The new New Economy Analyst Report – July 26, 2001

Juergen Daum’s new New Economy Best Practice service

©2001 Juergen Daum. All rights reserved.

 

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How accounting gets more radical in measuring what really matters to investors

News categories: the New Economy Economics,  finance,  business performance management, investor relationship management,  value based management

 

A corporate balance sheet, prepared according to generally accepted accounting principles, does a reasonable job informing about the physical assets and financial capital employed by a company. But when it comes to the increasingly important intangible assets of corporate enterprises, it provides next to no insight. Usual financial reporting reveal very little that’s meaningful to assess if a corporation is successful or not when it owns a considerable portion of intangible assets. And intangible assets such as the value of the relationship to the people or organizations a company sells to (customer value), the value of the relationship to organizations or individuals through which a company sells or is doing business with in general (business partner network value), the R&D pipeline of new leading edge products that will increase a company’s market share and will generate new revenue and free cash flow in the future (R&D pipeline or innovation capital), a highly skilled and talented work force which is committed to the company (human capital), leading edge business processes, organization structures and a corporate culture that help to convert individual knowledge and skills of employees into relationship value and innovation capital which the company owns when employees go home (structural capital), represent the major value drivers of today’s new economy and the basis for innovation, economic growth and wealth – both for companies and nations.

 

Under GAAP, expenditures made to increase brand awareness, to foster innovation, or to improve the productivity of employees cannot be capitalized. Instead, the logic goes, they must be expensed through the income statement, because the future benefits of such investments are so uncertain. The problem is, that corporate investments in tangible assets have stagnated while corporate value creation has surged at the same time. The S&P 500 index, reflecting the market value of the major U.S. corporations, surged between 135.76 at the end of 1980 to 1342.62 on November 20, 2000 – a ten fold increase. In the same period investments into tangible assets in the U.S. (as a percentage of corporate GDP) decreased from 14.1% in the 1980s to 12.6% in the 1990s (see Leonard Nakamura, “Intangibles: What put the New in the New Economy”, page 4). This suggest, that a large portion of the growth in corporate value over the past two decades has been created through investments into intangibles, for which financial reporting and accounting does not account for. It is the investments in R&D, in organizational innovation and organizational capital, in marketing and customer acquisition, that drive the performance of companies today.

 

If you look at the average return for financial, physical and intellectual assets, this becomes very clear:

 

Financial
Ten-year average return on U.S. Treasury bonds:        4.5%                           

 

Physical
Average ROE for all companies with physical
assets and inventories:                                               7.0%

 

Intangible
Average expected return on equity for

biotech and software industries:                                  10.5% 

 

This was the result of studies conducted by Baruch Lev, Professor of Accounting and Finance with the Stern School of Business at New York University. In a study for the chemical industry he found, that R&D investments of 83 companies over a span of 25 years returned 17%  after tax, whereas capital spending earned just the cost of capital of 8%. So investments into intangible assets remain not only invisible through the traditional accounting approach, they are also the investments that yield the highest return ! So accountants and CFOs obviously need to do something about it to make this hidden value drivers more manageable and provide investors with more useful information. 

 

 

Traditional accounting does not help to manage and to report on Intangible Assets

 

But unfortunately the value creation process of this type of investments is hard to grasp. We had long had a good idea of how to value manufacturing inventory or assess what a factory is worth. Today, the value of R&D invested in a software program, or the value of a user base of an Internet shopping site like Amazon.com is a lot harder to quantify. As intangible assets continue to grow in both size and scope, more and more people are questioning whether the true value – and the drivers of that value – is being reflected in a timely manner in accounting and in publicly available disclosure. Accounting’s fundamental purpose is to provide information that is useful in making rational investment, credit, and similar decision. In 1978 book value, as presented in the balance sheet of companies, was on average around 95% of the market value of companies in the US. Twenty years later, book value was just 28% of market value. So investors simply don’t value what accountants count.

 

 

How to change the actual and insufficient measurement, accounting and disclosure practice ?

 

In October 1999, former Chairman of the U.S. Securities and Exchange Commission (SEC), Arthur Levitt, asked Dean Jeffrey E. Garten of the Yale School of Management to form a task force of leaders from the business community, academia, the accounting profession, standard setting bodies, and corporate America to examine how the current business reporting framework can more effectively capture these momentous changes in the economy. On June 06, 2001 the task force presented its final report “Strengthening Financial Markets: Do Investors Have The Information They Need?”. In that report the task force made two recommendations for improvements:

 

1.      Create a new framework for supplement reporting of intangible assets. It recommends that the SEC pull together the work that has already been done by academics, the accounting firms and projects sponsored by organizations such as the U.S. Financial Accounting Standards Board (FASB) in order to move forward with a framework for voluntary supplement reporting for intangible assets, operating performance measures and other information that would help investors to assess a company’s  future performance. Such a framework of voluntary supplement reporting should complement existing GAAP-based financial statements by creating a common language for companies and investors to communicate about intangible assets and operating performance measures.

