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Rande - Today on MoneyTalk a caller asked BB what he thought of this 11/20 Barron's cover article. What do you think of "The New Math"?

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The New Math

Why an accounting guru wants to shake up some basic tenets of his profession

By Jonathan R. Laing

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As an 18-year-old Israeli soldier, Baruch Lev was decorated for valor, for a successful bazooka attack against a heavily fortified Egyptian Army position in the 1956 Suez War. Now 62 and a New York University professor, he's trying to blow up another target: the conventions of modern accountancy, many of which he views as outmoded.

His crusade is the culmination of a long intellectual journey.

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These days, Lev's passions are focused on another game: the bedrock principles that have ruled accountancy since the 15th century, when Luca Pacioli, a Venetian monk and mathematician, developed the modern system of double-entry bookkeeping. Pacioli's achievement was monumental; his system has reigned for centuries.

Yet Lev argues that the New Economy has rendered many of its precepts obsolete both for managers trying to make informed business decisions and, more importantly, for investors attempting to determine companies' rational value. So far, Lev's crusade has largely been confined to a flurry of academic articles, submissions to obscure trade publications and occasional appearances before congressional committees and accounting rule-making bodies.

But Wall Street is beginning to take notice. Lehman's chief investment strategist, Jeffrey Applegate, for one, has met with Lev and professes to be impressed. "Brains have become far more important than bricks in the post-Industrial Economy and Lev is one of the few accountants around trying to come to grips with this sea change," Applegate observes.

In Lev's view, the intangible nature of the value being created today is largely beyond the ken of traditional accounting methods. These intangibles can be product or service innovations arising from research and development, brand enhancements that allow companies to sell products at higher prices than their competitors, or advantages conferred by smarter business models or technological edges.

This explosion in intangible spending in recent decades, whether on R&D, information technology, brand marketing or employee training and other human capital, is largely a byproduct of today's increasingly deregulated and hotly-competitive global economy. In this environment, companies must constantly cut costs, boost productivity and innovate just to survive. And that's why, between 1929 and 1990, intangibles grew to nearly 63% of U.S. total business investment, while brick-and-mortar tangible investment slid to around 31%, according to a celebrated study by George Washington University economist John W. Kendrick. At the start of that period, almost the reverse held true. The replacement of tangibles with what Lev calls "knowledge assets" has only intensified in the past decade.

Yet few of these intangibles are ever "capitalized" or put on balance sheets, even though they clearly meet the basic test of assets. Namely, they clearly generate future revenues and other benefits beyond the current financial reporting period.

The cost of new machinery, for example, goes straight to a company's balance sheet as an asset. That expense is amortized over a number of years as an annual depreciation charge, designed to roughly match the machinery's cost with the revenues it generates. Not so with intangibles. They get fully expensed in the year they're incurred.

These accounting incongruities result in all sorts of perversities, Lev asserts. Perhaps most important, many of the traditional accounting tools that investors use to value stocks have been rendered "misleading at best and perhaps deceiving," he avers.

Baruch Lev: "Traditional accounting systems don't capture much of what goes on."
Take, for example, that long-venerated stock-market gauge, share price to book value. Traditionalists claim that stocks remain wildly overvalued even after the market's recent downturn, because the S&P 500 still sells at some six times the book or liquidation value of its individual constituents. But Lev isn't so sure.

"Since the balance sheets of these companies ignore maybe 70%-90% of [their] true asset values because of the exclusion of intangibles, I'm convinced that the true book or net asset value of the index is a lot higher," he asserts. "I don't make stock market calls, but clearly the price-to-book metric no longer has the relevance it once did."

Indeed Lev, with the assistance of a former student, Marc Bothwell of Credit Suisse Asset Management, has developed a method of estimating the value of companies' intangible or "knowledge" capital that should be added to existing book value to give a truly "comprehensive" net asset number. The estimate takes into account a company's full stream of expected future earnings, culls out the contribution attributable to physical and financial assets from the balance sheet, and then discounts the remainder of the earnings to determine the present value of the company's intangibles.

The knowledge capital estimates that Lev and Bothwell came up with during their run last fall of some 90 leading companies ..... were absolutely huge. Microsoft, for example, boasted a number of $211 billion, while Intel, General Electric and Merck weighed in with $170 billion, $112 billion and $110 billion, respectively.

Many of these stocks had market price to book values that were off the charts. Microsoft as of September 30, 1999, sold at 28 times its book value, while Dell's market capitalization exceeded 46 times its net worth. But these ratios fell to 2 1/2 times book value or less after intangible/knowledge capital was added in. And many of them, like PepsiCo, Dell Computer and Time Warner, ended up trading at around one times book after the adjustment for knowledge earnings was made.

According to Lev, other mischief arises from the failure of traditional accounting to factor in intangibles. Managers get fatter pay packages and option awards than they perhaps deserve, because their performance is often measured against distorted measures of returns on assets and equity. The profits of their companies would be far less impressive if the assets and net worth of the enterprise were bulked up to reflect intangible assets, too.

