The new New Economy Analyst
Report – March 06, 2002
Juergen Daum’s new New
Economy Best Practice service
©2002 Juergen Daum. All rights reserved.
à Deutsche Version
How the
Balanced Scorecard can help to
master the challenges of the more intangibles intangible-based
new economy – an interview with
David P. Norton, co-creator of the Balanced Scorecard concept Interview
with Baruch Lev: Accounting, Reporting and Intangible Assets
News categories: The
New Economy Economics, Finance and accounting, Performance management and
controlling, Investor and Stakeholder Relations
Baruch Lev
is Professor of Accounting
and Finance at New York University, Stern School of Business, the Director of
the Vincent C. Ross Institute for Accounting Research and the Project for
Research on Intangibles1. He is an internationally
recognized expert for accounting and reporting issues related to Intangible
Assets, working
closely with such institutions as the U.S. Securities and Exchange Commission
and the Financial Accounting Standards Board, OECD, the European Union, and
the Brookings Institution (see also at the bottom of this page: Lev's Congressional
testimony in the Enron case, February 6, 2002).
This is
a shortened version of an interview with Baruch Lev from the book “"Intangible Assets or the Art
to Create Value"”2 by Juergen Daum (April 2002). This
shortened version has been
published in the German Newsletter “Controlling & Finance”, issue 02/2002.
Juergen Daum:
Why is traditional
accounting in our knowledge and information based economy an
outdated model ?
Baruch Lev: One of the major problems with today’s
accounting systems is, that they are still based on transactions, such as
sales. In the current, knowledge-based economy much of the value creation or
destruction precedes, sometimes by years, the occurrence of transactions. The
successful development of a drug creates considerable value, but actual
transactions, such as sales, may take years to materialize. Until then, the
accounting system does not register any value created in contrast to the
investments made into R&D, which are fully expensed. This difference,
between how the accounting system is handling value created and is handling
investments into value creation, is the major reason for the growing disconnect
between market values and financial information.
Juergen Daum:
Why do companies not account for their intangible assets ?
Baruch Lev:
Intangible assets, such as new discoveries like drugs, software programs,
brands or unique organizational design and processes that provide a competitive
advantage, are by and large not traded in organized markets, and the property
rights over these assets are often not fully secured by the company. The risk
of these assets – for example the risk involved in developing a new drugs or
software programs – is generally higher than that of physical assets.
Therefore, under current GAAP, these expenditures cannot be capitalized.
Juergen Daum:
The Dotcom hype represents probably the most condensed version of
“intangibility” and demonstrated, that the risks involved with intangibles are
real.
Baruch Lev:
What happened with the Internet has happened with any other revolutionary
invention. Always people become overly enthusiastic with new technologies. That
happened with electricity, with railways, and with automobiles. In the
beginning everybody fears to miss the train to wealth and invests significant
amounts of money in the new stocks. Later doubts will come up, if all that will
work out. At the begin of the 20th century there had been over 200 car
manufacturers in the U.S. alone. People had been enthusiastic about these car
companies and share values skyrocketed. Today, we have only three left,
basically two, because Chrysler is part of Daimler-Chrysler. So the Internet is
a special phenomena related to a technology. You cannot compare it with
established markets and companies. But if investors would have had more
reliable information about intangibles of these Internet companies, it would
have been easier to assess their true value. The absence of reliable
information about intangible assets represents a major economic and social
problem today.
Juergen Daum: Why ?
Baruch Lev:
GAAP-based financial accounting and reporting produces insufficient information
about Intangibles, with the result that investors are in the dark and managers
operate by guess. With coauthors I examined more than 1,500 R&D intensive
companies. And we found that companies
with a high growth rate of R&D expenditures – but relatively low growth
rate of earnings, typical to young, intangible-intensive enterprises – are
systematically undervalued by investors. This increases cost of capital for
these companies and the costs to finance future wealth of economies at large.
And it reduces prosperity by distorting flows of investment capital, which
should go where it can be most productively employed.
Juergen Daum:
Which accounting and reporting model do you propose instead ?
Baruch Lev:
The most relevant information to managers and investors concerns the
enterprise’s value chain. By value chain, I mean the fundamental economic
process of innovation that starts with the discovery of new products, services
or processes, proceeds through the development and the implementation phase of
these discoveries and establishment of technological feasibility, and
culminates in the commercialisation of the new products or services. And this
innovation process is where economic value is created in today’s knowledge
based businesses from nearly all industries. So what I recommend as one important
complementing element of a new accounting system is a so called Value Chain
Blueprint, a measure based information system for use in both internal decision
making and disclosure to investors, that reports in a structured and
standardized way about the innovation process.
