Accounting's cure: shifting focus--from lenders to shareholders. (Financial Reporting).

Accounting and corporate governance are in trouble, says G. Bennett Stewart 3rd, and not because a few companies broke or tweaked rules. The real problem is that the U.S. generally accepted accounting principles (GAAP) are outdated and misguided, and governance is suffering the consequences.

The man is on a mission, and with the pendulum swinging towards enhanced corporate accountability and governance practices, some of the major changes to the U.S. accounting system he's proposing could be just around the corner.

In an interview with Financial Executive Managing Editor Ellen M. Heffes, Stewart expresses his views on what is wrong with accounting and steps he's taking to influence change. A senior partner and co-founder of consulting firm Stem Stewart & Co., he is a pioneer in developing the managerial and valuation applications of the economic profit concept under the banner of EVA -- economic value added.

Heffes: How does one begin revamping accounting rules that have developed over the past 500 years or so?

Stewart: The big issue is that accounting does not have an objective function. The reported net income of a company is the result of applying a hodge-podge of rules to a variety of business transactions and situations. The net effect is a profit measure whose meaning is quite obscure and unreliable as a measure of shareholder value. Yet, the business press, boards of directors, CEOs and management teams tend to take reported earnings seriously and at face value. And that distorts their decisions and their incentives.

The root of the problem is that accounting's original function was for control and not for valuation or decision support. It was developed at a time when there really weren't any equity markets, and bank finance was the only source of capital. And because bankers would rather be surprised on the upside than the downside, accountants embraced the principle of conservatism. The accounting system of the modem era is still wedded to its past -- far too oriented towards the bankers' perspective, with the shareholders' perspective given short shrift.

One consequence is that accounting is woefully unprepared to measure intangible assets. Accountants expense the money spent on building brands, training people, innovation, learning, reengineering and so on, although those are the only real assets any company has these days.

Heffes: You are saying, then, that the accounting system simply doesn't reflect or measure the way today's business is done?

Stewart: Yes, the "Smokestack America" era, when creating value was about agglomerating piles of physical assets, is long gone. Now it's all about developing, codifying and leveraging ideas and information. Wal-Mart Stores Inc.'s value is not in its hard assets -- its stores and inventory -- but, rather in its business model, the practices that go with charging everyday low prices, to its stocking strategies, supplier coordination, just-in-time delivery, warehouse double-docking, vendor collaboration, its ERP system, to, really, its people. Sam Walton's claim that "people are the most important asset" is probably true, because Wal-Mart's "people" are given training and detailed information so they can run each department in a store as an entrepreneur -- a "store-within-a-store," as they call it.

Heffes: So you want to change the system to value intangibles?

Stewart: No, not the accounting system -- valuation is the market's job; reliable information is the accountant's job. I want accountants to categorize and record the amount of money spent investing in intangibles as balance sheet assets and depreciate that over time according to centrally set schedules. Then the market can judge their value by measuring the returns management earns from those investments. Why should investing in intangibles be any different than investing in hard assets? From the shareholder's point of view, what matters is the cash-to-cash return on investment and not what the cash is invested in.

Heffes: From your perspective, why is that not part of the current system?

Stewart: Since accounting has taken on the lender's perspective, it is inherently conservative as opposed to realistic. Lenders don't want to lend against intangibles because they fear, probably correctly, they will have little value in liquidation; and so the accountants charge them off.

Also, the tort system, regulators and Congress exacerbate the excessively conservative lender orientation, because the last thing accountants want is to be sued for overstating earnings. So they have even more impetus to understate earnings -- which means that managers are essentially being "straight-jacketed." They are being measured by a measure that doesn't really measure value, so they look for other ways to do it. They go to measures like EBITDA (earnings before interest, tax, depreciation and amortization); pro-forma earnings; and, in some cases, balanced scorecards.

Not that scorecards or the other "black-market" metrics are bad ideas, but they may be attractive to use only because accounting is doing such a poor job of measuring what matters. But once accounting loses its anchor to shareholder value, it forfeits its moral authority to guide and control. The integrity is lost; thus, ethical weaklings think they can make up the rules as they go and will do anything to "beat the Street."

The Enrons, Tycos and WorldComs are one step removed. It's a pattern, and ironically and perversely, the attempts to fix accounting have only bottled it more tightly into a system that is ever more insufficient to measure value, and will only end up making the problems worse.

Heffes: So, how do we fix accounting?

Stewart: While there a large number of changes, I have grouped into 10 areas those that I see as key for moving away from the lender perspective and toward the shareholder and true economic value. By far, the most significant change needed to make the income statement more useful is to recognize that all capital -- equity as well as debt -- is costly. (See list in sidebar and visit www.eva.com to download "How to Fix Accounting -- Measure and Report Economic Profit.")

Heffes: How do you expect the change will happen? It will change -- there are too many pressures now for it not to change, correct?

Stewart: Maybe, but the accounting profession will be tempted to address the changes piece-meal. They'll jigger pension fund accounting, tinker with intangible accounting, etc. What I am urging is the recognition that all of these issues are connected to one fundamental question: What should the earnings mean -- what should be the objective of the accounting system? Which leads to other questions: How should the data be organized? What should go onto the income statement? What should go on the balance sheet? What should go in the footnotes?

At the most ambitious level, I would like to see the authorities decide that the measurement and reporting of economic profit should become the primary financial reporting objective, with other roles and missions relegated to footnotes.

I'm a born optimist, who has witnessed seminal changes in my lifetime, like the Berlin Wall falling. With boards, managers, shareholders and accountants all wanting a solution that works, we could be at a tipping point for a big shift in thinking.

That's why I am personally working to create this campaign about: What is the objective of our accounting system? What is the meaning of net income? And how can we make it so that the net income -- the accounting bottom line -- is a measure that does two simple things: 1) It is truly a measure of shareholder value; and 2) It is a measure that lends itself to a mission of continuous improvement -- that you can unambiguously say that more of that measure is good, and less of that measure is bad. Then we should be able to report with pride to Wall Street and to the press that earnings are up, and that means something of substance has been accomplished. Unlike at Enron, with earnings per share up, it was all smoke and mirrors.

Heffes: Finally, what is your thinking on the FASB and International Accounting Standards Board (IASB) initiatives towards converging accounting standards -- both the rules-based and principles-based?

Stewart: The principles-versus-rules issue is far less important than what the principles and rules are about. You can have principles in the current system, or you can have principles in the economic profit system. That argument is secondary to the argument about: Should accountants measure accounting profits or should they measure economic profits?

Finally, I believe that the Big Four accounting firms would find a great deal of merit in this proposal because it absolves them of many of the liabilities to which they are now exposed by [presenting issues] much more clearly and narrowly defining their mission. And, that's very important -- gaining support from the Big Four for my proposal. But even if the rule-makers refuse to switch over to the measurement of economic profit, companies should switch on their own.

RELATED ARTICLE; ACCOUNTING REFORM: Concepts For Moving From Accounting Profit To Economic Profit

1. Account for the cost of equity.

2. Don't mix operating and financing decisions.

3. Haul off-balance sheet financing into the light of day.

4. Eliminate pension subsidies to earnings.

5. Adopt a going concern, shareholder view vs. a liquidating lender perspective.

6. Clamp down the lid on the cookie jar reserves.

7. Recognize and amortize intangible investments.

8. Use full-cost cash accounting, not successful efforts.

9. Measure depreciation with mortgage schedules.

10. Expense stock option grants.