The new New Economy Analyst Report – March 06, 2002
Juergen Daum’s new New Economy Best Practice service
©2002 Juergen Daum. All rights reserved.
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Juergen Daum: Why is traditional accounting in our knowledge and information based economy an outdated model ?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.
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 non e -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 . B ut
the US tends to be much more reserved about communicating bad information to
shareholders. So t here 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).
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:
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 subscribe for Juergen Daum’s free-of-charge e-mail push newsletter click here.
©2002 Juergen Daum. All rights reserved.