A Blog by Jonathan Low

 

Mar 1, 2019

Will Accountants Be the Weavers Of the 21st Century?

Accounting has refused to address the growing importance of intangible values like brand, intellectual capital, software and experience.

The reason is partly because changing GAAP accounting to reflect that reality would cause some of their clients would suffer even though some would prosper. But some of it is just intransigence, tradition and fear of the unknown.

Unless the profession updates itself to address the realities of the dominant forces driving the economy it will,justifiably, be replaced by machines and algorithms. JL


Jon Lukomnik reports in Accounting Today:

Today's drivers of value are largely intangible, such as data, intellectual property, branding, code, and business model. Intangibles now make up 84% of the market value of the S&P 500. Investors believe these will create revenues in the future. But accounting can’t figure out how to value those non-tangible assets, so it treats those investments as expenses. Limiting the focus of the profession to traditional financial statements will limit accounting to reporting a shrinking share of the information investors use. Increase relevance, or become the 21st century equivalent of the Worshipful Company of Weavers. The profession faces a existential crisis. But it’s also an opportunity.
I am an investor, not an accountant. But sometimes the view from the outside is useful. And from where I stand, accountants are facing a slow-moving existential crisis.
A profession, any profession, needs two things to thrive. First, it needs to be relevant, that is, to fulfill a needed purpose for society. Second, it needs professionalism and competence.
So, in the case of accounting and auditing, the profession needs to be reporting and assuring relevant information. I’ll define that as information that the users find valuable in making investment decisions. It needs to be professional in doing that, meaning accountants need to be educated, independent, ethical.
Though there are exceptions, the profession generally gets professionalism right. So why do I say the profession is facing a slow-moving existential crisis that, left unchecked, will reduce accounting and auditing to a fragment of its current import?
Today's drivers of value are largely intangible assets, such as data, intellectual property, branding, code, and business model. These are notoriously difficult to discern from traditional accounts. That is understandable; our accounting system was created when capital -- in the form of tangible assets -- was king. But understandable doesn’t mean acceptable. Make no mistake, it is not acceptable anymore. Consider these statistics:
  • Intangible assets now make up 84 percent of the market value of the S&P 500. That’s up from just 17 percent in 1975. We investors clearly value things like investment in brands, new business processes, skills development for employees, R&D, etc., as drivers of future value. In other words, we believe these investments will create revenues in the future. But accounting can’t figure out how to value those non-tangible assets, so it treats those investments as expenses. That just doesn’t make sense.
  • Here is a specific example: As of when I wrote this, Amazon was trading at a price/earnings ratio of 149 and a price to book of more than 26. This is a company with an enterprise value of $940 billion and is followed by 44 sell-side analysts and thousands of buy-side ones. Clearly, either we investors have collectively lost our minds, or book and earnings are understated in economic terms.
  • What makes that understatement so important is that services now are more than 80 percent of the US economy and growing.
  • A Google search for “same store sales” yields 359 million hits. Search for “EBITDA” and you’ll return 16 million citations. Neither of those measures, one a key performance indicator and one a non-GAAP metric, are defined by the Financial Accounting Standards Board. Yet they drive investment decisions. Unfortunately, the profession seems to prefer going deeper into the rabbit hole of fine-tuning financial-statement accounting standards – seven years for revenue recognition and now who knows how many years for lease accounting – rather than poking their heads out from the burrow and saying: Investors are using these types of non-GAAP metrics and KPIs, wouldn’t it be nice if they were actually defined? And then we could account for and assure against those definition? (Now that is a relevant business opportunity.)
