Accounting's cure: shifting focus--from lenders to shareholders.

• Author: Heffes, Ellen M.
• Position: Financial Reporting - Interview

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 The real problem is that the U.S. generally accepted accounting principles (GAAP) are outdated and misguided, and governance is suffering the consequences.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...