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Interesting article at http://www.fastcompany.com/online/31/lev.html
JW
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New Math for a New Economy
by Alan M. Webber
Photographs by Robert Maxwell
first appeared: Fast Company issue 31 page 214
What's wrong with the 500-year-old way in which all companies keep their
books? Just about everything, says Baruch Lev, who has proposed a new method
for determining the value of the intangible assets that are at the heart of
the new economy.
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Accounting is all about accuracy. Accounting is all about hard numbers.
Accounting is all about accountability. Accounting is a time-honored tool
for making hard decisions about dollars and cents, about profits and losses.
Accounting is the land of bean counters, of number crunchers -- men and
women with green eyeshades and calculators.
Accounting, says Baruch Lev, the Philip Bardes Professor of Accounting and
Finance at New York University's Leonard N. Stern School of Business, is
increasingly irrelevant. And, for that reason, it is increasingly essential
and interesting to all of us. The problem, says Lev, is that the systems of
accounting and financial reporting that are being used today date back more
than 500 years. These systems are not only part of the old economy, they're
part of the old, old economy. Luca Pacioli, an Italian mathematician who
lived in Venice in the 1400s, developed double-entry bookkeeping in order to
offer businesspeople a simple method for keeping track of their
transactions -- and, even more important, for making sense of the way that
they did business. "If you cannot be a good accountant," Pacioli wrote, "you
will grope your way forward like a blind man and may meet great losses."
Today, argues Lev, being a good accountant doesn't guarantee good eyesight.
The old lens cannot capture the new economy, in which value is created by
intangible assets: ideas, brands, ways of working, and franchises.
The disconnect, says Lev, affects more than just financial analysts and
corporate financial officers: Employees don't know how to value their
contributions accurately. Managers don't have good numbers to refer to when
deciding whether to back a project, or when assessing a project's
performance. Are knowledge-based companies overvalued on the stock market?
Are companies paying too much to acquire knowledge-based assets? These
questions, says Lev, and more, cannot be adequately answered with today's
accounting and financial-reporting methods. Accounting, in other words, no
longer delivers accountability.
Lev, who is also director of the Vincent C. Ross Institute of Accounting
Research and the Project for Research on Intangibles, has become the most
articulate, thoughtful, and outspoken critic of old-fashioned accounting,
and the most creative advocate of a new, knowledge-based approach to
accounting. He has pioneered the development of a Knowledge Capital
Scoreboard, which attempts to put hard numbers to intangible assets.
To find out more about what's wrong with traditional accounting, what is
needed to fix it, and why it matters to all of us no matter what our job or
industry, Fast Company interviewed Lev in his office in New York City.
Why are you calling for a rethinking of the principles of accounting and
finance?
In the past several decades, there has been a dramatic shift, a
transformation, in what economists call the production functions of
companies -- the major assets that create value and growth. Intangibles are
fast becoming substitutes for physical assets. At the same time, there has
been complete stagnation in our measurement and reporting systems. I'm not
talking only about financial reports and Internet investments but also about
internal measurements -- accounting and reporting inside companies. These
systems all date back more than 500 years.
So here's the situation: We are using a 500-year-old system to make
decisions in a complex business environment in which the essential assets
that create value have fundamentally changed.
What's the evidence for this transformation?
Look at the Standard & Poor's 500 -- 500 of the largest companies in the
United States, many of which are not in high-tech industries. The
market-to-book ratio of these companies -- that is, the ratio between the
market value of these companies and the net-asset value of the company ( the
number that appears on the balance sheet ) -- is now greater than six. What
this means is that the balance-sheet number -- which is what traditional
accounting measures -- represents only 10% to 15% of the value of these
companies. Even if the stock market is inflated, even if you chop 50% off
the market capitalization, you're still talking about a huge difference
between value as perceived by those who pay for it day-to-day and value as
the company accounts for it.
Another example: John Kendrick, a well-known economist who has studied the
main drivers of economic growth, reports that there has been a general
increase in intangible assets contributing to U.S. economic growth since the
early 1900s: In 1929, the ratio of intangible business capital to tangible
business capital was 30% to 70%. In 1990, that ratio was 63% to 37%.
