Accounting For The Long-Term Interests of Investors

Robert McGarvey
January 26, 2021

An over focus on short-term financial performance has been blamed for many a corporate ill, including rushed (often incompatible) acquisitions, ruinous capital allocation choices, and - more generally - an habitual pattern of management sacrificing the future to boost quarterly financial numbers.

Although there are companies (Coke Cola, Ford Motor Company, etc.) that have longer-term strategies, Stock Exchange analysts representing investors’ earnings-per-share needs, force the vast majority of publicly traded companies to adopt short-termism as a priority.

The problem lies with accounting and the Income Statement, the financial statement that records revenues, associated costs and - finally - net profit for the period in question.

Regrettably, the Income Statement is only a ‘snap shot’ of corporate performance. Its partner statement, the balance sheet, is the statement that tells (or should tell) the longer-term story. The balance sheet describes the assets and liabilities of the company, the causal source of future earnings and, of course, the residual equity owned by shareholders.

Unfortunately today, analysts and investors routinely ignore the balance sheet. The question is why? How did one part of the financial statements come to dominate investor priorities?

Part one of this paradox lies in the fact that intangible assets are absent from most company’s balance sheets. Given that intangibles like software, patented innovations, social media apps and networks-of-value like Facebook’s, dominate the economy today, they are either absent or vastly under-represented on the balance sheet.

The second part of the balance sheet problem lies in changes in investment banking that occurred early in the last century. Henry Goldman, son of Goldman Sachs founder Marcus Goldman, drove the investment banking revolution focusing on the previously unnoticed world of commercial retail – a market with companies that had good fundamentals with solid cash flow but which lacked the high-profile capital assets that made railroads and heavy industry so attractive to commercial bankers.

Developing a new investment-banking concept that was highly biased towards earnings, Goldman focused on the flow side of the ledger while ignoring assets and his clients’ lack of formal balance sheet strength.

Henry knew that corporate earnings are effects, caused by (or derived from) underlying assets. Therefore, if successful, wholesalers and retailers must, by definition, have some other kind of assets behind their earnings streams and profits. Today, these invisible sources of value would be classified as intangible assets like corporate brands or customer equity.

Together with his friend and financial partner Philip Lehman, Henry launched a new securities industry focused almost entirely on a corporation’s cash flow. In the process they reoriented investors’ attention almost exclusively to the income statement, while shifting risk assessment from the collateral value in assets to the credit worthiness of the borrower.

A logical consequence of this was the inauguration of our present era of credit ratings based on statistical forms of risk analysis.

Starting with United Cigar and emerging retail giant Sears-Roebuck, the Goldman investment banking concept propelled Goldman Sachs and other investment banks to global pre-eminence as consumer demand rose swiftly to dominate the highly productive industrial economies in the second half of the 20th century.

But, there was a downside to this new strategy, bankers use assets as security; they are the source of banking stability. In a world where assets are implied rather than being clearly identified, managed and collateralised, a lot of things can (and will) go wrong.

It does not take a financial specialist to see that many a modern financial ill, including the 2008 Financial Crisis, stems from ignoring underlying assets and their potential risks.

A return to financial statement balance is one of the cures for short-termism, and it has investors’ needs at its heart.

We can think of a properly constituted balance sheet (inclusive of both tangible and intangible assets/liabilities) as a report card measuring management’s strategic performance.

The Income Statement, no less important, is however more narrowly focused. It represents management’s tactical performance in the short-term.

A balance between these perspectives is vital to truly represent the company and its performance. Particularly today, as companies like British Petroleum and Shell are pivoting to new green energy futures that will require significant investment in environmental strategies, equipment and other internally generated intangibles that will ensure that future.

Only a balanced view, including both statements, can fully represent that future accurately, and preserve the long-term best interests of investors.

Robert McGarvey

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