Unseen Wealth: Report of the Brookings Task Force on Intangibles
136
Unseen Wealth: Report of the Brookings Task Force on Intangibles
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Overview
Product Details
| ISBN-13: | 9780815701132 |
|---|---|
| Publisher: | Rowman & Littlefield Publishers, Inc. |
| Publication date: | 05/01/2001 |
| Edition description: | New Edition |
| Pages: | 136 |
| Product dimensions: | 6.00(w) x 9.00(h) x 0.32(d) |
About the Author
Read an Excerpt
Unseen Wealth
By Margaret Blair and Steven M.H. Wallman
Brookings Institution Press
Copyright © 2001 The Brookings Institution.
All rights reserved.
ISBN: 0815701136
Chapter One
"Given that no company can establish a monopoly on brains, how do you keep the people that make it work? There are no tangible assets to divest. There is intellectual property and that's about it—and a building."
The U.S. economy, like the economies of most industrial countries, is increasingly one in which the "products" that firms provide are not simply physical goods but are services or experiences. Even the physical goods we buy are greatly enhanced in their value to us by the technology embedded in them or by the brand image they carry. Indeed, market services and intangible goods now account for more than two-thirds of gross domestic product (GDP) in the United States.
A critical difference between an economy that is based on the production, trade, and consumption of physical goods and an economy that involves extensive trade in services, experiences, technology, and ideas is that the former can be readily measured. It is extremely difficult to measure the volume of trade in the latter in any units other than the price paid for them. Likewise, it is difficult to quantify the investment and expenditure of resources required to produce intangible goods or to assess whether expenditures on the inputs into the production of intangibles are well spent. How does one measure the capacity of an economy to exchange services, experiences, technology, and ideas? How does one measure national wealth in this kind of an economy? How does one know whether the economy is growing or shrinking, whether productivity is increasing and how fast, whether one company is performing better than another, or whether our citizens are better off this year than they were last year? Perhaps most important, how do we know whether we are, individually or as a nation, making investments that will increase productivity and economic wealth in the years ahead?
Market services and intangible goods account for more than two-thirds of U.S. GDP. Some day-to-day examples:
financial or legal advice
insurance
education
nursing
child care
physical therapy
hotel stays
catering
Internet connections
telephone and cable
connections
air travel
extra memory or
computing power
anti-lock car brakes
the latest allergy
medications
reduced cholesterol
mayonnaise
vitamin-enriched cereals
high-performance fibers
in athletic wear
concerts
movies
sports events
restaurant meals, from
elegant cuisine to
"fast" food
sky diving
bungee jumping
cruises
Nike footwear
Coca-Cola
Rolex watches
Starbucks coffee
Tommy Hilfiger denim
pants
Ralph Lauren bed
linens
This report is about the vast uncertainty around such questions and its implications both for public policy and for the allocation of investment resources by the private sector. In particular, it focuses on the problem of providing accurate and useful information about the intangible inputs into such an economy—the ideas, special skills, organizational structures and capabilities, brand identities, mailing lists and data bases, and the networks of social, professional, and business relationships that make it possible for hundreds of millions of people to exchange services, experiences, technology, and ideas.
The Importance of Intangibles
Intangibles is a difficult term to define. One reason for the lack of consensus about a definition is that the elements of what could or should be regarded as intangibles depend on whether one is talking about accounting concepts or measures of national income and wealth or how to develop and manage the nonphysical inputs into a business. For purposes of this analysis, the task force adopted the following broad definition: intangibles are nonphysical factors that contribute to, or are used in, the production of goods or the provision of services or that are expected to generate future productive benefits to the individuals or firms that control their use.
Historically, intangibles have not been treated as part of national wealth, nor have they generally been accounted for as part of the assets of firms. In 1911 Irving Fisher defined economics as "the science of wealth" and defined wealth as "material objects owned by human beings." These definitions have formed the basis of the measurement conventions used in the national accounts. Similarly, business accounting was developed to keep track of transactions that enhance or diminish the assets of firms. Here again, the convention has been that only physical items or intangibles purchased in arms-length transactions (such as patents) should count as assets, whereas other inputs have to be counted as services and treated as transitory.
