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New Accounting for the New Economy

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New Accounting for the New Economy ...

    NEW ACCOUNTING

    FOR THE

     NEW ECONOMY

    By

    Baruch Lev*

     Please do not use

    or reference this study

     without the author’s

     written permission.

May 2000

__________________________

    * Philip Brades Professor of Accounting and Finance, Stern School of Business, New York University

    (212-998-0028; blev@stern.nyu.edu; www.stern.nyu.edu/~blev).

    I am grateful for the comments and suggestions of Jim Leisenring (FASB Vice Chairman), George Massaro (Arthur

    Andersen) and Jim Ohlson (NYU). Responsibility for the views expressed here is mine.

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    I. The Current State of Accounting

    Accounting's 500 year exceptional durability is being severely tested by the New

    Economy, characterized by the fast pace of technological change and the consequent increased

    uncertainty, the substitution of intangible for tangible assets as the major drivers of value, and

    the blurring of the boundaries between the firm and its customers, suppliers and even

    competitors. The traditional accounting model, recognizing primarily tangibles as assets, dealing

    asymmetrically with uncertainty (recognizing expected losses but ignoring expected gains), and

    focusing on legally-based transactions (sales, purchases, capital expenditures) while abstracting

    from many value-changing events (e.g., a failure of a drug to pass clinical tests), was not

    designed to deal with the new economic environment, and therefore no longer serves essential

    managers' and investors' needs. Stress signs are all too visible. The average market-to-book

    (M/B) ratio of the S&P 500 companies exceeds now 6.0, indicating that five of every six dollars

    of corporate market value are missing from the balance sheet. New economy M/B values are

    much higher -- some (Cisco, Dell) in the two and even three digit stratosphere. True, balance

    sheets are not intended to mimick market caps, but they should not be trivial either.

    Academic research corroborates the general uneasiness with the usefulness of financial

    information. Several large-scale empirical studies have documented that over the last couple of

    decades, a period not coincidentally paralleling the ascendance of the New Economy, there has

    been a steady deterioration in the statistical association between stock prices and key financial

    1variables, such as earnings, book values or cash flows. A weakening association implies that the

    role of accounting-based information in investors' decisions is fast decreasing. To be sure, an

     1 For example, Baruch Lev and Paul Zarowin, "The Boundaries of Financial Reporting and How to Extend Them," 2Journal of Accounting Research, Autumn 1999; Brown, Lo and Lys, ―Use of R in Accounting Research,‖ Journal

    of Accounting and Economics, December 1999.

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    earnings disappointment may still tank a stock, but this is mostly pronounced for momentum or

    dream companies (high flyers), and many of the price declines reverse themselves, at least

    partially, in short order (e.g., Procter and Gamble's stock price which dropped 31% on a

    disappointing quarterly report published March 7, 2000, advanced by more than 20% over the

    subsequent month).

     Managers, too are increasingly realizing the diminishing usefulness of accounting-based

    information, voting with their feet for various alternatives, such as Economic Value Added and

    various Balanced Scorecards. The increasing reference to non-GAAP measures in financial

    reports, such as AT&T's extended discussion of EBIT and EBITDA in its 1998 MD&A section,

    though sometimes aimed at masking poor earnings, is another manifestation of managers' search

    for complements or alternatives to GAAP performance measures.

    The general uneasiness about the usefulness of GAAP accounting led both the SEC and the FASB to establish task forces to identify inadequacies of financial reporting and suggest

    improved disclosure modes. A widespread search for an improved or even a new accounting

    system is thus taking place, but what should be the nature of the new paradigm?

II. The Search for a New Paradigm

     Accounting policymakers have traditionally followed the "user needs approach" to chart

    the course of change. Thus, for example, the AICPA Special Committee on Financial Reporting

    (AICPA 1994) based its conclusions about the inadequacies of business reporting primarily on

    "direct input from users," such as financial analysts and institutional investors. Similarly, the FASB’s current effort in the nonfinancial indicators area focuses on managers' emerging

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    2information needs and the ways such needs are being satisfied. It is, of course, useful to consult

    customers in the design of products, and investors/managers in the determination of new

    information systems. However, the limitations of this user needs approach -- primarily bias and

    lack of awareness--should be recognized.

