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The Special Report discussed the impact of new economy model to the business and financial reporting. It rises up the question that whether modification in business and financial reporting is necessary to suit the changes in "new economy".
The economy of 20th centuries has changed fundamentally if compare to the economy before. However, the traditional financial statements do not capture and change accordingly to the value drivers in the new economy.
In general, new economy is refers to knowledge, knowledge capital, intellectual capital, internet, technology, information, intangible assets, knowledge sharing and new forms of organization, network effects and globalization.
There are four propositions that critic accounting's failure to keep step with a changing economy:
1) Proponents state that the existing financial reports are mostly backward-looking. A new financial reporting idea is needed to the entity's creation of value.
2) Proponents also state that the existing financial reports ignore the nonfinancial values driver in the new economy. Some measurement should be developed so that it can be used by the external users to evaluate the entities.
3) Recognition and measurement of intangible assets becoming more important in the new economy. However, the existing financial reports only recognize the entities' assets when they acquired from others.
4) Proponents argue that the value of employees' ideas and cultural factors should be included in the balance sheets as they are the drivers of the company's profitability. Some propose that intellectual capital measurements should also be reported on balance sheets as they can affect the public policy and credit markets.
However, the proponent, Mr. Rutledge refutes that balance sheets cannot include people or ideas. This is because people are not assets as they cannot be owned. Ideas are also not assets because, partly due to the fact that the people who generate them cannot be owned. (Rutledge)
Particularly, financial statement users need more disclosure of nonfinancial information, more forward-looking information and more information about intangible assets.
Findings on Business and Financial Reporting from Accounting Bodies
There are many accounting bodies discuss about the disconnection between new economy and business and financial reporting issue. Here, we summarize the findings of studies from the accounting institutions, CICA and FASB.
Canadian Institute of Chartered Accountants (CICA)
According to CICA, the need for replacing the current accounting model with better performance measures is supported by many professional parties. The existing accounting model cannot precisely reflect the reality of economy as most of the business currently is knowledge-intensive businesses. Therefore, knowledge intensive business needs to create a new accounting model to suit to this era.
The new accounting model will likely integrate both accounting for knowledge-based businesses and also green accounting. Green accountingÂ is a type ofÂ accountingÂ that attempts to factor environmental costs into the financial results of operations.
Financial Accounting Standards Board (FASB)
In their findings, there are five elements that the FASB most concern about in their report. FASB notarize the aspects that can lead company to success and notarize management's plans and strategies to deal with those critical success elements in the future and past. Besides, FASB also notarize metrics that use to control and measure plans and strategies performed by management. That metrics ought to be disclosed consistently from time to time. Failure to voluntary discloses the company's forward-looking plans and strategies will influence the company's competitive status.
Chapter 2-New Reporting Paradigm
Traditional financial statements focus on the entity's ability to recognize value from existing assets and liabilities which is backward-looking. New financial reporting paradigm is considered necessary so that the entity is able to capture and report on its value. There are two approaches that report on the entities balances and flows which using monetary measures that based on traditional financial statements.
The CICA Total Value Creation (TVC) System
Canadian Performance Reporting Initiative (CPRI) is a new reporting model intended to capture entity's value-creating activities. It is profession's view on the subject of traditional accounting to measure performance in new economy. Innovative performance measurement tools are provided to deal with information and report the needs such as intellectual capital, environmental performance and measurement of shareholders value creation performance. TVC is leading to be accepted internationally and reporting standards on value-creation performance. External and internal users are allowed to assess organization's performance and its value creation performance. Basically, TVC relies on six items:
-fully discounted cash-flow model
-ongoing on-line disclosure of changes
-completely transparency which allow readers to understand any assumption
-professional assurance of completeness and internal consistency of disclosed assumptions, consistency of discounted cash flow model and correct TVC application
-diligence of disclosed assumptions
-disclosure and analysis of outcome variance
CICA commented that traditional financial reporting will never replaced by TVC. Overall, TVC is created corresponding to traditional financial reporting which allows measurement and reporting on value creation. Initially, it was designed for internal use. Yet, they found that external users are using it as well. TVC is a sophisticated event-based present value model which is designed to capture and report information about the entity's planned activities.
