In recent decades, the global economy has undergone a rapid transformation, from an economy driven by “traditional hard assets- plants, warehouses and the like”, to an economy driven by patents, software, intellectual property, and brands. These items fall into a category that has become hugely important in the world of financial reporting, “intangible assets”. Increasingly, the value of a firm is derived not from its tangible assets such as stock, property, plant and equipment but by its knowledge capital, its employees, even by its business processes. As Baruch Lev notes in 2001:
“Pfizer’s value comes from its discovery activities (drug development, patents, ...view middle of the document...
Weaknesses in Financial Reporting
Before we can consider the weaknesses in the accounting system we must first understand the characteristics of intangible assets as well as the processes involved in their development.
The key word to consider when discussing intangible assets is innovation. In the new globalized economy, companies are in a state of constant change, they must continually innovate either to retain or gain competitive advantage. Intangible investments are the major driver of business change, creating new products, franchises and improved production processes. Firms initiate this change through investment in Research and Development (R&D). Firms invest in R&D for one of two reasons, either to develop a new product or service, or to improve their business process and retain their competitive position. The product of this investment in R&D generally comes in the form of intellectual capital. The main question from a financial reporting perspective thus becomes: how should this intellectual capital be measured and reported? The traditional accounting methodology fails to provide an adequate answer to this question as shall now be discussed.
Traditional accounting methodology relies primarily on transactions, or exchanges, with an outside party. It was developed at a time when a firm’s value was derived primarily from its tangible assets: its stock of property, plant and equipment, along with its stock of product and its profits. The traditional methodology aims to assign a conservative value to a firm as historically, the conservative estimate was generally considered to be the most reliable and useful. Up until the 1980’s this system worked well as tangible assets are characteristically widely traded and monetary measurement is relatively straightforward. However with the rise of the new economy, and as internally developed intangible assets became increasingly more valuable, the usefulness of traditional accounting methods began to decline. In their paper The Boundaries of Financial Reporting and How to Extend Them, Lev and Zarowin analyzed empirical evidence relating to the share price of a firm as compared to its accounting measures. They were able to conclude that “the usefulness of reported earnings, cash flows, and book (equity) values has been deteriorating over the years”. The decline in the usefulness of accounting is a result of the difficulties in measuring an internally developed intangible asset, firstly how does one assign a value to knowledge capital, secondly, what is the fair value of this capital if no exchange has taken place? In the interest of conservatism and reliability, regulators require all investments in R&D to be immediately expensed. This creates a problem since the benefits of this research are not realized until a later period, thus the concept of matching goes out the window. This increased expenditure resulting from R&D expenditure distorts earnings on the income...