So intangible assets are becoming more important. But what are intangible
assets?
It's extremely difficult to come up with a comprehensive definition of
intangible assets. I've tried to group them into four categories. First are
assets that are associated with product innovation, such as those that come
from a company's R&D efforts. Second are assets that are associated with a
company's brand, which let a company sell its products or services at a
higher price than its competitors. Third are structural assets -- not flashy
innovations or new inventions but better, smarter, different ways of doing
business that can set a company apart from its competitors. And fourth are
monopolies: companies that enjoy a franchise, or have substantial sunk costs
that a competitor would have to match, or have a barrier to entry that it
can use to its advantage.
What is it about intangible assets that creates value -- value that is more
significant than that of tangible assets?
The best way to answer that question is to use another example -- and here
I'm intentionally steering away from the Web-based and high-tech companies
that people usually point to, such as Cisco Systems and Amazon.com. Let's
look at American Airlines, or, more accurately, its parent company, AMR
Corp.
In October 1996, AMR Corp. sold 18% of its computer-reservations system,
called SABRE, to the public. It held on to the remaining 82%. That one
transaction provides a beautiful way of evaluating tangible and intangible
assets. When I recently checked the market, SABRE constituted 50% of AMR's
value. This is mind-boggling! You have one of the largest airlines in the
world, with roughly 700 jets in its fleet, nearly 100,000 employees, and
exclusive and valuable landing rights in the world's most heavily trafficked
airports. On the other hand, you have a computer-reservation system. It's a
good system that's used by a lot of people, but it's just a computer system
nonetheless. And this system is valued as much as the entire airline. Now,
what makes this asset -- the computer system -- so valuable?
One big difference is that when you're dealing with tangible assets, your
ability to leverage them -- to get additional business or value out of
them -- is limited. You can't use the same airplane on five different routes
at the same time. You can't put the same crew on five different routes at
the same time. And the same goes for the financial investment that you've
made in the airplane.
But there's no limit to the number of people who can use AMR Corp.'s SABRE
system at once: It works as well with 5 million people as it does with 1
million people. The only limit to your ability to leverage a knowledge asset
is the size of the market.
Economists call physical assets "rival assets" -- meaning that users act as
rivals for the specific use of an asset. With an airplane, you've got to
decide which route it's going to take. But knowledge assets aren't rivals.
Choosing isn't necessary. You can apply them in more than one place at the
same time. In fact, with many knowledge assets, the more places in which you
apply them, the larger the return. With many knowledge assets, you get what
economists call "increasing returns to scale." That's one key to intangible
assets: The larger the network of users, the greater the benefit to
everyone.
So that's how intangible assets can create extraordinary value. But is there
a downside to knowledge assets?
As my former teacher and colleague Milton Friedman used to say, "There's no
such thing as a free lunch." Knowledge assets are very expensive both to
acquire and to develop. And they're extremely difficult to manage.
Look at the extremely high prices that high-tech companies are paying to
acquire smaller companies, as they look for knowledge assets that they can
leverage. On November 1, 1999, Cisco announced that it had acquired Cerent
Corp. for $6.9 billion. For the first six months of 1999, Cerent's sales
totaled roughly $10 million. That's what it can cost to acquire a knowledge
asset. Or look at the high cost of developing a knowledge asset: In the
world of pharmaceuticals, it costs close to $500 million to develop a new
drug. One last example is America Online, which spent nearly $1.5 billion on
customer acquisition when it was creating its franchise. That's what it can
cost to create a high barrier to entry.
There's another downside of knowledge assets: Property rights are fuzzy.
When it comes to a tangible asset, such as an airplane, American Airlines
doesn't have much to worry about. No one is going to steal an airplane. But
American Airlines definitely has to worry about someone stealing its
software. The proliferation of thousands upon thousands of very costly
patent-infringement lawsuits attests to the difficulty of defining and
keeping property rights when you're dealing with knowledge.
And while the benefits that come with knowledge assets can be enormous, they
are much more uncertain than the benefits of tangible assets. When you
invest in a tangible asset, such as an office building, you always get some
kind of return -- even during a recession. And when boom times come, your
property really pays off. But when you're building a knowledge asset, you
could quite possibly end up with nothing.
