Problem with Conventional Accounting

Discussion

ECSA:

"So here’s the problem in conventional accounting.

In financial economics, there is a sentiment (and it should be framed no more strongly than that) that companies have a ‘fundamental value’. Somehow, markets will gravitate to an equilibrium that is not just in balance, but that reflects production costs plus a competitive profit. Of course this sentiment is qualified in all sorts of ways: markets aren’t competitive, information is in constant change, etc. But the ontological premise is that there is gravitation to a fundamental value. This is the efficient markets hypothesis.

It was a prevalent notion up to the 1980s, perhaps reaching its zenith in the leveraged, private equity buyouts of the 1980s, which were based on the calculation that a company was worth more when broken up and its ‘parts’ sold than as a going concern. That proposition required a technique to value corporate assets and work out that they were undervalued. That’s fundamentals analysis at work.

Since the 1980s, it has become increasingly difficult to determine the value of companies, including the world’s giant corporations. This is not about a rise of ‘speculation’: if anything, that is the consequence, not the cause. It is about a change in capital accumulation and the rise to prominence of ‘intangible capital’. It is about the entrance of immaterial elements into production and the troubling consequences it has to the old industrial mediations (Virtanen, 2006).

Changed nature of fundamental value

Intangible capital is the investments that produce innovative and untouchable products based on immaterial labour and capital such as knowledge, firm-specific skills, and ‘better ways of doing business’, organizational capabilities etc. (Barnes and McClure, 2009 and Young, 1998).

This sort of capital is not new, but for a century it could be treated as an exception and as an accounting residual, most prominently sitting under the category of ‘goodwill’ (the inexplicable part of why companies may be priced above their technical value). If we go back to the 1929 stock market crash, and the great depression that followed, we find the conditions for a previous new era of valuation. The seminal work here was Graham and Dodd’s Security Analysis, first published in 1934. Benjamin Graham, later called the ‘Dean of Wall Street’ was the teacher/mentor of Warren Buffett. Buffet is an avowed advocate for this style of analysis.

Graham and Dodd sought to develop techniques that the everyday investor could use to put a value on a company and inform their decision to buy/hold/sell shares. They focused on things like the asset type, earnings, dividends, and definite prospects as distinct from (potentially fanciful) market quotations. They didn’t have any truck with day-to-day changes in share prices – what we would call noise or speculative investing; they were concerned with ‘intrinsic value’ of what is often called ‘fundamental value’ or simply ‘the fundamentals’.

It is important that we do not caricature their approach as a mechanical ‘reading off’ of capital value from technical data. They knew the future, which financially impacts on valuation in the present, is unknowable. Their view was not therefore rejecting the role of book value (1940: 585): “We do not think, therefore, that any rules may reasonably be laid down on the subject of book value in relation to market price, except the strong recommendation already made that the purchaser know what he is doing on this score and be satisfied in his own mind that he is acting sensibly.”

In the era of Graham and Dodd, intangibles didn’t appear as part of the calculation of intrinsic value. They were minor and could be ignored. Now they can’t be. As the Table shows, the assets of the world’s largest companies are predominantly intangible.

Companies by Total Intangible Value by 2017 (Global Intangible Finance Tracker, p. 42, June 2017)

When intangible capital changes from being a residual to the predominant form of capital, there is a measurement crisis. Accountants now struggle with putting a value on companies like Google and Facebook: how can the value of their assets be measured when its hard to say exactly what its major assets are? They are intellectual property, information, reputation, brand, goodwill, people’s attention etc. Pricing these is not like pricing a machine in a mid 20th century factory where you know it will run to expiry, and be replaced by something similar. Those can be valued, but this nebulous current stuff can’t.

From ROE to ROI to RCE to what is calculated as a design question

From the 1980s ROE (return on equity) replaced ROI (return on investment) as the performance calculation of companies after the 1980s (Levy, 2014). The effect was that prospective future income streams enter into measurement of ‘value’. For intangible assets, this meant that accountants did not have to give them an explanation; they just needed to estimate an expected future revenue stream on intangibles and discount it to a present value.

The traditional (accounting) valuation methods for ‘high-tech’ companies have been debated, especially after the dot.com boom period (1995-2000). With virtual platforms backed by intangible capital, metrics like price to earnings ratio (P/E), price to earnings to growth ratio (PEG), and enterprise value to earnings before interest and taxes ratio (EV/EBIT) became obsolete. Indeed they were blamed for so-called ‘irrational exuberance’ that was the dot-com bubble.

Alternative measures have started to emerge, though none can be said to have universal legitimacy. Milano et al (2016: 48) contend that investors are looking for an optimal balance of both growth and profitability captured in a measure that is called ‘residual cash earnings’ (RCE): “For students of finance and accounting, this finding makes perfect sense since RCE is a cash-flow-based variant of ‘residual income’, which is viewed by many finance scholars as the single-period, or ‘flow’, measure of corporate operating performance that ties most directly to ‘stock’ measures of corporate value, such as net present value (NPV) and discounted cash flow (DCF), that are supposed to be reflected in stock prices.”

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