Rethinking accounting: Traditional accounting, designed for an industrial economy of tangible assets, is under increasing pressure to modernize and reflect the value of the New Economy's intangible assets. (Cover Story).

Financial Executive invited two prominent gurus on the subject of measuring and managing intangible assets to write about those areas, and what they believe should -- and will -- happen.

Baruch Lev, the Philip Bardes Professor of Accounting and Finance at New York University's Stem School of Business, has been called "the father of intangible valuation," and even "the investor's Ralph Nader." He wants us to rethink accounting and apply new principles that communicate an organization's value in a world of intangibles.

Robert A. Howell, a Visiting Professor of Business Administration at the Tuck School of Business at Dartmouth, says financial reporting is broken, and he makes a strong argument for financial statement overhaul.

INTANGIBLES ATA CROSSROADS: What's Next?

Baruch Lev

Baruch Lev says what he refers to as Phase I of the Intangibles Movement" -- creating awareness of the vast magnitude and impact of intangibles, and of the serious information deficiencies and the resulting social harms related to these assets - is currently at a crossroads, and raises the question of "what's next?" He addresses the question here, offering what he deems "a new perspective on the attributes of intangible assets, followed by a proposed shift of focus for the future work on intangibles that is relevant to researchers, executives, investors and policymakers." This is the first of a two-part series.

The pioneers of the intangibles movement strove in the 1990s to alert managers, investors and policymakers to the dramatic shift in the production functions and asset compositions of business enterprises -- the fast-increasing role of intangibles, which were becoming the primary drivers of corporate value and growth. The awareness creation effort was initially based on conceptual developments in the macroeconomic theory of growth ("endogenous growth models"), and subsequently on the empirical process of documenting the magnitude and impact of intangibles.

Research, for example, indicated that in the late 1990s, the annual U.S. investment in intangible assets -- R&D, business processes and software, brand enhancement, employee training, etc. -- was roughly $1.0 trillion, almost equal to the $1.2 trillion total investment of the manufacturing sector in physical assets. Further, intangible capital currently constitutes between one-half and two-thirds of corporate market value, of both old and "New Economy" enterprises, as reported by this author in Intangibles: Management, Measurement and Reporting, Brookings Institution Press, 2001.

At the dawn of the 21st century, the prominence of intangibles as value and growth creators -- at both the corporate and national economy levels -- is widely accepted. Indeed, there is general agreement that traditional (accounting-based) information systems fail to provide adequate numerical underpinning for intangibles and their economic impact to managers, investors and public policymakers for the purpose of national accounting measurements. In fact, in response to these informational deficiencies, the Financial Accounting Standards Board decided in January of 2002 to add to its agenda an "intangibles disclosure project."

Research indicates that these "information failures" cause serious private and social harms, such as excessive cost of capital to intangibles-intensive enterprises, hindering their investment and growth; abnormally high volatility of stock prices, causing undue losses to investors and misallocation of resources in capital markets; systematic biases in managerial decisions; and excessive trading gains to corporate insiders, eroding investors' confidence.

While there is widespread agreement about the causes and consequences of the intangibles-related information deficiencies, there is a heated controversy about the necessary remedies, ranging all the way from doing nothing (let free-market forces work their way to improve the situation) to a significant overhaul of corporate accounting and financial reporting practices. In between, are various proposals for encouraging voluntary corporate disclosure of intangibles-related information. For one, an SEC-initiated task force of company executives, financial analysts and academics recommended in late 2001 that "...the SEC...move forward with a framework for voluntary supplemental reporting for intangible assets...that will help investors assess a company's future performance."

Thus, the intangibles movement has largely succeeded in the first phase of its mission -- creating wide awareness and active discourse about the economic role of intangible assets and their consequences. This effort, however, appears to now face a crossroads.

