The big Accounting Crisis

A new study shows that key financial figures are increasingly failing to reflect new business models.
This is a serious problem for investors – if they do not use alternative information.

The core thesis of Baruch Lev has it all. “The reported earnings of most firms no longer reflect enterprise performance,” writes the professor of accounting at the renowned Stern School of Business in New York. The reason why financial ratios no longer reflect the actual development of companies is also provided in his paper “The deteriorating usefulness of financial report information and how to reverse it“: Current standard setters would fail to adapt the rules to the fundamental shift in value creation from tangible to intangible assets.

Lev backs up his thesis with this graph, which shows how the relevance of accounting has declined in recent decades. In the 1960s, it was three times as high – measured by the measurable correlation between the profits and book values of companies and their stock market value – as it has been since 2000. As the graph shows, expenditure on marketing on the one hand and research and development on the other increased in parallel. Today, they are on average around 25 percent higher than in the 1960s.

Baruch Lev concludes that intangible assets such as brands and patents are becoming increasingly important and that traditional accounting does not adequately reflect this shift. If you switch from theory to practice, it becomes clear what he means: Apple, Microsoft, Netflix, Facebook and Co. have been creating huge added value for shareholders for years. However, their value creation is not based on land, machines and other tangible assets as it used to be. They make so much money thanks to elusive assets such as brand strength, innovation and network effects – Intellectual Property (IP).

However, these values do not appear on the book according to the rules of classical accounting. As long as these things hardly appear on the balance sheet, however, the book values of companies will become optically more and more expensive – a dilemma for many value investors, who have largely lagged behind the market over the past 12 years.

Because companies cannot capitalize self-created brands and patents as assets, their book values are distorted downwards. At the same time, companies with strong IP also show lower profits than companies with weak IP. This is because marketing and research and development expenditures must be immediately included in the expenditure item, while the investment in a new factory can be spread over depreciation. As a solution, Baruch Lev proposes a much more liberal practice for the capitalization of intangible assets. Trademarks and inventions created in-house should be capitalizable if they are protected by the appropriate intellectual property rights.

Until then, investors can take advantage of the information inefficiencies resulting from traditional accounting: Those who adjust book values and profits accordingly now will probably get a more accurate picture of companies in IP-relevant industries and make better decisions – even if the book value looks expensive in visual terms. Nothing else is our approach to Quant IP. By quantifying innovation using patent data, we come closer to the truth and thus create added value for investors.

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