The
new New Economy Analyst Report – March 06, 2002
Juergen Daum’s new New Economy Best
Practice service
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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, strategic
enterprise management and business performance management
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in our knowledge and information based economy an outdated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
2Jürgen
H. Daum, "Intangible Assets oder die Kunst, Mehrwert zu
schaffen" ("Intangible Assets or the Art to Create
Value"),
Galileo Business, ISBN 3-89842-112-0
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
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Juergen Daum. All rights
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