What should follow the awareness-creation phase? Some hope that by observing how firms manage intangibles and report their values internally, we would be able to develop "best practice" cases for managers and design reporting modes for information disclosure about intangibles. Others believe that we could develop optimal valuation and disclosure practices for these assets by surveying the valuation practices of financial analysts and fund managers. A reading of the numerous surveys and questionnaire studies in this area leads to the conclusion that, with but few exceptions, the persons being asked -- both managers and investors -- are at a very early stage of grappling with the management, valuation and reporting of intangibles.

To be sure, some companies report internally, and sometimes even externally, on certain aspects of intangible assets (such as employee and customer satisfaction), but such haphazard, non-standardized reporting is of little value for resource allocation or investment decisions. It is, therefore, questionable whether significant advances in the work on intangibles can be based on such observational studies. "The blind leading the blind" metaphor seems appropriate here.

Another route of investigation involved empirical research on intangibles, which contributed significantly to the understanding of the causes and consequences of intangible investments. But this effort, too, reached the stage of diminishing marginal returns, due primarily to the paucity of raw material for research -- public information on intangible assets. Research and development in the U.S. is the only intangible investment publicly reported by companies, and while we learn a lot from R&D -- and related patent-based research -- R&D is just one component of intangibles. There are no comprehensive data on other important intangibles to support research on measurement and valuation.

So, where do we go next? And go we must, because the available knowledge about intangibles is insufficient to address fundamental concerns of managers and investors, as the following examples demonstrate.

Limits of the Current Intangibles Knowledge Base

Two early 2002 controversies demonstrate the need for refocusing investigative efforts in the intangibles area. The first, the proposed merger between Hewlett-Packard Co. (H-P) and Compaq Computer Corp. pits major shareholders against their CEOs. The CEOs, promoting the virtues of the merger, claim that the new organization will cut costs substantially, streamline products and become a major player in the highly profitable tech services sector. Antagonists, led by the Hewlett and Packard heirs, counter that practically all past big mergers between technology companies (such as the 1991 AT&T Corp. and NCR Corp.) failed dismally, that H-P and Compaq lack a cadre of business service professionals poised to develop a meaningful services business and that the merger's raison d'etre is flawed, since PCs, a major product of

both companies -- essentially commodities with razorthin profit margins -- are unlikely to create much value.

This controversy seems ripe for experts on intangibles to analyze and resolve. The two companies are intangibles-intensive. In fact most of their assets are intangible: valuable patents, widely recognized brands and highly qualified employees. Alas, the two sides to the controversy hired investment bankers to make their case to shareholders, rather than experts such as intangibles valuation consultants. Did H-P and Compaq hire the wrong people? There is no sure response here. One would be hard-pressed to see what the accumulated work on intangible (intellectual) capital could contribute to the H-P/Compaq merger and similar ones.

At issue are fundamental questions of corporate structure and performance: Why did H-P and Compaq -- with all their valuable intangibles and knowledge management systems -- lose market share consistently in recent years, and why have they seen their growth stagnate? Why did the innovation processes of these organizations -- erstwhile innovation leaders -- atrophy? Is a merger between two giants better suited to jump-start the companies than small, targeted acquisitions coupled with organic growth? These are among the questions posed by David Yoffie and Mary Kwak in a December 2001 article in The Wall Street Journal.

Sadly, the concepts and tools developed to date in the intangibles field are not ready for "prime time" in several respects: for resolving fundamental issues of corporate structure and performance; or for addressing questions of innovation going awry, loss of competitive edge or how to rejuvenate intangibles' value.

The second case is Enron Corp., a company that was hailed by New Economy gurus and other pundits as the epitomization of value creation by intangibles -- energy and broadband markets, patents and brands and advanced knowledge management systems. All those intangibles, valued not long ago at some $60 billion by investors, vanished into thin air.

Abstracting from the thorny issues of alleged fraudulent reporting to investors, careless auditing and insiders' self-dealing, one should still ask, "What happened to the intangibles?" Were our tools for intangibles valuation or knowledge management capable of predicting the implosion of Enron? Are we able to predict now who will be the next Enron? Is the accumulated knowledge about intangibles sufficient to provide policymakers with guidelines to prevent future massive losses of intangibles?