And Lev remembers well President Clinton pillorying the pharmaceutical industry for "price gouging" back in 1993 when the Chief Executive was trying to push through his ill-fated health-care reform package. He pointed to the "unconscionable" 50%-60% returns on equity that the industry was showing at the time. Of course, that number was vastly inflated because the huge research and development charges the industry had incurred over the years had been expensed annually, rather than put on the balance sheet. Lev and others found that this resulted in overstatements on ROE of as much as 50% for many of the drug makers.

A central tenet of sound accounting is the matching of costs with the revenues they generate. Yet early-stage, highgrowth companies suffer mightily by being forced to expense intangibles annually and suffer frequently heavy losses years before any associated revenues are realized.

Lev recalls, by way of example, the hue and outcry raised when America Online in 1994 and 1995 tried to capitalize some of its customer acquisition costs, arguing that customers it was attracting through its promotion blitz of free software tended to become long-term subscribers. The company was accused of earnings manipulation and forced to take a one-time $385 million charge of customer acquisition costs. To Lev, the entire brouhaha is faintly amusing today, given the company's current profitability and $109 billion market cap.

Lev also remembers the heavy losses the cellular telephone companies experienced in the early 'Nineties during their takeoff phase. "Accounting rules forced them to immediately expense the $250-$500 commissions they paid the retailers for each cell phone they sold, even though the customers ended up staying with them for years," he explains.

As a consequence of this mismatch, earnings records become distorted. More mature companies can frequently show dazzling earnings growth because the revenues they generate are bereft of many of the intangible costs that should be allocated to current results but were expensed years earlier. The stocks of newer companies are frequently underpriced.

Under the current accounting system, companies contemplating an initial public offering or a subsequent stock issue will often cut R&D spending to make current earnings look better. And investors buying the shares are none the wiser.

A study by Lev and associates of over 300,000 stock trades by corporate insiders between 1985 and 1997 revealed that officers of R&D-intensive companies enjoyed gains in their shares three to four times as large as those garnered by executives making insider trades in companies without R&D programs, even after the trades were adjusted for risk.

Lev also contends that shortcomings in the accounting treatment of intangibles contribute to stock-market volatility. Investors increasingly lack the contextual information needed to make informed decisions. New bits of information, even of a trivial nature, therefore often have a disproportionate impact. "It's madness, for example, that Home Depot should lose 30% of its market value in one day as a result of missing its third-quarter earnings number by a few cents, but investors are operating in something of an accounting void these days," he grumbles.

That Pacioli's invention of double-entry accounting was a signal intellectual achievement is certainly confirmed by its centuries of use. The balance sheets it gave rise to showed with precision where a business stood at any point in time. Income statements developed later, essentially to show in detail how the net-worth line in the balance sheet changed during an accounting period. Cash-flow statements came yet later.

The Pacioli system registers legally based transactions -- the purchase or sale of goods, the payment of wages, the lending and borrowing of money, outlays for capital investments and the issuance of common stock. In other words, exchanges of tangibles. Subjectivity intrudes only when judgments are rendered as to the useful life of plant or equipment or the size, say, of a provision for shaky receivables.

But the New Economy has radically altered the stable business environment in which traditional accounting operated. Cutthroat competition and ceaseless innovation have radically compressed the life cycles of products and, indeed, entire industries. "Cycles that were once generational now seemingly have the life spans of fruit flies," Lev jokes.

"Transactions are no longer the basis for much of the value created and destroyed in today's economy, and therefore traditional accounting systems are at loss to capture much of what goes on," Lev argues. "When a drug passes a key clinical test, a software program is successfully beta-tested, great value is created without any transaction taking place. There's no accounting event because no money changes hands."

Likewise great value can be destroyed years before accounting systems register the change. Regional telephone service in the U.S. was deregulated in the late 'Eighties, and the Baby Bells underperformed the stock market over the next four to five years, as a result of the loss of their operating monopolies. Yet it wasn't until 1994 and 1995 that the companies finally bit the bullet and took some $28 billion in writedowns.

As a result, investors are putting less credence in balance-sheet values and reported earnings. Lev found in one study covering some 6,000 stocks that changes in earnings seem to influence only 5% or so of the annual returns (price change, plus dividend) of individual stocks. Fifteen years ago, the correlation was double that. Changes in cash flow and book values have similarly anemic impacts on stock prices these days. Far more robust is the link between changes in knowledge-based earnings -- for items like patent licensing fees -- and stock returns.

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Some intangibles also benefit from the "network effect." The larger the number of users in a network, the more valuable it becomes....

...In fact, tangible-rich companies like Intel, Microsoft, eBay and Cisco Systems have better than 70% dominance in their respective markets. The old Robber Barons could only dream of market shares this stupendous because of the limitations of physical assets. It's no accident the New Economy has made first-mover advantage, the network effect and winner-take-all markets part of the business lexicon.

Perhaps the most important intangibles of all are what Lev dubs "organizational assets" -- unique managerial and business structures. Here he would include such distinctive business models as Dell's build-to-customer-order concept and Wal-Mart's use of information technology to cut distribution costs and push inventory expenses back to suppliers.