Juergen Daum:
And which improvements do you recommend concerning the accounting system ?
Baruch Lev:
In a second step the current financial accounting practice has to be changed as
well. The broad denial of intangibles as assets detracts from the quality of
information provided in the balances sheet. Even more serious is its adverse
effect on the measurement of earnings. The matching of revenues with expenses
is distorted by front-loading costs by the immediate expensing of intangibles
and recording revenues in subsequent periods unencumbered by those costs. As
for example R&D projects advance from formulation through feasibility tests
such as alpha and beta tests of software products, to the final product, the
uncertainty about technological feasibility and commercial success continually
decreases. Accordingly, I propose the recognition as assets of all intangible
investments with attributable benefits that have passed certain prespecified
technological feasibility tests.
Juergen Daum:
What do you recommend to managers concerning intangibles in the actual economic
situation ?
Baruch
Lev: Managers should develop the capability to assess the
expected return on investment in R&D, employee training, information
technology, brand enhancement, online activities, and other intangibles and
compare these returns with those of physical investment in an effort to achieve
optimal allocation of corporate resources. Today, most business enterprises do
not have the information and monitoring tools required for the effective
management of intangibles. So investing in these new type of management systems
may become an important tasks especially during an economy slowdown. In a
challenging business environment I foresee a need for increased, rather than decreased,
attention to intangibles – the major driver of corporate value and growth – by
both managers and investors. It is now time for the full incorporation of
intangible capital in the managerial processes as well as in investor’s
analysis of securities and portfolio performance.
Juergen Juergen
Daum: This trend to report to the outside not just financial but also more
non-financial figures in a structured way is very interesting. I discussed this
recently with controlling experts here in Germany. And the fact is, that
controllers here are already required to be involved in this type of
communication on the none-financial
drivers, which provide external parties, mainly investors, with insight into
the long- term
value creation process of the company.
David Norton:
Yes, I think you will probably see that happen faster in Europe than in the US.
The trend is happing in both places,.
bBut
the US tends to be much more reserved about communicating bad information to
shareholders. So there is a real
reluctance on the part of corporate executives to communicate anything they
don’t have to. I think that’s less so in Europe. You tend to see more
innovation that way.
Daum: Professor Lev, thank you very much for this interesting interview.
1 see: Baruch Lev, Intangibles: Management, Measurement,
and Reporting, (Washington, D.C.: Brookings Institution Press, 2001), ISBN
0-8157-0094-6 – book
review
2 English Edition:
Juergen H. Daum, "Intangible Assets and Value
Creation", John Wiley & Sons Ltd., ISBN 0470845120 (Mai 2002).
German Edition: Juergen
H. Daum, „Intangible Assets
oder die Kunst, Mehrwert zu schaffen“, Galileo-Press, ISBN 3-89842-112-0
(April 2002).
Lev's Congressional testimony in the Enron case:
Baruch
Lev presented before the Committee on Energy and Commerce of the US Congress
his testimony on accounting issues in the Enron case. He specifically stated,
that our current accounting system is geared for an industrial era based
economy of tangible assets and records only past transactions. It ignores
intangible assets, unexecuted obligations and risk:
Lev's
Congressional testimony in the Enron case, February 6, 2002
Follow-Up
Congressional Questions from February 20, 2002
Lev's
Answers to Congressional Questions
Additional Resources:
Interview with Leif
Edvinsson: Intellectual Capital: the new wealth of corporations
Interview mit David P.
Norton: Intangible Assets und die Balanced Scorecard
In
today’s intangible assets dominated economy companies need new accounting,
controlling und management systems - in an interview with sapinfo.net, Jürgen H. Daum, the director
of program management at SAP AG for mySAP Financials, explains the function of
intangible assets in enterprise management
Corporate Performance
Management: Managing profitability and growth in the new environment – article by Juergen Daum
How accounting gets more
radical in measuring what really matters to investors – article by Juergen Daum
Today’s #1 management
challenge: How to better exploit intangible assets to create value –
article by Juergen Daum
Business Management in the
new, New Economy - How to exploit Intangible Assets to Create Value
- Presentation held by
Juergen Daum at SAP's European mySAP Financials Conference, June 2001, Basel / Switzerland
The new FASB rules for
reporting on Intangible Asset - The European versus the U.S. way - Report about the new US-GAAP rules for Goodwill and
Intangible Assets as the American way to deal with Intangibles. In addition the
new Danish rules are presented, which oblige companies with significant
Intellectual Capital to report about them through a Intellectual Capital
Supplement in addition to its financial reports
More about New Economy Economics and Management
Best Practice in general, and about other related topics will be continued here
in this new New Economy Analyst reports (see for example
this report). To
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