Generally Unaccepted Accounting PrinciplesChapter 13 – From “The Wealth of Knowledge” - Thomas A. Stewart ( 2001)

ARCHANA KC12th Nov, 2010

Outline

Something’s Rotten - Inadequacy of corporate accounting

Intangible Assets, Tangible Harm

The Big Three – income statement, balance sheet, statement of cash flow

Time and Tide – A cry to change

Indefinite Intangible – A strategic look at brand values

Inadequacy and Needs

Technological changes, globalization, expanding information processing were reasons.

Today, we have knowledge work, intellectual capital, software, patents and brand value, DELL, Facebook, internet user base and no-office companies.

Something’s Rotten

Accounting Today

“To provide information that is useful in making rational investment, credit and similar decisions” - Financial Accounting Standards Board

Existing difference between market value and book value.

Financial reports – Stock values have to show the same picture.

Asset or Expense – A question to be accounted.

Something’s Rotten

Then and Now..

It is a lot harder to quantify the value of a user base and the value of R&D in a software program than it was to quantify the value of a manufacturing base.

To create transparency and fair trade – valuation of intangibles is imperative.

“Certain outlays are capital expenditures ;irrespective of what accountants call them “

Something’s Rotten

Surreal Pictures

Accounting’s failure to disclose intellectual capital is more than theory – it costs investor’s money, distorts flows of capital.

The question – How do we put value to a company with few tangibles today, and a future on ability to make and leverage investments in R&D?

Intangible Assets ; Tangible Harm

Intangible Reporting

Baruch Lev and Paul Zarowin, Stern School of Business, NYU conducted a research on – Does financial reporting convey information that investors find useful?

Three foundation pieces of financial information – earnings, cash flows and book value were evaluated.

A sample of over 6800 companies were studied.

Conclusion – “The association between key financial statement variables and both stock returns and prices have been declining over the last 20 years”

Intangible Assets ; Tangible Harmc

Twin VillainsIntangible Assets ; Tangible Harm

InnovationChange

Measuring value is hard for young companies which,

they change a lot significantly increase/decrease

investments in R&D

Human Capital – Unaccounted Investments A slowly growing body of knowledge

demonstrates that top-of-the-line HR practices have bottom line benefits.

Mark A. Huselid of Rutgers University ranked companies according to the sophistication of HR practices and examined market value per employee. Companies in top groups in HR made their investments much wealthier than others.

Wall Street values it lower. IPO’s were priced lower for companies that invested in human capital.

Reason – Financial statements do not tell if money invested in human capital is put to good use.

Intangible Assets ; Tangible Harm

Brand – An expensive affair

Brand equity, an intangible asset is largely ignored in accounting.

A homegrown brand cannot be accounted. An acquired brand has to be depreciated, irrespective of market status.

Brand values are significantly associated with equity market values.

Intangible Assets ; Tangible Harm

Important Intangibles

R & D ( Structural Capital), High performance work systems ( Human Capital) and Brand equity ( Consumer Capital) are considered expenses by accounting.

The more a company invests in R&D and advertising, the more research Wall Street does on it.

Investors look for information on intellectual capital ; 72 percent look for it in their portfolios.

(Contd)

Intangible Assets ; Tangible Harm

Management quality is a important criteria for investment decisions – accounting cannot help.

Investments in intangibles are treated as expenses and their values are hardly disclosed.

Costs are mostly lumped in with other expenses – are split across departments, offices and is impossibly to be calculated.

Managers do know the value but do not know how to value it. Financial reporting is no longer fulfilling its first responsibility.

Important IntangiblesIntangible Assets ; Tangible Harm

The Big Three

Income statement is a way to highlight the most important cost – the cost of goods. How does that help companies like Microsoft, whose COGS is at 14 % of sales; or Coca Cola has it at 30 %?

Three Blind Mice

(Contd)

A Traditional Income Statement

The Big ThreeThree Blind Mice

Focuses on real work of twenty-first century corporations; with lesser focus on raw materials.

Draws a definite line around administrative expenses

For many service companies, the cost of selling is the same as the cost of producing a service.

(Contd)

Howell’s Bare Bones View of a Operating Statement

The Big Three

A balance sheet is a statement frozen in time picture, intended to tell what resources a company controls and from where it got it.

Three Blind Mice

(Contd)

Assets = Liabilities +Equity Investments =

Financings

The Big Three

Three Blind Mice

*From operating statement.

Free cash flows has to equal financing flows – a company either invests the money it has or has to raise more – thus tying all three statements together.

A clear, sensible architecture – digital age accounting and new age businesses.

It focuses on real concerns of business; producing cash and creating value.

A cry to change

“We don’t have a place in the balance sheets for intelligence or knowledge and that is becoming a much more important factor than physical assets” – Ray Lane, former COO, Oracle and a now angel investor.

Balanced Scorecard is a acceptable method- to place intangibles along measures.

Fear – in acceptance of vague methods, of disclosing confidential information.

Accuracy is possible in calculations, not in estimations.

It is true that managers do add back R&D as capital expenditure internally.

Time and Tide

Indefinite Intangible – A strategic look at brand values

Interbrand calculates a brand’s value by comparing the operating earnings of branded products to what could be earned by generic, commodity versions of the same goods; multiplying this figure by a measure of the brand’s strength.

Coca- Cola brand has been on the list for over 10 years, and is worth $70 billion is 2010.

Top Global Brands 2010

Brand Value in $Billions

Coca-Cola 70.4

IBM 64.7

Microsoft 60.8

Google 43.5

GE 42.0

Mc D 33.5

Intel 32.0

Nokia 29.4

Disney 28.7

Hewlett - Packard

26.8

Commitment

Protection

Clarity

Responsiveness

Authenticity

Relevance

Understanding

Consistency

Presence

Differentiation

Takeaway

Accounting fails to disclose intellectual capital – and it costs investor’s money; not necessarily fraud.

Accounting methods developed for an industrial economy do not work well for today’s organizations.

Internally, intellectual capital has been important but has always been reduced in value from the eyes of investor.

However, GAAP is too prudent a method to be cast away with.

It is important to read between the lines, and to understand an organization beyond financial statements.