Look please at the Figure above, produced by two highly respected economists, Carol Corrado and Charles Hulten. The Figure traces the total U.S. private-sector investment in intangible assets (R&D, patents, brands, IT, business processes) by the top curve, and the investment in tangible assets (buildings, plant, machinery, inventories) by the bottom curve. The constant rise of intangibles and fall of tangibles isn’t a great surprise, however. Everybody knows that corporate value is created these days by smart people, armed with the best technology, developing new products and services, differentiated (branded) from competitors. Plants and machines, things that make noise when they fall, hardly create value any more. They are just commodities, available to all your competitors.
So, the tangibles/intangibles pattern isn’t surprising. What is surprising, or depressing, is that accounting regulators (GAAP) consider internally-generated intangibles as regular expenses, like salaries or interest expenses, whereas tangibles are considered assets. So, corporate balance sheets proudly exhibit industrial age buildings, machines, and inventory, while blockbuster patents or leading brands are MIA on the balance sheet. So, if you look one last time at the Figure, you will realize that reality (corporate performance and growth potential) is on the rise along the top curve, while the relevance of accounting and financial information goes down with the bottom curve.
If you think that all this doesn’t adversely affect your investment decisions, think again. The accounting mistreatment of intangibles and the inherent bias in the rules (internally-generated intangibles are expensed, while acquired intangibles are capitalized) will make you think that companies heavily investing in intangibles (telecom and internet companies building their customer franchise, or biotech companies heavily investing in R&D) are perennial losers. Companies cutting intangible investment will report earnings increases. Pfizer, for example, cut its R&D by 23% during 2011-2013. More subtly, accounting rules preclude a meaningful comparison between companies with different innovation strategies. Boeing develops internally most of its strategic assets, whereas competitor Lockheed Martin primarily acquires such assets. Accounting rules makes Boeing’s ROA seem substantially lower than Lockheed Martin’s. But this is just an accounting artifact, not reality.
How to overcome such impact of bad accounting on your investments? In my recent book with Feng Gu, The End of Accounting and the Path Forward for Investors and Managers (Wiley, 2016), we direct you with multiple real-life examples, to conduct a meaningful strategic analysis of the company’s real value creators, rather than relying on deficient financial report information. You can liberate yourself of GAAP deficiencies. Yes, Virginia, there is hope.
Please leave any comments below.