This is what is meant by "intangibles efforts at a crossroads" -- the difficulties addressing fundamental issues, such as those raised by the HP/Compaq and Enron cases -- by the concepts, models and tools developed in the intangibles (intellectual capital) field. Why do we encounter these difficulties?

The Inertness and Commoditization of Intangibles

Intangibles are inert -- by themselves, they neither create value nor generate growth. In fact, without efficient support and enhancement systems, the value of intangibles dissipates much quicker than that of physical assets. Some examples of inertness:

* Highly qualified scientists at Merck, Pfizer, or Ely Lilly (human capital intangibles) are unlikely to generate consistently winning products without innovative processes for drug research, such as the "scientific method," based on the biochemical roots of the target diseases, according to Rebecca Henderson, a specialist on scientific drug research, in Industrial and Corporate Change. Even exceptional scientists using the traditional "random search" methods for drug development will hit on winners only randomly, writes Henderson.

* A large patent portfolio at DuPont or Dow Chemical (intellectual property) is by itself of little value without a comprehensive decision support system that periodically inventories all patents, slates them by intended use (internal or collaborative development, licensing out or abandonment) and systematically searches and analyzes the patent universe to determine whether the company's technology is state-of-the-art and competitive.

* A rich customer database (customer intangibles) at Amazon.com or Circuit City will not generate value without efficient, user-friendly distribution channels and highly trained and motivated sales forces.

Worse than just inert, intangibles are very susceptible to value dissipation (quick amortization) -- much more so than other assets. Patents that are not constantly defended against infringement will quickly lose value due to "invention around" them. Highly trained employees will defect to competitors without adequate compensation systems and attractive workplace conditions. Valuable brands may quickly deteriorate to mere "names" when the firm -- such as a Xerox, Yahoo! or Polaroid -- loses its competitive advantage. The absence of active markets for most intangibles (with certain patents and trademark exceptions) strips them of value on a stand-alone basis.

Witness the billions of dollars of intangibles (R&D, customer capital, trained employees) lost at all the defunct dot-coins, or at Enron, or at AOL Time Warner Co., which in January 2002 announced a whopping write-off of $40-60 billion -- mostly from intangibles.

Intangibles are not only inert, they are also, by and large, commodities in the current economy, meaning that most business enterprises have equal access to them. Baxter and Johnson & Johnson, along with the major biotech companies, have similar access to the best and brightest of pharmaceutical researchers (human capital); every retailer can acquire the state-of-the-art supply chains and distribution channel technologies capable of creating supplier and customer-related intangibles (such as mining customer information); most companies can license-in patents or acquire R&D capabilities via corporate acquisitions; and brands are frequently traded. The sad reality about commodities is that they fail to create considerable value. Since competitors have equal access to such assets, at best, they return the cost of capital (zero value added).

The inertness and commoditization of most intangibles have important implications for the intangibles movement. They imply that corporate value creation depends critically on the organizational infrastructure of the enterprise -- on the business processes and systems that transform "lifeless things," tangible and intangible, to bundles of assets generating cash flows and conferring competitive positions. Such organizational infrastructure, when operating effectively, is the major intangible of the firm. It is, by definition, noncommoditized, since it has to fit the specific mission, culture, and environment of the enterprise. Thus, by its idiosyncratic nature, organizational infrastructure is the major intangible of the enterprise.

Focusing the Intangibles Efforts

Following Phase I of the intangibles work, which was primarily directed at documentation and awareness-creation, it's now time to focus on organizational infrastructure, the intangible that counts most and about which we know least. It's the engine for creating value from other assets. Like breaking the genetic code, an understanding of the "enterprise code" -- the organizational blueprints, processes and recipes -- will enable us to address fundamental questions of concern to managers and investors, such as those raised above in relation to H-P/Compaq and Enron.

