Are financial statements still useful?

Intro:
Hello and welcome to the CPA Australia Podcast, your weekly source for business, leadership and public practice accounting information.

Ram Subramanian:
Hello. My name is Ram Subramanian, Policy Adviser in Reporting at CPA Australia. For more than a century, it's established knowledge that financial statements are the primary window into the financial performance and position of a company and that's an established scenario that most accountants and others in the finance industry accept. But, in recent times there've been some questions raised over whether financial statements do what they're supposed to do so effectively financial statements are meant to inform investors and other stakeholders when they look into put their money in a particular company or take money out of a particular company through the purchase or sell of shares or to providing a debt facility or otherwise.

Some of these questions have been raised in quite a significant way. In one particular research study that I would refer to is a book called "End of Accounting and the Path Forward for Investors and Managers" which was published in the US a couple of years back by two academics, Professor Baruch Lev and Associate Professor Feng Gu. In that book, they effectively suggest or state that financial reporting doesn't do what it's supposed to do. Effectively, they say that financial reporting is not as useful as it's believed to be. The way they make that proposition is by making a comparison between the financial information that is in the financial reports when they're released and the impact it has on share price.

This is quite an intriguing challenge that was thrown out to the profession and we here in Australia particularly CPA Australia wanted to explore this particular challenge in a local context. We spoke to a few like minded academics both at Melbourne Uni, University of Melbourne and Monash University. They were happy to take on that particular challenge and see what that means here, what that question would come up with in terms of an answer here in Australia.

CPA Australia funded a research project a couple of years back to explore this issue in an Australian context so that's the story so far. We brought here today Professor Michael Davern who is one of the academics who was involved in the research study. He's here to talk to us a little bit about the work that they've done on this project and also some of the findings and some of the interesting facts and figures that are in the project. Professor Michael Davern holds the Chair of Accounting and Business Information Systems in the faculty of business and economics at the University of Melbourne where he's also a co-founder of the Melbourne Centre for Corporate Governance and Regulation. Welcome, Michael.

Michael Davern:
Thank you. Pleasure to be here.

Ram Subramanian:
I just wanted listeners to know in case you here some banging or knocking noises that's because of some construction work that's going on underneath us. Apologies for that but let's get on with it and hopefully, you'll enjoy the rest of the podcast.

Okay, maybe I'll just ask you a starting question, "What are your thoughts on what I've said so far and what is your interest in this particular topic?"

Michael Davern:
Well I think it's always a fundamental question. What is the information we're providing as accountants to the marketplace? Are they finding it useful and how can we make it more useful? How's that changing over time as the marketplace changes? We've seen booms and busts. We know that there's underlying value that the accounting numbers have difficulty capturing, intangibles being a classic example in that regard. I think it's a question we've always got to be ready to answer, to justify why we're here and the contributions we make.

I also think it's an interesting question because there's a lot of misunderstanding about the role that financial reporting plays in the market place. You mentioned the idea of informing investors and providers of debt. Informing is very different to the way a lot of people look at when they colloquially look at a set of financial statements. They think so an assets on the balance sheet that's the value of the firm and if you're going back to your basics of the conceptual framework, it's not about providing a valuation, it's about informing investors and others in making that valuation. That's a very different role of financial statements than calculating an actual value. There's a subtlety there where we may be contributing a lot of the information that helps them come up with the valuation even though the numbers we're providing aren't a valuation in a market sense.

It's one of the exercises I often use with my students at the start of the accounting degree and we present them company results. We say, "Look. Here's the book value and here's the market capitalization." Sometimes their orders of magnitude are different. I love to throw out to them, "Which number is right?" Because that's what they're all thinking and we have a nice discussion. They end up realising that neither number is right. They're both inputs to my judgement as an investor about how much I want to value that firm.

The market capitalization, my finance colleagues hate it when I describe it this way but it's a collective opinion of the market place. It's a consensus opinion of what the market thinks and it's not even really an agreement in the sense that if I'm willing to sell a share at $100 and you're willing to buy a share at $100, we've actually got different expectations there. I wouldn't be selling if I thought it was going to go up and you wouldn't be buying it if you didn't think it was going to go up. We've got different expectations about what that value is that is coming to that consensus valuation.