Accounting for the Future (AFTF)
This is a "value-added" approach to accounting. Same as TVC model, the proposer, Mr. Nash uses a projected future cash flows system to generate a company's financial activities. However, according to the observation by Mr. Nash, these new reporting paradigms have several practical and conceptual problems.
These are the issues arise from developing a new reporting model:
Complexity and cost
Developing a project can be difficult and costly. Cost is the main factor that the company should take into consideration for carrying out a prospective accounting model. A prospective reporting system shall not ignore the traditional cost accounting and cost-allocation problem in any managing reporting system.
According to the prospective measurements nowadays, FASB Concepts Statement No 7: "Using Cash Flow Information and Present Value in Accounting Measurements", is about developing the current measurements using prospective information. In order to become effectiveness, discrete series of cash flow which can define reasonable is needed by prospective measurements. The modern business does not have life limitation venture.
Definition, Measurement and Recognition
Designers need to develop some decision rules so that the AFTF system is related to the definition, measurement and recognition so that the information provided is understandable and comparable from one reporting body to another.
Completeness and Existence
These two assertions need many time and effort to identify. There are uncertainties about whether those prospective systems can apply the completeness and existence assertions on its reporting model.
Chapter 3-New Metrics
The significant value drivers in new economy, for instance the company's workforce, customers and innovation ability are mostly nonfinancial. However, the information is not presented in the financial statements. Therefore, a set of nonfinancial measurements like market share and capacity utilization could be developed so that the investors and creditors can use the information to assess the entities and compare them with other entities.
1. Balanced Scorecard is a performance indicator of intellectual capital under new economy. It is based on four areas of measurements, which are financial, customer, internal process and learning and growth measures.
Weakness: It can only be applied in certain industry.
2. Skandia AFS is a metric that measures intellectual capital which comprises human capital and structural capital. Structural capital includes customer capital and organizational capital like information systems, database. Organizational capital consists of innovation capital (patents, business secrets etc.), process capital and culture.
Weaknesses: It can only be applied in certain industry. Managers should only choose the appropriate metrics based on the environment involved. External users have problem in nonfinancial information comparison. It also raises the completeness assertion. It does not provide explanation on the metrics which can help users understand.
3. Karl-Erik Sveiby and the Swedish Movement proposes "intangible assets monitor". The matrix discuss about the External Structure, Internal Structure and Competence. The three metrics are then subdivided into three sets of indicators which report Growth, Efficiency and Stability.
Weaknesses: It is build for servicing industry. Management tends to omit certain metric when it reports bad news. The metrics and descriptions rely on very subjective analysis.
4. The Value Chain ScoreboardTM is a nonfinancial metric which is designed to fit into the cycle of development and commercialization in new economy. The designer proposes that there are three criteria for the measures which the indicators should be quantitative, the measures should be standardized for comparison purpose and the measures should be relevant to the users.
5. The Value Creation Index (VCI) is used to assess the significance of different nonfinancial measurements in explaining the market value of companies.
Weaknesses: Management may behave differently from what they think is important. Different indices are developed for different industries.
In summary, in order to develop a useful presentation of nonfinancial metric, the metric must be presented in a systematic and ordered fashion. The metric should be presented in the context of the entity in its market and industry. The presentation and computation of metric shall be consistent from period to period. Nonfinancial information provided using the metric will be more useful if it is comparable. A metric should show both good and bad news. Other than that, a metric must be understood. The cost of a metric should not outweigh its benefit as well.
Chapter 4- Intangible Assets
The recognition criteria in the IASC (International Accounting Standard Committee) framework and FASB (Financial Accounting Standard Board) concepts statements provide the instrument for understanding which intangibles are candidates for recognition and which are not.
According to IAS 38 of IASC, an intangible asset is an identifiable non monetary asset without physical form. Unlike a tangible asset, such as computer, we can't see or touch an intangible asset.
An entity has the power to control the asset that is result of past events (for instance, purchase or self creation) and from which future economic benefits (inflows of cash) are expected.
IAS 38 states that an intangible asset is to be recognized if and only if the following criteria are met:
it is possible that future economic benefits from the asset will flow to the entity.
the cost of the asset can be measured reliably.
If the asset is separable (i.e., it is capable of being separated or divided from the entity and sold, exchange with related contract) and arises form contractual or other legal rights, the asset is mean to meet the identifiably criterion. Possible intangible assets include patents, copyrights, and license.