Part 2, coming in the May 2002 issue, will be devoted to a detailed program for Phase II work on intangibles, integrating research with applied work. The success of such efforts will elevate the work on intangibles to the highest managerial echelons -- since, after all, organizational infrastructure is what management is all about; and it will provide investors with an understanding and with analytical tools concerning the elusive concept of "quality of management." This emphasis on organizational infrastructure will also integrate intangibles research with mainstream work in economics, industrial organization and management where business structure and design are major concerns.

Baruch Lev is the Philip Bardes Professor of Accounting and Finance at the Stern School of Business, New York University. He can be reached at blev(c)stern.nyu.edu; www.baruch-lev.com.

Fixing Financial Reporting: Financial Statement Overhaul

Robert A. Howell

Financial reporting is broken and has to be fixed -- and fast! If it isn't, we will continue to see more cases such as Xerox, Lucent, Cisco Systems, Yahoo! and Enron. Xerox's market value is down 90 percent, or $40 billion, in the past two years. In the same period other market losses include; Lucent, down more than $200 billion; Cisco Systems. off more than $400 billion; Yahoo!, more than $100 billion; and Enron, down more than $60 billion in the largest bankruptcy of all time.

Some argue that these are extreme examples of "irrational exubuerance." Some in the accounting profession say that such cases represent a small percentage of the aggregate number of statements audited -- some 15,000 public company registrants. Perhaps. But a financial reporting framework that permits these companies to suggest that they are doing well, and, by implication, to justify market valuations which, subsequently, cost investors trillions in the aggregate, is unconscionable.

Financial reporting, especially in the U. S., with its very public capital markets, has reached the point where "accrual-based" earnings are almost meaningless. Reported earnings are driven as much by "earnings expectations" as they are by real business performance. Balance sheets fail to reflect the major drivers of future value creation -- the research and product, process and software development that fuel high technology companies, and the brand value of leading consumer product companies. And, cash flow statements are such a hodgepodge of operating, investing and financing activities that they obfuscate, rather than illuminate, business cash flow performance.

The FASB, in its Concept No. 1, states, "financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and similar decisions." This is simply not so.

The primary financial statements -- income statement, balance sheet and cash flow statement -- which derive their foundation from an industrial age model, need major redesign if they are to serve as the starting point for meaningful financial analysis, interpretation and decision-making in today's knowledge-based and value-driven economy. Without significant redesign, ad hoc definitions such as pro forma earnings, returns and cash flows will continue to proliferate. So will significant reporting "surprises!"

Starting Point: Market Value Creation

The objective of a business is to increase real shareholder value -- what Warren E. Buffett would call the "intrinsic value" of the firm. It's a very basic idea: Investors get "returns" from dividends and realized market appreciation. Both investments and returns are measured in cash terms, so individuals and investors invest cash in securities with the objective of realizing returns that meet or exceed their criteria. If their judgments are too high, and that later becomes clear, the market value of the firm will drop. If judgments are too low and cash flows turn out to be stronger, market values increase.

From a managerial viewpoint, the objective of increasing shareholder (market) value really means increasing the net present value (NPV) of the future stream of cash flows. Note, "cash flows," not "profits." Cash is real; profits are anything, within reason, that management wants them to be. If revenues are recognized early -- or overstated -- and expenses are deferred or, in some cases, accelerated to "clear the decks" for future periods, resulting earnings may show a nice trend, but do not really reflect economic performance.

There are only three ways management may increase the real market, or "intrinsic," value of a firm. First, increase the amount of cash flows expected at any point in time. Second, accelerate cash flows; given the time value of money, cash received earlier has a higher present value. Third, if a firm is able to lower the discount rate that it applies to its cash flows -- which it frequently can -- it can raise its NPV.

Given that cash flows drive market value, financial statements should put much more emphasis on cash flows. The statement of cash flows now prescribed by the accounting community and presented by management is not easily related to value creation. Derived from the income statement and balance sheet, it's effectively a reconciliation statement for the change in the balance of the cash account. A major overhaul of the cash flow statement would directly relate to market valuations.

Cash Earnings and Free Cash Flows Managers and investors should focus on "cash earnings" and the reinvestments that are made into the business in the form of "working capital" and "fixed and other (including intangible) investments." The net amount of these cash flows represent the business's "free cash flows."

