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29th November 2021

The End of Accounting

Season 1 Episode 9

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We were joined by an industry expert and the hosts of Cipher Vision podcast

Highlights of the Episode

Strategic Assets – The Intangibles

About 25 years ago, I was a professor at the University of California, Berkeley, both in the business school and in the law school. I was also a partner in a consulting firm. I was in charge of finance, accounting and particularly valuations of companies for mergers and acquisitions. When I valued companies, particularly new types of companies at the time, like cellular phone companies, biotech companies, as an accountant, I started with the financial reports. And it initially became clear to me that the financial reports are not just useless for valuation, but they are actually misleading.

I looked at the balance sheet, and it reminded me of the old song, ‘Where Have All the Flowers Gone?’. I asked myself, ‘Where have all the strategic assets gone?’.

Where are the patents, where is the IT,  human resources – nowhere to be seen. And that’s because intangibles are expensive in accounting, they basically disappear after they expand. So I got interested in the whole area of intangibles very early, I must say, and I became the guru of intangibles.

The End of Accounting

My book deals with financial information that is routinely disclosed by companies either quarterly, like United States, semi annually in the UK and other countries, annually, of course, and this is supposed to be the information in those reports – which are by now voluminous, sometimes 250-300 page reports – that is the backbone of the data that investors are using. That’s why securities and laws in the United States, going back to the 30s, mandated disclosure by managers. We show this empirically in the book. It’s not a book about suppositions and thoughts.

The value of information, the relevance to investors of the information in financial reports, despite the fact that they keep getting larger and larger, decreases drastically. This decrease correlates very nicely, with the increase of intangible assets. So, we have a graph that shows the increase of investment of companies in intangible assets and we have the decrease in the value of financial reporting information. It’s almost a perfect, a negative correlation.

It is absurd, that in the 21st century companies will provide investors with a balance sheet that doesn’t show their key assets. So that’s what we have in the book, The End of Accounting. It really shocked most readers and it has incredible longevity.

A year ago, Forbes magazine listed our book as a must read for CFOs. My co-author told me about this and I said it’s impossible four years after it was published that it’s still a must read.

Research and Development 

R&D: a single number in reports and accounts. Do you think there’s progress being made to unpack the R number which I always regard to be the foundational research from the D number, which is possibly more incremental?

It is the only investment in intangibles that is at least disclosed by companies. It is an expense in the income statement, but it is disclosed. All other heavier investments in intangibles like investment in information technology, for example, they’re all lumped in big expense items like sales, general administrative expenses, cost of sales, or investors. At least with respect to R&D, they have some total. But with respect to the ‘other’, they are completely in the dark.

Now to your particular question, the difference between the R and the D is crucial in terms of race; the ‘R’ is the research, the search for new technology which is, of course, much riskier than development. But the returns are also higher and it’s very important if companies changed the mix over time, if they have a different mix that they’re close competitors. So you’re perfectly right to ask about that. My answer, unfortunately, is that there is no company that I know of that provides this distinction and it’s not required.

If you internally generate intangibles like, R&D, it doesn’t show on the balance sheet. But if you acquire patents, for example if Pfizer were to acquire the vaccine patents from another company, it would be on the balance sheet. Since they develop them internally, it’s not on the balance sheet. So it has terrible incentives on their managers in terms of acquisition versus internal development. I talked to the Financial Accounting Standards Board years ago about this difference, and they told me if you acquire, it’s an arm’s length transaction.

How would you define these strategic assets?

Strategic assets are those that create value. So if I have an office building, that is not a strategic assets, because all of my competitors have office buildings. If I have laboratory equipment, I’m sure that all my competitors will also have state of the art laboratory equipment. If your competitors have these assets, you cannot create value from them. Strategic assets are assets that are unique to the company, and that your competitors cannot mimic quickly. If I wanted to develop Google tomorrow, even if I have money, it will take me probably 25 years to develop something which is similar to their search engine. So something which is unique and cannot be mimicked or copied by inventors quickly is a strategic assets. And those are the assets that create value.

The way you’ve described those strategic assets, I know Jonathan Haskell who wrote the book capitalism without capital, he was one of our podcast guests, and he focused on those areas; they’ve got to be valuable, they’re rare, and they’re really hard to imitate.

How do you feel that patents fit in as strategic assets?