    Persons’ response to questionnaires and interviews are often colored by biases and self-

    serving motives. Not coincidentally, the most vehement objections to recognizing an expense

    for stock options were voiced by executives of options-rich tech companies. Even more serious,

    the user needs approach is restricted because quite simply, users are often not fully aware of their

    needs. Imagine having asked managers in the 1970s whether they ―need‖ a personal computer,

    consumers in the 1980s about their ―need‖ to shop on-line (Internet), or physicians today about their specific uses of genetic coding. True innovations satisfy unrecognized needs, and those

    cannot be gauged by surveys of consumers, decision makers or information users.

     Thus, charting a course of change, or a blueprint for a New Accounting system requires

    complementing the interview/observation approach, with an inductive, empirically-supported

    framework for change, as outlined below. The starting point is an appreciation of the business

    model of a New Economy, knowledge-based enterprise.

III. The Knowledge-Based Enterprise

    Successful knowledge-based companies, operating in the high tech, science-based,

    Internet and service sectors, as well as a fair number of companies in the bricks and mortar world

    of chemicals, oil & gas, consumer products and retail sectors, engage in a systematic, carefully

     2 A similar approach is currently followed in Denmark and the Netherlands, where government agencies initiated

    studies which are aimed at learning from business uses of nonfinancial, knowledge-based measures about new

    information modes.

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    planned and executed process of innovation, depicted in Figure 1. The three fundamental phases

    of the innovation process are:

    ? Discovery/Learning: In which new products (drugs, software, consumer electronics),

    processes (Internet-based supply or distribution channels), and services (risk

    management or internal control systems) are developed. These innovations are

    sometimes discovered internally by scientists and engineers (R&D), but increasingly

    3are acquired from outside the organization. Learning from within (communities of

    practice) and from the outside (reverse engineering) plays an increasingly important

    role in the innovation process. The discovery/learning process is sometimes an

    4outcome of a systematic strategy (e.g., the scientific approach to drug development),

    and other times the result of trial and error or sheer luck.

    ? Implementation: Achieving the stage of technological feasibility of products and

    services, such as drugs passing successfully phase III clinical tests, software products

    satisfying beta tests, or websites reaching a threshold number of unique visitors or

    repeat customers. Establishment of legally protected intellectual property rights, in

    the form of patents and trademarks often takes place during this phase.

     3 Cisco Systems, for example, spent in 1999 $…… on internal R&D, and $…… on the acquisition of technology. 4 For elaboration on the scientific approach to drug development, see Iain Cockburn and Rebecca Henderson, ―The

    Economics of Drug Discovery.‖ MIT and NBER, 1998.

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    Figure 1

    The Innovation Chain

    Discovery/Learning Implementation Commercialization

     Innovation Revenues Knowledge Generation:

    Technological Feasibility (share from new ? R&D

     products/services) ? Learning-by-Doing

     ? Patents ? Intranet systems Cost Savings from New ? Cross-Licensing Processes

     ? Trademarks Knowledge Acquisition:

     ? Reverse engineering Internet Activities

    ? Coded Knowhow ? Technology Acquisition (Business-to-Business and

     ? Research Collaborations Business to Customers)

     and Alliances

    Networking: ? Inter- and Intranet Systems Technology Royalties and ? Communities of Practice License Fees ? Supplier/Customer Integration

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? Baruch Lev, 2000, All rights reserved.

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    ? Commercialization: Technological feasibility is a necessary but not sufficient

    condition for economic success. Bringing new products/services quickly to the

    market and earning above-cost of capital return on the investment caps the innovation

    process. Procter & Gamble spends heavily on R&D yet (according to The Wall

    Street Journal, March 7, 2000) "hadn't come up with a true runaway hit since Pampers

    40 years ago.‖ The cellular phone technology was developed in the 1970s by AT&T,

    yet while reaching technological feasibility AT&T abandoned the invention due to

    perceived lack of potential.

     Current accounting (GAAP) does not convey relevant and timely information about the

    innovation process--business model--critical to the survival and success of business enterprises.

