We, the writers of this book, are veteran accounting and finance researchers and educators, and one of us has extensive experience in public accounting, business, and consulting. For years we have documented in academic journals the failure of the accounting and financial reporting system to adjust to the revolutionary changes in the business models of modern corporations, from the traditional industrial, heavy asset-based model to information-intensive, intangibles-based business processes underlying modern companies, as well as documenting other accounting shortcomings. While not alone in this endeavor, our impact on accounting and financial reporting regulations has regrettably been so far very limited. But we now sense an opportunity for a significant change, motivating this book. The deterioration in the usefulness of financial information has been so marked, that it can no longer be glossed over. Corporate managers, realizing the diminished usefulness of financial information, respond by continuously expanding the voluntary disclosure to investors of non-GAAP (accounting) information. Thus, for example, the frequency of releasing proforma (non-GAAP) earnings doubled from 2003 to 2013, standing now at over 40 percent. Researchers, too, sense a serious problem: A recent study by leading accounting researchers examined the impact on investors of all the accounting and reporting rules and standards issued by the Financial Accounting Standards Board (FASB) from its inception (1973) through 2009—a staggering number of 147 standards—and found that 75 percent of these complex and costly rules didn’t have any effect on the shareholders of the impacted companies (improved information generally enhances shareholder value), and, hard to believe, 13 percent of the standards actually detracted from shareholder value. Only 12 percent of the standards benefited investors. Thus, 35 years of accounting regulation came to naught. The SEC is concerned, too:
Consider, for example, the current initiative of the US Securities and Exchange Commission (SEC)—Disclosure Effectiveness—aimed at “ . . . considering ways to improve the disclosure regime for the benefit of both companies and investors.” The SEC invited input and comments to this initiative, and indeed, a Google search reveals scores of mostly extensive comments and submissions by business institutions, accounting firms, and individuals. Reviewing some of these submissions, we are struck by the following common threads, which sadly remind us of previous futile attempts to enhance financial reporting effectiveness: Commentators generally presume to know what information investors need without articulating how they gained this knowledge (research, surveys), and proceed with improvement recommendations that often boil down to generalities, like reduce information overload, focus on material information, or streamline and increase reliability of information, without identifying how exactly this should be done. The exceptions are suggestions with a specific agenda, calling for environmental, social, or sustainability disclosures that are bound, we suspect, to antagonize most information suppliers (i.e., corporate managers). Finally, most suggestions cut across all industries—a straightjacket approach, typical to current financial disclosure. Thus, despite the good intentions, we are skeptical that the current SEC’s effort will fare better than its predecessors’ in leading to real improvements in disclosure effectiveness, bringing to mind the famous remark: “Everybody complains about the weather, but nobody does anything about it.”
We approached our mission in this book—to alert investors to the information they should seek and use for successful investment and lending decisions, and in the process enhance disclosure effectiveness and improve capital markets efficiency—differently:
- First, rather than assume that financial disclosure lost its effectiveness, we document comprehensively, on large samples of companies, the fast diminishing relevance of this information to investors, and proceed to identify, again, evidence-based, the major reasons for this information fade (Parts I and II). This identification of failure drivers guided our choice of the information modes that will improve investors’ decisions.
- Second, rather than presume to know what information investors need, we conducted a detailed examination of hundreds of quarterly earnings conference calls and investor meetings in four major economic sectors, distilling from analysts’ questions the specific information items crucial for investment decisions. This, we backed up with lessons from economic theory to construct new industry-specific information paradigms—the Strategic Resources & Consequences Reports—proposed in Part III.
- Third, again, in the tradition of research, we don’t just claim that our proposed information is required by investors—we prove it. We show that selected nonaccounting information items we propose, like insurance companies’ data on the frequency and severity of claims, are correlated with companies’ stock prices and future earnings, hence their relevance to investors.
- Last, our only book agenda is to outline to investors and lenders the information needed for assessing the performance and potential of twenty-first-century business enterprises, thereby improving investment decisions and enhancing the functioning of capital markets. Corporate financial reporting will benefit, too.
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