These simple but transcendent breakthroughs fall under the radar screen of traditional accounting. "It's ludicrous, for example, that when Ford Motor buys a car dealership, the investment is recognized on its balance sheet, while Dell's Web-based distribution system, which accounts for over 40% of its sales, appears nowhere on its balance sheet," he acidly observes.

Then there's that most difficult-to- value intangible: sharp execution.....

GE..... boasts huge intangible capital, Lev says, even though many of its businesses are quite low-tech. Yet there's no executive in the U.S. better at executing simple strategies, such as insisting on being No. 1 or 2 in every market, utilizing Six Sigma techniques to cut cost and enhance quality or wringing lush service revenues from GE's mammoth installed base of equipment.

Lev concedes that valuing intangibles isn't easy. Accountants and executives prefer the certainty of immediate expensing of intangibles over the creation of a balance-sheet asset, subject to differences of opinion over value. Immediate expensing also avoids the embarrassment of a future asset writedown. Mistakes can be buried.

And property rights to such assets are often hazy, even when covered by pa tents. Infringement suits have proliferated, and intellectual-property theft abounds, especially in Asia. Besides, smart new business paradigms can be copied by competitors.

And while the financial benefits that accrue to knowledge capital are incontestably huge, so are the risks. Little was salvaged, for example, after billions of dollars were sunk into the ill-fated Iridium satellite telephone system.

But how can accounting be changed to give proper weight to intangibles? For one thing, Lev would reverse Generally Accepted Accounting Principles mandating the immediate expensing of all R&D, customer acquisition costs and brand-promotion expenses. These items would mostly go on the asset side of the balance sheet on a total incurred cost basis. They'd then burn off or be amortized as the future revenues they create are realized.

In Lev's view, GAAP accounting most distorts when companies using the "purchase method" in making acquisitions are required to estimate the fair value of the development-stage R&D that's being purchased and immediately write off the entire amount. Such in-process R&D charges can be huge. Cisco expensed 77% or $1.36 billion of the $1.77 billion in purchase accounting acquisitions between 1997 and 1999. This massive expensing of in-process R&D acquisition costs artificially inflates future profits, because revenues derived from those acquisitions won't be burdened by amortization of the acquisition costs, according to Lev. His solution: place in-process R&D on the balance sheet.

Current accounting standards call for software development costs to go onto the balance sheet once products achieve a certain technological feasibility. But that provision is ignored by major forces in the industry, including Microsoft and Oracle. They continue to immediately expense. Lev wouldn't only capitalize all post-feasibility stage expenses. He'd go back and reverse the costs incurred at earlier stages of development and likewise add them to the balance sheet. "Sure, tech-heavy companies would constantly have to be restating their historic earnings, but so what?" he says. "The U.S. government makes multiple revisions of GDP numbers as new information comes in. This would be a small price to pay for eliminating the mismatch of costs to future revenues."

Massive restructuring charges have become a staple of the current corporate scene. Lev, however, would only permit companies to immediately expense real losses, such as asset writedowns from discontinued operations.

Lev has developed a scorecard that helps companies and investors quantify, to a degree, even the most intangible assets.

Among other things, he feels, companies should break down the exact dollar amount of their investments in research, information technology, corporate alliances and joint ventures. "Corporations have become externalized in their operations -- with Merck, for example, having more than 100 R&D alliances and joint ventures -- and yet most companies report very little about these activities," he observes.

Likewise, the success of companies' intangible investments can be gauged by such measures as the number of patents won, external citation of those patents, cross-licensing and royalty income from the patents, revenues from alliances and joint ventures, new-product pipelines and data showing the percentage of sales generated by products of different vintages.

Perhaps most interesting was the attempt by Lev and his associate Marc Bothwell to actually estimate total knowledge capital at some 90 leading U.S. companies. The computations were done about a year ago. The list was published in CFO Magazine early this year.

"If I can estimate a company's future cash flow, then I can come up with an asset value by simply discounting that cash flow to present value," Lev says.

To do this, the two first tried to separate knowledge earnings from those generated by tangible (inventory, plant and equipment) or financial assets. They computed the "normalized" current earnings of each company, factoring out special gains and losses. They then culled out the portion of those earnings attributable to balance-sheet assets by assuming an after-tax expected return on tangible assets and financial assets of 7% and 4.5%, respectively. They ascribed remaining earnings to intangibles....

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... The explosion in intangible assets has changed the face of investing -- and humbled some value investors -- by diminishing the importance of old stock-market valuation tools like price-to-earnings and price-to-book ratios.

Most of the value in the New Economy was created off traditional accounting's radar screen. Capitalism has evolved mightily during its journey from the counting houses of Pacioli's 15th-century Venice to the high-tech companies of the 21st century's Silicon Valley. And Baruch is hopeful that accountancy will someday make the same trip.

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Such a long article - hope I didn't cut out anything important. I like Lev's "New Math" because it gives a way to evaluate biotech and internet companies that have no real earnings.....Jen

-- posted by JenL_2