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Wake of the flood: the accounting scandals weren't all bad. Yes, they shook investor confidence. But they're also driving overdue changes in financial reporting. (Finance).

It's all a matter of perspective. What some consider a catastrophic flood, others deem a cleansing bath. Witness the wave of bad news that began with stirrings of scandal at Enron and built over the past year into a crisis of confidence in corporate accounting.

Did we say bad news? On second thought, some experts suggest, maybe it wasn't so bad. "It seems to take a crisis to allow substantive and significant change," observes Ira Solomon, head of the accounting department at the University of Illinois at Urbana-Champaign. The crisis, he posits, may be just what the market needs to bring relevance to financial reporting.

Solomon and other critics believe the problem lies not in a few dishonest executives who gamed the accounting system, but rather in the system itself. Currently, corporations report too much useless information and too little that investors actually need, they argue.

"Accounting's function is to signal to potential suppliers of capital and labor the productive capacity of an organization, so that capital can flow to its most productive uses," Solomon says. "But the productive capacity of an organization is no longer revealed by its financial statements."

In fact, the fundamental economic case for a new approach to financial reporting has become so well accepted that it hardly admits debate. Put simply, value isn't where it used to be, and financial reporting standards fail to reflect that. A hundred years ago, factories and equipment were the keys to value. Andrew Carnegie's real wealth lay in his steel mills -- raw materials, plant and equipment and finished product. Today, intellectual capital represents the key to value. Bill Gates' real wealth rests in the heads of his software engineers.

Even manufacturing companies today see factories less as a key to wealth than a necessary evil. Often, they aim to minimize fixed-asset investments through such measures as strategic alliances, off-balance-sheet financing and outsourcing.

The body of generally accepted accounting principles, or GAAP, hasn't kept pace. There are more rules than ever, but all of them follow the same dated assumptions about what matters to a business. Testifying before Congress in February 2002, Federal Reserve Chairman Alan Greenspan found it necessary to warn about "the ever-increasing proportion of our GDP that represents conceptual, as distinct from physical, value." He stressed "the difficulty of valuing firms that deal primarily with concepts."

The Financial Accounting Standards Board implicitly confirmed Greenspan's observation in July, when it proposed establishing standards for measuring intangibles. Take patents, for example. Those acquired in a merger have to be identified, accounted for and carried on the balance sheet as intangible assets. But patents earned through in-house research and development cannot be identified as assets, because under GAAP, R&D is treated as an expense in the period in which it occurs.

As a result, two companies with the same investment in patents will have very different balance sheets, depending on whether they bought their patents or developed them. Clearly, this makes no sense, which has prompted FASB to propose addressing such inconsistencies. But if past performance is an indicator of future results, the accounting board will move cautiously. It seems a safe bet that any standards it defines in the near term will fail to capture the entire economic reality.

The most valuable assets of, say, Wal-Mart and Dell Computer aren't stores or factories but rather intangibles--business models--that don't appear on financial statements. Both companies outstrip their competition with unique expertise in organizing their supply and distribution systems. In a world where strategic alliances make increasingly powerful value drivers, financial statements fall short. "Airline alliances create tremendous value for airlines but don't appear anywhere in the financial statements," Solomon points out.

Investors uninformed

This kind of discussion is anything but theoretical. Investors increasingly demand more information than traditional accounting statements provide. And they penalize companies that don't that meet their demands. It's not that companies aren't reporting by the traditional rules; with some glaring exceptions, most of them are. It's that the rules -- by relying on historical costs, for instance-- are out of date.

A recent survey of petroleum companies suggests that even when companies try to make their reporting more relevant by including nontraditional value drivers, a disconnect persists between managers and investors. Eighty percent of executives believed their company's share price was lower than its true value. But investors surveyed said the companies fell short of providing adequate information on three out of every five important value drivers.

The problem cuts across industries, asserts Bob Eccies, president of Advisory Capital Partners. a senior fellow at PricewaterhouseCoopers and coauthor of Building Public Trust: The Future of Corporate Reporting. Like Solomon, Eccles sees the recent wave of scandals as a blessing, not a crisis. "I've been working in this area for 10 years," Eccles says, "and this is the best opportunity I've seen for real change."

But precisely what change is needed? The Sarbanes-Oxley Act may be the most significant accounting legislation in a generation. In January, the SEC issued guide-lines for public companies to disclose off-balance-sheet transactions and to reconcile pro-forma reports with GAAP, steps that will make it harder for companies to understate their assets and liabilities. But critics argue that the act fails to address the core of the problem.

"I don't think Sarbanes-Oxley gets at the underlying issue, which is that you can't make a decision based on historical cost information," asserts Eccies. "You basically have two systems in companies. One apparatus prepares SEC financial statements, the other prepares management accounting information. The solution is to have management report to the markets the same information it uses to run the company.

