Do financial statements still matter?

NASDAQ-listed Tesla has never reported a profit but for a while in 2017 investors who bought its futuristic electric car and battery vision pushed the company’s market capitalisation above that of General Motors.

Tesla sold about 76,000 cars in 2016 and expects to deliver 100,000 cars in 2017; General Motors sold 10 million cars in 2016, and pays a dividend.

The stratospheric valuations given to companies such as Tesla, Amazon and Google support the argument of US academics Baruch Lev and Feng Gu that information such as balance sheets, income and cash flow statements have “fading usefulness” when investors have access to information from other sources that can quickly move share prices.

The increasing value the market assigns to knowledge-based intangible assets also means that traditional accounting does not always capture true company value, they argue in their book The End of Accounting and the Path Forward for Investors and Managers.

Financial statements still matter in Australia

Three Australian academics have tested the Lev/Gu arguments, however, and say financial statements are still relevant to Australian investors.

Nikole Gyles, Dr Dean Hanlon and Professor Matthew Pinnuck followed Lev and Gu’s research approach to discover that reported net profit and shareholders’ equity are still relevant for investment decisions, “and remain so over time”.

Their research, funded by CPA Australia, used the annual reports of Australian Securities Exchange-listed companies over a 24-year period, from 1992 to 2015 and resulted in 29,838 observations, an average of 1243 listed firms a year.

“Reported net profit and shareholders’ equity are consistently incorporated into companies’ share prices over the time period examined with, on average, 64 per cent of share prices comprising information contained within reported net profit and shareholders’ equity,” they say.

How to value companies

Lev and Gu argue a company’s value lies in its strategic, value-enhancing resources and more value should be placed on non-accounting information, such as:

• enterprise strategy, or business model, and its execution
• fundamental indicators such as number of new customers, churn rate, proven oil reserves or insurance policy renewal rates

Non-transactional events such as the failure or success of a drug test, a competitor’s new product, or regulatory action can quickly affect a share price, they note. Even the result of a company’s own action will take time to be reported in financial statements.

A major part of Lev and Gu’s argument, which the Tesla example illustrates, is that investors are placing increased value on intangible assets.

They say intangible capital “is becoming the leading corporate value creator” but intangible values are often understated while profitability measures such as return on equity and return on assets are overstated.

Why the difference between the US and Australia?

Gyles, Hanlon and Pinnuck say their findings might relate to the differences between Australian and US accounting standards and the countries’ markets.

“In the US, reported net profit and shareholders’ equity are calculated using US GAAP, which are often referred to as ‘rules-based’ standards. In Australia, however, net profit and shareholders’ equity are calculated using IFRS-based accounting standards, which are often referred to as ‘principles-based’ standards and have a primary focus of capturing a transaction’s substance over form,” they say.

US markets are more liquid than Australia’s, with more frequent trading based on information, some of which is non-accounting.

Australian investors may still rely on reported net profit and shareholders’ equity to make investment decisions, while US investors consider other firm fundamentals including cash- and intangibles-related amounts.

The Australian researchers tested whether there was divergence between US and Australian investors on intangibles, Dr Hanlon told INTHEBLACK.

For industries such as telecoms with high intangible asset valuations, they still found financial reports were valuable to Australian investors.

Hanlon said financial statements often fulfil a “confirmatory role”. The information might not be new but confirms investors’ expectations.

“While we are not suggesting there is no room for improvement, our findings do not mark the end of accounting as we know it, as has been the call from some industry and academic writers,” says the report, first presented at the Australian Accounting Standards Board research forum on November 24, 2017.

The Australian research continues.

* Nikole Gyles is an enterprise fellow in the Department of Accounting, University of Melbourne; Dr Dean Hanlon is a senior lecturer in the Department of Accounting, Monash University; and Professor Matthew Pinnuck is head of the Department of Accounting, University of Melbourne.

Baruch Lev and Feng Gu, The End of Accounting and the Path Forward for Investors and Managers, Wiley Finance Series.