Are Our Accounting Systems Innovation Killers?
from author Robert Brands:
"Halling says, “Our present accounting systems never show [that] internally funded inventions produce any value.”[1]To illustrate this point, he uses the example of a new cellular telephone that has come about due to millions of dollars worth of investments in numerous inventions. Even with the case of a new cellular telephone where most of the phone’s profits are based on its inventions and not to manufacturing, our present accounting systems “only allocate a return for the manufacturing of the phone and nothing for the inventions that made the phone possible.”[2] This seems perverse as the massive difference in price between the latest and greatest cellular phone and a cellular phone with old and outdated technology is due to the inventions in the new phone, not to manufacturing."
Interesting article with some interesting solutions. Check out his blog :)
"Halling says, “Our present accounting systems never show [that] internally funded inventions produce any value.”[1]To illustrate this point, he uses the example of a new cellular telephone that has come about due to millions of dollars worth of investments in numerous inventions. Even with the case of a new cellular telephone where most of the phone’s profits are based on its inventions and not to manufacturing, our present accounting systems “only allocate a return for the manufacturing of the phone and nothing for the inventions that made the phone possible.”[2] This seems perverse as the massive difference in price between the latest and greatest cellular phone and a cellular phone with old and outdated technology is due to the inventions in the new phone, not to manufacturing."
Interesting article with some interesting solutions. Check out his blog :)
Clear away all of the obtuse methodology.
Clear away all the twisted economic systems.
The facts are simple. Our entire economic system including accounting methodology is not based on tangibles, but on intangibles. Our economic system(s) have become more of a religion than an accounting method whose very foundation is faith. It would be funny if it weren't so sad.
The problem is one of interpretation, many expect accounting numbers and reports to do what they cannot do, that is, tell the future. Financial reports have a limited role. They look back.
The standards require the stated value of assets to reflect with high certainty a monetary value - on the market or sometimes as a income stream.
While the cost of research and acquiring rights as described is easy to quantify, the future benefit will always be subject to uncertainty especially with hi tech and inventions. So, the standards are correct in treating such costs as operating and not as capital.
The solution is as savvy investors know, look at the financial reports - yes. But look more carefully at those other assets, this requires expertize in the field and good judgement.
While I am rambling, accounting reports have three functions:
demonstrate fiduciary duty and legal compliance,
provide information for management decisions,
and sometimes, for behavior modifiction.
They do not and can not provide all information needed by a prospective investor.
My company utterly relies upon a software product that we've created as the core of its business. Any valuation of our company would have to take that into account as well as the potential of the customer base in terms of volume and location. None of that matters on a day to day basis.
On a day to day basis, what matters is what money we spend and what we spend it on and what money we get and where it comes from. This is the realm where accounting is king. While our program is a valuable asset, it doesn't allow us to pay people. Selling licenses and installing systems does.
But blaming the accounting system is like blaming the hammer for not working well with screws. You use the wrong tool and you get the wrong results.
In business, I've often used the metaphor of an airline flight. You plan your course and destination. To succeed you need to be able to hit your destination. However, it's not enough to follow the right course. You're altitude must always remain positive or you won't get there even if your course is right.
Accounting is the altimeter.
The point that inventions and IP assets are a core value for a company is certainly valid. They provide for future growth and survival. They don't, on the other hand, provide cash for this weeks' payroll. That has to be in the bank.
I would suggest that accounting is a short term management tool and an understanding of your IP and other assets is a long term management tool.
Let them offer real value and people will be willing to pay for it.
On the other hand don't downplay the importance of producing goods. IP is worthless unless someone manufactures goods and sells them. If you have developed IP you can:
1. produce and sell products yourself which will give you money based on your production.
2. license the IP to someone else who is going to produce and sell products to get money.
3. become a patent troll and sue other companies who are producing and selling products to get a portion of the money they get.
In the end, the source of the money is the products that are produced and sold. Attributing all your revenue to the IP will distort your production decisions and your subsequent revenue.
1. Much like Newton, who, having a number of profound thoughts about gravity and motion, had to invent the Calculus in order to demonstrate and prove their “truth;” or as Rand, who, having a vision of how she wished to display her love of writing, had to invent a philosophy in order to project the heroic “truth” of her characters; the ancient merchants, who, wishing to engage in trade using endless numbers of middle-men when transacting with their customers, invented “double-entry” accounting in order to successfully do so. It is an absolutely essential aspect of keeping proper score of economic “truth.”
On the other hand, it carries with it the potential, when economic “truth” becomes but one of many values pursued, of being a “double-edged” (no pun intended) sword. It does so because:
2. To the extent an enterprise becomes focused internally rather than on its external market and customers, it tends to serve a false God. It quickly builds a bureaucracy that becomes primarily concerned with its internal political “workings” at the expense of the external reasons for its existence.
Becoming focused on “keeping score,” whether forced to do so by the law, or because of perhaps trying to obtain something for nothing, is wasteful, and carries with it the potential for disception.
A deceptive waste that in a competitive environment will lose to those less deceptive and wasteful.
are you kidding?
The marketing manager wanted to brainstorm ideas for increasing market acceptance and penetration of our new and allegedly promising technology.
Lots of ideas were offered up. Finally, I said that we should GIVE lots of systems and software to Colleges and Universities' computing schools.
The 'kids' would love to be Part Of Things and provide fresh eyes for innovations and debugging, AND when they graduated and entered "the real world," they'd be more comfortable and familiar with the benefits of OUR product.