Extreme as that may sound, some companies seem well on the road to doing it. Consider Infosys Technologies, based in Bangalore, India, whose stock trades not only on Indian exchanges but also on the Nasdaq. It hires well-educated, low-cost Indian talent to develop software for such U.S. clients as VISA, Northwestern Mutual Life Insurance and Nordstrom. Of its $545 million in revenues, nearly 70 percent comes from the United States.

Larry Pressler, a former senator from South Dakota who sits on the Infosys board, explains: "We normally think of the U.S. as the leader in corporate governance, but in many ways Infosys has been a leader. The company has set a very high standard."

Infosys has one of the most extensive corporate disclosure policies of any company. Its annual report presents detailed results according to both Indian and U.S. generally accepted accounting principles. It also offers summary results based on the GAAP of Australia, Canada, France, Germany, Japan and the United Kingdom.

Intangible capital

But Infosys goes even further. No country's GAAP takes into account such intangibles as intellectual capital and brand value -- a glaring omission. "We think that in today's economy, the intangible assets of a corporation are more valuable than land, buildings and cash," explains Nandan Nilekani, the company's CEO.

"Infosys exists because 13,000 people who work here are creating intellectual capital that somebody thinks has value and pays for," he adds. "A company like Infosys is in the knowledge business. So we recognize people as our most strategic asset. And the reason Infosys is able to get a premium price for its services is that it has a brand. So the value of the brand has to be recognized."

Since no existing body of GAAP offers guidance on accounting for such intangibles, Infosys took the initiative. Its annual report contains a section called "Additional Information for Shareholders." Included in it are: an intangible assets score sheet, a human resources accounting statement, a statement of brand value and an economic value added, or EVA, statement.

The intangible assets score sheet reports not only revenue growth, but the percentage of revenue from image-enhancing clients, exports and new clients added during the year. It reports on efficiency, stability, information technology and R&D investment, as well as on the education level and age of staff, the value added per employee and the proportion of support staff.

"The philosophy is very clear: When in doubt, we disclose," Nilekani says. The company's fiscal 2002 annual report ran to 208 pages, and shipped in a box. Infosys may be unique in its level of disclosure. But other companies are also going beyond GAAP to give investors a better picture of what makes their businesses run.

Herman Miller, the second-largest office furniture maker in the United States, overcomes some of the shortcomings of GAAP by following the EVA methodology developed by the consulting firm Stern Stewart. "We very deliberately choose to report both GAAP and EVA results -- GAAP for reasons of consistency and comparability with our peers, and regulatory compliance. But we believe EVA is ultimately the best economic representation of our business performance," says CEO Michael Volkema.

GAAP ignores the cost of capital, the money that stockholders have invested in a company. EVA, by contrast, measures success as delivering a return above the cost of capital. The difference between the two becomes clear at the operating level. It is almost always possible to grow revenues by investing capital, and companies that ignore the cost of capital are likely to take this course. But if revenues do not return at least the cost of the capital invested, they represent an economic loss.

"Even though intangible assets aren't specifically listed on the GAAP balance sheet, under the EVA methodology certain expenses related to the creation of intangible assets are capitalized," notes Beth Nickels, the CEO of Herman Miller, in Holland, Mich. "We believe that if a company's intangible assets have real value they will eventually drive future EVA generation."

Beyond profits

The Dow Chemical Co. is another company that 1 stresses economic profit for internal and external reporting. However, Dow doesn't use EVA, nor does it limit its reports to profits. In 1994, the Midland, Mich.-based company resolved to achieve a return on equity of at least 20 percent and to earn 3 percent above the cost of capital. "In 1997," notes Dow's president and CEO, William Stavropoulos, "we added a growth-oriented objective: Grow earnings per share by 10 percent a year across the cycle. Taken together, our financial objectives represent a level of performance attained by less than 10 percent of the S&P Industrial 400."

Complementing its straightforward statement of financial objectives, Dow discloses its progress toward social and environmental goals. "The bottom line is that we believe clear lines of accountability and responsibility drive higher levels of performance," the CEO says.

Currently, transparent disclosure means going beyond GAAP requirements. But greater levels of transparency may soon be required by regulators who are paying unaccustomed attention to the "Management Discussion and Analysis," or MD&A, section of financial statements. In December 2001, the Canadian accounting industry issued guidance for disclosure principles for MD&A, and U.K. authorities took up the cause last June, followed a month later by the SEC, which is considering "new interpretive guidance."

Not everyone is applauding the regulators. Critics of the disclosure movement argue that the market is a better mechanism for sorting out opacity than regulators in Washington. But the examples of such vanguard companies as Infosys, Dow Chemical and Herman Miller suggests that the market is already moving well ahead of the bureaucrats. How widely these examples will be followed remains to be seen.

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Author:Millman, Gregory J.
Publication:Chief Executive (U.S.)
Geographic Code:1USA
Date:Jan 1, 2003
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