U.S. Financial Reporting Is Stuck in the 20th Century

Much has been written about the death of value investing as it was known historically i.e, buying stocks at low PE or PB multiples. Increasingly the debate has moved to value investing still works but simply not based on reported earnings and book value, both of which fail to capture the real assets and profits of companies in the new age economy. This piece in the HBR emphasises the point that the real assets of companies are no longer restricted to land & buildings or plant & machinery but more often in soft assets as innovation, culture, human or knowledge capital, networks, etc which current accounting rules fail to capture adequately and therefore might understate the real assets and earnings of companies and in turn overstate the corresponding valuation multiples. This they argue is the cause for several value funds failing off late as they miss out on seemingly overvalued companies. The authors recommend specific changes to the accounting rules to factor these transformations.
“If you consider the mechanics of the modern organizations whose stock prices increased most dramatically in the 21st century, they spend large amounts on innovation, product development, process improvement, information technology, organizational strategy, hiring and training personnel, customer acquisition, brand development, and on wringing efficiencies from their peer and supplier networks. The current accounting rules, however, require that these amounts should not be reported as assets and also must be treated as costs in calculation of profits. The more a modern company invests in building its future, the lower are its reported profits. So, a company that builds unique competencies, based on knowledge and ideas, appears as extremely expensive stock based on the traditional value investing philosophy, instead of as a promising investment opportunity.
Many value funds, especially those closing now, mechanically relied on accounting numbers and missed out on investment opportunities such as Microsoft, Google (Alphabet), and Facebook, because those companies have little land, buildings, inventory, and warehouses, that are included in reported assets – instead they have knowledge capital. In the last decade, those investors not only missed out on great opportunities but could also ended up buying wrong stocks.
…So is there a way to bring promising stocks into value portfolios but also helps investors identify young companies that will become a future Microsoft or Facebook? One solution is to identify companies that spend large amounts on building knowledge-based or a unique idea-based competency. To bring them into value portfolios, fund managers would have to recreate financial statements.
…we believe that the developments this year, particularly, the demise of value funds, show the urgency for a thorough overhaul in financial reporting. The current system is causing confusion among investors and may even lead to misallocation of investment capital. It’s time to make concrete revisions to what must be reported in financial reports. First and foremost, firms must provide information on revenue and its drivers. Second, a detailed statement on outlays, presented in three broad categories. The first category should describe the amount spent on supporting current operations. (For example, Twitter provides “cost per ad engagement.”) The second category should describe the investments on future-oriented projects, such as developing a new electric car or a new mobile phone. In the third category, the company must itemize its so-called one-time, special, or extraordinary items. The purpose of financial reports should once again become enabling investors to take good decisions, instead of causing confusion and leaving them in the dark.”