Well, that was like tossing a baked-dry meadow-muffin against the side of a barn. Didn't stick at all, and to my non-surprise, the long term result was a very mediocre acceptance (and success) of those products in the overall market.
Such is Life In The Big City... and in Big Corporations.
But I've worked at two corporations which were, for sometimes a LONG time... successful despite a lot of poor management thinking. I brought some great innovations to the first one and brought some valuable skills to the second one. The second one had a very strong antibody-like reaction to NIH ideas that didn't "come from the right sources," and I think that kind of non-Critical Thinking really hurt them in a lot of markets.
And I'm retired now and still in friendly contact with many alumni of both companies.
Although we Are starting to die off... age does that, to a degree...
Assuming this is true, wouldn't an internal charge to manufacturing and a revenue credit to R & D display the value being earned by the IP (similar to a royalty fee as if the IP was licensed to manufacturing)?. This internal accounting is done frequently for other items. I have no data but I imagine some companies are already doing this.
Yes that would work, but in fact I do not think it is being done at all
Here is my post that explains this better http://hallingblog.com/2010/03/14/acc...
"As Nathan Myhrvold puts it, inventing is funded under a charity model. "
Look at the startup companies which have gone big, like Google or Facebook. They started out where the compensation plans were wholly dependent on the long-term and largely unknown intellectual capital being put into each. Only after they started seeing market success could their true value start to be calculated (with past returns being used to estimate future growth and profitability). It's one of the reasons Google still rewards risk-taking and side-projects with no quantifiable future value - because they recognize that they don't know how to quantify the future.
Managers depend on measurements to get anything done. Most managers don't get to their positions as department heads, etc. based on "I think I can do that", but rather "I DID do that". One is ambiguous, the other concrete. Can it be measured easily and concretely: Did the project get completed? How many widgets did we sell last month? These can all be specifically and precisely measured. Accountants and managers operate on measurement - on history being used to portray a picture of the future. Their tools are based on the same.
Leaders are much more rare. Leaders are the ones who see the valuable potential in a course of action. Potential, however, is not quantifiable with any degree of precision or accuracy (being used in the scientific definitions). You can't budget around potential. It's almost impossible to get an operating loan from a bank based on potential. So how do you build tools around the unknown? I work in IT and this is our constant battle. And no one is ever satisfied with "I don't know" even though it is the most common answer we have to give!
Yes, focusing on historical, quantifiable measures tends to lead to laying out budgets and future business plans based on those measures. I agree. The question is whether or not the head of the company is a leader who can not only envision the future but sell that future to the company in terms which translate the abstract into the concrete enough to get someone to believe and follow that vision. I know you're going to hate the analogy, but it fits: management is like science - it deals with empirical evidence. Leadership is like religion, because it deals with a vision of the future and relies on the faith of the follower.
Your complaint is that many companies don't continually invest in visionary leaders. That's a valid concern IMO. And it becomes even more difficult to retain a visionary leader as a company becomes successful and goes public because now there is a more concrete expectation of return on investment, which shifts the focus away from the novel and visionary to the stable and strategic. I look at Steve Jobs as a visionary and his problems with Apple Computer over the years as a perfect example of this.
Blame the people who unethically or ignorantly manipulate them, not the tools.
We in the Gulch don't blame guns for homicides either.
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Which is why valuing a company and managing it looks beyond accounting -- if you are doing it right.
Its not the accounting rules that are the problem. Yes, valuations are not accurately allocated, but I don't see any solution being presented that accountants and users will accept. Yes, the data is manipulated.
The people that publish these documents don't actually want the reports to be better so there is no demand to change them. Analysts use other sources of data to estimate value and don't want the public to have easy access to that data. Most of the public doesn't do due diligence so they don't care. Accountancy historically prefers to be "conservative" in valuing things that aren't easy to quantify. The accountants are at risk of suit by company and shareholders if they don't.
Better to try to break the securities rules that allows only "approved" firms to sell company equities in volume.
From a balance sheet point of view only assets that you can own should be on the balance sheet, so that means inventions that are patented or have a copyright or are a trade secret.
The IP is a necessary but not sufficient requirement for production. Its costs do not scale with quantity like manufacturing. Similarly my revenue scales with manufacturing quantity. Doubling my quantity will double my revenue (if I can sell it all).
While accounting for revenue based on IP will emphasize the importance of IP, it will distort the production and revenue process because revenue really does come from manufacturing and selling goods.
This only works in the bizarro world where inventing things is the only revenue producing thing. Yes, invention moves us ahead, but we only make revenue if SOMEONE actually makes a product and sells it.
the best invention is how to manage and downsize costs such as COG or cost of government. Since COG comes after legitimate overhead and before profit it may be trimmed by increasing expansion, improvement costs which would otherwise come under COG before final profit. Doesn't matter if it should or shouldn't it 'is'
therefore the sharp accountant and cpa work to pare the highest cost which is also the weakest producer. ....unless part of the COG is buying elected officials
The money I get comes from the manufacturing and sale of mouse traps, not from the patent which, without manufacturing creates no revenue. The patent gives me the right to do this, it makes the business possible but not profitable.
It's vitally important that unlike the famous Lucille Ball episode, your manufacturing costs do not exceed your sales price. Accounting helps you with this.
I agree that the valuation of the company needs to take into account the value of the patent, but that's incredibly hard to judge. You never know when someone is going to invent a new way of catching mice. The RoboCat will completely destroy your IP value.