New Math for a New Economy

Accounting is all about accuracy. Accounting is all about hard numbers. Accounting is all about accountability. Accounting is a time-honored tool for making hard decisions about dollars and cents, about profits and losses. Accounting is the land of bean counters, of number crunchers -- men and women with green eyeshades and calculators.

Accounting, says Baruch Lev, the Philip Bardes Professor of Accounting and Finance at New York University's Leonard N. Stern School of Business, is increasingly irrelevant. And, for that reason, it is increasingly essential and interesting to all of us. The problem, says Lev, is that the systems of accounting and financial reporting that are being used today date back more than 500 years. These systems are not only part of the old economy, they're part of the old, old economy. Luca Pacioli, an Italian mathematician who lived in Venice in the 1400s, developed double-entry bookkeeping in order to offer businesspeople a simple method for keeping track of their transactions -- and, even more important, for making sense of the way that they did business. "If you cannot be a good accountant," Pacioli wrote, "you will grope your way forward like a blind man and may meet great losses."

Today, argues Lev, being a good accountant doesn't guarantee good eyesight. The old lens cannot capture the new economy, in which value is created by intangible assets: ideas, brands, ways of working, and franchises.

The disconnect, says Lev, affects more than just financial analysts and corporate financial officers: Employees don't know how to value their contributions accurately. Managers don't have good numbers to refer to when deciding whether to back a project, or when assessing a project's performance. Are knowledge-based companies overvalued on the stock market? Are companies paying too much to acquire knowledge-based assets? These questions, says Lev, and more, cannot be adequately answered with today's accounting and financial-reporting methods. Accounting, in other words, no longer delivers accountability.

Lev, who is also director of the Vincent C. Ross Institute of Accounting Research and the Project for Research on Intangibles, has become the most articulate, thoughtful, and outspoken critic of old-fashioned accounting, and the most creative advocate of a new, knowledge-based approach to accounting. He has pioneered the development of a Knowledge Capital Scoreboard, which attempts to put hard numbers to intangible assets.

To find out more about what's wrong with traditional accounting, what is needed to fix it, and why it matters to all of us no matter what our job or industry, Fast Company interviewed Lev in his office in New York City.

Why are you calling for a rethinking of the principles of accounting and finance?

In the past several decades, there has been a dramatic shift, a transformation, in what economists call the production functions of companies -- the major assets that create value and growth. Intangibles are fast becoming substitutes for physical assets. At the same time, there has been complete stagnation in our measurement and reporting systems. I'm not talking only about financial reports and Internet investments but also about internal measurements -- accounting and reporting inside companies. These systems all date back more than 500 years.

So here's the situation: We are using a 500-year-old system to make decisions in a complex business environment in which the essential assets that create value have fundamentally changed.

What's the evidence for this transformation?

Look at the Standard & Poor's 500 -- 500 of the largest companies in the United States, many of which are not in high-tech industries. The market-to-book ratio of these companies -- that is, the ratio between the market value of these companies and the net-asset value of the company (the number that appears on the balance sheet) -- is now greater than six. What this means is that the balance-sheet number -- which is what traditional accounting measures -- represents only 10% to 15% of the value of these companies. Even if the stock market is inflated, even if you chop 50% off the market capitalization, you're still talking about a huge difference between value as perceived by those who pay for it day-to-day and value as the company accounts for it.

Another example: John Kendrick, a well-known economist who has studied the main drivers of economic growth, reports that there has been a general increase in intangible assets contributing to U.S. economic growth since the early 1900s: In 1929, the ratio of intangible business capital to tangible business capital was 30% to 70%. In 1990, that ratio was 63% to 37%.

So intangible assets are becoming more important. But what are intangible assets?