Is accounting keeping pace with the times?
When Benjamin Graham was first developing the principles of fundamental analysis some 80 years ago, the bulk of a firm’s value came from its tangible assets, the physical materials the firm was composed of: its factory, its inventory on hand, its fleet of delivery trucks.
In the ensuing shift away from manufacturing, a firm’s assets are increasingly in its entrepreneurial ideas, brands and research and development. Distribution systems have replaced delivery trucks as the main source of value. A firm can book these so-called intangible assets to the balance sheet if it has acquired them on the open market. Copyrights and patents, or even laboratory equipment for R&D, for example, are frequently brought onto the balance sheet at the price they were acquired for, their so-called historical cost.
But the lion’s share of intangibles cannot be assigned market prices; without clear market information, there is no sound basis on which to determine value. Accountants have resisted booking intangibles to the balance sheet largely because doing so runs counter to the principle of conservatism, an axiom of accounting practice. Conservatism says that speculation should not come into the accounts — and intangibles are speculative.
But critics have charged that accounting, by failing to provide a method for valuing and booking intangibles, has not kept up with the changing pace of business. In a new white paper, Professor Stephen Penman counters that charge and provides evidence that income statements are the best source for deciphering the value that intangible assets bring to the bottom line. “If the earnings from the intangibles are coming through income statements, then you can get the value by looking at the earnings. There is no compelling reason to book these intangibles to the balance sheet,” he says.
In one example, Penman uses a recent financial statement from Microsoft that illustrates how value can be traced through the income statement to provide a picture of firm value. In 2008, Microsoft’s book value was $36.3 billion, while its shares were trading at $25, for a total value of $228.8 billion. The high market-to-book ratio (the ratio of the total value of outstanding shares to book value) of more than six means the market sees a lot of assets missing from the balance sheet. Microsoft is a fine example of the modern firm that reflects the shift in value from tangibles to intangibles.
Microsoft’s income statement reported a net income of $17.7 billion for 2008. Using information from the income statement, Penman employed a simple residual earnings valuation technique to calculate the equity value of expected earnings for 2009, arriving at a share price of $23.03 — much closer to Microsoft’s share price of $25 at the time than a look at the balance sheet (absent market share, intangible R&D assets or brand) would suggest.
“If you used the same technique on Microsoft in 2000 when it was trading at $60 — a bubble price — you’d understand that the market was overpriced at the time,” Penman says. “The earnings weren’t justifying the difference from the balance sheet that the market imputed. The market was overestimating the value of the missing assets.” Similarly, the Coca-Cola Company typically trades with a price-to-book ratio of five, because its most important asset doesn’t appear on the balance sheet: the Coca-Cola brand itself. “You can gauge the value of the intangible, the brand, by looking at the income statement, for earnings from the missing brand flow in there.”
However, not all intangibles can be valued by looking at the income statement. Certain intangibles don’t contribute to earnings, and booking such assets would violate the principle of conservatism. “Speculative value is just that — speculative,” says Penman, “and should not be included anywhere in the accounting, balance sheet or income statement.” For example, a new drug that has not yet secured FDA approval cannot generate income at present, however much potential it may have. Similarly, a newer firm or entrepreneurial start-up may have intangible value, but not for the accountant to record. “A start-up company might have a lot of entrepreneurial potential from its ideas,” Penman says, “but there is no identifiable value until earnings show up on the income statement. Ideas are important, but ideas have to attract customers.”
Just as some intangibles are not reflected through the income statement, neither should they be forced onto the balance sheet — a practice some experts advocate. “Trying to put an estimate of the value of an unapproved drug on the balance sheet is a risky undertaking,” Penman says. “What if the drug doesn’t ultimately get approval? You must have objective evidence before booking assets, so you don’t just get caught up in booking speculation in the accounts. Values on the balance sheet have to be amortized. But since individual intangible assets can’t be pegged to a market price, what amortization rate are you going to use on the balance sheet? You introduce guesses and lose information, and you destroy the earnings information you would otherwise have.”
Penman’s recommendations underscore how intangible assets work together rather than as individual revenue streams to generate income: an entrepreneurial idea can’t work independently of a brand or a marketing strategy. Intangible assets do not have stand-alone value, but earnings do report the value from using assets together.
“Coca-Cola’s value comes not just from the brand it created, but how the brand works in combination with its distribution system. The brand is an intangible working together with other intangible ideas about how to get value from customers. What if Coke sold off its brand? All the other intangible assets, like its distribution systems, and even tangible assets such as bottling facilities — would be worth far, far less than they are with the brand intact,” Penman says. “You cannot isolate the value of individual intangibles.”
Stephen Penman is the George O. May Professor of Accounting and codirector of the Center for Excellence in Accounting and Security Analysis (CEASA) at Columbia Business School.
Read the Research
"Accounting for Intangible Assets: There Is Also an Income Statement"