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Tim Watts "Value the Intangible Dream" BRW December 1, 2000
Rollercoasters are fun but, after the
10th ride, even the hardiest thrill seeker is happy to be back on steady
ground. The United States investment community, as Wall Street's
record-breaking year of volatility draws to a close, is keen to find
steady ground. Share prices in all sectors have been yoyo-ing all year
and, although the much predicted crash has not arrived, collective
soul-searching is going on in earnest. Investors are facing up to the unsettling
truth that accurate valuing of the high-technology and dot-com companies
is often a mysterious process and a highly unscientific business. In a
global economy in which growth is increasingly being driven by
"intangibles", such as intellectual capital, research and development,
brand names and human capital, valuation methods based on conventional
financial information alone are inadequate. The performance of new-economy companies,
and of a growing number of old-economy companies, hinges on non-physical
factors such as strategic alliances, staff retention rates and customer
loyalty. The data in corporate balance sheets that companies must disclose
tells only a small part of the story. The depth of the problem was revealed by
a 1999 survey for PricewaterhouseCoopers. It found that only 22% of US
investors regarded financial statements as "very useful" in gauging the
value of companies. With such a paucity of data, investors
have been relying on qualitative assessments, guesswork, rumor and
anything else they can get their hands on. The result is an environment of
uncertainty and surprise, wildly fluctuating share prices and an investor
"mob psychology" that US Federal Reserve chairman Alan Greenspan famously
described as "irrational exuberance". Individual investors panicking about
their portfolios are not the only ones concerned. US policy makers have
begun questioning the broad consequences for the American economy of the
dearth of information on intangibles. Capital markets, when they work
well, allocate society's productive resources to the firms that can most
efficiently generate wealth. Without the means of differentiating between
genuinely innovative companies and also-rans, markets tend to go a little
haywire. Capital gets wasted on poorly run businesses, good companies are
starved of funds, economic growth slows and unemployment rises. With serious concerns now being voiced in
the US private and public sectors, a view is that steps need to be taken
to improve the quality of information available about companies'
intangible assets. In October, the Brookings Institution, an influential
centrist panel of specialists, convened a 42-person taskforce from
government, accounting firms, corporations and universities to investigate
policy alternatives. Recently, it presented its findings to the US Senate. One of the taskforce co-chairs, Steven
Wallman, a former commissioner at the Securities and Exchange Commission
(SEC), the main US markets regulator, says the time is right for reform.
"We all have a stake in this," he says. "For a long time, people in the
accounting profession have viewed it as a crucial issue, but I think now
economists, executives, regulators and investors are behind it too. Not
enough information on intangibles is available to investors, and market
volatility occurs when knowledge about the drivers of wealth production is
weak. It is vital we develop our knowledge on this." Three key recommendations for government
action are in the Brookings taskforce report. The first proposal is for
the establishment of a publicly funded intangibles databank to enable the
private sector to construct reliable new business models that better
reflect the dynamics of wealth creation in the information economy. The second proposal is for the SEC to
expand disclosure requirements of publicly traded companies. This would
mean better explanation of cost information and expanded discussion of
"value drivers". Included in this proposal is a recommendation to
strengthen rules that protect executives from lawsuits when they attempt
to discuss and describe "soft variables" that they believe are value
drivers. The third proposal is for reform of
intellectual property laws to increase the certainty of protection for
patents, trademarks and trade secrets. The taskforce says the US should
back the setting up of international registration and arbitration bodies
for patents and trademarks. A more detailed understanding of the role
of investment in intangible assets - including information technology,
R&D, customer acquisition and employee training - would benefit managers
and investors. Unlocking the mystery of what spurs
innovation and creativity is one of the great obsessions of corporate
life. However, individual firms do not have the incentive to make the
substantial investment required to develop such information. Baruch Lev, professor of accounting and
finance at New York University and author of a new book, Intangibles:
Management, Measurement and Reporting, says: "This is not just a simple
accounting issue; a matter of just getting the information from within the
organisation out into the public domain. Most managers have no idea about
the value of their own companies' intangible assets. Managers have no
data, for example, on employee training or other measures like retention
rates, which have a direct link to the long-term value of a business. The
disclosure issue is derivative of the core internal problem." Regulators' efforts to improve
information on intangibles are crucial, Lev says. "Corporate executives
and auditors have very few, if any, incentives to expand the information
available about intangibles. Extending the mandatory reporting rules to
cover intangibles and to establish the language and the framework of
disclosure for these standards is vital. Managers with good news to report
will start the revelation process and then those with bad news will be
forced to follow. They won't be able to risk the investment community
jumping to the wrong conclusions." The push for a revision of corporate
disclosure rules in the US is gathering pace. On October 23, the SEC
