I teach three sets of classes at Columbia: (i) a deep dive into business models using financial statements as a window into the business (labeled FAIME at Columbia, course numbers B8010 and B7010) for daytime and weekend MBAs; (ii) a half-semester class on dissecting sovereign financial statements (course number B8024) for daytime MBAs; and (iii) a PhD seminar that tries to integrate theory with practice (B9022). A brief description of these courses and the attached syllabus follows:
Fundamental Analysis for Investors, Managers and Entrepreneurs (FAIME):
Economics 101 tells us that value is added by some combination of materials, labor, capacity and managerial talent. However, the standard reporting model for U.S. companies classifies expenses by function (cost of goods sold, SG&A and so on). The functional classification is not very useful to an analyst curious about these value drivers. In general, it is difficult for an analyst to estimate how much material the firm consumed as that number is hidden in COGS. COGS includes manufacturing labor costs and overhead and most companies do not separately disclose those numbers. Labor costs are hidden in every functional line item on the income statement where labor is employed. For instance, compensation paid to scientists and engineers is in the R&D number. However, very few U.S. firms actually disclose total labor costs, dis-aggregated by function. Capacity costs are poorly handled by the current model because we typically straight-line the historical cost of property, plant and machinery without asking how much capacity costs the firm needs to incur to ensure it retains its market share (also referred to as “maintenance capex.”). Such maintenance capex should be expensed in the income statement, as opposed to growth capex (capacity costs incurred to acquire new customers and new markets), which should ideally be capitalized. Financial statements tell us very little about the quality of managerial talent and corporate culture.
On top of that, there is little information in the current reporting model to parse out the fixed and variable components of the firm’s cost structure. Absent detailed data on costs, it is difficult to answer a question that confronts analysts every quarter: if sales go up by 5%, how much would net income go up by? Answering that question requires information about operating leverage and these data are not easily available from the current income statement.
In FAIME, we ask the students to use supplementary data outside of the financial statements to think hard about the actual drivers of value (materials, labor costs, capacity, advertising and other operating expenses). Revenue is decomposed into volume, price and fluctuations in foreign currency (FX). Costs are parsed into fixed and variable. The objective is to integrate insights from standard costing in managerial accounting (volume variance, price variance and other variance from other line items such as foreign currency) to understand the sustainability of a firm’s earnings. The intuition is that revenue and income increases driven by price hikes or currency changes, as opposed to quantity changes of the product sold, are less likely to sustainable in the long run.
Sovereign Risk Assessment:
The post-crisis world is characterized by high levels of government debt. Sovereign risk stemming from Government debt is in the news frequently (e.g., Greek debt, Argentina’s default, emerging market debt). The market for sovereign bonds runs into trillions of dollars and is far larger than equity markets in several countries. Yet, it is highly suspect that sovereign risk, inherent in these bonds, is priced correctly.
A major driver of such mis-pricing is the lack of awareness of deficiencies in governments’ financial statements among bondholders, the rating agencies, and the citizenry. Only a small number of countries in the world (e.g., U.S., Canada, U.K., Israel, Switzerland, Austria, Australia, and New Zealand) actually report something close to accrual accounting, the standard in the corporate world, to reflect their assets and liabilities. Some governments, such as Austria and Switzerland, even leave out legally contracted public employees’ pensions from their financial statements. Many advanced countries, such as Japan and Germany, report results on a cash basis and more worrisome do not report consolidated financial statements. For instance, Japan reports a list of financial and non-financial assets and liabilities at different places on the websites of the Ministry of Finance and the Bank of Japan. Some governments, such as the Vatican and Abu Dhabi do not release any financial statements. In the absence of financial statements, stakeholders have little information related to how specific assets and liabilities are measured, whether the liabilities, especially contingencies and commitments are comprehensive, and what is the actual net debt owed by the Government.
In this class, students learn how (i) to consider the fundamentals of governmental financial statements; and (ii) to exploit these fundamentals to make better investment decisions related to sovereign risk. In particular, we will ask one simple question over and over again: “what would these governmental obligations, assets, spending and revenues look like if we applied accounting and measurement policies designed to provide a true and fair picture of economic reality as prescribed by U.S. GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting System), or the IFRS public sector comparable IPSAS (International Public Sector Accounting Standards)?” GAAP and IFRS are the standard measurement and disclosure frameworks employed by corporate America and global companies. A systematic approach to answering these questions will lead to insights on (i) the glaring gulf between the stated and true economic obligations of governments; and (ii) a better appreciation for sovereign risk.
Adjunct Professor: Paul Kazarian is the CEO and founder of Japonica Partners and the Charles & Agnes Kazarian Foundation. During the 2013 Greek government-debt crisis, Paul became one of the largest investors in Greek government bonds, eventually offering a bond portfolio of €2.9 billion euros (approximately $3.8 billion U.S. dollars). Paul has told me that an accounting insight initiated this Greek bond investment. He has often said that international standards for sovereign accounting are not used within the Eurozone. Instead, the EU opts for a legal framework meant for legal compliance rather than accountability and hence distorts the Eurozone's financial positions.
PhD theory meets practice class:
I am worried that published accounting research is increasingly trying to find answers to questions that no one has. However, the costs of producing a publishable paper in our field are sky rocketing. To address this imbalance, I have suggested that business schools should consider ideas on funding research from engineering and medical schools. These schools produce more “practical knowledge” that stakeholders such as private companies and grant giving agencies are more willing to finance.
This thought process led me to a need to encourage work that is more relevant to policy makers and to practitioners. The American Accounting Association (AAA) has begun emphasizing the issue in a series of commissioned reports and conferences as well. My class and this syllabus takes a small step in this direction. I have tried to pick topics that are potentially interesting to practice and policy makers and are still “publishable” in our top journals. This class does not explicitly address the usual “capital markets based Ball and Brown” or “positive theory from Watts and Zimmerman” type themes. Rather, these are covered indirectly when we discuss issues related to measurement and incentives.
The research areas discussed in this seminar are ripe for future investigation: (i) understanding the operating performance of a firm; (ii) reliance on heuristics; (iii) the importance of corporate culture; (iv) measuring the ESG impact of a firm; (v) assessing a country’s sovereign risk via its financial statements; and (vi) improving measurement practices in accounting research.