The balance sheet is a remarkable invention, yet it has two fundamental shortcomings.
First, although it is in theory useful to have a summary of the values of all the assets owned by an enterprise, these values frequently prove elusive in practice.
Second, many kinds of things have value and could be construed, at least by the layperson, as assets. Not all of them can be assigned a specific value and recorded on a balance sheet, however. For example, proprietors of service businesses are fond of saying, “Our assets go down the elevator every night.” Everybody acknowledges the value of a company’s “human capital”—the skills and creativity of its employees—but no one has devised a means of valuing it precisely enough to reflect it on the balance sheet. Accountants do not go to the opposite extreme of banishing all intangible assets from the balance sheet, but the dividing line between the permitted and the prohibited is inevitably an arbitrary one.1During the late 1990s, doctrinal disputes over accounting for assets intensified as intellectual capital came to represent growing proportions of many major corporations’ perceived value. A study conducted on behalf of Big Five accounting firm Arthur Andersen showed that between 1978 and 1999, book value fell from 95% to 71% of the stock market value of public companies in the United States.2 Increasingly, investors were willing to pay for things other than the traditional assets that GAAP (generally accepted accounting principles) had grown up around, including buildings, machinery, inventories, receivables, and a limited range of capitalized expenditures.
At the extreme, start-up Internet companies with negligible physical assets attained gigantic market capitalizations. Their valuations derived from “business models” purporting to promise vast profits far in the future.
Building up subscriber bases through heavy consumer advertising was an expensive proposition, but one day, investors believed, a large, loyal following would translate into rich revenue streams.Much of the dot-coms’ stock market value disappeared during the “tech wreck” of 2000, but the perceived mismatch between the informationintensive New Economy and traditional notions of assets persisted. Prominent accounting theorists argued that financial reporting practices rooted in an era more dominated by heavy manufacturing grossly understated the value created by research and development outlays, which GAAP was resistant to capitalizing. They observed further that traditional accounting generally permitted assets to rise in value only if they were sold. “Transactions are no longer the basis for much of the value created and destroyed in today’s economy, and therefore traditional accounting systems are at a loss to capture much of what goes on,” argued Baruch Lev of New York University. As examples, he cited the rise in value resulting from a drug passing a key clinical test and from a computer software program being successfully beta-tested. “There’s no accounting event because no money changes hands,” Lev noted.3