Yet intangibles are important in the production, marketing, and distribution of physical goods as well as the delivery of services. Intangibles are not the same as services, but they are linked, and the delivery of highly skilled services and professional services involves substantial inputs of intangibles. How important have intangibles become? This report grew out of the concern that data on the role of intangibles in the economy is seriously inadequate. But even the indirect evidence gives strong reason to believe that the economic importance of intangibles is growing rapidly.
Role of Services in the Economy
Services have increased steadily as a share of measured total output in the United States, from 22 percent of GDP in 1950 to about 39 percent in 1999. Intangibles such as skills and professional knowledge, organizational capabilities, reputational capital, mailing lists and other collections of data, are important factors in the provision of many services.
Value of Financial Claims
Although investments in intangibles such as R&D, brand name development, and software systems are generally not recorded as part of the book value of corporations (unless they were purchased externally), outside investors recognize their worth and tend to place high value on firms with high levels of these sorts of investments. In the past twenty years, there has been a rapid increase in the total value of financial claims and securities issued by the corporate sector (debt plus equity), despite low growth in tangibles; only a small part of this increase can be accounted for by purchases of physical capital or even by inflation in the value of existing physical capital. Economist Robert Hall has analyzed the rather large discrepancy that has developed in the past decade between the value assigned to firms by the financial markets and the value recorded on their books. He concludes that this empirical discrepancy can only be reconciled with financial theories about how stocks are valued if "corporations own substantial amounts of intangible capital not recorded in the sector's books or anywhere in government statistics." He has since named this unrecorded intangible capital "e-capital."
Hall's analysis is based on aggregate economic data for all nonfarm, nonfinancial corporations, but the same conclusion seems almost inescapable if one looks at the balance sheets of even a few individual firms. As of early August 2000, for example, the market value of Walt Disney Co. stock totaled around $83 billion, and the firm also had about $34 billion in outstanding liabilities, for a total market capitalization of $117 billion. But on the books the firm had only $43.7 billion in assets. This total included some $11.3 billion worth of recognized intangible assets. Apparently the financial markets thought that Disney had closer to $85 billion worth of intangibles—almost eight times the recognized book value of such assets. Similarly, Sprint Corp. had a total market capitalization of $60.2 billion in early August 2000, compared with $39 billion in book assets, which included $9.6 billion in recognized intangibles. Here again, the financial markets apparently thought that Sprint had nearly $31 billion worth of intangibles, more than three times what its balance sheet showed. The remarkable bull market in stocks—and especially the huge run up in technology and Internet stock prices—over the past decade cooled somewhat in the last few months of 2000, but not nearly enough to change the analysis. In fact, equity prices would have to fall by two-thirds or more, across the board, for the significant discrepancy between market value and book value to disappear.
Cross-sectional evidence on firms also suggests that some significant part of the discrepancy between market value and book value is due to investments in intangibles. The discrepancy is greatest in firms that are known to have been investing most heavily in certain kinds of intangible complements to computers. Erik Brynjolfsson and Shinkyu Yang, for example, find a strong correlation between the total value of computers in a corporation and the implicit value assigned to the intangibles in that corporation by the stock market. "It is not that the market values a dollar of computers at $10," Robert Hall observes about this finding. "Rather, the firm that has a dollar of computers typically has another $9 of related intangibles." Likewise, Timothy Bresnahan, Brynjolfsson, and Lorin Hitt find that firms that invest heavily in computer technology get the greatest boost in productivity if they invest simultaneously in human capital—upgrading the skills of their work force—and in organizational capital, specifically, by restructuring work to devolve decisionmaking authority downward and outward within the firm to rank and file employees.