Given the nature of knowledge assets, what is the conflict between these new
assets and the old laws of accounting?
One problem is that you end up with accounting practices that are virtually
antithetical to the business practices that they're trying to measure. Let
me give you an example. In 1994 and 1995, America Online capitalized some of
its customer-acquisition costs -- which means that it considered part of
those costs assets. In other words, AOL was saying that, in acquiring new
customers, it was creating a unique asset -- one that would help the company
become even more profitable in the future. Financial analysts called that
cheating! It was a new industry, competition was fierce, and analysts
thought that AOL was trying to manipulate its earnings. Finally, in October
1996, AOL gave up and completely expensed its $385 million in
customer-acquisition costs.
Today, AOL has a market value of roughly $140 billion. Compare that with the
$385 million that it tried to capitalize, and it's almost humorous! And yet
only five or six years ago, financial analysts were proclaiming that AOL was
a cheat.
Or take, for example, what happened when IBM acquired Lotus in 1995. As an
accounting requirement, IBM had to estimate the fair-market value of the
assets that it had acquired. IBM estimated that the portion of Lotus's R&D
that was in process -- R&D for which there was not yet a product -- was
worth $1.84 billion. That's 53% of the entire $3.5 billion acquisition
price. IBM expensed the entire thing -- because those are the rules of
accounting: Once you estimate that something is in-process R&D, you have to
expense it. As a result, no trace of an asset remains.
This kind of mindless writing-off of all investments in knowledge assets
means that there is no accountability -- and no ability to measure the
performance of an investment or to learn from it. And the problem is only
getting worse: Over the past 20 years, as the actual value of companies'
intangible assets has been going up, that value, as it is represented in
financial reports, has appeared to be consistently going down.
How do you account for this failure of accounting?
Accounting is based on the matching principle. To determine your earnings,
you match your revenues against your expenses. It's that simple -- that's
what an accounting system does. And if the matching is good, you get a
reliable income number.
Now here's the problem: With knowledge assets, you get a complete mismatch,
and the system breaks down completely. Take the AOL example. During its
period of tremendous growth, AOL immediately expensed all of its
customer-acquisition costs. So for that period, the company was showing
those costs as big losses. Then, once the customers were acquired, the
company realized large benefits -- which then increased its income without
any associated costs! So both periods are misstated in financial reports.
Companies that are on a steep growth curve -- for example, Internet and
biotech companies -- are most likely understating their results. And older
companies that have plateaued are most likely overstating their results. The
outcome is a disconnect with the market, which is supposed to reflect
reality.
There's another disconnect between the world of accounting and the world of
knowledge assets: Accounting records transactions, but much of value
creation or value destruction precedes any transaction. Look at regional
telephone companies. In the late 1980s, deregulation started to hit the
regional phone system. The old system was based on a guarantee of a
reasonable rate of return for phone companies. The companies had an assured
monopoly and assured profits. The new system was more open and competitive.
Investors immediately understood the implications of moving from a secure
monopoly to a competitive system: higher risks, lower returns. But the
accounting system didn't reflect any change at all -- because deregulation
is not a transaction! Five or six years after deregulation began, the Baby
Bells finally said that their assets must be much lower than before, and
wrote off $27.6 billion of assets. But in the preceding five years, there
was an almost total disconnect between what the company was actually worth,
what the accounting system showed, and what the markets understood.
Remember: This system was invented hundreds of years ago. Luca Pacioli, the
monk who created it, was a genius. He developed a system that is still
working 500 years later. But Pacioli's system is frail. After all, it relies
on transactions. But when you're working with knowledge assets, value is
created or destroyed without making any transaction at all.
When a drug passes its clinical tests, huge value is created -- but there's
no transaction. Nothing changes hands. Nobody buys anything, and nobody
sells anything. When software passes a beta-test, it suddenly becomes
valuable -- but there's no transaction. Or think about how value is
destroyed: When a big, old company is late in figuring out how to enter the
world of e-commerce, huge value is destroyed -- but there's no transaction.
