This article was first published in the October 2011 China edition of Accounting and Business magazine.
A few pennies’ worth of aluminium, some red and white paint, assorted sweeteners, and 30 centilitres of carbonated water should not be worth more than a few pennies, maybe 25p on a hot day. So what is it that people are actually paying for every time they buy a can of Coca-Cola?
Clearly, there is much more than is physically present – a century of brand equity; a trademark; a secret formula; the unique organisation that sells and markets that syrup – but not much that would actually show up anywhere on Coca-Cola’s books unless the soft drink giant decided it wanted to sell its cola business to another company.
Nor is Coke unique. Today, scholars at The Conference Board have estimated that as much as 40% of the value of publicly traded US firms is intangible, in that sources of value don’t really show up on the books.
Old language, new economy
A number of critics argue that conventional accounting is inherently incapable of dealing with today’s economy. It was developed in the Middle Ages, they say, back when people dealt in physical things – like hides or salt or wine – rather than software, brand names or services.
On paper, for instance, the value of a major accounting firm might amount to not much more than desks and laptops, even if the value of the enterprise amounts to billions.
Such concerns might sound arcane, but Baruch Lev, a professor of accounting at New York University’s Stern School of Business, has outlined a number of problems lack of intangibles reporting can lead to, including systematic undervaluation of intangible-heavy companies, and unfair gains to research and development (R&D) officers, who can profit unfairly from their early knowledge of an idea’s true worth.
For nearly two decades now, accounting scholars and regulators have struggled to find ways to bring the language of accounting into this new age. But it hasn’t been easy.
The accounting standards boards have tried to add more reporting requirements for intangibles over the past decade, but most of them have been in mergers and acquisitions accounting, and aimed at breaking down the goodwill of an acquisition into more refined components subject to fair-value testing, not a single lump.
Ultimately, the difficulties are not so much technical – scholars have worked out various ways to value intangible assets – as conceptual, argues Roya Ghafele, an academic fellow at the Oxford Intellectual Property Research Centre of the University of Oxford and the director of OxFirst, an economic consultancy specialising in innovation. ‘We as a society have not come to grips yet with the economy in which we are operating,’ she says.
Many accountants aren’t very excited about helping governments identify a new taxable asset, according to Ghafele. At the same time, legislators aren’t keen on spending much political capital on an issue the public does not care about.
However, she argues that politicians are missing a beat. Being able to put more of that know-how on the books would actually be a great low-cost way for countries to encourage innovation, by making it easier for investors to understand a company’s true value.
One compromise many Western companies have made in recent years has been to disclose much more information about their research efforts – giving investors more insight into their research activities while avoiding the trap of trying to value property that’s not easily derived.
Asia’s special risks
Asian companies may still deal in more ‘real’ things than Western companies, but many are increasingly facing these problems too. China, South Korea and Japan now have three of the five largest patent portfolios in the world, with even more knowledge on the way: China alone has earmarked $1.5 trillion in its next five-year plan for R&D.
Some experts say that Chinese companies in particular face a serious catch-22. ‘People in Western companies have seen lots of examples where the government in China, particularly the local government, is not necessarily following international standards in enforcement of intellectual property (IP) rights,’ says Feng Gu, an assistant professor of accounting and law at the University at Buffalo School of Management in New York. Needless to say, copying with impunity is a major advantage.
On the other hand, Chinese companies know that developing their own IP is ultimately the only way the country can really compete with the developed world. ‘As time goes on, China has realised that it can’t just continue to be the factory for the world. It has to move up the value chain, and the only way to do that is to come up with its own technologies and innovation,’ says Feng.
This fairly lax view of IP rights may already be holding Chinese companies back. First, Feng says that it’s making Western suppliers skittish about making further investments. Second, unlike many listed companies in developed countries, which do detail to investors what they are spending the money on, Chinese companies tend to play their R&D cards very close to their chest. They will talk about the spending, Feng says, but not the specifics.
In boom times, veiled references to big brainwaves may be enough to entice investors. In 1720, during England’s South Sea Bubble, history’s first great stock bubble, some investors were even persuaded to buy shares in ‘an undertaking which shall in due time be revealed’. In less credulous eras, however, investors won’t give companies the benefit of the doubt.
Behind the lab door
Investors are right to be suspicious about the value of research, Feng warns. ‘There are many fundamental questions that need to be answered before we can really be sure that $1 of R&D investment is going to really become something,’ he says.
This is unfortunate because more research transparency is actually rewarded by investors. A number of studies have suggested that companies that are more transparent about their research programmes are better liked by investors, and their cost of capital tends to be lower. Stock price volatility is also lower, according to Feng.
Ultimately, self-interest seems likely to push China toward stronger enforcement of its IP laws. Indeed, as its patent portfolio grows, incentives to protect all that unreal estate will too. However, Feng is not optimistic that the issue will be addressed any time soon. ‘It is still dealing with far more basic issues than R&D disclosure. I guess it’s going to be awhile,’ he says.
Bennett Voyles, journalist