    Investment in discovery/learning is by and large expensed immediately in financial reports, and

    most investment items (e.g., employee training, software acquisitions, investment in Web-based

    5systems) are not even reported separately to investors. The value creating implementation stage

    of the innovation chain (e.g., an FDA drug approval, a patent grant or a successful beta test of a

    software product) is all but ignored by the transaction-based accounting system. And even the

    commercialization stage, which generates recordable costs and revenues, is generally reported in

    a highly aggregated manner, defying attempts to evaluate the efficiency of the firm’s innovation process, such as the assessment of return on R&D or technology acquisition, the success of

     6collaborative efforts, and the firm’s ability to expeditiously ―bring products to the market.‖

    Nor can users glean from financial reports the extent and success of firms’ Internet involvement,

     5 A large part of technology acquisitions, often in excess of 50% of purchase price, is also immediately expensed as

    in-process R&D. 6 Cisco systems acquired during 1997-1998 12 companies (using the ―purchase method‖) for $1.3 billion and immediately expensed $1.1 billion as in-process R&D. How can investors assess the success of those acquisitions?

    Merck and Co. is currently involved in more than 90 alliances and joint ventures, yet no information is provided to

    outsiders about the performance and contribution of these alliances. Thus, investors are lacking the information

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    a crucial survival factor in the New Economy, and a major component of the innovation process,

    as depicted in Figure 1. This failure to adequately reflect in a timely manner important aspects

    of the innovation process is largely responsible, in my opinion, for the decrease in the usefulness

    of financial reports.

IV. Innovation and Risk

    Risk, an integral part of the innovation process plays a major role in the accounting

    treatment of innovation, particularly in the expensing of intangible investments. Granted the

    riskiness of the innovation process--the business folklore is replete with statements like ―one in

    20 drugs succeeds,‖ or ―one of 30 software programs makes money‖--three points, which play an

    important role in the information system proposed below should be noted:

    (a) There is a marked difference between the riskiness of individual projects and that

    of a portfolio of innovations. Pfizer’s individual drugs under development or

    Oracle's new Internet-oriented software programs are obviously risky, but the

    portfolio of innovations of medium-size and large companies is generally stable

    and profitable. This accounts for the remarkable fact that with all the

    revolutionary technological changes of the last 2-3 decades, the current leaders in

    chemicals (DuPont, Dow), pharmaceutics (Merck, Pfizer), or software (Microsoft,

    7Oracle) were also the industry leaders 10, 20 and even 30 years ago.

    (b) The risk of innovations progressively decreases along the chain from discovery to

    commercialization (from left to right in Figure 1). While it may be true that one

needed to evaluate major managerial innovation activities (technology acquisition, R&D collaborations) in a timely

    manner. 7 The portfolio, rather than the individual asset perspective is sometimes adopted by GAAP, such as in the

    ―successful efforts‖ method of oil & gas companies.

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    in 20 drugs at launch succeeds, the probability of an FDA approved drug making

    it to the market is close to one. This implies that the stage of development

    reached by a product or a process is an important indicator of its risk, and should

    affect the accounting treatment (e.g., capitalization) accorded to it.

    (c) Risk has been traditionally viewed as a problem to be avoided or mitigated (risk

    hedging). Options theory and experience instruct us that risk is often an

    opportunity. The value of an option is positively related to the operation’s

    underlying risk--the higher the risk, the higher the option value. The R&D

    investment of a pharmaceutical company in collaboration with a biotech startup,

    for example, is viewed by accountants as a high-risk endeavor to be expensed.

    Alternatively, this R&D can be perceived as buying a call option on a new family

    of drugs, where the exercise price is the required development investment, if the

    initial research (price of option) pans out. Valuation models for such ―real

    options‖ (i.e., options on real, rather than financial assets) are increasingly used

    by innovative companies as a strategic device and could be employed to value the

    R&D investment.

     The importance of specifying the dynamics of the innovation processes of knowledge-

    intensive enterprises (Figure 1) and the associated risk, namely understanding the ―business

    model‖ in financial analysts' parlance, is that it guides one in constructing new information

    modes useful (whether the need is currently recognized or not) to investors and managers. But

    prior to elaborating on the proposed information system--a brief discourse on networking.

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