Whereas, I look at the book value is that capturing all the elements of the value? No, I don't expect it to but it's a starting point. I know that in usual circumstances, the book value is a nice base from which I can build from whether I would go as far as the market capitalization for the value that's the million dollar question and there's a lot of debate around that. It is a judgement call but now I have two inputs into that judgement about what I think a firm is worth.

Ram Subramanian:
Thanks for that, Michael. Okay, maybe if you could just jump into the research itself that you were part of and perhaps if you could just highlight why ... I think you've already said why you did the research but maybe if you could give us an idea as to some of the key findings in the research in this particular study.

Michael Davern:
Sure so we took a very standard value relevance, what's called a value relevance approach and we we're looking at the association in the statistical sense between some of the numbers that are in the financial reports so EBITDA, profit after tax, those sorts of numbers, balance sheet numbers, book value, and correlate those with share price over time. You look at a time series and we looked from about 1990 to 2015 and you try and see is there a correlation between the financial numbers that the companies are putting out into the market place and what's going on with their share price and therefore their value over the time and are they related.

Ram Subramanian:
Effectively you are copying some of the research techniques that the American professors that I mentioned earlier were doing in the American study.

Michael Davern:
It's a very standardised methodology that's been around this sort of approach of trying to associate accounting numbers to share prices, goes back to a classic study in 1968 by Ball and Brown. There's been variations on this on a lot of econometrics and statistical ways of trying to deal with the challenges that happen in terms of dealing with the time series of numbers and trying to control for a range of different effects but in essence we're looking at do these things move together?

Ram Subramanian:
What did you find? What is the answer? Are financial statements useful?

Michael Davern:
Well looking at that as a correlation and it's one direct no is that's a correlation not causality and I'll talk a bit more about that as we go through. We were finding around 50 to 60% of the share price is explained statistically by those accounting numbers so EBITDA and profit after tax, book value, equity and that when you put those numbers together so you're seeing as share price moves up and down in concept with that underlying that is movement in those accounting numbers over time. That's suggesting that there is some relationship there.

Now that's a statistical correlation. There's always questions of a causality and so the methodology we employed was not just to look at those numbers, we actually went out into the field and said, "Let's go and talk to investors, regulators, and practitioners and find out what exactly they are doing with the accounting numbers that are out there in the market place, how do they make use of those, and seeing those sort of things." Of course, we were actually incredibly surprised in two respects. Both about how much they value the information but also the consistency in viewpoints between investors, regulators and practitioners about the way in which that information is used to make investment decisions for equity investors in particular.

In both the inview data that we have gathered and in that statistical analysis, we're seeing significantly that financial statements matter. We are doing something important. We are doing things that are informing the market place very much so. It's a very reaffirming sort of thing that you know I haven't wasted my career on something that doesn't matter but it was ... You know given the amount of scepticism in the market place that even amongst standard setters and the like, we were very pleasantly surprised that yeah, we are doing the right thing and sticking to the knitting of what we're doing in the accounting is really important.

Ram Subramanian:
Wow. That's good to hear, Michael. Now, you did mention EBITDA there a couple of times.

Michael Davern:
Mm-hmm (affirmative).

Ram Subramanian:
Which is of course earnings before interest, tax, depreciation and amortisation and it's one of those numbers that is commonly found in financials which people refer to as a non-GAAP or non-IFRS number because it's one of those numbers which isn't actually catered for through the financial reporting standards, the IFRS framework that they're used to. There are many other such numbers that populate a set of financials. What normally people refer to as non-GAAP financial information or non-IFRS financial information. I know that you did some work looking at the impact of such information and the usefulness of such information to shareholders and others. Could you tell us a little bit about what you discovered?

Michael Davern:
So we didn't just look at what firms were saying their EBITDA was. We actually used the raw data and calculated the EBITDA so we're consistent in the way we are looking in that across the forms. We find if I'm remembering the numbers right around a 57% correlation between the share price and EBITDA numbers over time. That's suggesting that there is a strong amount of information there. Now in terms of the non-GAAP nature of those, if you're thinking about while EBITDA is not regulated, the underlying numbers that are going in earnings, interest, taxes, depreciation that all these things are subject to the standard. You're looking at something that's not a completely fabricated number or completely subjective number. It's something that has some roots in that so it's a halfway house between fully standards and regulated number and what you might call true non-GAAP in that there is no regulation at all over those sorts of disclosures. It's interesting to see that

In our interview data there was a lot of discussion with investors some of who were quite sceptical about numbers like EBITDA because they see there's relevance in depreciation, amortisation amounts. They do look at EBITDA as a way of getting some information. They're also interested in depreciation and amortisation because of what it's capturing. They're trying to determine what is the language they use was persistent future earnings. What is earnings going to be? What's going to be the stable part of earnings projecting into the future and all elements of those become relevant even depreciation, amortisation are informative in that assuming that the way we're following standards and thinking about how we're trying to allocate those across accordingly because it gives an idea of how much we're consuming the underlying assets.