Other studies have found that firms in key growth industries (the high-tech, life sciences, and business services sectors) tend to have high ratios of R&D spending to sales, and, in turn, firms with high levels of spending on R&D tend to have high ratios of market value to book value. Studies also show that the firms that make the greatest investments in the education and training of their work force have above average productivity and financial performance. Taken together, these findings suggest that stock prices, although they are an extremely noisy signal, probably have at least some validity as an indicator of the growing role of intangibles in the economy.
Anecdotal Evidence from Firms
Another indication that intangibles are among corporations' most important investments is the accumulating anecdotal evidence from firms themselves. The Conference Board, for example, has produced two major studies that reveal substantial corporate interest in developing new and better measures of performance that go beyond financial measures alone. The most recent study reports that companies are developing indicators to measure "activities and processes ... such as the development of intellectual capital, and improving customer satisfaction and retention as well as workplace practices.... In many cases, these 'intangibles' provide the best indicator of a company's potential for growth." It also cites evidence that institutional investors are interested in knowing more about these intangible investments. Interest in these issues has exploded in the past few years and months, and the major accounting and consulting firms are pouring resources into projects to help their clients develop better business models and better measures of performance.
Human capital investments have come to be seen by many corporate executives as a source of competitive advantage. This intuition is confirmed by research over the past ten to fifteen years demonstrating that investments in bundles of innovative work practices (sometimes called high-performance work systems) in areas such as training, job design, selection, staffing, employee involvement, labor-management cooperation, and incentive compensation positively impact firm performance. The reputation of the chief executive officer (CEO) has also been shown to be important to business success. In their advertising, companies are increasingly emphasizing their technical leadership, the speed and quality of their service, and the sophistication, commitment, and skills of their employees. Yet factual information about investments in intangible resources is conspicuously lacking from most companies' annual reports and 10-K filings.
Measurement Difficulties
One major reason why good, hard data on the importance of intangible assets in the economy are not available is that intangibles are inherently difficult to measure, quantify, and account for. Because one cannot see, or touch, or weigh intangibles, one cannot measure them directly but must instead rely on proxies, or indirect measures, to say something about their impact on some other variable that can be measured. Just as one cannot answer the question "How satisfied are the company's customers?" in the same one-dimensional way as one can answer "How many hamburgers did the company sell?" one cannot measure how much customer loyalty a firm's advertising campaign created in the same way as one can measure how much office space the firm added with its new building. To be sure, assigning value to many tangible assets may require considerable subjective judgment, but while valuing tangibles can be difficult, valuing intangibles is generally a much more complex proposition.
Accounting Rules
Accounting rules are designed to record what happens in specific transactions and thereby track the flows of assets into and out of a corporation. Under the accounting principles used in the United States and in most developed countries, for resources to be considered assets they must be well defined and distinct from other assets, the firm must have effective control over them, it must be possible to predict the future economic benefits from them, and it must be possible to determine whether their economic value has been impaired (for example, through depreciation or depletion) and to what extent. These criteria mean that the term assets is generally interpreted to mean property, plant, and equipment; financial assets; and purchased identifiable intangible assets, such as patents, trademarks, and mailing lists.
To be sure, accountants have long understood the need to recognize some assets that do not fit neatly into any of these categories. "Purchased goodwill" is one of the few additional categories recognized in the United States, however. When company A acquires company B, for example, A adds B's net assets (assets minus liabilities) to the net assets on its own balance sheet. If B has $500 million worth of property, plant, and equipment, financial, and other identifiable assets and zero liabilities on its books, those assets will be added to the books of A. But suppose that A has paid $750 million for B. How does it account for the additional $250 million that are not reflected in B's book value? If possible, A would first "write-up," or assign a higher value—based on appraisals—to, the acquired hard assets. Then it would assign a value to any specific intangibles that could be identified and valued. Finally, A would add the remaining amount (say $200 million) to its books as goodwill. Goodwill, rather than referring to specific assets, is just a catch-all residual category, a label given to the going concern value of assets in the target company over and above those that can be kicked, or counted, or weighed, or valued with some precision.