We have a culture clash. Capital markets are, by nature, innovation machines. And the real economy is dominated by disruptive technologies and new entrants. The average lifespan of an S&P 500 company was 33 years in 1965. It was down to 24 years in 2016. The pace of innovation continues, so that the lifespan is projected to be down to just 12 years a decade from now. By contrast, accountants and auditors are, and should be, conservative by nature -- not in the political sense, but in the “holding to traditional values” dictionary definition. For each individual engagement, that’s not only appropriate, but good. There is value to professional skepticism and to using precedent as a guide. But for the profession as a whole, it creates a problem: What is being accounted for and attested is an ever-decreasing share of the information available and used.
Investors are information junkies, and the amount of data available is stunning. The “digital universe” (i.e., all the data in the world) grew from 0.13 zettabytes in 2005 to 16 zettabytes in 2016, a 12,300 percent increase. (A zettabyte is 1 trillion gigabytes.) And it’s predicted to grow to 163 zettabytes by 2025, or another 1,000 percent increase. Equally amazing is that artificial intelligence and computer power will enable we investors to take an ever-increasing portion of that unstructured data and turn it into decision useful information.
Ideally, we’d like more of that data to be standardized, structured and assured, because that’s better-quality data. But if that’s not available, we’re still going to use it.
Here’s the analogy. When I was in London recently, I was honored to be asked to speak at the Guild Hall of the Worshipful Company of Weavers, Spinners and Dyers. The hall was huge, located in prime real estate in the square mile of the City of London. Even the bathrooms were wood-paneled and decorated with 15th century silk weavings, any one of which I would be proud to own and display on the largest wall of my living room, though I probably could not afford any of them. Judging by the display of wealth, weaving was obviously central to the medieval and early industrial economy of England. But it’s not today. Weaving is still a viable craft and business, but on a much smaller, less central scale. Other parts of the economy grew faster and weaving did not keep up. Already, there are investors using artificial intelligence, crossed with risk algorithms, to create live portfolios. Even in that world, traditional accounting is still valuable -- but of less value than it was a decade ago, a year ago, a month ago, a day ago, a minute ago. The trend is not going to reverse. Limiting the focus of the profession to traditional financial statements will, by definition, limit accounting to reporting and assuring a shrinking share of the information investors use.
If that happens, accounting will be the Worshipful Company of Weavers of the 21st century. Once important, still an honorable calling, but nowhere near as central to the capital markets as it used to be, or could be.
What does the profession have to do to avoid that fate?
  • First, broaden what is accounted for and assured, so as to increase relevance to investors. This is not an easy process. I have sympathy for the standard-setters. On the one hand, no one wants to be reactive to the newest fads, lest the standard-setters spend time on things like “eyeballs” in the lead-up to the dot-com crash. But there are time-tested non-GAAP metrics investors use, like EBITDA, and KPIs, like same store sales. Perhaps the profession should adopt the rules the Rock and Roll Hall of Fame uses: If a metric is still important after 25 years, it should be considered for induction into a FASB Hall of Standards.
  • Second, create an industry-wide effort to rethink the entire area of intangible assets. There are scores of great thinkers and researchers looking at this already, but there is no consensus toward fundamentally reforming accounting to accurately reflect them on financial statements.
  • Third, look at what we can be done to standardize sustainability metrics. Yes, this is controversial, but I am not suggesting it for political reasons. The signatories to the Principles for Responsible Investment comprise the vast majority of the world’s largest asset owners and asset managers, with aggregate assets under management of some $80 trillion. That is four times U.S. GDP. The very first requirement of being a signatory is, “We will incorporate [environmental, social and governance] issues into investment analysis and decision-making processes.” While there may be some signatories who only pledge but don’t act, even if you assign a gargantuan 50 percent discount on how many of those firms actually use ESG metrics, there is a need for better information and a major opportunity for the profession. Last year, 395 of the S&P 500 put out some type of sustainability report. But only 38 percent are assured, and 90 percent of those are only partially assured. And even those are often not assured by accountants.
Accounting faces a choice: Increase relevance, or become the 21st century equivalent of the Worshipful Company of Weavers. Still viable, but not central to the economy of today. Yes, the profession faces a slow-moving, but existential crisis for the profession. But it’s also an opportunity.

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