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What’s ahead for the New Decade: The Good News

January 4, 2010

Although there is much gloom and doom around these days, and some very real structural problems in the global financial system there is some good news as well. One of the most significant sources of good news is the fact that the Western economies are growing much more strongly than reported.

At present GDP calculations ignore or seriously undervalue the growth contributions of newer non-traditional (intangible) assets.  According to a recent University of Maryland study, (Corrado, Hulten and Sichel), when intangibles are added to the statistical mix, our economies looks measurably stronger than reported. Consider capital deepening, the economist’s measure of capital efficiency. In the period 1973 – 1995 the efficiency of capital as a measure of capital stock per labor hour was .43, the equivalent figure for the period 1995 – 2003 (the period of most rapid growth in non-traditional assets) is .84. In other words, the rise of the knowledge economy has translated into (approximately) a doubling in the efficiency of capital. The impact of the knowledge revolution on Labor productivity is equally impressive. The average productivity per worker in the United States as a measure of output per hour has jumped from 1.36 (1973 – 1995) to 2.78 (1995 -2003), put another way productivity per worker has more than doubled.

“The key finding of this research is that intangible investment by U.S. businesses averaged $1.2 trillion per year during the 1998-2000 period (it has now risen to $3 trillion per year, 2010). This amount is equal to the total amount spent by businesses for their tangible plant and equipment. This is also the amount by which U.S. GDP is increased by the capitalization of this broad list of intangibles. In other words… intangibles matter.” (Corrado, Hulten and Sichel, 2009) 

So what’s the Problem?

The message is clear, “when intangibles are included in the analysis, they explain more than a quarter of the total growth rate of output per worker and become the most important systematic source of growth in our economies.” So why don’t we acknowledge this growth? What’s the problem?

The problems are widespread, and deep-seated. To begin with conventional economics is struggling, focused almost exclusively on exchange processes and markets, ignoring asset development. As a result important changes in the nature of production in an emerging knowledge economy in combination with the profound impact of globalization continue to challenge traditional economic modeling which in large measure continues to be based on “factory-type industrial production taking place in isolated national economies”.

But economics is not the only profession wandering around lost, the accounting profession is in a worse state. Although there have been many advances in new asset recognition at the official level (accounting standard boards), the practice of accounting continues – almost universally – to ignore new assets, which do not appear on corporate balance sheets or other financial statements.

What Should Management Do?

Management needs to get up to speed on the real value drivers in their organizations, and fast.

An asset is anything you own or control from which you can expect future benefit. In other words assets are ultimately THE sources of your corporate earnings. However, if you asked most managers today to directly link their earnings to defined assets, they’d tell you it’s impossible, or that the earnings are associated with ‘services’ not real assets. The fact of the matter is that very few managers today have a firm grasp on the productive assets in their organizations, and as a result are making critical errors in judgment.

According to Corrado, Hulten and Sichel (CHS, 2005), there is no clear-cut distinction between tangibles and intangibles that would justify a distinction between the former being capitalized and the latter being expensed. In fact “any outlay than is intended to increase future rather than current consumption is treated as a capital investment” (CHS, 2005, p. 13).

Why does this matter? For one thing NOT capitalizing your broad asset potential increases the cost of capital to knowledge-rich companies. When you walk into the bank, or a room full of investors with an ‘empty’ balance sheet it’s an uphill struggle to convince anyone that you’re a good investment or that you even know what you’re doing. More importantly, particularly for larger more established companies, the treatment of assets is vastly different from services. And it is the behavioral differences that are critical in both developing the stream of earnings in the first place and sustaining the capital value from that effort for the company longer term.

Things to Think About

  1.  During the next few years, most of the developed world will adopt International Accounting Standards. The International Accounting Standards Board (IASB) is in the process of defining and legitimizing over 30 new classes of (non-traditional) assets including the formal kinds, patents, copyrighted software etc, but also many contractual based assets and other ‘relationship’ based assets including brands, trademarks and other customer equity related assets. How familiar are you with these developments? What are you doing about them?
  2. Don’t mistake cause and effect. Corporate earnings are the ‘effect’, the ‘cause’ of which is solid well-managed assets. In other words, management’s focus on earnings, share price and other financial variables needs to be balanced by greater knowledge and measurement of all the assets (sources of earnings) in their organizations.

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