Patents are major strategic assets. Several years ago, in a very important TV programme in United States, Jeff Bezos at Amazon said, ‘I’m going to tell you a great secret. We are developing drones for delivery to customers,’ and he went on to elaborate about drones. After the programme, I really wanted to know whether they really have invested in drones for delivery. I went to the patents, and particularly to those early patent disclosures that are disclosed 18 months after applications. And indeed, I saw a large number of patents on drones. So I got a pretty good idea that Jeff Bezos was talking about something that they are actually working on, rather than some kind of a dream for the future.

So patents are incredibly powerful tools and are reliable. It’s not accounting information, it is a fact. They’re reliable about the technological capabilities of companies. Of course, I need to mention one of the main measures, which is forward citations to patents citations in subsequent patents to the company’s patents, which I showed many years ago, that is a very good predictor of Fair Success of companies. So I like patents.

We at Cipher love patents, but we also love the insight trapped within patents. They’re the largest library of scientific information in the world, they document the history of the world’s invention. So as a starting point, they’re a very rich source of information.

ESG

ESG is very problematic. As it stands now, ESG reports by companies, whether they are mandatory, like in many European countries, or more voluntary, like in the United States, are close to useless. They are essentially PR reports and the reason why they are useless is that for information to be useful for decision makers, it has to have three attributes.

The first attribute is reliable measurement. If you think about sales of companies, they can be reliably measured. The contribution of a company to a community cannot be reliably measured. For example, the company finances a football stadium, which is quite frequent in the United States. It’s impossible to separate the advertisement part of it and the contribution part of it. How much is really contribution and how much it is advertising?

The second is what we call ‘after fact verification’. For information to be of high quality, the receiver should be able to verify the information six months later, 12 months later. If a CEO tells investors that the return on equity of the company will be 15% next year, this can be verified and by the end of next year they can see what the return on equity is. After the fact variability forces managers to be honest. The knowledge that the information can be checked later by the receiver.

The third and final attribute of good information is comparability that you will measure it the same way across company. Earnings, for example, are comparable. They are measured the same way by practically every company. Carbon footprint is not comparably measured.

So, as it stands ESG reports today show none of my three attributes of good information. Guidelines that companies will be able to follow and be comparable, will be very useful. As it stands now, even good guidelines are missing.

The Future

What do you think needs to happen to drive that transparency in terms of company value, and do we need to look at regulation or more mandatory measures to make sure that the elements that you discuss around the ‘strategic resources and consequences’ report actually are a regular feature for investors?

There should be a drastic change in financial reports of companies. One element of this change is to finally recognise that intangible assets are the assets that create value. Most physical assets are not really strategic assets. So you have to recognise them as assets, meaning they will not be subtracted from income, but they will appear on the balance sheet. People sometimes object to this by saying intangibles are hard to value. I’m not asking for valuation, I’m asking for the investment in these assets to be recognised.

How much did you pay for the development of this patent? Similar to this, how much did you pay when you bought the patent?

The second element to this, is to start providing relevant information. There is absolutely no data required to be disclosed on patents. How many patent applications, patent grants, patent abandoned methods, patents that you really didn’t renew in this case? And what are the royalties from patent licensing? Which for some companies, it’s a major income. So these are the elements of new reporting. But I don’t see them coming soon.

And that’s such a shame. Our last Cipher Vision was with David Kappos who is now a partner at Cravath, formerly the head of the USPTO. And he was talking about transparency. You won’t even believe what the podcast was talking about; transparency around patent ownership. We’re in 2021 and it’s still not possible to go and get accurate information about who owns a patent because there isn’t mandatory recording of that foundational fact. So you can see why some financial people think that intellectual property doesn’t always behave like an asset class.

Cipher Vision Takeaway

My takeaway is for corporate managers, for investors, for academics: do what you’re supposed to do the best way you can and no more than that. So don’t delve into side issues, into political issues, into other issues. Focus on what you are supposed to do. This led me my entire life, and probably with some modest measure of success. And I think it will also benefit lots of other people if they focus without divergence.

Message from the CEO

It’s an amazing privilege for us on Cipher Vision to have you with us Dr Lev. I was going to suggest that you were the guru of intangibles without even knowing that someone had already given you that title before. The idea that reports and accounts are the foundational information for investors, and yet seems so empty of the fundamental information that they need is a travesty.

When we look at patents, they’re public information and yet the information is not made public. Companies, as you say, have the ability to do the right thing. I don’t think your book should just be on the Forbes list as essential reading for CFOs. It should be the essential reading for all business managers, not just because it talks about intangibles, because it says it’s the duty of a company to disclose what’s important.

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