With negative cash flows -- frequently the case for young startups and high-growth companies -- a business must raise more capital in the form of debt or equity. The sooner it gets its free cash flows positive, the sooner it'll begin to create value for shareholders. Positive free cash flows provide resources to pay interest and pay down debt, to return cash to shareholders (through stock repurchases or dividends) or to invest in new business areas.

The traditional cash flow statement purportedly distinguishes between operating, investing and financing cash flows, and has as its "bottom line" the change in cash and cash equivalents. In fact, the operating cash flows include the results of selling activities, investing in working capital and interest expense, a financing activity. Investing cash flows include capital expenditures, acquisitions, disposals of assets and the purchase and sale of financial assets. Financing cash flows consist of what's left over.

Indeed, the bottom-line change in cash is not a useful number, other than to demonstrate that it may be reconciled with the change in the cash account. If one wants a positive change in cash, simply borrow more. These free cash flows ultimately drive market value, and should be the focus of managers and investors alike.

Replacing Income With Cash Earnings

The traditional "profit and loss," or "income," statement needs modification in three ways, two of which are touched on above, along with a name-change, to "Operating Statement." That would suggest a representation of the business' current operations, without the emphasis on accrual-based profits.

Interest expense (income) should be eliminated from the statement, as it represents a financing cost rather than an operating cost. A number of companies do this internally to determine "net operating profit after taxes"

(NOPAT).

Also, NOPAT needs to be adjusted for the various non-cash items, such as depreciation, amortization, gains and losses on the sale of assets, tax-timing differences and restructuring charges -- which affect income but not cash flows. The resultant "cash earnings" better represents the current economic performance of a business than accrual income and, very importantly, is much less susceptible to manipulation.

A third adjustment is the order in which the classes of expenses are displayed. Traditional income statements report cost of goods sold or product costs first, frequently focus on product gross margins, and then deduct, as a group, other expenses such as technical, selling and administrative expenses. This order made sense in the industrial age when product costs dominated. It does not for many of today's high-tech or consumer product companies. It would be more useful for companies to report expenses in an order that reflects the flow of the business activities. One logical order that builds on the concept of a business' value chain, is to categorize costs into development costs, product (service) conversion costs, sales and customer support costs and administrative costs.

Reinvesting in the Business

For most companies -- especially those with significant investments that are being depreciated or amortized -- cash earnings will be significantly higher than NOPAT. Unfortunately, cash earnings are not free cash flows because most businesses have to reinvest in working capital, property, plant and equipment and intangible assets, just to sustain -- let alone increase -- their productive capabilities.

As a business grows in sales volume, assuming that it offers credit to its customers who pay with the same frequency, accounts receivable will increase proportionately. As sales volumes increase, so, too, will product costs, inventories and accounts payable balances. Working capital -- principally receivables, inventories, and payables -- will tend to increase proportionately with sales growth, and will require cash to finance it. The degree to which it grows is a function of receivables terms and collection practices, inventory management and payables practices.

Companies such as Dell Computer Corp. collect payments up front, turn inventories in a few days and pay their vendors when due. The net effect is that as Dell grows it actually throws off cash, rather than requiring it to support increases in working capital. Most companies are not as efficient; the amount of cash needed to support increases in working capital can be as much as 20-25 percent of any sales increase. The degree to which working capital increases as sales increase is an important performance metric. Lower is better, which absolutely flies in the face of such traditional measures of liquidity as "working capital" and "quick" ratios, for which higher has been considered better.

Balance sheets ought to reflect investments that represent future value. What drives value for many businesses in today's knowledge-based economy -- pharmaceuticals, high technology, software and brand-driven consumer product companies -- is the investments in R&D, product, process and software development, brand equity and the continued training and development of the work force. Yet, based on generally accepted accounting principles (GAAP) accounting, these "investments" in the future are not reflected on balance sheets, but, rather, expensed in the period in which they are incurred.

