, and talent acquisition and training.

From there it wouldn’t be a large leap back to the territory of integrated reporting, although this particular article doesn’t take that leap.

Such commentaries are all valuable, and yet for an accountant involved in conventional financial statement preparation they might (should?) promote considerable anxiety about the long-term value and wisdom of being confined to such a narrow strip of the reporting runway…

The opinions expressed are solely those of the author.

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