It’s getting harder and harder to make sense of published financial accounts, and the relentless tweaking of accounting standards has done little to improve the situation. In fact, it has arguably made it worse.
If published accounts were a reliable reflection of the commercial health of companies, then trouble at Steinhoff and Tongaat would have been picked up years ago. Investors rely on analysts to reconstruct accounts to strip out distortions and hopefully provide better insights into each firm’s investment merits. But even analysts get it wrong sometimes, as happened with Steinhoff and Tongaat.
In a study on the usefulness of published accounts, researcher Baruch Lev places much of the blame on the proliferation of estimates in financial reports: “To a large extent, financial reports are based on estimates, judgments, and models rather than exact depictions.
“Estimates increase the noise and error in financial information, particularly when they are made by persons (i.e. managers) having strong incentives to affect the perceptions of investors.”
Analysts and investors rely on earnings-centred valuation models. Their spreadsheets are aimed at predicting earnings, and for this they seek guidance from company managers. But reported earnings no longer reflect actual enterprise performance, says Lev. A 2017 study shows that even if you made perfect earnings predictions, your investment performance would not be significantly better than those who were poor predictors of earnings. This perhaps explains the flight from managed to index funds. Over the last five years Amazon missed almost half of the quarterly analyst consensus forecasts, while becoming one of the most valuable firms in the world.
If published accounts are leading investors astray, what’s the solution? Read more on Accounting Weekly.