Other than purchased goodwill, accounting rules generally require that internal expenditures on such intangible assets as R&D, training, advertising, and promotion be "expensed," that is, treated as expenses in the period in which they are incurred and charged against current earnings. This implies that the inputs paid for by those expenses are used up in production in the period in which the expenses are incurred, and that such expenditures do not create any asset that will provide an input into future production.
Within the accounting profession, there has been growing debate over whether this treatment is appropriate, especially for R&D. A number of scholars have argued that expenditures on R&D should be treated as investments, just like expenditures on new plant or equipment. When a company spends money on a new warehouse, for example, the expenditures are not treated as expenses in the current period but are recorded as a reduction in cash assets and an addition to the plant and equipment assets of the firm. In each subsequent period, the company records a charge against current earnings to reflect the fact that some of the value of the asset has been used up or worn out. This accounting treatment is called "capitalizing" the expenditure, and the subsequent periodic charges against earnings are called "depreciation." Thus the debate over the accounting treatment of R&D is a question about whether R&D ought to be understood as a current cost of doing business, and therefore expensed, or it should be capitalized, on the theory that the expenditures are adding an asset to the firm.
Indeed, there is disagreement among prominent accounting standards bodies worldwide about how to record R&D expenditures. The International Accounting Standards Committee (IASC) requires that research be expensed, but development costs that meet certain criteria must be capitalized. In the United Kingdom, the Accounting Standards Board (ASB) requires expensing of research but permits development to be capitalized. And in Japan, the accounting profession permits capitalization of research, development, and a range of other internally generated intangibles. In the United States, however, the Financial Accounting Standards Board requires full expensing of R&D, except for the final development stages of potential software products.
If measuring, quantifying, and accounting for R&D assets is difficult, human capital poses even greater challenges. To be sure, the accounting treatment is well defined and not particularly controversial: wage and nonwage labor costs are expensed in the same accounting period as the labor services are performed, unless the costs are associated with the building of fixed assets or the manufacture of products that are added to asset inventories. In these cases, labor costs are expensed as the assets produced by the labor services are sold or depreciated.
To the extent that such costs are associated with ongoing operations, this makes sense. The costs of labor services are reported either in the same period as the services are provided or in the period in which the products generated by the services are sold or used up. But to the extent that some of the expenditures on labor (such as for training, team building, and reorganization) generate benefits in future periods, this accounting treatment produces a distortion. Because such expenditures never show up on the company's balance sheets as an asset, they are not managed in the same way as other assets, and the firm can only guess at the rate of return it gets on them. When a firm is acquired and the acquiring firm adds goodwill to its books, that goodwill may reflect the value of a skilled work force in the acquired company. Yet this is not transparent. Moreover, in future periods the acquiring firm must take a charge against its earnings for depreciation of the goodwill, even if it is simultaneously recording the expenses associated with investments in maintaining the asset through training or updating the know-how, competences, and skills of the workers.
A final reason why the traditional accounting model has not been very helpful in providing information about intangible assets to business managers is that accounting rules are designed to record and track discrete and sequential transactions and to show their cumulative effect. The value created by investments in intangibles is rarely tied to discrete transactions, however. Rather, it is often highly contextual and dependent on complementary investments in other intangibles. The value of a brand, for example, may depend on patent rights to some underlying technology as well as expenditures on advertising or other reputation-enhancing activities. Furthermore, the process of creating valuable intangible assets is not always linear or direct. A "failure" in an R&D program might lead to insights that interact with the findings from another program and end up creating value in unexpected ways. And value can be destroyed in similarly unexpected and indirect ways.
Other Measures
If accounting models do not generally produce good measures of intangibles, are there other measures that do? So far the answer appears to be maybe, for some assets, in some situations, and for some purposes.
