Adapting A 1930’s Financial Reporting Model to the 21st Century Testimony by Professor Baruch Lev New York University Tel: (212) 998-0028 July 19, 2000 Fax: (212) 995-4001   Website: www.stern.nyu.edu/~blev   © 2000, Baruch Lev, All rights Reserved. Presentation Map Salient Economic Developments Information Deficiencies in Capital Markets Social and Private Harms Remedy: A Forward-Looking Managerial Statement Benefits of Proposal Response to Objections I. Major Economic Developments Enhanced Competition, Innovation and Deregulation Induce Frequent and Far-Reaching Changes in Corporate Strategies and Business Models. Backward Looking Information (Accounting) Is a Poor Guide to the Future. Intangible (Knowledge) Assets Replace Physical Assets As the Major Driver of Performance and Value. Incomplete Control, Relatively High Risk and Non-tradability of Intangibles is Used as Justification (Excuse) For their Expensing, Often Leading to Uninformative and Misleading Financial Reports The “Networked Corporation”: Collaboration with Suppliers, Customers and Sometimes Competitors and Extensive Outsourcing of Major Activities Replace Vertical Integration and Self-Sufficiency as the Dominant Business Model in the New Economy. Corporate Boundaries Blur, and the Legally- Structured Financial Reports Lose Relevance. II. Social and Private Harms Resulting from Information Deficiencies Increasing Stock Volatility and Abrupt Sectoral Shifts In- and Out-of-Favor (Internet, Biotech). Substantial Losses to Investors, Large Sunk Costs, Increased Cost of Capital. Abnormal Gains to Corporate Insiders. Losses to Outsiders, Harm to the Integrity and Efficiency of Capital Markets. Uncertainty (“Lemmons”) Discount on Knowledge Assets, Leading to Systematic Undervaluation of Knowledge-Intensive, Non-Star Performers. Excessive Cost of Capital of Early-Stage, Fast Changing Companies, Impeding Their Growth. Reporting Manipulation to Meet and Beat Analysts’ Expectations (The “Earnings Game”). Non-Economic Decisions (e.g., Cut R&D and Training), Harm to the integrity of the Market, Waste of Managerial Resources. III. What’s Needed? Publicly Disclosed Future-Oriented Information On The Essentials Of The Corporate Business Model (Strategy and Structure) – – A Road Map Of How Management Intends to Get “From Here to There,” Where “There” Means Economic Sustainability of Early-Stage Enterprises and Growth for Established Companies. IV. Managerial Statement On Strategy and Structure (S3) Outline of Expected Revenue Growth For Next 3-5 Years and the Major Products/Services Generating This Growth. Discussion of Cost Structure, Major Efficiency Measures and Expected Time to Break-Even. Elaboration on the Competitive Environment and Its Effects on Sustainability of Operations and Growth. Discussion of the Adequacy of Financial and Human Resources to Support Expected Revenue Growth. Financial Indicators (e.g., Innovation Revenues, Customer Acquisition Costs and Internet-Based Revenues) and Non-Financial Data (e.g., Employee Turnover, Repeat Customers) Underlying the Statement. V. What Will The Statement Achieve? Provide Capital Markets With Key Forward-Looking Information, Essential in Times of Rapid Change. Level the Playing Field, to Some Extent, With Large Institutional Investors and Well Connected Analysts Privy to Business Model Information. Augment the Limited Financial Information Currently Available with Essential Operating Non-Financial Data. Encourage Entrepreneurs and Managers of Early-Stage Companies, In Particular, to Formulate and Think Carefully Through Their Plans and Strategies. VI. Expected Objections Required Statement Is Too Intrusive, Disclosing Competitively Harmful Information. Response: Much of the Information Is CurrentlyReleased to Privileged Investors and Analysts. The Aggregate Nature of the Information (e.g., Total Sales Growth) Mitigates Competitive Harm. Required Information Will Expose Managers to Litigation. Response: A Valid concern; May Require Enhancement of Safe Harbor Rules. In Many Cases, Entrepreneurs and Managers are Unable to Articulate Strategy and Structure (Business Model). Response: Probably True for Some Internet and Biotech Startups, Among Other Young Companies. Proposed Statement will Motivate Managers and Boards to Carefully Calculate and Articulate Future Course of Action.