Ram Subramanian:
Interestingly enough of course the International Accounting Standards Board has stated and recognised that non-GAAP information is an important part of the puzzle, an important part of financial statements and they obviously got a project looking at how to address some of the concerns around the information that is traditionally not part of IFRS but is considered useful. Anyway, that's a different matter.

Michael Davern:
There is a little bit more to the story here too because you've also then got those true non-GAAPs. When we talked to the investors, a lot of them were looking in adding the strips so it's specific non-GAAP measures. If you think about say the airline industry load factors, in TELCOM there's a measure called ARPU, which looking at revenue-related measure. These are not regulated measures. They are industry specific. They are useful and informative but the other thing that investors also are very clear about with this was that there's a degree of scepticism about those because sometimes they're not particularly transparent in the way that those numbers are calculated. There's no guarantee that the way that the firm is calculating that number this year versus last year is the same. It's not an audited number so the reliability and trust that you can put in that number does cause some concerns with them but they still see it's that relevance-reliability trade off that we've known about for years. They get some value out of it. They like those but they also recognise the notations of those. Where the numbers are like something like EBITDA or based on the GAAP numbers, they were very interested in seeing clarity and transparency around reconciliations are appropriate back to that.

Absolutely, this is an area where we're actively researching now. Other PhD student was actually looking at non-GAAP disclosures and issues around the regulations about how prominent and salient those non-GAAP disclosures are relative to the GAAP disclosures. If you look at the regulatory environment globally for example the SEC in the US has gone quite tight then loose, tight, then loosen so people are trying to work out how much regulation goes into play here because as you lock it down you might take away from the industry-specific relevance of what's going on. The usefulness may be impacted and you're sacrificing too much the reliability to try and get that little bit of relevance. At the same token, you can look the other way and try and provide something that's highly relevant but if it's not reliable how can you actually use it in the decision?

Ram Subramanian:
They are very true and you referred to the importance of industry specific non-GAAP information just in. I think one of the things that you did as part of your study was looking at the impact of specific industries so specific sectors and the relevance of information for decision making by investors based on sector-specific information. Can you share some news on that?

Michael Davern:
Sure so one of the things when we looked it out, our results at the statistical results what we were seeing is a different pitch store was going on in the US. Of course one of the questions that then raised was what's leading to the differences that we're seeing? The big questions was well are we a less of a intangible-driven economy than say the US? Mining sectors and things like that play much bigger here than what they do in the US environment where you've got more of the IT companies and those sorts of things that are driving some of it whether is a lot of the value is not recognised in the traditional financial statements. Our expectations was maybe it's an industry thing so we parcel out an industry we'll see the difference in industry mix. Again, we were pleasantly surprised. It's actually not there at all and in fact when we looked at industries like IT and TELCOs, they're amongst the strongest in terms of their association with the share price and the accounting numbers.

Ram Subramanian:
These are industries where intangibles are heavy.

Michael Davern:
Exactly so we expected, "Okay let's do an industry breakdown, where are we going to see that it disappears?" "Oh it'll probably tail off in the IT and TELCO. That's where the intangible's really high," and it held up. That sort of ruled out to us very much that the issue was one of intangibles not being captured as a relevant story.

Michael Davern:
We then start to search for alternative hypotheses and a kind of working hypothesis that we have about why we're seeing a slightly different picture to the US is that in the US there's mandated quarterly reporting and filings with the SEC. We don't have the same degree of mandated reporting in the regulated context granted those quarterly reports aren't audited but they're regulatory filing which means that if you're looking at the information that's in the end annual financial statement, there's a lot less new information there if I've got mandated quarterly reporting because I've revealed that over the course of the year. We have information going to the market continuously but we don't have regulated information going to the market in that stronger sense like an SEC filing. There's less so opportunity to get that out in a reliable sense to the market so the market is looking much more at that annual report in Australia for that value. That's our working hypothesis. We haven't quite worked that out further unpack that and see whether that's in evidence.