Internally Generated Goodwill
However, IAS 38 also mentions that internally generated goodwill should not be recognized as an asset. This is because it is difficult to identify the events or transaction which contributes to the overall goodwill of the entity. Even if the goodwill can be identify, the extent to which they generate future benefits and the value for such benefits are not capable of being measured reliably. Internally generated goodwill which is not recognized as an asset is to be charge as expense. Internally generated brands, publishing and customer database are the examples of internally generated goodwill.
Research and Development
According to the IAS 38, research costs should be written off to the income statement as an expense when incurred. While development costs are capitalized only after the entity able to complete the intangible asset and either use it or sell it and be able to demonstrate how the asset will generate future economic benefits.
Due to the uncertainty of future benefits, lack of causal relationship, incapability to measure future benefits and lack of usefulness, FASB statement no 2 treats research and development cost as expense when it is incurred.
According to FASB statement 86, the creation of computer software can be divided into two phases. First, cost incurred to establish the technological feasibility of a product is considered as research and development expense. Second, cost incurred after establishing technological feasibility and before the product is available for general release are capitalized.
An entity controls an asset if the entity has the authority to obtain the future economic benefits and also can restrict the access of others to those benefits. In Para 14 of IAS 38, it mentions that the technical and market knowledge can lead to future economic benefits if the entity has such knowledge protected by legal rights such as intellectual property or copyright.
Control is essential as a part of describing item in a way that allow for monetary measurement. Items presented in the financial statement (assets, liabilities, equity, revenue and expense, and cash flows) are stated in terms of monetary unit. Besides that, market requires a legal and customary framework so that they know what they are trading and understand the value of things being traded.
However, the presence of control criterion excludes some items like work force and customer satisfaction form satisfying the definition of an asset. We cannot say 5 workforce and 10 customer satisfaction. Monetary measure is a direct or indirect representation of an entity activity and market participant require a perception of control to define the things being bought and sold.
There are some alternatives that the writer recommended that address the gap between investment in research and development and return of it, which refers to time gap and the correlation gap.
1. Retroactive Capital
Retroactive capital is the company will recognize the intangible as an expense incur in that period of time before it can be commercialized. Company will recognize the intangible as an asset after it is commercialized.
Some researches argued that retroactive capital is not a good alternative because the intangible could be recognize as expenses but after retroactively capitalized the intangible, it becomes asset and being amortize back as expenses for twice.
2. Recognize the Discovery and Identification
There are some researchers criticized that recognition of the discovery will affects the reliability of the financial report. Other than that, there are some criticisms on FASB Statement 86 because the time to recognize the discovery and identification of the intangible things is too flexible. The recognition of the intangible may be delay for a long period of time and become immaterial.
3. In-Process Assets
There are two different point of view people looking at the in-process asset:
a) Traditional View
The in-process account is not an asset but an account that sum up all the costs incurred in producing a thing that will become an asset. If the company sure that the particular thing will not become an asset, it will turn that costs incurred to expenses.
b) Other View
The other view believes that in-process is an asset that has its own value. When there is in-process of R&D, the efforts of the company are being appreciated by others and they are willing to pay for it. Even though the result of R&D is unable to produce a successful product, its efforts on R&D are important and there are at least some values for the in-process R&D.
Measurements in Recognizing Intangible Asset
Cost- Based Measurement
The academic researchers recommended cost-based measurement. However, there are some difficulties in applying cost-based measurement to recognize the intangible assets. The results from the R&D may not be performing as planned by the company. However, the company may use the findings of R&D for other usage. The R&D may also lead to another kind of creation or new techniques. It is hard to justify whether the company should include the full costs of the R&D.
Other than that, it is hard to define the cost of the intangible when the intangible assets like the code developed for software A can be use in software B. It is also hard to define when the costs incurred in Project A change to Project B and C halfway.
Chapter 5- Conclusion
As a conclusion, forward looking perspective information is important for business and financial information users in new economy. There are many proposals in this Special Report study about the disconnection between business and financial reporting and new economy. However, none of those proposals offer a comprehensive solution. Although there are metrics invented to measure the nonfinancial information, the metrics still have their weaknesses. An entity is difficult to recognise an intangible asset due to its measurability and reliability. Therefore, improvement should be done to provide a standardized and useful conceptual basis to recognise intangible asset.