Rethinking accounting: Traditional accounting, designed for an industrial economy of tangible assets, is under increasing pressure to modernize and reflect the value of the New Economy's intangible assets.

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Financial Executive invited two prominent gurus on the subject of measuring and managing intangible assets to write about those areas, and what they believe should -- and will -- happen.

Baruch Lev, the Philip Bardes Professor of Accounting and Finance at New York University's Stem School of Business, has been called "the father of intangible valuation," and even "the investor's Ralph Nader." He wants us to rethink accounting and apply new principles that communicate an organization's value in a world of intangibles.

Robert A. Howell, a Visiting Professor of Business Administration at the Tuck School of Business at Dartmouth, says financial reporting is broken, and he makes a strong argument for financial statement overhaul.


Baruch Lev

Baruch Lev says what he refers to as Phase I of the Intangibles Movement" -- creating awareness of the vast magnitude and impact of intangibles, and of the serious information deficiencies and the resulting social harms related to these assets - is currently at a crossroads, and raises the question of "what's next?" He addresses the question here, offering what he deems "a new perspective on the attributes of intangible assets, followed by a proposed shift of focus for the future work on intangibles that is relevant to researchers, executives, investors and policymakers." This is the first of a two-part series.

The pioneers of the intangibles movement strove in the 1990s to alert managers, investors and policymakers to the dramatic shift in the production functions and asset compositions of business enterprises -- the fast-increasing role of intangibles, which were becoming the primary drivers of corporate value and growth. The awareness creation effort was initially based on conceptual developments in the macroeconomic theory of growth ("endogenous growth models"), and subsequently on the empirical process of documenting the magnitude and impact of intangibles.

Research, for example, indicated that in the late 1990s, the annual U.S. investment in intangible assets -- R&D, business processes and software, brand enhancement, employee training, etc. -- was roughly $1.0 trillion, almost equal to the $1.2 trillion total investment of the manufacturing sector in physical assets. Further, intangible capital currently constitutes between one-half and two-thirds of corporate market value, of both old and "New Economy" enterprises, as reported by this author in Intangibles: Management, Measurement and Reporting, Brookings Institution Press, 2001.

At the dawn of the 21st century, the prominence of intangibles as value and growth creators -- at both the corporate and national economy levels -- is widely accepted. Indeed, there is general agreement that traditional (accounting-based) information systems fail to provide adequate numerical underpinning for intangibles and their economic impact to managers, investors and public policymakers for the purpose of national accounting measurements. In fact, in response to these informational deficiencies, the Financial Accounting Standards Board decided in January of 2002 to add to its agenda an "intangibles disclosure project."

Research indicates that these "information failures" cause serious private and social harms, such as excessive cost of capital to intangibles-intensive enterprises, hindering their investment and growth; abnormally high volatility of stock prices, causing undue losses to investors and misallocation of resources in capital markets; systematic biases in managerial decisions; and excessive trading gains to corporate insiders, eroding investors' confidence.

While there is widespread agreement about the causes and consequences of the intangibles-related information deficiencies, there is a heated controversy about the necessary remedies, ranging all the way from doing nothing (let free-market forces work their way to improve the situation) to a significant overhaul of corporate accounting and financial reporting practices. In between, are various proposals for encouraging voluntary corporate disclosure of intangibles-related information. For one, an SEC-initiated task force of company executives, financial analysts and academics recommended in late 2001 that "...the SEC...move forward with a framework for voluntary supplemental reporting for intangible assets...that will help investors assess a company's future performance."

Thus, the intangibles movement has largely succeeded in the first phase of its mission -- creating wide awareness and active discourse about the economic role of intangible assets and their consequences. This effort, however, appears to now face a crossroads.

What should follow the awareness-creation phase? Some hope that by observing how firms manage intangibles and report their values internally, we would be able to develop "best practice" cases for managers and design reporting modes for information disclosure about intangibles. Others believe that we could develop optimal valuation and disclosure practices for these assets by surveying the valuation practices of financial analysts and fund managers. A reading of the numerous surveys and questionnaire studies in this area leads to the conclusion that, with but few exceptions, the persons being asked -- both managers and investors -- are at a very early stage of grappling with the management, valuation and reporting of intangibles.

To be sure, some companies report internally, and sometimes even externally, on certain aspects of intangible assets (such as employee and customer satisfaction), but such haphazard, non-standardized reporting is of little value for resource allocation or investment decisions. It is, therefore, questionable whether significant advances in the work on intangibles can be based on such observational studies. "The blind leading the blind" metaphor seems appropriate here.

Another route of investigation involved empirical research on intangibles, which contributed significantly to the understanding of the causes and consequences of intangible investments. But this effort, too, reached the stage of diminishing marginal returns, due primarily to the paucity of raw material for research -- public information on intangible assets. Research and development in the U.S. is the only intangible investment publicly reported by companies, and while we learn a lot from R&D -- and related patent-based research -- R&D is just one component of intangibles. There are no comprehensive data on other important intangibles to support research on measurement and valuation.

So, where do we go next...

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