The other part of the picture here is we didn't just look at the statistics. We went out and spoke to the investors. There we got to understand some of the nature of the value and part of that led to understand how they were using the information and it's not just as a here is a measure of value and therefore I come up with my valuation. They use the information in much more subtle and complex ways. Sometimes the information is used almost as a screen to say, "Is this a company worth looking at?" You know you're not going to see a strong correlation because you're either worth looking at or you're not. Are you getting into the consideration set? The information is really useful in helping do that but you're not going to see that coming out of a covariation in a statistical sort of sense. You see other ways and they're subsequently down to my consideration set of firms I might look at. Then I might see I'm looking at these numbers to help me come up with a valuation but it's now what am I looking for and what the investors were telling us was they like a reliable starting point to enter into their models.

Their OP as a professional investor is the valuation models and processes that they have. What they don't want is a number full of assumptions and everything that they have to backtrack from. They want a number that's the starting point for them and a reliable number they can trust. We saw this come out and we were very open-ended in the way we discussed. The first question we would often ask the investors is, "Tell us about how you choose a firm to invest in and how you evaluate it. What's your investment process?" The last question we would ask was, "Is there ever a circumstance whether you invest in a company without audited financial statements?" So we're getting narrower and narrower and more specific. We're trying not to lead them in any particular way.

Interestingly when we come to that last question the immediate gut reaction is, "Oh, absolutely not" and then "Oh, well yeah there are a couple of circumstances". Interesting the couple of circumstances where I've got firsthand information the direct contact with a director or et cetera or some other unique information, private information channel that gives me a lot of confidence that I can assess directly the reliability of the information. It's understanding that role of the financial statements then as what we recall a necessary but not sufficient condition to be able to make a valuation judgement.

You can't do it without financial statements but obviously financial statements are never going to tell the whole picture because there's news coming to the market every day but that starting point is crucial for them and they want a starting point they can trust. That audited financial statements is the starting point they can trust and it was a nice to hear the degree of scepticism amongst the investors about anything that might have been said that wasn't ordered a number.

Ram Subramanian:
I mean as accountants and finance professionals, I think we all accept and have come to accept that financial statements are very important part of the information that a company provides. It's glad to hear that there's some evidence to support that understanding and acceptance.

Michael Davern:
Yeah

Ram Subramanian:
Now one of the other things I wanted to explore with you was that obviously the research study only focused on the listed companies and within that area, I think one of the things you looked at is the size of the company and the impact it has on shareholder decisions. I mean the financial information and the impact it has on say shareholder decisions. Could you say a little bit on that?

Michael Davern:
So in terms of size, we didn't see huge size effects unless we're going to something that's very small and once you go into the bottom 25% of listed companies then you start to see things trail off. But, you have some real problems there because you're looking sometimes at more startup oriented things. You're looking at things that might be loss making which changes the whole regime and now I'm not upcoming with the value. I'm trying to predict bankruptcy. The correlations don't hold out in that regard because there's so much variation and different configurations of the judgements you're going to be making about what's happening with that company. But if you're looking at the 75% top end of the market, we didn't see huge differences in size. Size was another hypothesis we thought might be going on there.

Also when we're talking to the investors, we weren't restricted to just listed although that was obviously the main focus. Again it goes back to that question of if they in the non-listed case they'll often have direct access to information. The financials are still a nice starting point and sometimes they will want audited financial statements for the non-listed because that's a reliable starting point and it's all to do with how close they are to that company and whether they can get information that they can first-hand validate themselves versus wanting to have someone come in as that third party evaluation of the reliability and trustworthiness of the information.

Ram Subramanian:
Okay, thanks for that Michael. I think hearing you speak right now we could perhaps draw a conclusion that in Australia at least we have found that the evidence points to financial statements are useful and do have a part to play when investors and others are looking to put their money in a particular company or otherwise.

Michael Davern:
Yeah.

Ram Subramanian:
Where do you think we go next with this?

