Concerns about value prompt new thinking. (Accounting Regulation).

Accounting bodies and regulators are increasingly intent on having key value drivers, especially intangibles, reflected in financial statements. Some sense that the current accounting crisis represents an opportune time for change.

Some see a silver lining in this year's dark cloud of corporate malfeasance and accounting sleight-of-hand. "It seems to take a crisis to allow substantive and significant change," says Ira Solomon, head of the department of accountancy at the University of Illinois Champaign-Urbana. The kind of change Solomon is talking about, however, goes well beyond the provisions of this summer's well-publicized legislation.

Far beneath the radar of the headline-writers, regulators and professional bodies have been moving swiftly along a path long advocated by those who argue that the generally accepted accounting principles (GAAP) framework as we know it is inadequate and ill-suited to today's economic realities.

Now that the spotlight is shining on accounting abuses, Alan Anderson, senior vice president and member in the public interest of the American Institute of Certified Public Accountants (AICPA), says that there is no time to lose. "I think the window of opportunity is short," he says. "Once this current turmoil starts to settle down, the motivation for change will start to wane. That's why it's important to accelerate this process while the opportunity is ripe."

By the same token, there is new attention on management discussion and analysis (MD&A), the key section in company reports that asks management to talk to shareholders about its business and its prospects. Investors and market observers are increasingly vocal in arguing that shareholder communications fail to address key strategic drivers or offer meaningful transparency about the company's operations.

Accounting bodies like the Financial Accounting Standards Board or regulators like the Securities and Exchange Commission are looking at some of these issues and may become more active in the coming months.

Groping for Intangibles

The fundamental economic case for a new approach to financial reporting is now so well accepted that it hardly needs debate: value isn't where it used to be, but financial reporting standards pretty much are. Testifying before Congress in February, Federal Reserve Chairman Alan Greenspan found it necessary to speak with some concern about "the ever-increasing proportion of our GDP that represents conceptual as distinct from physical value" and about "the difficulty of valuing firms that deal primarily with concepts." Put simply, intangible assets are at the crux of a crisis in accounting.

"Nowadays, value is created to a greater extent than ever before by intangibles," Solomon says. "What makes a Wal-Mart or Dell so successful? Its superior business models, tied very closely to superior business processes, and the interesting thing is that these value drivers don't appear anywhere on any of the traditional financial statements."

The issue of accounting for intangibles first compelled broad attention during the dot-com mania, when market valuations far outstripped the levels suggested by traditional value metrics. If markets were efficient and rational, the argument went, the highflying New Economy companies must have assets not reflected by GAAP. The surprise is that when the market bubble popped, that argument didn't go away. In some quarters, in fact, the recently exposed frauds have made it more imperative to somehow account for intangibles.

"The softening of the market in the last two years means that the ratio of aggregate market value to hard-asset value is down. But it's still big. A substantial part of the value in our corporate sector is not being picked up on the books, and is not being accounted for in a way that allows us to look at the books and say, 'That's why they're valuable,'" says Margaret Blair, Sloane Visiting Professor at Georgetown University Law Center in Washington, D.C. Blair is co-chair of a Brookings Institution task force on intangibles and co-author of the book Unseen Wealth.

Some say that the accounting system's failure to deal with intangibles may, in fact, have made it easier for unscrupulous executives to abuse the public trust. "Saying that the difference between market value and what appears on the balance sheet is intangibles can be a terrible mistake," explains Baruch Lev, New York University's Philip Bardes Professor of Accounting and Finance and Director of the Vincent C. Ross Institute for Accounting Research.

"Sometimes, as in the case of a Microsoft or a Pfizer, there is no doubt that the difference between market and book value mainly reflects intangibles," Lev says. "But in most of the companies that went belly up, the difference between market and book was just froth and hype, nothing real. If we had a good way of reporting for intangibles, it would be much easier for people to distinguish the cases where the difference is a real difference and the cases like Enron and Global Crossing, where the difference is basically fraud."

As it happens, this past July the FASB released a proposal for a new project to establish standards for treating intangibles. The proposal points specifically to some of the more contradictory outcomes of GAAP accounting, especially evident in light of last year's new standards for merger accounting. Those standards (SFAS 141 and 142) eliminated pooling of interests accounting and did away with amortization of goodwill, but required acquirers to appropriately allocate the purchase price to identifiable intangible assets.

Take patents, for example. Patents acquired as the result of a merger now have to be identified and valued, and appear on the balance sheet as intangible assets, subject to amortization over their useful life. If instead of acquiring the patents, however, the acquirer were to spend the same amount developing patents through in-house R&D, it would not have an intangible asset on its balance sheet. This is because R&D is treated as an expense in the period in which it occurs.

The counterintuitive result is that two companies making the same level of investment in intangible assets have very different financial statements if one invests in R&D while the other does acquisitions. The fact that value can only be recognized on the books when an asset is bought or sold has led to some complex financial engineering, says Margaret Blair. "A number of companies with intellectual property are creating holding companies. Then, these holding companies that are subsidiaries of the parent buy patents and copyrights and lease them back," she says. "That's not a completely stupid thing to do; there's an argument to be made that they need to do it to have the books reflect the real value, but it's an area with a huge potential for abuse."

While the FASB proposal directly addresses the discrepancy in treatment between acquired intangibles and the home-grown sort, it also opens the door wider, inviting comment on how financial reports ought to treat such value drivers as market share, customer satisfaction levels, employee retention, etc.