For example, stock and bond prices provide a measure of the value that financial markets place on the financial claims (debt plus equity) of individual corporations. This value can be viewed as a claim on the aggregate value of the physical and financial assets of those corporations plus the value of the intangible assets, or the going concern value, in those corporations. Thus, as indicated above, one can look at the difference between the market value of the financial claims against a corporation and the value of its tangible assets and come up with a measure of the financial market's estimate of the value of that firm's intangible assets.
A few companies and creative financial institutions have also been attempting to "securitize" the income streams from bundles of intangible assets, especially intellectual property, by using financial instruments such as asset-backed securities (ABSs). These are debt securities for which the issuing companies have pledged the cash flow (often enhanced by third-party guarantees) from some collection of assets or some subset of the firm's business. ABSs backed by financial assets, such as receivables, have been issued for many years, but only in the past five or six years have firms and financial institutions put together a significant number of deals based on intellectual property. Implicit in the fact that the lending institutions are willing to buy the securities backed by these assets is the notion that it is possible to estimate the value of the pledged intangible assets.
These measures of securitized intangibles may be a useful indicator of how important intangibles have become in individual firms. And the aggregate difference between the value of financial claims and the value of tangible assets says something about their importance in the economy as a whole. But such measures have serious drawbacks for other purposes. The market prices of financial assets are notoriously volatile and noisy indicators of underlying value. They also provide only an aggregated measure and give no hint about the nature of the specific assets, resources, or other factors that produce that value, let alone the factors that might enhance or diminish that value. Hence financial asset prices, by themselves, are currently of limited use to managers for day-to-day decisions about investing in or using intangibles and preserving or enhancing their value.
Although the implicit information in ABS issues is, perhaps, useful at the level of individual firms, intellectual property ABSs have so far only been issued in private placements to financial institutions, and there is no public market in these instruments. Moreover, the details of such transactions are usually confidential. Thus, although such transactions suggest that certain intangible assets can be valued, the information on value that they yield is not shared as well as it might be with other investors or the market as a whole.
As noted in the previous chapter, however, there is empirical evidence that expenditures on certain kinds of intangibles development, especially R&D, are generally reflected in higher stock prices. This suggests that participants in financial markets are somehow gathering and interpreting information about intangibles, even if that information is not formally reported by companies in their public documents or otherwise widely shared with investors.
In attempting to get behind the aggregate story told by stock prices, a number of companies, organizations, and individuals have developed measures for internal use. These have been used to help measure and monitor nonfinancial performance and to show the linkages among the intangible factors that contribute to that performance, as well as the link between nonfinancial and financial performance. Some of these measures have gained a certain prominence and have apparently proved to be useful management tools in individual companies. None, however, is being used consistently by a large enough group of firms to provide useful cross-sectional or time-series data, or even reasonable benchmarks that one company could use to compare its performance with that of another. So far, at least, the information generated by these efforts is still ad hoc and situation specific. As the Strategic Organizational Issues subgroup of the task force concluded, "companies have no coherent, consistent or regular approaches to representing, managing, and valuing their intangibles.... Investment decisions in the area of intangibles seem more a matter of faith than fact."
Consequences of Poor Measurement
What harm, if any, comes from the fact that there is currently no way to quantify or, in many cases, even articulate and describe in clear comparable terms the factors that lead to better business performance? It is known, in general, that education and training are important in producing a skilled work force; that innovation is important; that market share is valuable; and that brands, reputation, and image are important factors in gaining market share. Does it matter that it seems hard to be more specific? It is the job, the creative act, if you will, of management to make resource allocation decisions and to engage employees, business partners, and other participants in value- creating activities. Does it matter that this creative process is still fundamentally quite mysterious?
The task force believes that not being able to identify and measure the intangible inputs into wealth creation creates substantial costs for society. Although many of these costs are unavoidable, this project has been motivated by the belief that one could know more than is known, and that because of the high costs of not knowing, it is worth expending resources to learn. Below, we briefly review some of the costs of not knowing.
