Dimensions: 5.5'' x 8.5'' 96 pages AEI Press  (Washington) Publication Date: November 2000 Paperback ISBN: 0844741477 Price: $ 10.00 Add to Cart   Examination Copies

November 2000
The GAAP Gap: Corporate Disclosure in the Internet Age
By Robert E. Litan and Peter J. Wallison

Today’s knowledge-based economy requires a new framework for corporate disclosure. The authors of this book envision an entirely new system of assessing the value of companies--a system tapping the vast communication capabilities of the Internet. Corporate financial reporting would become forward-looking, would be based on precise, comparable measures, and would be presented in real time.

Robert E. Litan directs the economic studies program and holds Cabot Family Chair in Economics at the Brookings Institution. He is also the codirector of the AEI-Brookings Joint Center for Regulatory Studies. Peter J. Wallison is a resident fellow at AEI and codirector of AEI's project on financial market deregulation.

The Generally Accepted Accounting Principles (GAAP) in use today evolved out of an accounting system designed to measure and report the value of companies that used tangible assets--such as rolling stock, machinery, or land--to manufacture goods or provide services. In that system, the cost of the assets used in the production of income was the foundation of the values recorded on the balance sheet. That made sense because the cost of those assets was their value--they could be duplicated in most cases for the amount at which they were carried on the company’s balance sheet. Moreover, the depreciation of those assets over time allowed costs to be allocated to revenues in order to provide a more accurate measure of profitability.

But now the foundations of GAAP accounting are challenged by the growing importance of intangible assets. Generally, these assets are things like ideas, information, or knowledge, and they are used in the production of goods and services in the same way that the industrial economy produces goods and services with machines and equipment. Accordingly, the productive assets in the Knowledge Economy--he assets that spell the difference between success and failure for many companies--are things such as research and development, employee know-how, trademarks, brand names, patents, and even alliances with suppliers or distributors.

The costs of these assets, however, bear little relationship to their value. The cost of acquiring the knowledge or skill necessary to create a new drug, a computer program, or a computer chip is clearly not an index of the value that that knowledge can produce. Accordingly, the value of companies that make extensive use of intangible assets cannot be effectively measured through the traditional methods used in GAAP accounting.

That is a significant problem for the capital markets. Some estimates suggest that as much as 80 percent of the total value of the stocks in the S&P 500 index is based on intangible assets, and the wide discrepancy between the market values and the balance-sheet values of today’s companies indicates that investors see more value in successful companies than their balance sheets can describe. Even income statements are of limited assistance in this environment, since profits cannot be fairly measured if the assets that produce them cannot be properly valued and depreciated.

The result is that financial reports based on GAAP are becoming less and less relevant to investors. Yet nothing has been developed to take the place of or to supplement GAAP, even though the declining usefulness of financial statements may be creating greater uncertainty concerning company values in the markets. While investors seem to believe that real values exceed balance sheet values, they are in effect guessing the size of the discrepancy--a process that increases the cost of capital for companies and produces greater volatility in the securities markets.

Accounting theorists have recognized that problem for about a decade, but it has no easy solution. The accounting profession appears to have come to the view that indicators of various kinds--such as measures of customer loyalty, efficiency of research and development efforts, and management or employee skills--could effectively fill what the authors call the "GAAP Gap." Another constructive idea is real-time disclosure over the Internet of basic financial and operating information. That would permit analysts, over time, to build better models for predicting which companies will be successful. Companies themselves--through benchmarking and internal measurement techniques--have developed ways of evaluating their success, but these measures have not become part of the disclosure process.

Many possibilities exist, the authors note, but nothing will be done without leadership from government policymakers--particularly the Securities and Exchange Commission. The SEC is charged with assuring that investors get timely and accurate information, but it has yet to recognize the importance of the GAAP Gap. Although the SEC should not establish hard and fast rules for company disclosure beyond the requirements of GAAP, the authors believe that the commission should use its convening power to get companies, accountants, and analysts to discuss which measures are practical and useful. Eventually, a consensus will emerge.

Without such steps by the SEC, little if any voluntary action by companies can be expected. Companies fear both litigation and competitive disadvantage. The authors argue that both possibilities are remote for the kinds of disclosure that are necessary. But without some action in the near future, the GAAP Gap will continue to produce uncertainty in the securities markets, resulting in higher capital costs, less efficient allocation of capital, and greater volatility in share prices.

This book's thesis, spelled out in chapter one, is that the rise of the Knowledge Economy has generated the need for a new system of corporate disclosure. To explain why, chapter two traces the historical roots of the existing system of disclosure, including the development of modern accounting standards. Avoiding a bog of details on accounting theory and practice, the authors paint a broad picture of who now sets corporate disclosure standards--accounting standards in particular--and what legal structure governs the system.

Chapter three then outlines why the move toward a knowledge-based economy--symbolized by the increasing discrepancies between book and market values of companies--poses a fundamental challenge to the current system of corporate disclosure. The authors discuss both the demands by investors for different kinds of forward-looking information, permitting equity markets to set stock prices more rationally, and the responses of some cutting-edge companies.

The last two chapters lay out the authors' vision of how corporate disclosure could--and should--evolve in the next few years. As indicated above, the authors do not believe that the SEC or other regulatory bodies should dictate a one-size-fits-all approach for all companies. Market developments and investor needs are too fluid--and too uncertain--for any regulatory authority to set down in stone an entirely new system of mandated disclosure that is intended for all time.

Instead government regulators should facilitate and encourage the private sector to establish its own new rules and practices. A virtuous cycle in disclosure can and will exist in such an environment. Companies at the cutting edge of providing access to information about themselves will reap a cost-of-capital advantage relative to companies that are not so forthcoming. The result should be the opposite of Gresham's law: Given the opportunity, good disclosure practices should drive out bad without the need for excessive regulatory intrusion or securities litigation.

Wallison and Litan are not advocating that the cost-based accounting standards, developed and gradually refined by the Financial Accounting Standards Board, be abandoned. In their view, those standards serve an important purpose--they represent the best thinking about the financial-statement presentation of physical and financial assets. At the same time, the authors are skeptical that a top-down process with mandatory standards is best suited for fashioning widely accepted practices. For that task the market, encouraged and facilitated by policymakers, is likely to provide the best answers, especially in the current environment of rapid change.