How Accounting Can Distort Valuations

By Jeremy Schwartz , CFA, Global Head of Research, WisdomTree Last week, we had the pleasure of interviewing Baruch Lev, Philip Bardes Professor of Accounting and Finance at NYU Stern, on his views about the distortions in earnings statements that make these reports less relevant to investors. Lev wrote The End of Accounting and the Path Forward for Investors and Managers. This is an important topic we will explore in future research. There used to be a cleaner line between the “investments” companies made to generate cash flows in the future and the “expenses” for physical structures like the buildings they needed to operate their current business. There was a clean matching between revenues and the cost for delivering those revenues. But 25 years ago, the structure of corporations changed, and now there is greater investment in intangibles, research and development, and brands. Intangible investments are around $2.5 trillion now, and tangible investment are just half those levels. The challenge with accounting for intangibles is that they are deducted from the current income statement, resulting in a large mismatch with the expenses generated today for future revenues. Lev cited 2019 as a boom year, when 45% of all the companies he tracks reported losses and 70% of high tech and health care companies reported losses. While people refer to earnings as the bottom line, Lev thinks they are rather irrelevant. In addition to the standard GAAP earnings, companies provide non-standardized measures of earnings and other non-accounting metrics to report on business trends. Subscription service companies provide customer counts, custom acquisition costs, and churn rates—none of which are accounting numbers—which can be used to determine the lifetime values of customers to illustrate the longer-term trends for their business.