By Christopher Farrell America's capital markets are amazing things. Think about it: Masses of investors and lenders in the stock and bond markets exchange all kinds of rumor, gossip, data, information, and analysis, and transform this raw material into judgment and knowledge, all reflected through price changes.
Everybody in the game is out to make as much money as possible and, in the process, allocate scarce economic resources as they seek out the best new ideas for turning a profit. These ideas bubble up from university labs and multinational corporations. Meanwhile, money flows away from failed management strategies and decaying industries.
Of course, people can get carried away. The market goes through periodic waves of excessive enthusiasm (remember when Computer Literacy changed its name to fatbrain.com -- and its stock soared by 30%?) and bouts of depression (most investors treated stocks as if they were toxic waste even as a bull market started in 1982). Still, the extremely decentralized American capital markets are unparalleled at systematically distributing funds toward profitable activities and innovative ideas over time.
PUNISHMENT. Sound accounting standards are critical to keeping capital markets efficient. Investors rely on a common set of financial and business measures to scrutinize and compare investment prospects among the thousands of publicly traded companies. That's why former U.S. Treasury Secretary Lawrence Summers calls the development of Generally Accepted Accounting Principles (GAAP) in the 20th century one of the most important innovations in the history of the capital markets.
And that's why investors are punishing any company with opaque, questionable accounting reports in the wake of the Enron debacle. The crisis of investor confidence extends far beyond the onetime energy giant. Tyco, Quest, WorldCom, Cisco, Krispy Kreme, and other companies have paid a price after being suspected of indulging in overly aggressive accounting maneuvers.
A little history puts the problem in perspective. From 1981 to 1990, write-offs averaged only 4% of operating earnings, compared to 10.3% from 1991 through 2000 and an astonishing 40% in 2001, according to financial economist Peter L. Bernstein, an adviser to many endowment funds.
REFORM PROPOSALS. Even casual readers of business news know that changes are coming in accounting practices in the wake of Enron. Among the reform proposals gaining a receptive hearing on Capitol Hill is a requirement that accounting firms divest their consulting operations. Regulators like the Securities & Exchange Commission are lobbying for steep penalties for executives who deliberately mislead investors (see BW Cover Story, 3/25/02, "The Reluctant Reformer").
The nation's accounting predicament goes well beyond financial finagling and obscure reporting, however. Current accounting standards are not well suited to helping investors make savvy financial decisions -- and allocate investment money -- in the New Economy.
Wall Street veterans often cringe at the phrase, "this time is different," having seen so many economic cycles come and go. But I think there really are fundamental changes this time around. Corporate value increasingly rests on exploiting and generating information, ideas, and innovation while existing accounting measures reflect a world where physical plants, equipment, and other hard assets matter most.
ENORMOUS RETURNS. "When the assets of major companies are their ability to innovate, the morale and skills of their employees, the loyalty of their customers, and the temporary efficacy or popularity of their intellectual products, financial statements prepared in the customary manner cease to have much meaning or relevance," say scholars Robert Litan of the Brookings Institution and Peter Wallison of the American Enterprise Institute in their book The GAAP Gap: Corporate Disclosure in the Internet Age. "That will change only when new measures of these intangible assets are made and routinely disclosed."
The slim volume, published two years ago, is a timely read for anyone concerned about the existing state of accounting. (A PDF version is available at www.aei.brookings.org.) Take the role of knowledge in the New Economy. A small investment in an idea can return enormous sums of money, while a huge investment in an innovative concept can fizzle disastrously. But current financial-accounting standards largely depend on cost as a key index of value.
Put more broadly, intangible assets like innovation, employee education, customer loyalty, trademarks, software, strategic alliances, and research and development that generate much of the stock market value of American companies today are barely measured by the accounting system. Litan and Wallison note that Wall Street analysts often ask management for information far away from financial statements during investor conference calls.
BEYOND THE NUMBERS. For instance, during an Exxon/Mobil quizzing, analysts asked management 40 questions, and only six concerned the financial statement. The others were stabs at better understanding the business, such as "Of the employees expected to leave as a result of the merger, how many actually left?" and "Can you be more specific about the capital expense numbers for 2000-2001?"
Several organizations, such as the Organization for Economic Cooperation & Development, are trying to bring accounting into the 21st century. All the major accounting firms have published position papers on devising better quantitative, relevant measures in the modern economy. They argue that many accounting documents are relics released to the public with a lag, often of several months. Imagine -- companies are only now releasing their 2001 annual reports.
It won't be easy coming up with reliable, standardized yardsticks that will allow investors to delve deeper into today's corporate microeconomics. But in the meantime, management could deliver more information to investors on a real-time basis over the Internet.
NET INNOVATIONS. Today, most managers run their business with a constant flow of raw data. Why not release more of that information and let savvy investors devise their own measures of value while the accountants hold countless New Economy conferences? The Internet is a decentralized system that allows for ideas to bubble up faster than ever before. There's no shortage of individual and professional investors who would tear through a company's untreated data to gain a clearer understanding of its earnings prospects.
Technological advances will aid the process. Right now, corporate documents released over the Net are of limited value since the numbers can't be manipulated to gain a measure of qualitative value. But a Web-based format known as extensible markup language (XML) would allow Internet users to dip into published company data and manipulate the raw material any way they wish. "Once the necessary financial data are freed from the rigid confines of GAAP financial statements and large amounts of nonfinancial data are also made available over the Internet, anyone with a model can access the data and test ideas about the value of companies," say Litan and Wallison.
The impact would be revolutionary. Sure, the history of accounting is one of a long, bitter struggle between management's desire for secrecy and the markets' desire for more openness. But the long-term trend has been toward more disclosure. The reason is simple: Good information lowers the cost of corporate capital. And bringing honest bookkeeping into the 21st century economy would allow for the more efficient allocation of capital and a healthier, more innovative economy. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online