Key13 Financial statements have trouble measuring future opportunities properly
Because GAAP is focused on what has already occurred, financial statements might not measure future opportunities properly. What about transactions that have implications for future changes in value that is presently unclear? How do financial statements represent them?
To answer these questions, we need to learn about intangible assets. Intangibles are non-physical assets having unknown useful lives. Companies can create or acquire intangible assets that GAAP does not recognize. A good example is the treatment of Research and Development costs. R&D is aimed at discovering and implementing knowledge to be used for selling new products or achieving cost savings in the future. Under SFAS No. 2, R&D is expensed as incurred. Let’s consider the implications of this policy as it affects Lucent Technologies.
Lucent (lucent.com), a spin-off from AT&T, is a company involved in managing data, optical networking, and wireless systems. The company’s future is based upon its ability to discover new technologies, and to innovate in employing technology, which it undertakes through its Bell Laboratories division. The name Lucent gave to its 1998 annual report, “At the center of the Communications Revolution,” tells you how the company sees itself.
In 1998, Lucent had revenues of $30.1 billion and net income of $970 million. Its Cash Flow from Operations was $1.4 billion, and it spent $3.7 billion on R&D costs. Clearly, R&D plays a crucial part in what Lucent does. For every $8 of revenue it received in 1998, the firm invested $1 on research and development.
Remember, as Key 4 explained, that expenses are outflows of assets. In other words, expenses are recorded when assets are used up. Treating all $3.7 billion Lucent spent on R&D effort occur only in 1998. Clearly that is not the case. The benefits extend to future periods, although which periods benefit and to what extent is uncertain.
Because of the difficulty of quantifying the benefits of R&D investment, SFAS No. 2 requires companies to treat the entire outlay as an expense. Consequently, Lucent’s total assets and net income are effectively understated. Some of the market price for Lucent shares reflects technology advantages provided by its R&D. At the end of fiscal 1998, the market value of Lucent common stock was about $91 billion. Meanwhile, the book value of stockholders’ equity was $5.5 billion. Every year Lucent expenses all its R&D investment. Every year, the difference between the market and book value of its stockholders’ equity grows larger.
Similar distortions occur for other sorts of intangible assets. Expenditures to establish brand-name associations (e.g., Sony dependability, “Miller time”, “Ford trucks are built tough”) and other advertising costs are expensed. The reasoning is analogous to the treatment for R&D: benefits are difficult to measure reliably. Likewise, the know-how and expertise a company develops from manufacturing its products or delivering services does not appear as an asset on the balance sheet. “Human” capital is thus another intangible that GAAP ignores.
Some intangibles are capitalized and put on the balance sheet. The cost of establishing a patent, copyright, or trademark is treated as an asset. Note, however, that the cost of developing a patented item is R&D, and would be expensed. Exclusionary rights (e.g., a cable license, a cellular service territory, or a taxi medallion) are also intangibles. They are reported as assets, but valued at historical cost, despite the considerable market potential monopoly power offers.
Understanding how GAAP treats intangibles lets us appreciate the orientation of historical-cost financial statement. If a company invests in projects that have uncertain future benefits, the book value of its equity tends to understate market value. This phenomenon is particularly pronounced in industries that invest in large amounts of R&D. The reported earnings of pharmaceutical, biotechnology and software firms are generally lower than they would be if their R&D costs were capitalized. Their assets are understated, as is their stockholders’ equity, which in turn raises the observed rate of return on assets and return on equity.