Touchy-feely
May 17th 2001, From The Economist print edition

Accountants want to start measuring intangible assets and new economy “value drivers”. They are unlikely to be any good at it

SHOULD “female potential” be rewarded with a place in companies’ annual reports? Or how about the share of the staff who are younger than 40 and possess a college degree? These criteria, and many more like them, are to be found in supplements to past annual reports from Skandia, a Swedish financial group. Telling the world about its female managers and the average age of its workforce, the company thought, would attest to its wealth of “intellectual capital”.

Skandia’s efforts in this direction seem to have petered out after 1999, when its most recent supplement was published. Now its touchy-feely approach looks prescient. Inside accountancy a debate is growing about recognising and measuring internally generated intangible assets—such things as intellectual capital and research and development. Many argue that more attention also needs to be paid in annual reports to non-financial, “soft” measures such as speed-to-market, quality of management and customer satisfaction. Ideally, the fans say, there should be rules about what extra information companies must disclose, and how.

Late in 1999 America’s Securities and Exchange Commission (SEC) gathered some people together to look into how accountants might get better at revealing “value in the new economy”. According to Jeffrey Garten, dean of Yale’s business school and leader of the SEC’s task-force, which will report its findings later this month, changes in the world’s industrial structure are threatening to make existing accounting standards obsolete.

Profits in the Internet age, the argument goes, are generated less from solid assets such as factories than from intangibles such as research and development or software programs. The SEC’s report will conclude that companies should experiment with disclosing new types of information. A report in April by the Financial Accounting Standards Board (FASB) said that it would undertake four projects on non-financial metrics and intangible assets.

The problem with all of this is that nobody inside the accountancy profession has much idea of how to put a numerical value on internally generated intangible assets, at least not while staying true to the principle of reliability. Under the present regime, most intangible assets are recognised in the balance sheet only when one company buys another and has to account for the “goodwill” part of the cost.

In the case of research and development, arguments have raged for years over whether companies should be allowed to make an asset out of R&D spending, instead of charging it as an expense through the profit-and-loss account. Yet even with R&D, one of the most concrete of intangibles, there is often little connection between the amount of money invested and a new product’s eventual return. For some inventions the return will exceed costs a hundredfold; others, such as a drug that fails its final tests, will produce no reward at all. Putting R&D on the balance sheet therefore risks drastically under- or overstating the size of a company’s assets, and so misleading investors.

Brands, another favourite candidate for inclusion on the balance sheet, are clearly valuable, but they are also volatile. What happens to the value of a brand in the event of a product being taken off the market, like Firestone’s dangerous tyres? Intellectual capital is also hard to pin down, since employees leave companies whenever they like, taking it all with them.

Soft measures, if required by the authorities, could end up being used to hoodwink investors. Companies would have an incentive to create flattering statistics. Would auditors, given the task, catch them if the figures were misleading? “Accounting firms have a difficult enough time auditing the hard numbers, let alone the soft ones,” says Arthur Levitt, the SEC’s chairman in 1993-2000. Some measures could be used to hype companies, he suggests. Another limitation, says the FASB, is that non-financial measures tend to be peculiar to a single industry or even company, making comparisons hard.

There is already plenty of non-financial information floating around about companies. The front sections of many annual reports voluntarily disclose details about margin shifts, capacity utilisation and the like. Because these details are neither audited nor subject to strict presentational rules, investors know they should take them with a pinch of salt. Consultants such as Interbrand have developed ways to judge the value of brands, while human-resource firms sell expertise in the field of intellectual capital. Fund managers and analysts come up with their own, subjective valuations of intangible assets.

Big accountancy firms want to seize some of this territory. They worry that they are being left out of the “new economy”, especially now that they are under pressure to avoid conflicts of interest that come from selling consulting services alongside audits. A book by three partners of PricewaterhouseCoopers called “The Value Reporting Revolution: Moving Beyond the Earnings Game” says that audit firms risk being ignored—as do the old-style financial statements they check.

These fears look misplaced. Now that once high-flying technology companies have seen their market capitalisations fall to earth, investors have less time for the kind of new valuation gimmicks—remember average value per marketing dollar spent?—that emerged at the stockmarket’s peak. Good, old-fashioned accounting looks like coming back into vogue.