Put aside the wild daily swings in the market for a moment and concentrate on this key fact: the ratio of market values to book values of S&P 500 companies has ascended from one-to-one in the late 1970s to six-to-one today.
For some, this reflects excessive speculation, an unsustainable bubble. But a better explanation may be that during this period the source of value creation in our economy moved from tangible to intangible assets, from hardware to software—literally, from bricks and mortar to brains.
A transition this significant requires big changes in the legal and regulatory framework in which the economy functions. Significant modernisation has occurred in the frameworks applicable to financial services and telecommunications. Yet, surprisingly, as the information age has advanced and balance sheets have become less relevant as measures of true value, there has been relatively little change in the regulatory requirements for disclosure, including the contents of the financial statements that form the heart of our corporate disclosure system.
The growing gap between balance sheet and market values tells us that we will need something different in the future, as more and more companies earn their profits from intangible assets. Failure to properly value intangibles can result in distorted valuations, volatility and, perhaps, a bubble.
So what is to be done? First, the existing model for financial disclosure must be updated so that it does a better job of reflecting the value of the intangibles that are the core assets of the information economy. Investors will be best served if all assets—tangible and intangible—are measured and reported, even if the value of some intangibles can only be communicated through indicators. Such an indicator could consist of a company’s product returns, for example.
In addition, financial reporting must be forward-looking, describing not only historical cost, but providing as accurate a snapshot as possible of an organisation’s current operations and likely future prospects. In part, this can be done through business releasing non-financial data that can be analysed against the data of competitors and industry benchmarks.
To achieve these objectives, a number of prominent analysts and accounting theorists have suggested that companies supplement their current financial reports with databases, accessible through the internet. These would contain more finely grained components of the current asset, liability and expense categories than the information aggregated in conventional quarterly and annual reports. Other useful data elements would include indicators from which the status of such intangibles as customer loyalty and employee satisfaction might be derived. The number of times a customer makes purchases of a household item from a particular company is a clear example.
Work is already under way in many industries to settle on the precise definitions of various data elements that would be used for electronic data interchange. This work uses a new data processing language known as extensible markup language (XML) that permits the tagging of the multiplicity of data elements that are part of the movement of goods in a supply chain. The tags allow software applications of various kinds to dip into this pool of data and extract the information necessary for carrying on business transactions in a common language. When applied to financial information, it would permit more rapid and thorough analysis and benchmarking. Most important, it would permit assessments of company prospects to become user-driven, rather than issuer-driven. But a framework is clearly necessary to achieve this.
We need a reliable model encouraged by regulators but user and market-driven, and developed by analysts, corporate financial officers and the accounting profession.
As new approaches to disclosure take hold—such as the recent and unconventional release of customer acquisition costs by Amazon.com—the role of accountants will change. Instead of certifying financial statements, accountants may work on defining data elements and providing assurance for the reliability of company data disclosures. In addition, as US and international accounting standards converge, accountants may acquire responsibility for reporting on the reliability of indicators used to measure the intangible assets—such as that increasingly represent the core value of many companies.
The US economy continues to spawn innovative companies and new ideas. It would be ironic if the capital markets, which supply the necessary financing for innovation and change, were unable to benefit from the vast improvements in information use that the internet has made possible.