GAAP is so Web 0.0

Gordon Gekko

I’m continually surprised at how much interest exists for the quarterly financial results of the online tech powerhouses such as Google, Microsoft and Yahoo!, as if they’re any indication of value created by the business during those three months. It’s fairly clear to me that AOL and Yahoo! are managing while spending an awful lot of time looking through the rear-view mirror of financial results at the moment, and that’s not a good sign for their businesses or their shareholders. Even promising tech lightweights such as LinkedIn and Slide are being mentioned in the same sentence as IPO. Thank goodness the slowdown in the US economy has put a damper on those dangerous plans. Managing a tech business according to the quarterly financial-result demands of public equity markets is a recipe for failure.

Peter Drucker first asserted in his 1969 book The Age of Discontinuity that we are transitioning to a knowledge economy, in which businesses invest proportionally larger amounts into intangible assets than into physical production factors, the opposite of which was true in the industrialised or production economy.

The elephant in the room that no one wants to talk about in financial circles is that the widely adopted and deeply entrenched traditional financial reporting frameworks, including national flavours of Generally Accepted Accounting Practice (GAAP) or the International Financial Reporting Standards (IFRS), are currently incapable of accurately measuring the knowledge assets at the heart of the knowledge economy. Beverley Brennan, chairperson of the Canadian Institute of Chartered Accountants at the time, said as far back as 1999 that intellectual capital is relatively more important in a knowledge-based economy and that a failure to account for intellectual capital adequately may lead to the misstatement of operating results (among others).

According to John Kendrick, a US economist, the ratio of intangible to tangible business capital was 30:70 in 1929, but that by 1990 it was 63:37, a complete reversal. In a separate study, Professor Baruch Lev of New York University’s Leonard N Stern School of Business found that the market value (MV) to net asset value (NAV) of the non-tech S&P500 companies was greater than six by the end of 2000. Stated differently, traditional accounting could only measure 10% to 15% of the market value of most non-tech businesses in 2000.

What hope can such a framework have of measuring the value of high-technology knowledge-economy businesses where the biggest investments are in intangible assets such as information, IT, e-commerce, brands, patents, rights, research and innovations, product breakthroughs, global reach and a global customer base — the new driving factors for innovation and profit growth? The fact is that while web businesses rely largely on the application of intangible assets to drive future revenues, managers focus on the generation of the tangible assets that can be summarised neatly on a balance sheet.

There’s little doubt that traditional accounting measures are the most commonly used business performance measures and that convention plays down the urgency for new reporting frameworks. The implicit point that is perpetuated in this paradigm is that if no web businesses are reporting on unrealised intangible assets, then all the statements of financial results and position are incorrect, but at least they are incorrect along the same dimension, for all web businesses. If we exclude the unknown dimension of investment and growth in intangible assets, then surely what we have left over is something that is a comparable measure of success? Such logic is as faulty and dangerous as it is common.

Using a traditional financial-accounting reporting framework to report on the success of two different kinds of web businesses is similar to taking an apple seed and an orange seed and tracking their growth against the developmental framework of a banana (in this case representing a business that has a low intangible:tangible assets ratio). Firstly, both fruits will be judged as failures at any point in time, because they will both fail to develop into bananas and, secondly, if, say, the apple develops less like a banana than the orange, then the observer will be tempted to say that it is less of a success than the orange, which is ridiculous because the original intention was never for either of the fruits to become a banana. Their failure to develop into bananas is actually irrelevant.

To take the analogy further, if a knowledge-economy business fails to generate earnings (a traditional performance measure) for the period that measurement takes place, it does not automatically mean that it is a failure if the intention, for example, was to grow the size of its user base (invest in an intangible asset, not cash and receivables, both tangible assets).

Furthermore, there are anomalies in both the way that intellectual capital is generated and the type generated at the industry and company level. No two web businesses generate the same kinds of intangible assets, because of differences in business strategy, resources, locational and even cultural factors. Similarly, despite how close an orange and a grapefruit are developmentally to each other (citrus family, colour, taste and so forth), a grapefruit cannot be judged on how close it comes to becoming an orange, because they are not the same thing. In the same way, we fool ourselves when we see Google in the potential of every new Web 2.0 project that we undertake.

So, as web entrepreneurs, why should we seek to create intangible assets when we could satisfy our investors or the market in the short term by creating tangible assets through earnings growth? In order to create tangible assets such as cash and receivables (arising out of sales), one has to sacrifice the creation of intangible assets, which reduce earnings as they are typically expensed.

Tangible assets are rival assets, which means that they cannot be used in more than one place at a time and their scarcity is reflected by the cost of using the asset. Intangible assets, however, are non-rival assets. Their use does not preclude their use elsewhere and there is no marginal usage cost, so these assets enjoy increasing returns to scale.

When you seek to create intangible assets (like a user community for a free SoS) instead of immediate profits in your web business, you likely create assets that don’t exhibit equivalency between cost and value. That is why a business that generated $150-million out of a guaranteed income deal with Microsoft can be valued at $15-billion. The value is there in the user community, not on the balance sheet. Baruch Lev talks about the existence of an “information-age asymmetry”: all companies have intangibles, but the difference between what is reported to outsiders and what is known to insiders is much greater for companies with high ratios of intangible:tangible assets.

It is for all intents and purposes impossible for traditional financial-accounting reporting frameworks to measure the success of a web business or to enable comparisons between web businesses on their degree of success over short periods of time when the individual nature and emphasis of the dimensions along which success is being measured are totally different for each business and when each business will be at a different stage along its own developmental path. Over short periods of time, the only success that is believable is the quality of the management’s strategy and how well it has implemented that strategy. Most of everything else is noise.

An objective measure of business success over short periods of time is impossible in a knowledge economy. Quarterly financial results are totally meaningless as an indication of value created. Throw out your income statement and your balance sheet and get cracking on creating intangible assets if you want to make it in this knowledge economy.