The New Economy and Intangible Assets
The Nation’s economy has changed a lot over the last 50
years. Half a century ago, our biggest companies extracted coal from the earth
and forged I-beams in blast furnaces. Today, the prime creators of wealth for
many firms are brands, patents, customer service, licensing agreements,
distribution routes, intellectual property, innovative technology and even
imagination. All of these are “intangible growth-producing initiatives that
didn’t exist years ago.
Traditional accrual accounting treats investments made in these "intangible assets" as operating expenses (expenses that generate benefits only in the current year) whereas a manufacturing firm who put investments in plant, equipment and buildings is treated as a capital expense (expenses that create value over many years).
Accountants assume that the benefit made in investing in research and development (technology, pharmaceutical firms), brand name advertising (consumer companies) and training and recruiting (consulting firms) are too uncertain to project into the future so they are treated as operating expenses. Because of this earnings, cash flows and capital expenditures tend to be understated in these "new economy" companies.
The traditional accounting measures of book value, earnings and capital expenditures can be misleading when applied to firms with intangible assets. These intangible assets are rarely valued properly on the balance sheet as the standardization of financial statements does not allow for the recognition of these vital growth inducing initiatives. It's important to remember that investing in a company involves much more than just reading their numbers; it is also about going beyond the numbers and trying to get a sense of the real company.
This area is fertile ground for the intuitive investor who reads the annual report and begins to feel things that go beyond the reported numbers. This is where the narrative of the company comes into play (business model, industry structure, capital allocation history of management.
Traditional accrual accounting treats investments made in these "intangible assets" as operating expenses (expenses that generate benefits only in the current year) whereas a manufacturing firm who put investments in plant, equipment and buildings is treated as a capital expense (expenses that create value over many years).
Accountants assume that the benefit made in investing in research and development (technology, pharmaceutical firms), brand name advertising (consumer companies) and training and recruiting (consulting firms) are too uncertain to project into the future so they are treated as operating expenses. Because of this earnings, cash flows and capital expenditures tend to be understated in these "new economy" companies.
The traditional accounting measures of book value, earnings and capital expenditures can be misleading when applied to firms with intangible assets. These intangible assets are rarely valued properly on the balance sheet as the standardization of financial statements does not allow for the recognition of these vital growth inducing initiatives. It's important to remember that investing in a company involves much more than just reading their numbers; it is also about going beyond the numbers and trying to get a sense of the real company.
This area is fertile ground for the intuitive investor who reads the annual report and begins to feel things that go beyond the reported numbers. This is where the narrative of the company comes into play (business model, industry structure, capital allocation history of management.
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