NCPA - National Center for Policy Analysis

Accounting For The New Economy

July 28, 2000

Increasingly, says Peter Wallison of the American Enterprise Institute, companies' capital stock is intangible. And unfortunately, the information investors need to evaluate these companies doesn't appear on their balance sheets.

  • An estimated 80 percent of the value of companies on the S&P 500 is attributable to their intangible assets -- such as patents, trademarks and software, and less familiar items such as employee skills, customer satisfaction and efficiency of product innovation.
  • However, conventional accounting has no effective means to record intangible assets on balance sheets, and thus corporate balance sheets may omit most of the company's assets.
  • Worse still, earnings may be overstated or understated because the assets producing the earnings are not on the balance sheet and are thus not being depreciated or amortized.

When most of what companies used to earn profits were tangible assets like plant and equipment, the difficulty of valuing intangibles was inconsequential; but when profitability depends on intangible assets, the inadequacy of standard accounting has serious consequences.

For example, America On Line (AOL) treated its cost of acquiring new customers as a depreciable capital cost -- while the Securities Exchange Commission demanded that it expense it. If these very large costs were capitalized, AOL showed earnings from 1994 to 1996; if they were expensed, it would have shown losses. In 1997 and following years, AOL expensed customer acquisition costs, which reduced current earnings, but relieved its future earnings of the burden from amortizing these assets.

This may explain why stocks -- especially Internet and electronics stocks -- appear to be overvalued, suggests Wallison: if capital isn't properly accounted for, earnings are also misstated, and the ratio of share prices to earnings may appear absurdly large.

Source: Peter J. Wallison (Resident Fellow, American Enterprise Institute), Prepared Testimony, "Hearing on Adapting a 1930's Financial Reporting Model to the 21st Century," July 19, 2000, Subcommittee on Securities, Senate Banking Committee, Washington, D.C.

 

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