National Accounts
In the United States, large amounts of data on the performance of the economy are collected and developed each year by the federal government (and the governments of other countries). Much of the data for the national accounts are developed by aggregating up from individual or firm-level data or projecting from survey data to produce measures such as GDP, corporate profits, personal savings, aggregate capital stock, productivity, and inflation. The national accounts are used in setting a variety of policies. In 1999 and 2000, for example, the Federal Reserve Board was concerned about the rapid growth rate of measured GDP, the low unemployment rate, and the high capital utilization rate, fearing that an overheated economy might lead to increased inflation. So the Fed increased interest rates in hopes of slowing down economic activity. Was this the right response, or was the U.S. economy now capable of higher sustained levels of economic growth without inflation?
In the early 1990s, many policymakers were concerned about projected deficits in the federal budget and took actions (in the form of tax increases and spending cuts) to reduce those deficits. But the U.S. economy performed far better in the 1990s than anyone might have hoped six or eight years earlier, and by 2000 the federal budget was producing substantial surpluses. Why were the forecasts so far off the mark? And today policymakers are concerned about the ability of the economy to provide for millions of retiring baby boomers in the near future. What kinds of investments are needed today to boost productivity ten, twenty, or thirty years down the road? These and other serious questions of public policy cry out for a better understanding of the role of intangible assets in the economy.
There is good reason to believe that the failure to account adequately for investments in intangibles results in the understatement of GDP, of corporate profits, and of personal savings because accounting systems that treat investments in intangibles as expenses thereby overstate the costs of producing current output. Leonard Nakamura has argued, for example, that if corporate expenditures on R&D had been capitalized instead of expensed, measured corporate profits would have been higher in recent years, and stock prices in 1999 relative to these adjusted profits would not have been seriously out of line with historic experience, nor seen as a matter of policy concern. Measured GDP would also have been higher if R&D had been capitalized. To the extent that expenditures on other kinds of intangibles (such as marketing, human resource development, and software development) were increasing as a share of GDP in the 1990s, the same argument would apply; measured profits and output would have been even higher, and price-earnings ratios would seem more reasonable by historic standards.
More generally, it seems likely that the failure to understand the role of intangible assets in the aggregate economy will lead repeatedly to misdiagnoses of economic problems and inappropriate policy responses.
Capital Markets
It is widely accepted that stock prices tend to incorporate some information about intangibles. However, a variety of disclosure problems stem from the lack of transparency of the information and the process by which investors learn about and act on this information. These problems likely increase the cost of capital and reduce the perceived fairness of the capital markets to individual investors.
The requirements for disclosure of key corporate financial information in the United States are among the most extensive and stringent in the world. Corporations are required to file detailed financial information with the Securities and Exchange Commission when they first register their securities for public trading, and they must provide a full and detailed update annually, condensed interim reports every quarter, and immediate updates in the case of extraordinary events. These extensive disclosure requirements are a central part of a corporate governance and financial system that, more than any other in the world, has encouraged small investors to invest in corporate equities. The result has been a powerful engine for turning personal savings into investments, investments into technical advances, and technical advances into economic growth. But the effectiveness of disclosure requirements at ensuring good corporate governance and performance is being eroded, because as intangibles become more important relative to tangible assets, this required disclosure reveals less about the real assets and sources of value inside a firm.
Baruch Lev argues, for example, that commonly used performance measures, such as return on equity or return on total assets, become much less useful in intangibles-intensive firms, because "major investments are missing from the denominator." Likewise, the human capital assets of firms—their reserve of skills, competencies, and knowhow and the resources being expended to renew and expand them—are beyond the spectrum of information that is typically available to investors. The lack of clear, quantifiable, and comparable information about intangibles-intensive companies tends to encourage selective disclosure of inside information to key investors, making it easier for people with inside information to gain at the expense of outsiders and small investors.
(Continues...)
Excerpted from Unseen Wealth by Margaret Blair and Steven M.H. Wallman. Copyright © 2001 by The Brookings Institution. Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.