Question : With reference to your textbook summarize the value creation model in one page or more ?

Value Creation Reporting Is financial accounting information actually useful? Over 50 years ago, William Beaver answered this question in the affirmative in his seminal study, The Information Content of Annual Earnings Announcements.63 However, during the 1990s, the financial press began to question the information content of traditional historical cost balance sheets. For example, Peter Drucker commented that: Balance sheets were designed to show what a business would be worth if it was liquidated today What managements need, however, are balance sheets that relate the enterprises current condition to its future wealth-producing capacity Financial accounting, balance sheets, profit-and-loss statements, allocations of costs, etc., are an X-ray of the enterprises skeleton. But much as the diseases we most commonly die from "heart disease, cancer, Parkinsons" do not show up in a skeletal X-ray, a loss of market standing or a failure to innovate do not register in the accountants figures until the damage has been done.64 Over the years, several new reporting measures were developed that arguably could address this criticism. They include the following: Key Performance Indicator (KPI) A measurable value that demonstrates how effectively a company is achieving key business objectives. For example, zero defects in a manufacturing process. Businesses currently use KPIs to evaluate their success at reaching targets.65 Value Reporting Revolution Investors want to know more about what companies actually do to create value to be able to make sound, long-term investment decisions. They need information about market dynamics, corporate strategy, and nonfinancial value drivers that are leading indicators of a companys future financial performance and stock price. Advocates of this concept point out that many companies focus on short-term earnings rather than future stock price performance. They suggest instead that to make sound, long-term investment decisions, investors want to know more about market dynamics, corporate strategy, and nonfinancial value drivers that are leading indicators of a companys future financial performance and stock price.66 Intellectual Capital Reports The world has moved from an industrial economy, in which economic growth was considered to be mostly determined by the employment of material resources, toward a knowledge-based economy in which wealth creation is associated with the development and maintenance of competitive advantages based on intangible elements that are frequently grouped under the generic term knowledge. Traditional financial statements do not provide the relevant information for managers or investors to understand how these resources many of which are intangible create value in the future. Intellectual capital statements bridge this gap by providing information about how intellectual resources create future value.67 Enhanced Business Reporting Model Focuses on shifting the reporting model from one that is based primarily on historical or lagging financial information to a model that incorporates relevant value drivers, financial and nonfinancial performance measures, and qualitative information around managements strategy, plans, opportunities, and risks. Proponents believe that this improved business reporting model would deliver a broader view of current performance and provide greater understanding of an entitys future.68 Integrated Reporting A process that would provide a periodic report about value creation over time. This report would communicate information about how an organizations strategy, governance, performance, and prospects lead to the creation of value over the short, medium, and long term. Proponents believe that an Integrated Reporting financial accounting model would provide greater context for performance data, clarify how value-relevant information fits into operations or a business. When utilized by businesses, Integrated Reporting helps management to make company decision-making more longterm and adds value to financial and sustainability reports including the following; Natural capital: such as natural resources Social and relationship capital: such as ties to the community and government relations Intellectual capital: such as patents and copyrights. Human capital: such as the skills and know-how of an organizations professionals as well as their commitment and motivation and their ability to lead, cooperate, or innovate Financial capital: is the traditional yardstick of an organizations performance. The capitals available to the organization are increased, decreased, or transformed as a result of its value-adding activities.69 Over the years, these techniques have not gained a great deal of traction primarily due to the lack of a widespread recognition that the current accounting model is deficient. Thus, the structure of accounting reports remains basically unchanged. Recently, however, the global economic crisis of 20072008 provides a reminder that financial reporting alone cannot provide sufficient insight into business performance. Stakeholders have increasingly become interested in obtaining a more holistic (complete) picture of how organizations create value and of the external drivers that impact their business model now and in the future. One possible solution was recently advanced by Baruch Lev and Feng Gu (L&G) in their book The End of Accounting and the Path Forward for Investors and Managers.70 L&G maintain that flaws in GAAP severely limit the usefulness of financial reporting. One review of this work termed it the Moneyball of financial analysis.71 L&G base their conclusion on an analysis they conducted of the following four main sources of information available to investors for a sample of all publicly traded US companies with the required available information: 1. Financial reports such as annual and quarterly reports 2. Other corporate SEC filings such as the 4-K and 8-K 3. Analysts forecasts of earnings, sales, and subsequent revisions 4. Managers forecasts such as future performance. In each case, the question asked was did the stock price of a company change because of the availability of a particular piece of information? This question was investigated by using regression analysis 72 for the period 19932013. The results indicated that the contribution attributed by financial reports declined over the years to about 5%6% while the contributions of other corporate filings and analysts reports significantly increased. The authors state that there are three major reasons for these findings and why accounting reports have lost relevance: 1. The treatment of intangible assets. In the past few decades, the major corporate value drivers have shifted from property, plant, machinery, and inventories, to patents, brands, information technology, and human resources. That is, studies have shown that since the 1990s, companies spend more on intangible assets and other strategic assets such as brand development, advertising and marketing, and unique personal talents than on physical assets. However, GAAP has failed to adapt to this change and has continued to treat the cost of internally developed intangibles as ordinary expenses. L&G document that investment in physical assets declined by 35%, whereas, investment in intangible assets has increased by almost 60% since 1977. 