The FASB proposal isn't the only initiative underway. The AICPA, through its Value Management and Reporting Collaborative (VMRC), aims to create a new reporting framework with an emphasis on comparable, consistent and transparent financial reporting. "I think that GAAP and historical financial statements still have a place, but the amount of information available is so vast that the relevance of a historical financial statement is waning," Anderson says. The AICPA is cooperating with the Canadian Institute of Chartered Accountants (CICA) in this project, working to identify best practices, debate existing concepts and test new approaches to meeting the needs of users of accounting statements.

Beverly Brennan, a corporate director of Philom Bios, a private Canadian agricultural biotechnology firm, and a former chair of CICA, has been meeting with the AICPA on the new collaborative. "The objective is that somebody reading the material from a company could understand where the company was going, what it expected to achieve, and assess whether that is realistic," she says.

"What is the value of a company, now? The assets on your balance sheet are supposed to be those things that will give future value for the company. At some point, they will be expensed, but in the course of being used they will generate revenue. Yet, the way we now report, many things we expense in a period are really building long-term value." R&D is an obvious example. Less obvious is the cost of building a marketing department. "There's a difference between building greater capacity in marketing and maintaining that capacity," Brennan observes, "But it's pretty hard to make a judgment about which is which."

In Brennan's opinion, accounting for many kinds intangibles will probably have to take place outside the current accounting model. She doesn't believe, for example, that all intangible assets ought to be on the balance sheet. "The current financial statements are built on a different conceptual base -- that of transactions with external parties," she says.

Of course, there's a sound argument in favor of GAAP doing exactly what it does now, and that is that value is an abstraction until it's realized through a transaction. "I personally do not ascribe to booking intangibles on the financial statement," says Billie Rawot, vice president and controller of the Eaton Corp. and a vice chair of FEI's Committee on Corporate Reporting. "I think it's going to be fraught with lots of valuation issues."

The dilemma is that an attempt to enhance financial statements by booking intangibles may make them even less useful and informative than they are now. Yet the dilemma is not insoluble -- and a key to resolving it may lie in the MD&A of financial results.

MD&A

"I think MD&A has suddenly come into the limelight," says Alan Willis, project director of the CICA's Performance Reporting Initiative. "Two or three years ago, it was not seen to have such potential usefulness."

There is action afoot. In December 2001, the CICA issued draft guidance for disclosure principles for MD&A. In June 2002, the Accounting Standards Board of the United Kingdom published an exposure draft for the Operating and Financial Review, the British equivalent of MD&A. In July, Alan Beller, the SEC's director of the Division of Corporate Finance, observed that since the agency hadn't issued a general statement updating or supplementing its 1989 guidance on MD&A, "it may well be time to consider new interpretive guidance."

The thrust of the new guidance in the UK and Canada, and the expressed intention of the SEC, is to enable readers of the MD&A to see the company through management's eyes. So far this year, however, the SEC has stressed disclosure issues -- off-balance-sheet financing, related-party transactions, cash, cash flows, and liquidity, risks and ratings.

The Canadian and UK initiatives go farther into unexplored reporting territory. The UK's Accounting Standards Board suggests that the management discussion address both financial and nonfinancial measures -- including corporate responsibility -- as well as such intangibles as brand equity, market dominance and R&D. The CICA's guidance suggests that the MD&A be framed to discuss vision, core business and long-term strategy, critical success factors, capabilities, results, analysis and risks.

Ira Solomon suggests that such breadth is indispensable. "We have a measurement system based on concepts that were okay in the industrial age, but fall short of creating transparency now," he explains. Some vital value drivers cannot, and perhaps should not, be booked on the balance sheet or income statement proper, because they challenge the most fundamental assumptions of the accounting system. But that doesn't mean they should be ignored in the financial reporting process.

"Traditionally in accounting," he observes, "one of the fundamental constructs has been the notion of an entity. What is an entity? Airline alliances create tremendous value for airlines but don't appear anywhere in the financial statements."

The problem cuts across industries. A recent survey of petroleum companies by PricewaterhouseCoopers found an astonishing disconnect between the information investors want and the information companies provide. Eighty percent of petroleum company respondents in the survey believed that their share price was lower than the their true value. But investors surveyed said that companies fell short of providing adequate information on three out of every five important value drivers.

Only a few of the indicators involved traditional financial reporting information. Among the most important were geopolitical environment, strategic direction and quality of management. "We're not proposing to change accounting rules," says Rick Roberge, leader of the Oil and Gas Transaction Services Group at PricewaterhouseCoopers, "We're proposing that companies be more transparent about offering information."

Vehicles for communication would include not only financial reports, but investor presentations, Web sites, press releases and more. "You've got to do a quarterly earnings release, but you can offer lots of other information to give investors a more transparent look at your company," Roberge says.

Whether the pressure comes from investors, accounting bodies or regulators, it seems clear that companies are under increasing pressure to bring new information about how they should be valued and to identify their key value drivers. Those may be largely intangible, but users of financial statements want something more than what they're getting now -- in a phrase, something more tangible.

RELATED ARTICLE: Action on MD&A

* Dec. 2001 Canadian accountants' group issues draft guidelines for disclosure principles

* July 2002 UK Accounting Standards Board issues guidance on improving British equivalent of MD&A

* Summer 2002 SEC publicly weighs issuing new guidance to update 1989 standards

Gregory Millman is a freelance business writer in New Jersey and a regular contributor to Financial Executive. He can be reached at [e-mail].