Accounting needs new standards for capitalizing intangibles.

HOW IRONIC THAT ACCOUNTING is the last vestige of those who believe that things are assets and that ideas are expendable.

The profession should know better. In recent decades the usefulness of financial reports of public companies has steadily declined, despite their increased gloss and girth. One indicator: In the 1960s and 1970s, about 25% of the differences in stock price changes could be attributed to differences in reported earnings. But by the 1980s and early 1990s, this figure had dropped to less than 10%.

That's a lot of lost relevance. Everybody in this economy ought to be concerned. Reliable financial reporting guides capital to the most promising investments. But bad or outdated information can lead to an inefficient allocation. This leads to volatile markets and investors who demand higher-risk premiums to cover the increased uncertainty. That's why, for capital markets to function best, financial statements need to be as informative as possible.

Conventional accounting performs poorly with internally generated intangibles such as R&D, brands, and employee talent—the very items considered the engines of modern economic growth. Example: Today's generally accepted accounting principles call for the immediate expensing of R&D costs. But, unlike rent and interest payments, intangibles often produce rich future rewards. Why else would firms invest so heavily in them? Expensing them now produces serious distortions in reported earnings and detracts from the relevance of financial reports.

Many defend immediate expensing because it is conservative (i.e., a practice that leads to the reporting of lower profits). But, in fact, it is biased and inaccurate. Expensing is only conservative when outlays on intangible investments exceed their revenues, which usually occurs early in a company's life. Later on, as investment in intangibles subsides while revenues from intangibles increase, reported profitability is often overstated.

This is not a situation conducive to the vitality of capital markets. Something has to change.

To regain its relevance, traditional accounting needs to develop new standards for the capitalization and subsequent amortizing of intangible investments. They should be treated similarly to investment in physical assets. Any intangible investment that can be associated with identifiable and measurable benefits is a worthy capitalization candidate.

Most R&D projects, products under development, and customer (franchise) acquisition costs meet these criteria—their benefits are often both identifiable and measurable. By comparison, certain employee development costs do not—attribution of specific benefits to these programs remains difficult.

In practice, as the capitalized investments in intangibles reach the marketing stage, they should be amortized according to the expected duration of their benefits. Projects that fail the market test will be written off as an extraordinary charge to earnings or capital. Such an approach will not only improve the relevance of financial reports by restoring revenue-cost matching but will also help managers evaluate and control their investment in intellectual capital.

All of this may seem self-evident. It has instead been a subject of considerable contention. Proposals to capitalize intangible assets have generally been opposed by managers, financial analysts, and accountants for the following reasons: (1) intangibles are too uncertain (risky) to be considered assets; (2) amortization of the capitalized values is subjective and could be misused to manipulate financial reports; (3) the costs of intangibles (the basis of capitalization) bear no relationship to their real value in light of future benefits; and (4) failure of intangible projects presented on balance sheets as assets may expose managers and auditors to frivolous shareholder litigation.

These concerns are overstated. Let's look at them individually.

1. Managers' and analysts' objections notwithstanding, investors already act as if they capitalize intangibles. Research has shown that R&D and certain customer acquisition outlays are positively associated with stock price changes (returns). This indicates that, on average, investors consider them valuable assets promising future benefits, rather than expenses.

2. While investors largely adjust for the expensing of intangibles, they also appear to substantially discount the value of intellectual capital. This apparent under valuation may be related to the lack of available information concerning the nature and prospects of intangible investments. If so, managers' internal information, conveyed to capital markets by the capitalization and amortization of intangibles, may boost investor confidence and add to shareholder value.

3. Although the cost of intangibles generally differs from their real value (which is also true of tangible assets), research from recent acquisitions of in-process R&D and technology shows that there is a high correlation between prices paid for such intangibles and the cumulative R&D cost of the acquired enterprises. While not identical, capitalized values may provide reasonable proxies for fair market values of intangibles.

4. Regarding the fraud, manipulation, and shareholder lawsuits that allegedly will follow the capitalization of intangibles, let's review the only industry that is exempted from the universal R&D expensing requirement—software. Since 1985, most software producers have capitalized a portion of their R&D and product development costs in a manner similar to that proposed above. While no small number of shareholder lawsuits and SEC actions have been aimed at software companies, they generally allege improper accounting practices, such as fraudulent revenue recognition (front loading) and understatement of expenses and provisions. A litigation avalanche alleging fraudulent capitalization of software development costs simply has not emerged.

All of this would seem to make a strong case for treating most intangibles the same as hard assets—and for the systematic and universal measurement of intellectual capital. But old traditions die hard. For now, the forces of the status quo still reign.

Baruch Lev is the Philip Bardes Professor of Accounting and Finance at New York University's Stern School of Business. Professor Lev writes frequently on the subjects of financial reporting and intangible assets. blev@stern.nyu.edu