Michael Davern:
I think the area we'd like to explore is finding more about the processes of the decision making that the investors themselves are making and understanding the more complex roles that the information is playing. As alluding to that some of the information starts off just as a screening mechanism which is a binary decision and then goes into informing in different ways. It's understanding some of that process and the way I liken the situation to, we've done a lot of work in accounting research looking at the statistical relationship between the share price and the accounting numbers. That's been bread and butter of accounting research and financial accounting for quite a number of years.

What we haven't done a lot of that we're starting to see more research is going out, understanding what people are actually doing with the information. The simplest way of describing this is it's like you look at a model and you make a weather forecast or you step outside and see whether it's raining. We need to step outside and see if it's raining or not more. That's the work that we're doing and we're finding some interesting perspectives when you start to go out, talk to people, understand what they're doing.

For example, in the interview work that we did one of the things that was not on our radar at all was segment reporting. If it's said to me before we started this research, segment reporting not a particularly exciting area, not a contentious, is it? Standard setters weren't viewing as contentious. Unsolicited just about every interview participant that we spoke to brought up wanting better segment reporting including some who didn't know that it was formerly called segment reporting. We had one chief investment officer who described it and we said, "Oh, you mean segment reporting." "Yeah, that's what it's called." "All right." They want to see a better analysis of what's going on in the business from both product and geography because that helps them predict future persistent earnings, helps them understand the risk exposure which is an element that goes into the valuation for them as well.

The current set up of the standard is that you are supposed to segment report in the way that manages the business. Of course, the problem with that is there's nothing stopping management in saying, "I've changed the way I'm managing the business now so I won't segment report this way." Right? Which creates then inconsistencies and it also means that you can't get the perspective that management isn't taking that may be useful and informative to you because maybe management's not managing the business in the right structure. They're doing it by product when they should be thinking more about geography, et cetera. Again that's the other part that you see when you go out. You're understanding some of these differences and ways of thinking about research activities to see how those people who are making those decisions are thinking about, connected back and contrast it too with the way regulators are thinking about it, the way people being taught to deal with this sort of information. In that sense, it's a much more exciting environment because we're getting much richer in the way we're looking things

The other part where we're still staying quantitative because that's a useful part. You need that mixture is looking at a range of different sorts of disclosures that are then being made and we've got tools in text analysis and those sorts of things to understand the way in which things are being described not just in numerical sense but the disclosures that are happening in reports and how they are being expressed and the tone.

A lot of work for example in academia at the moment focusing on conference calls for example. What are the CEOs saying in the conference calls with the analysts. What can we do with that? That as a way of describing, how are they describing it and trying to almost analyse and understand how that's shaping it. It's not reliable information in that it's not audited but we're trying to put all that package. It's a complex information environment. For me as an academic, what excites me here is that these are problems that we'll make progress on but we're never going to find an answer here. There's no such thing as a perfect way to do accounting. It's a fundamentally challenging, difficult problem to appropriately and usefully describe the economic reality of a firm and that's what we get paid the big bucks for as accountants, to try and provide information to help people make better business decisions by understanding what the economic reality their organisations are facing I think internally or externally. For me, the future of accounting and financial reporting, very bright.

Ram Subramanian:
Absolutely. I mean we all know that it's all about professional judgement , estimates.

Michael Davern:
Absolutely.

Ram Subramanian:
And financial statements are littered with estimates and we do have to appreciate that. There's a lot of work that goes into making those estimates. As reliable and as valuable as possible. Thank you, Michael.

I just wanted to mention to listeners that Michael and some of his colleagues who have been involved in this project will be participating in sessions at the CPA Congress this year in various locations around the country and will be addressing this very topic at one or two sessions. Please do visit the CPA Congress webpages to have a look at the programme and if you're interested in this topic then please do make an attempt to come and hear Michael and his colleagues speak on this very topic. Also to add the academic team who's been working on this project have provided us with reports putting together some of their findings and we've already published report one which just looks at the summary findings and we're very close to publishing the rest of the reports as well. There will be five of them altogether and one of them is already on our website and the link to that particular report will be on the same page as this podcast so please do watch out for the other reports as they get published over the next few months. Thank you.

Michael Davern:
Thanks very much.

Outro:
Thanks for listening to the CPA Australia Podcast. To download the transcript and to find more information on today's episode, visit www.cpaaustralia.com.au/podcast.