A frequent argument for "expensing" is the unclear nature of the investments' future value. Apparently, investors believe otherwise, evidenced by the ratio of market values to book values having exploded in the past 25 years. In 1978, the average book-to-market ratio was around 80 percent; today it is around 25 percent. In the early 1970s, when accounting policies were established for R&D, product lines were narrower and life cycles longer, resulting in R&D being a much less significant element of cost. Expensing was less relevant. Now, with intangible assets having become so central and significant, expensing -- rather than capitalizing and amortizing them over time -- results in an absolute breakdown of the principle of "matching," which is at the heart of accrual accounting. The world of business has changed; accounting practices must also change.

Financial Statement Overhaul

Financial statements need marked overhaul to be useful for analysis and decision-making in today's knowledge-driven and shareholder value-creation environment. The proposed changes fall into three categories:

First -- Move to a much more explicit shareholder (market) value creation and cash orientation, and away from accrual accounting profits and return on investment calculations predicated on today's accounting policies. Start with a shareholder perspective for cash flows, then reconstruct the statement of cash flows to clearly provide the free cash flows that the business' operations are generating. Cash earnings and reinvestments in the business comprise free cash flows.

Second -- Expand the definition of investments to include intangibles, which should be capitalized as assets and amortized according to some thoughtful rules. This will better reflect investments that have potential future value.

Third -- Change the title to "operating statement" and other "housekeeping" of financial statements, to include categorizing costs in a more logical "value chain" sequence and aggregating all financial transactions, such as interest and the purchase and sale of securities, as financing activities.

Value creation is ultimately measured in the marketplace, so it stands to reason that if a firm's market value increases consistently, over time, and can be supported by improvements in its cash generation performance, real value is being created. For this to happen, the place to start is by fixing the financial statements.

Dr. Robert A. Howell is a visiting professor of Business Administration at the Tuck School of Business at Dartmouth. He can be reached at [e-mail].

RELATED ARTICLE: Organizational Infrastructure By Example:

A company's organizational infrastructure is an amalgam of systems, processes and business practices (its operating procedures, recipes) aimed at streamlining operations toward achieving the company's objectives. Following is a concrete example of a business process, part of the organizational infrastructure, which was substantially modified and thereby created considerable value. This was adopted from "Turnaround," Business 2.0, January 2002.

Nissan Motor Co. Ltd., Japan's third-largest automaker and a perennial loser and debt-ridden producer of lackluster cars, received in March 1999 a new major shareholder, Renault, and a new CEO, Carlos Ghosn, both imported from France. Ghosn moved quickly to transform Nissan into a viable competitor, and indeed, in the fiscal year ending March 2001, the company reported a profit of $2.7 billion, the largest in its 68-year history.

How was this miracle performed? Primarily by cost-cutting, achieved by a drastic change in the procurement process. Here briefly, is the old process:

Nissan's buyers were locked into ordering from keiretsu partners, suppliers in which Nissan owned stock. The guaranteed stream of Nissan orders insulated those suppliers from competition. Suppliers can't specialize and can't sell excess capacity elsewhere. Each supplier was assigned a shukotan, Nissan-speak for a relationship manager. It was the shukotan who would negotiate price discounts -- but favors got in the way.

Here, in brief, is the new procurement process, as drastically changed by Ghosn:

Ghosn gave Itaru Koeda, the purchasing chief, authority to place orders without regard to keiretsu relationships -- and, more important, insisted that he use it. Then, a Renault executive and Koeda dumped the shukotan system, instead assigning buyers responsibility by model and part. They formed a sourcing committee to review vendor price quotes on a global basis. "This is the best change in our process," Koeda says. "Suppliers are specializing in what they do best, making them more efficient."

The results? An 18 percent drop in purchasing costs, which was the major contributor to Nissan's transformation from a loss to a profit. Ghosn's next major set of tasks: To change the car design process in order to enhance the top line, sales; to rid Nissan of the myriad design committees and hierarchies that stifle and slow innovation; and to institute an efficient, effective innovative process.