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CIAO DATE: 06/04
Accounting Lags Behind a Knowledge Economy
On The Issues
March 2004
Peter J. Wallison
Abstract
Some financial analysts worry that high price-earnings ratios reflect unfounded optimism in corporate earnings potential and signal a return to the "bubble" market; however, conventional accounting methods used to determine the value of companies have not kept pace with changes in the U.S. economy and are therefore understating the value of America's most dynamic companies. High price-earnings ratios seem to indicate that investors are wise to that.
Now that the U.S. stock market is recovering, we are hearing again that speculation is increasing and the fearful "bubble" is coming back. The most commonly cited evidence for this is that price-earnings ratios are still high by historical standards and thus, it is asserted, investors' renewed interest in stocks must reflect an over-optimistic assessment of the future. This view neglects the vast changes that have occurred in the U.S. economy and how these changes have affected the usefulness of generally accepted accounting principles (GAAP) for determining the value of public companies.
GAAP accounting was developed in a world where productive assets were tangible and were purchased by companies from third parties. Thus, a railroad purchased its rolling stock, a manufacturer purchased machine tools, and a retailer purchased a building for use as a store. The costs of these items were placed on the purchaser's balance sheet through a process known as capitalization and were depreciated over time as the assets were used to generate revenues. This provided an accurate picture of a company's profitability, because—at least in theory—it gathered into the same period both the revenues of the company and the costs of the assets used to generate them.
However, this standard accounting treatment, when applied to today's companies, produces a misleading result. It is commonplace that the United States now has a knowledge or information economy, in which value is produced by intellectual effort—designs for computer programs, pharmaceuticals, clothing—rather than physical production. Indeed, the corresponding shrinkage of the manufacturing sector has become an issue for the presidential election. But while most people accept this idea, they do not consider its implications for accounting.
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