Special note: This excerpt is used with permission from: Harvesting Intangible Assets: Uncover Hidden Revenue in Your Company's Intellectual Property, by Andrew J. Sherman.
There was a time when, if you needed a “quick” understanding of the net worth of a company, you could examine its balance sheet to determine its assets, subtract the sum of its liabilities, and come up with its net worth. You may have seen a small line item for goodwill to recognize the value of its brand and customer relationships.
But, in today’s information-centric and intangible-asset-driven society, looking to the net worth line to determine a company’s value would be strategic equivalent of telling a farmer that the total value of his farm in limited to the projected wholesale value of the harvestable crops he currently has in the field. Such a valuation methodology would fail to take into account the intrinsic worth of his know-how, his show-how, his distribution channels, his relationship with his team, his land, his future harvests, his systems, his processes, and his leadership skills.
The flows in our 500-year-old double-entry accounting system for recognizing the value of intangible assets are at the heart of a current and pervasive debate in the accounting and finance professions.
At the heart of this debate is NYU Stern School professor Baruch Lev, who has been actively writing and speaking about the flaws in the current GAAP as a way to recognize the true intrinsic assets of knowledge and information-driven companies. Current accounting best practices fail to take into account the dramatic shift in the value-creating functions of today’s modern corporations and organizations — most of which are intangible. “Goodwill” is no longer an adequate general utility bucket in which to throw any asset that does not fit neatly into a ledger column.
Lev points out that the problem is significant. He has studied the balance sheets of the Standard & Poor’s 500 – 500 of the largest companies in the U.S., many of which are not 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 6 to 1.
What this means is that the balance-sheet number — which is what traditional accounting measures — represents only 10 percent to 15 percent of the true intrinsic and strategic value of these companies. Even if the stock market is inflated even if you chop 50 percent 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 the 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 early 1900s: In 1929, the ratio of intangible business capital to tangible business capital was 30 percent to 70 percent, but in 1990, the ratio had shifted to 63 percent to 37 percent, and it continues to shift as we evolve deep into information age.
The most relevant information to managers and investors concerns the enterprise’s value chain. By the value chain, I mean the fundamental economic process of innovation that starts with the discovery of new products, service, or processes, proceeds through the development and the implementation phase of these discoveries and establishment of technological feasibility, and culminates in commercialization of the new products or services.
Lev recommends that GAAP include a “Value Chain Blueprint,” a measure-based information system for use in both internal decision making and disclosure to investors and reports in a structured and standardized way about innovation process.
Lev also recommends that current financial accounting practices evolve around our intellectual-capital-driven society. The broad denial of intangibles as true assets detracts from the quality information provided in the balance 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.
For example, as 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, Lev proposes that accounting recognize as assets all intangible investments with attributable benefits that have passed certain pre-specified technological feasibility tests.
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 enterprise do not have the information and monitoring tolls required for the effective management of intangible assets. (Read also: The One Secret Ingredient for a Successful Exit.)