Accounting in the Age of Knowledge: Making Intangibles Tangible

Since the 1990s, capital investment has shifted from a greater reliance on physical capital to human or knowledge capital, notes Accounting Professor Sean Wang. Physical capital, such as labor and machines, has declined and shifted to human or organizational capital called “intangible” assets in accounting terms. Measuring these intangible assets to reflect economic truth has created a conundrum of sorts for the profession and those needing to analyze financial statements for the Apples, Netflixes and Googles of the world. In ambitious research, SMU Cox Accounting Professor Sean Wang and his co-authors develop a new way to measure intangible assets that has been lacking for decades.

The accounting rules governing intangibles were established in 1974 when manufacturing was the main driver of economic value. These rules mandate that intangible expenditures immediately go to the income statement as periodic expenses, and therefore never show up on the balance sheet. “Thus, in today’s economy, if you try to value a firm, like an Apple, Microsoft, or Google, based on their reported accounting statements, much of their assets will be missing, specifically those related to intangibles —human capital, brand equity and R&D,” says Wang. “A manufacturing company, because it consists primarily of physical capital like plant property and equipment, may have a balance sheet that reflects its economic truth well but for a high-tech firm it’s not nearly as good.”

There has been a “seismic shift” in what drives the value of the economy. Among the largest firms in the U.S. are the “FAANG” stocks which stand for Facebook, Apple, Amazon, Netflix, and Google. They don’t have plants, property and equipment to speak of. “Their balance sheets have virtually nothing and they’re worth hundreds of billions of dollars,” says Wang. “It’s the intangibles missing from the balance sheet that are largely responsible for this gap.”

The market understands there is a problem and attempts to fix it, but many of the fixes seem to be based on relatively ad-hoc assumptions. “People have to guess about how to estimate the value of intangibles, because they are missing from the accounting statements,” offers Wang.

Finding the hidden value
The authors developed a method to “re-build” the balance sheet to include what is missing. Wang says other studies have attempted this but were missing one key factor: What’s the market price of an intangible? “We need a clear way to measure what’s on the balance sheet,” he says. “Everyone knows it’s a problem but no one has a justified way of measuring intangibles so we can bring them back to the balance sheets.”

In the research, the authors use market prices of intangibles, as they are appraised during an acquisition. The SEC and GAAP (generally accepted accounting principles) require an acquiring firm to allocate the price paid for the target firm’s assets across three major categories: physical assets, identifiable intangible assets (IIA), and goodwill. The authors utilized an acquisition sample that spans the years 1996–2017 and comprises a substantial fraction of U.S. publicly-traded acquirer-target pairs. The authors then hand-collect IIA and goodwill from the purchase price allocation of over 1,500 acquisition events. They analyzed the relationship between IIA and goodwill to prior investments into knowledge and organizational capital and develop a set of parameters used to recreate the missing intangibles in any publicly traded firm. In a series of validation tests, their measures outperform existing assumptions.

“Essentially, we use intangible prices from acquisitions to create parameters that allow us to re-capitalize any firm’s intangibles which are missing from the balance sheet,” Wang explains. “We show in a variety of settings that our measures work better than the most recent ones being used.” Importantly, the authors’ measures allow practitioners to make better decisions and value companies more appropriately.

Knowledge rising
In a growing knowledge economy, the implications of intangibles missing from the balance sheet are extremely important. They will become more important in the future for understanding what drives economic value. In 2013, the U.S. finally began accounting for missing R&D spending as investment, which underestimated gross domestic product, but this classification (of R&D as investment) still has still not occurred on accounting balance sheets. The bias in these balance sheets can create issues in evaluating a firm.

On the campaign trail, for example, one presidential candidate called out the FAANGs as making too much money or having out-sized market power. Part of this perception stems from the lack of intangible assets on their balance sheets, which inflates certain measures of profitability. “They are certainly great firms, but differences in profitability can be larger than perceived if the total amount of capital investment is underestimated. At the end of the day, if policy decisions are even partially dependent upon measures created by accounting statements, the books should reflect intangible investment as accurately as possible such that we can most effectively evaluate their profitability and make optimal decisions for the country,” offers Wang.

By using Wang and his co-authors’ new measures, current business trends and activities will better reflect today’s economic truth— making the intangible tangible.

The paper “Acquisition Prices and the Measurement of Intangible Capital” by Sean Wang of Southern Methodist University’s Cox School of Business, Michael Ewens of California Institute of Technology and NBER, and Ryan Peters of Tulane is under review. Researchers are welcome to download and use their parameters by visiting http://bit.ly/intan_cap.

Written by Jennifer Warren.