Accounting – Frozen in the Industrial Past

Robert McGarvey
February 2, 2021

Unlike conventional accounting, Rethinking Capital’s normative accounting treatment starts with the principle that a company’s financial statements should represent - as closely as possible - its commercial reality. 

In practice this means that all the assets and liabilities, including the newer Information Age intangible assets and the organisation’s environmental liabilities should be identified properly and represented formally in the company’s financial statements.

The reason this sensible position is not followed today lies in the profession’s focus on ‘business as usual’, relying on tried and trusted practice.

Of course, there are many good reasons for this, but this constrains the accounting profession in the face of the asset revolution now underway.

We need new operating rules for the Intangible Economy – and we need them now.  Business decision making, investment analysis, accounting and other professions are all too often frozen in the industrial past, relying on out of date practices with frequently devastating impact.

They routinely under-estimate financial performance by leaving un-capitalised most of the key corporate value drivers and more importantly, disguise-through-absence, vital areas of corporate risk. 

In Cass and Airmic Business School’s seminal risk-management study Roads to Ruin, the authors identified several areas of systemic weakness that contribute to the misidentification and mismanagement of risk.

These weaknesses all too often originate from inadequate reporting. A lack of reliable information leads to a chronic inability of boards to hold senior executives accountable. In addition, a lack of adequate reporting, including a failure to include risks to reputation and a ‘licence to operate’, disguises potentially catastrophic risks.

So, how would Rethinking Capital’s normative financial statements help? Clearly, given that value resides in a company’s assets, formal reporting of these key sources of value and risk would be a logical place to start.

For example, consider THE classic M&A failure, the 2001 merger between AOL and Time-Warner.  

At the time of the merger AOL was a new economy star, a dial-up internet sensation with an astonishing market capitalisation of $164 billion (Time-Warner’s market capitalisation at the time was $83 billion). 

Few of Time-Warner’s senior managers or board members bothered to question AOL’s valuation, and given that AOL’s balance sheet did NOT include key intangible assets, most advisers simply accepted Wall Street’s numbers as reliable.

However, a normative balance sheet inclusive of all of AOL’s intangible assets, would have revealed that the company was not ‘asset light’ as described in the press at the time.

AOL was, in fact, underpinned by a variety of intangible assets, principally its intangible brand and customer equity assets. AOL’s attractiveness to its subscribers was predicated on its positioning as a leading dial-up internet service provider. In other words, intangibles were the key to the company’s impressive advertising revenues, which were in turn dependent upon its customers continuing to use dial-up internet services.

A normative balance sheet would have identified these intangible assets on AOL’s balance sheet. Being present these assets would then have been given a thorough examination. It would have been obvious that the broad-band revolution that was emerging at the time would undermine AOL’s business model, seriously impairing its intangible assets, earnings potential and market valuation. 

Normative treatment, in other words, could have prevented what happened next: the historically unprecedented collapse of AOL-Time Warner’s share price and market capitalisation. Investors lost hundreds of billions of dollars from inadequate reporting and the subsequent lack of informed due diligence.

The 21st century is experiencing an economic revolution on a scale not seen since the Industrial Revolution. Today’s economy is dominated by intangible assets like AOL’s brand assets, but also other intangibles like software, AI algorithms, big data and networks-of-value. 

The transition from industrial to post-industrial has occurred so rapidly that it has simply overwhelmed the accounting industry’s ability to react; the result is balance sheets with limited relevance. 

Identifying and formalising the reporting of all tangible and intangibles assets (and liabilities) would help management and boards of directors ‘do their job’, which is to protect and optimise the assets under their management. 

They would build on current non-financial reporting initiatives, impacting decision making by broadening the scope of financial information as well as reporting.

Most importantly, normative financial statements would provide clearer and more accurate reporting. This would simplify management’s role while clarifying risk management priorities, and investor lines-of-sight, substantially.

Robert McGarvey

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