2.      Create an environment that encourages innovation in disclosures. In addition to working to create a framework for disclosures about intangible assets and operating performance measures, the task force believes that the government should take as many actions as it can to create an environment that encourages innovative disclosures by reducing the risks associated with doing so. Many members of the tasks force felt, that the actual legal situation in the U.S. has discouraged companies from experimenting with supplement disclosures, despite already existing “safe harbour” provisions. The task force recommends to protect companies, who are willing to disclose more information, by new laws and/or new regulations from legal actions from shareholders. Companies should be permitted to provide more “soft” and speculative information as long as they warn investors that the information is speculative and provide explicit definitions about how such information is constructed. This could be done for example through a special marked section on a company’s investor relations website.

 

 

What is supplement accounting or reporting ?

 

Some innovators, like the Swedish financial service company Skandia, already introduced a supplement report to its annual report 1998. Under the leadership of Leif Edvinsson, its former director of Intellectual Capital Management, Skandia has pioneered a new system for visualizing and developing intellectual, intangible and organizational business assets, which it used to manage the business internally but also to report to the public in the form  a supplement report to its annual report

 

Figure 1: Skandia’s “Navigator” to manage and to report on the company’s intangible assets

He developed the “Navigator”, a kind of Balanced Scorecard, to do that. The Navigator consists of five value-creating fields which present measure and key performance indicators for each area (see figure 1): The financial sector represents the stored past, the company’s achievements so far. The company’s people, customers, and processes are its very existence. Its innovation and development powers form the foundation, its future perspective, the new bottom line. The Navigator provides, beside financial results, ratios and measures on the status of Skandia’s intangibles assets, such as number of customer contracts, which gives an indication of the value created for customers, such as number of contracts per employee, which gives an indication about effectiveness of processes and about organizational effectiveness at large. Another example is share of premiums from new launches (products), which gives an indication about the success of past product innovation (see the supplementary report of Skandia, the navigator, for 1998). This navigator at Skandia was the basis both for business planning and management as well as for outside reporting in form of a supplement report.

 

A new income statement and balance sheet ?

Another proposal for overhauling accounting and disclosure is, to change the structure and content of traditional financial statements such as the income statement, balance sheet, and cash flow statement.

The “old” income statement highlights the most important cost of the production orientated era: the costs of goods sold. When raw materials and direct labours made up most of a product’s cost, that was an important information for managers and investors. But today, intangible based businesses have very low variable costs or costs of goods sold, but high fixed costs or initial investments – for example into R&D or brand building. So costs of good sold is not that important any more. Marketing costs and costs spend for R&D are much more important. And also profit is not a reliable indicator of performance any more. Often profit has become a subjective number that depends on when revenues and expenses are recognized. This is because the relationship between revenues and costs/expenses is not that tight anymore with intangible assets based business. You invest today into R&D to get some day in the future revenues out of that – hopefully.

So one proposal, which was often made in the last couple of years, was to change to cash based accounting. If you take the other topics mentioned above into account and remove interest expense (an financing activity – I come back to that), the format of the new income or operating statement could look like that:

Revenues
minus costs to serve customers
minus costs to produce products/services
minus costs to develop products/services
minus admin costs

Earnings before interest and taxes
minus taxes
plus/minus non-cash adjustments

Cash Earnings

This change of the income statement should give readers an idea where a company spends money and it replaces manipulated “profit” with easy to verifiable cash money (you just have to look at the bank account). It focuses on the important tasks of companies today: taking care of customers (sales and marketing, shipping, service), producing things to sell (manufacturing or providing services, materials, equipment), and producing future offerings (research and development, knowledge creation). And it makes admin costs, a proxy for efficiency, visible and does not lump it into an item “sales, general, and administrative costs”.

The balance sheet is usually a snapshot of what resources (assets) a company controls and where it got the money to buy or built them (from shareholders/equity or through borrowings from third parties). In many industries today outsourcing of operations (and of the corresponding physical assets) has become usual.  And some companies, like retailers, work with negative working capital. So today’s companies need less of physical assets or working capital to do their job. So it is not control of resources versus funding of these resources what has to be in the focus of today’s companies, but investments, mainly investments into the future, into intangible assets versus financing of these investments. So the new balance sheet should not compare assets with liabilities and equity but investments with financings. On the investment side you will then find, beside working capital and fixed assets, intangible assets. And intangible assets like the R&D pipeline, the know-how of a work force, brand equity and a large customer base, relationships to business partners, are the real assets of knowledge-intensive companies. Therefore money spend on them should be treated and booked as investments. A balance sheet like this answers questions managers and investors need to ask: What are you really doing with the money you raise ? How are you investing into the future ?

