Since the 1990s, capital investment has shifted from a greater reliance on physical capital to human or knowledge capital. According to SMU Cox School of Business accounting professor Sean Wang, physical capital, including labor and machines, has declined and shifted to human or organizational capital, known in accounting terms as “intangible” assets. Measuring these intangible assets to reflect economic truth has created a conundrum for the accounting profession and those needing to analyze financial statements for the Apples, Netflixes and Googles of the world. In his paper “Acquisition Prices and the Measurement of Intangible Capital,” Wang and his co-authors — Michael Ewans, professor of finance and entrepreneurship at California Institute of Technology, and Ryan H. Peters, assistant professor of finance at Tulane University — develop a way to measure intangible assets that has been lacking for decades.
The accounting rules governing intangibles were established in 1974 when manufacturing was the main driver of economic value. These rules mandate that intangible expenditures immediately go to the income statement as periodic expenses and therefore never show up on the balance sheet. “Thus, in today’s economy, if you try to value a firm, like an Apple, Microsoft or Google, based on their reported accounting statements, much of their assets will be missing, specifically those related to intangibles —human capital, brand equity and R&D,” Wang says. “A manufacturing company, because it consists primarily of physical capital like plant property and equipment, may have a balance sheet that reflects its economic truth well, but for a high-tech firm it’s not nearly as good.”
There has been a “seismic shift” in what drives the value of the economy. Among the largest firms in the U.S. are the FAANG stocks, which stand for Facebook, Apple, Amazon, Netflix and Google. They don’t have plants, property and equipment to speak of. “Their balance sheets have virtually nothing and they’re worth hundreds of billions of dollars,” Wang says. “It’s the intangibles missing from the balance sheet that are largely responsible for this gap.”
Finding the Hidden Value
The authors of the paper developed a method to rebuild the balance sheet to include what’s missing. Wang says other studies have attempted this but lacked one key factor: the market price of an intangible. “We need a clear way to measure what’s on the balance sheet,” he says. “Everyone knows it’s a problem, but no one has a justified way of measuring intangibles so we can bring them back to the balance sheets.”
In the research, Wang and his co-authors use market prices of intangibles, as they are appraised during an acquisition.The SEC and GAAP (Generally Accepted Accounting Principles) require an acquiring firm to allocate the price paid for the target firm’s assets across three major categories: physical assets, identifiable intangible assets (IIA) and goodwill. The authors use an acquisition sample that spans the years 1996 to 2017 and comprises a substantial fraction of U.S. publicly traded acquirer-target pairs. The authors then hand-collect IIA and goodwill from the purchase price allocation of more than 1,500 acquisition events. They analyze the relationship between IIA and goodwill to prior investments into knowledge and organizational capital and develop a set of parameters used to recreate the missing intangibles in any publicly traded firm. In a series of validation tests, their measures outperform existing assumptions.
“Essentially, we use intangible prices from acquisitions to create parameters that allow us to re-capitalize any firm’s intangibles missing from the balance sheet,” Wang says. “We show in a variety of settings that our measures work better than the most recent ones being used.” The authors’ measures allow practitioners to make better decisions and value companies more appropriately.
In a growing knowledge economy, the implications of intangibles missing from the balance sheet are extremely significant. They will become more important in the future for understanding what drives economic value. In 2013, the U.S. finally began accounting for missing R&D spending as investment, which underestimated gross domestic product, but this classification (of R&D as investment) has still not occurred on accounting balance sheets. The bias in these balance sheets can create issues in evaluating a firm.
On the campaign trail, for example, one presidential candidate called out the FAANGs as making too much money or having outsize market power. Part of this perception stems from the lack of intangible assets on their balance sheets, which inflates certain measures of profitability. “At the end of the day, if policy decisions are even partially dependent upon measures created by accounting statements, the books should reflect intangible investment as accurately as possible such that we can most-effectively evaluate their profitability and make optimal decisions for the country,” Wang says.
By using Wang’s and his co-authors’ new measures, current business trends and activities will better reflect today’s economic truth — making the intangible tangible.
“Acquisition Prices and the Measurement of Intangible Capital” is authored by Sean Wang, assistant professor of accounting at SMU Cox School of Business; Michael Ewans, professor of finance and entrepreneurship at California Institute of Technology; and Ryan H. Peters, assistant professor of finance at Tulane University.
Written by Jennifer Warren.