If something as fundamental as the accounting and financial-reporting system
doesn't work in the new economy, why hasn't there been a more vocal call for
change?
There are two major barriers to change. The first is an objective difficulty
to this problem: The issue of knowledge assets is inherently uncertain --
we're still struggling to come up with a definition that works. And the
issue of intellectual-property rights, for example, continues to be fuzzy.
There's no one solution that will eradicate the problem -- and every new
solution presents new problems. Given how difficult the material is, it's
easier for people to wait for a better solution to come along.
The second barrier to change is an informal coalition that opposes any
change to the current system. Managers love the current system. They don't
want to put anything on the balance sheet that may turn out to be worthless.
Accountants share this love of the current system. If they don't have to
value intangible assets, such as AOL's customer-acquisition costs, their
legal liability is reduced. Let's face it: Valuing things that are
inherently difficult to value, and then standing by that valuation when
someone sues you, can be very unpleasant.
Institutional investors and financial analysts are also quite happy with the
current system because they think that they've got inside networks and
proprietary information. They have lunch with managers. They visit
companies. In doing so, they feel that they're getting important private
information. How would it serve their interests if that information were
made public? So there are some awesome forces against change.
If all of these people are against change, then the system must be fine,
right? What's the problem?
The problem is that lots of mistakes are being made. For example, I just
finished studying roughly 1,500 companies -- all of which have significant
R&D investments. About a quarter of these companies are systematically
undervalued by their investors. And many of them are computer, biotech, and
software companies with substantial R&D but below-average earnings. That
means that the cost of capital for these companies is unusually high -- and
that impedes their growth. The systematic undervaluing of these companies
brings serious economic and social costs to the companies, to their
shareholders, and to the economy. So the problem is not academic or
abstract; it has serious business implications. And although I do not have
the data to prove it, my guess is that many internal decisions are also
deficient because managers, too, are relying much too heavily on accounting
information.
What solutions do you propose to fix that problem?
I think that there are a few remedies -- none are complete, but all will
help. One is to improve the accounting system. Some people have given up on
accounting altogether. They say that the system is dead and that something
entirely new is needed. To me, that would be a big mistake. I believe that
accounting is still incredibly efficient. So the solution is not to do away
with the old system but to improve it.
I don't expect any breakthroughs but slight amendments that improve on what
already exists. One example: satellite accounts. These can be a set of
accounts around the regular ones that will provide more information about
the real value of assets. The U.S. government, for example, expenses R&D in
the same mindless way that companies do. But the government has also set up
satellite accounts in which it capitalizes R&D. It's not a great revolution,
but it does provide a way to compare things.
And your more revolutionary proposal?
Another remedy requires going outside of the existing system. I've developed
a way to measure knowledge assets, intellectual earnings, and knowledge
earnings. It's a computation that starts with what I call "normalized
earnings" -- a measure that's based on past and future earnings. When you're
dealing with accounting for knowledge, you simply cannot do it unless you
consider the potential for future earnings that knowledge creates. In fact,
that's one of the things that is fundamentally wrong with all of the other
ways we have of accounting for earnings, including improvements such as EVA
[Economic Value Added]: They are all based purely on history. They are
accounting in the past.
My approach looks at the past. But I also look at the consensus forecasts of
analysts. Based on those forecasts, I create an average, and I call that
average normalized earnings. From those normalized earnings, I then subtract
an average return on physical and financial assets, based on the theory that
these are substitutable assets. Merck & Co., for instance, has lots of
laboratories and manufacturing facilities. The equipment there is not
unique. What is unique are the people, the patents, the knowledge that is
being developed there. So when I subtract from the total normalized earnings
a reasonable return on the physical and financial assets, I define what
remains as the knowledge earnings. Those are the earnings that are created
by the knowledge assets.
For example, my recent computations show that Microsoft has knowledge assets
worth $211 billion -- by far the most of any company. Intel has knowledge
assets worth $170 billion, and Merck has knowledge assets worth $110
billion. Now, compare those figures with DuPont's assets. DuPont has more
employees than all of those companies combined. And yet, DuPont's knowledge
assets total only $41 billion -- there isn't much extra profitability there.