And the task of the new cash flow statement is not any more to tell about a companies effectiveness in using financial resources (that does the new operating statement and balance sheet). Managers and investors need to know how much cash a business produces over and above what’s needed to operate it: free cash flow. So the new cash flow statement might take cash earnings (from operating statement), deduct from that investing activities (into working capital, fixed assets, and intangible assets), and get as a result free cash flow.

With that approach, companies will be better able to focus on the real concern of business under today’s condition and under the growing dominance of intangible assets: producing cash and creating value.

 

Get more radical: Calculate Knowledge-Capital Earnings (KCE)

Another approach, more from a macro perspective, is, to start with a company’s performance – company earnings – and then go inside and identify what assets produced the earnings. This is an approach proposed by Baruch Lev, who was mentioned already above:

Start with a company’s earnings, for example $500 million and then look at its balance sheet to see what it has in financial (for example $1 billion) and physical assets (another $2 billion). As it was outlined above, the average after-tax return of financial assets is about 4.5% and of tangible assets it is 7%. So $45 million and $140 million respectively of the total earnings can be credited to financial and tangible assets. So $315 million must have been produced by other assets. Baruch Lev calls that residual “knowledge-capital earnings” (KCE). He then calculates the knowledge capital itself by dividing the earnings by an expected rate of return on knowledge assets (10.5% - see above). So, to produce $315 million in earnings, that company would need $3 billion in intangible assets.

With Marc Bothwell, a vice president of Credit Suisse Asset Management, Baruch Lev has been investigating the implications of his work. They analysed and ranked for the third time leading American companies in 22 nonfinancial industries by knowledge capital through a so called Knowledge Capital Scorecard. The result was published in CFO Magazine in April, 2001.  And it indicates clearly the value of incorporating knowledge capital into investment analysis. For example, the Scorecard shows that the market valuations of such New Economy stars as Dell Computer, Microsoft, and Intel, as well as knowledge-intensive companies in the pharmaceutical and biotech industries, have very little to do with the assets reflected on their balance sheets. Their stocks trade at huge multiples of book value (examples: Dell, 17.5; Pfizer, 18.2). But when knowledge capital is added to book value (a sum deemed comprehensive value by Baruch Lev), the ratio of market value to that comprehensive value becomes far more reasonable: Dell, 1.26; Pfizer, 1.90.

And Companies with a ratio of market value to comprehensive value significantly above 1 can be viewed as overvalued. Those with a ratio below 1 are probably undervalued. The negative correlation between this ratio and the subsequent stock returns of the 105 companies evaluated in the Scorecard was remarkably strong. Between the August 31, 2000, cutoff date for the Scorecard analysis and the end of last year, the average weighted return of 53 companies with a ratio of market value to comprehensive value below the median of 1.08 was 7 percent. For the 52 companies with a ratio above the median, the average return was -15.5 percent. Companies with some of the highest ratios, such as Broadcom (8.5) and Siebel Systems (5.8), have since experienced some of the most severe slides in the stock market. Broadcom was down 80 percent since last August, and Siebel is down 60 percent compared with their stock value in April 2001. In contrast, companies trading at low multiples of comprehensive value fared far better. The shares of Rockwell International, for example, with a ratio of 0.62, and Georgia Pacific (0.35) were both up 15 percent over the same period.

Summary

As we have seen, there are serious reasons to reengineer the traditional accounting approach and how business information for management and investors is prepared. There are already different concepts and methodologies available – each with a different focus. The solution probably lies in a combination of these different approaches and of some other important aspects into a new comprehensive accounting, management and reporting system. The design of that new system will need the engagement of consultants, accounting professionals, academics and practitioners. And it will take some time. Therefore I will continue here and in my forthcoming "Intangible Assets oder die Kunst, Mehrwert zu schaffen: Erfolgreiche Unternehmensführung im Zeitalter des  Intellectual Capital" ("Intangible Assets or the Art to Create Value: Successfull Enterprise Management in the Era of Intellectual Capitalism") to present the actual status of discussion and the new evolving concepts.

More about 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. To subscribe for Juergen Daum’s free-of-charge e-mail push newsletter click here. 

 

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