2. Accounting has become less about facts and more and more about managers subjective judgments, estimates, and projections. That is, there has been a move away from strictly reporting items at their historical cost. Accounting regulations have increasingly required financial statement items to be revalued by using estimates such as fair value. L&G found a fivefold increase in the use of estimates during the 19952015 period. 1. The increase in unrecorded business events that affect corporate value (competitor moves, regulatory changes, restructurings, alliances, etc.). These events are reported to the SEC on form 8-K but are not formally entered in the accounting records. L&G found a threefold increase in these events during the 19942013 period.73 L&Gs solution was to first use economic theory to define investor needs and subsequently they analyzed analysts earnings conference calls to develop a proposed information system. L&G adopt the view exposed by the theory of the firm that the major objective of a business organization is to achieve a sustained competitive advantage.74 This goal is achieved by creating sustained economic profit that they define as revenue minus all operating costs (measured at current cost) including the cost of equity capital. Economic value is achieved by the creation and utilization of strategic assets not available to competitors such as patents and unique business products and processes. L&Gs proposed information system is titled The Strategic Resources and Consequences Report (SRCR). SRCR is mainly based on nonaccounting information and focuses on a companys business model and its execution. SRCR highlights what the authors term fundamental indicators such as Internet and telecom companies new-customer additions and existing customer churn rates; car insurers accident severity and frequency and policy-renewal rates; biotech and pharmaceutical company clinical trial results; and energy companies proven oil and gas reserves. The SRCR contains the following five usefulness attributes. 1. Inform investors about the strategic resources available to the firm such as patents. 2. Inform investors about the expenditures made to acquire the strategic assets. 3. Inform investors about the major risks to the strategic assets such as patent infringement and the measures taken to mitigate those risks. 4. Inform investors how the company intends to extract value from the use of its strategic assets. 5. Inform investors of the quantifiable value achieved by using the strategic assets. L&G then acknowledge that the SCRC is industry-specific and illustrate it for four different industries: media, insurance, pharmaceuticals, and oil and gas. They also provide descriptions as to what financial disclosures should be made under the above five topics and for each of the four industrial examples. While most reviewers of this book agree that the disclosure of more nonaccounting information would be useful, not everyone agrees with their solutions. For example, Arthur Radin states that L&Gs positions are based on the following assumptions: 1. The issuance of corporate quarterly and annual financial statements does not move the markets. Prices are more responsive to nonfinancial reports. 2. The ratios of total market value of companies to their earnings and their net worth to their total market value have declined over the last 65 years. 3. Markets move more in relation to changes in cash flow than GAAP. 4. The function of financial statements is to be predictive of future results. 5. The determination that few analysts ask about the financial results, instead focusing on other developments. He suggests75 that for each of the above analyses, there is an alternative explanation: 1. With the improvements in current reporting, the information that moves a market should not be in the quarterly financial reports. The SEC Form 8-K requires disclosure of any material event within four business days of the event. The later publication of the financial results merely confirms what is already in the news and should not have an immediate effect on the stock price. 2. The world has changed over the last 50 years; certainly, most companies are not evaluated primarily on book value. The authors analysis of the effect of reported earnings on values appears to be simply an analysis of price/earnings ratios and how they have moved over the years. Radin does not believe that such an analysis denigrates GAAP. 3. Academia is more supportive of cash flow than GAAP. In view of all of the weaknesses of cash flow (the lack of accruals, delay in recording revenues, managements ability to time receipts and disbursements), Radin does not believe it is a useful measure. Furthermore, since the cash flow statements are part of all financial statements, I do not understand why it is an issue. 4. The purpose of financial statements is not to predict the future, but rather to show the present or recent past. Accounting is history; the financial statements are the beginning points from which predictions should be made. 5. The job of analysts is to look beyond the financial statements. Media stories about reported results are written after the issuance of financial statements. At the time of the analyst calls, these are old news, and the analysts assume the reported results and look for something else. He concludes that After ten chapters on the uselessness of accounting, I feel that the authors (solution) produced a molehill instead of a mountain.76 Additionally, in another review, Tom Selling voiced a desire to have a conversation about the diminishing quality of GAAP and stated that L&G contributes to this discussion. He also agrees with some of their recommendations to improve financial reporting, but strongly disagrees with their renewed emphasis on the capitalization of historic costs and matching of revenues and expenses. He noted that research and development (R&D) expenditures are now expensed under GAAP because the discretion to capitalize was abused by issuers, because too much of the R&D that should have been expensed was capitalized, and vice versa.77 Finally, a replication78 of the Beaver study mentioned at the beginning of this section for the 19712011 period found that earnings announcements convey significant information and that the information content increases over time with a dramatic increase from 2001 onward. This finding tends to contradict L&Gs research.