Take a look at other companies where different kinds of knowledge assets
make a big difference: I calculated that Phillip-Morris has knowledge assets
worth $160 billion, largely because of its huge brand value. Coca-Cola is
also a huge brand, and its knowledge assets are worth $60 billion. I
identified another type of knowledge asset -- structural capital. Structural
capital is a unique way of doing business. In the case of Dell Computer, the
company doesn't produce computers that are better than other companies'
computers, but the way in which it markets its computers is entirely
different. Which is why Dell's knowledge capital totals $86 billion --
higher than that of Wal-Mart.
This is my first measure. I call it a top-down approach because it's an
overall measure. According to the calculations that I've made, it performs
far better than earnings or book value.
Is the top-down approach sufficient?
To complement the knowledge measure, we need to identify the drivers of
knowledge. Here's how I think about it:
Economic theory and research tell us that almost all industries share a
similar development pattern. They start out with a large number of
companies, and then, usually after some kind of big innovation, there's a
shakeout period that eliminates many of those companies. ( At the turn of
the century, there were more than 100 American car manufacturers; now there
are only 2. ) During the shakeout, most of the original companies fall by
the wayside -- even those that previously were large and successful. General
Electric was once a major semiconductor manufacturer, but it had to get out
of the industry when the shakeout hit. So the question is, Who can survive
the shakeout that invariably hits every industry?
The survivors are those companies that have good technology, because they
have the ability to innovate. For me, technology also includes structural
capital like that of companies like Dell and Home Depot. I'm in the process
of developing a technological-capabilities index: an index based on measures
that are quantifiable, publicly available, and linked to value. These aren't
stories -- about good customer relations, good public relations, or good
service -- but measures that can be supported by real research.
Let me give you an example. Some people use patents as an important
knowledge attribute, but to me the number of patents that a company has is
not very meaningful at all. You can get patents on almost anything, so
simply having a large number of patents is absolutely meaningless. But there
are ways to measure the attributes of the patents that have real
significance. For instance, one powerful measure of the real value of a
patent is how many times subsequent patents refer to it. If you have good
science, then people will refer to you a lot, and you'll contribute a lot.
My technological-capabilities index is based on measures of inputs, such as
investment in R&D, investment in product development, investment in
information systems; on measures of intermediate outputs, such as patents
and trademarks; on measures of competitive position, such as the number of
people who access a particular Web site; and, of course, on measures based
on the ultimate output -- commercialization. Commercialization of R&D is a
powerful predictor of a company's success. Recently, a couple of French
economists conducted a study using data that French companies are required
to publish showing the percentage of their revenue that comes from new
products. The results of their study demonstrate how important
commercialization of new products is to a company's success in the
marketplace.
These are just a few examples of a whole system of knowledge and innovation
drivers -- a system that allows managers to benchmark and to focus on those
things that work or do not work, both of which indicate a company's
knowledge assets.
Let's say that I'm not a CFO. How does this accounting disconnect affect me?
Why should I care?
This problem affects each of us directly. Both employees and executives are
valued by accounting numbers, such as return on investment or earnings
growth. Bonuses, for example, are often based on these old-fashioned
accounting numbers. We need to be aware of the limitations of accounting,
and propose improvements that do a better job of reflecting our efforts and
achievements.
There's another way that accounting problems touch all of us. These days,
most of us are also investors, which means that we must analyze corporate
reports. We are all making investment decisions based on accounting
information that is, at best, limited and, at worst, badly distorted. All of
us need better information so that we can make better investment decisions.
But the biggest payoff comes from developing systems that improve accounting
and reporting. Last October, for example, Cisco announced that it was in the
process of developing an intranet that will provide users with an
up-to-the-minute look at its books. Systems that give outsiders real-time
access to some of a company's data will also be big business. In short,
technology has created far more data than ever before. But what we all
need -- and what we all need to work on -- is the transformation of this
data into valuable information and knowledge.
Alan M. Webber ( awebber@xxxxxxxxxxxxxxx ) is a Fast Company founding
editor. You can learn more about Baruch Lev on the Web
http://www.stern.nyu.edu/~blev ).
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