introduced new "fair disclosure" regulations that require executives to
end the practice of selectively releasing price-sensitive information to
closed meetings with stock analysts. All such information must now be made
fully public through a filing with the SEC or a press release. In February, the American Institute of
Certified Public Accountants released a report endorsing the practice of
real-time financial reporting in which corporate bookkeepers would update
revenue and earnings figures daily and continuously report them to
investors through the internet. Also, a consortium of 67 companies,
including Microsoft and the Big Five accounting firms, has developed XBRL
(extensible business reporting language), which will remove the technical
barriers to sharing financial information. Australia's regulatory standards are
already quite advanced in this area. Unlike the US, where laws require
companies to report only once per quarter, Australia has a continuous
disclosure regime that compels publicly listed companies to immediately
release any information that could reasonably be expected to have a
material effect on the company's share price. This includes information on
earnings, mergers, acquisitions, joint ventures, new products or
discoveries and changes in control or management. The immediacy of disclosures in Australia
may be greater than in the US market, however a survey of 20 big public
companies by James Guthrie, professor of management at Macquarie
University, shows that there are shortcomings in the content of corporate
disclosures on intangible assets. Guthrie studied the information in the
1998-99 annual reports of Australia's 19 biggest companies by market
capitalisation. He found that all companies made some attempt to discuss
their intellectual and human capital, but there were serious limitations
in the usefulness of the information for investors. "Nearly every instance of reporting
involved the intellectual capital attribute being expressed in discursive
rather than numerical terms," Guthrie says. "What is lacking is a clear attempt to
translate the rhetoric into benchmark measures that enable performance in
managing the human and relational attributes of the firm to be assessed
and, therefore, improved, in a systematic fashion." Intangible assets are not easily measured
quantitatively. Some subjective assessment will always be necessary and
this fact is one of the key objections raised by opponents to more
attention to intangible assets in accounting reports. Guthrie, who spends a lot of time arguing
with accounting traditionalists, says that everyone should acknowledge the
rubbery nature of the figures reported for the physical assets of
companies. "Is the current Australian financial
reporting system providing information that is truly objective regarding
the firm's position in the marketplace? No. At least by reporting
something for intangibles, we acknowledge their existence. This broadens
the scope for decision-making by those relying upon the financial
statements, and it also means that we have a platform to provide some
leverage in improving reporting methods." The most progress towards developing a
set of quantitative standards for the reporting of intangibles has been
made by Sweden. The insurance giant Skandia led the way in 1994 by
publishing an intellectual capital audit in addition to its annual
financial report. Dozens of listed and unlisted firms in the engineering,
management consulting, advertising and technology industries have followed
suit. Australia's corporate reporting
regulatory environment is controlled by a combination of agencies
including the Australian Securities and Investments Commission, the
Australian Stock Exchange, the Australian Accounting Standards Board and
Federal Parliament (through the Corporations Law). Guthrie says no single organisation
stands out as being the one to lead efforts to overcome the lack of
information on intangibles. "Australia is lagging considerably behind best
practice in Europe and North America. Policy makers and the business
community have responsibility." Australia has more at stake than most
countries. Intangible assets will become the dominant source of wealth in
the new economy. Guthrie points to the shift in the make-up of the 10
biggest Australian companies over the past two decades. In 1980, eight
were mining and resources companies, and the other two were
intangibles-driven, service-based businesses. Today, that ratio is
reversed. Finding a way of tracking the effect of
intangibles in the creation of corporate wealth and the growth of the
economy in general is not a straightforward exercise. Experimentation and mistakes will occur.
But the alternative is much worse. As traders who have been desperately
trying to ride out the Wall Street rollercoaster over the past year will
attest, guesswork is no foundation for lasting prosperity.
Tangible figures
Karl-Erik Sveiby wrote several books and
articles in Sweden in the late 1980s and early 1990s on intangibles
reporting, and the methodology he developed has become integral to
corporate disclosure practice there. He says that, initially, there was no
government or regulator involvement. Then business leaders started
experimenting, the Swedish Council of Service Industry began recommending
that its members adopt specific standards, and reporting of intangibles
became widespread. Sveiby now lives in Queensland, where he
runs a knowledge-management consulting business. He says Australia is a
long way behind Sweden in its understanding of the role of intangibles as
drivers of wealth creation. "The practice of intangibles reporting
requires a few bold managers and a willingness to experiment and share,"
he says. "I have not seen much of such attitudes in Australia so far. It
would be a pity if regulation in Australia would come before practice,
because that would most certainly produce a less effective system." Sveiby favors business/government partnerships to foster the development of standards. "In Denmark, for example, the Government has joined forces with a business school in a very interesting experiment covering three years of 'knowledge accounting' in 20 small firms."
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