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The Limitation Of Financial Reporting


Financial reports and statements are far from accurate in communicating the real value of the enterprise and its future performance potential. Companies that are publicly traded are valued by the market at multiples of their book value, sometimes as high as 20 times. Of course, a percentage of this market value can be attributed to market emotion and error. But when nearly 80 percent of corporate business assets are made of intellectual capital, which is one of the most developed branches of modern business according to job search USA data, and where financial reports report only on the 20 percent tangible assets, one starts to wonder about the accuracy and efficacy of these reports in reflecting the value of the enterprise and its future performance potential. Analysts, investors, CFOs, and accountants have all developed, in their own way, analytical tools and techniques to overcome its limitations. For internal management purposes, performance measures have played a major role in overcoming these limitations. Analysts developed analytical tools to value a company performance beyond financial results, taking into consideration factors like leadership, human resources, patents, brands, and specialized workforce. In addition, many companies, to reduce the amount of analysts and market speculation, voluntarily disclose information about their strategy, management objectives, and key success factors in supplements to their financial reports.


Lacking a formal standardized system for reporting on IC, investors, analysts, and companies will remain captive to this game of speculation and incomplete and inconsistent disclosures. In the industrial economy, this related only to around 20 percent of business assets, and thus was not a significant component that warrants changing or challenging the 500 year old accounting system. But when IC forms 80 percent of corporate America and corporate wealth in developed economies, creating formal standards becomes of significant importance both from a micro and macroeconomic perspective. At the micro level, lacking consistent procedures and standards to report on IC leads to confusion, dissipation of intellectual resources and assets for lack of management focus, and overemphasis on short term financial gains rather than long term and sustained performance. At the macro level, it creates confusion as to the actual state of the economy as there is no accurate reflection or measure of the wealth of corporations.


One of the reasons frequently cited against reporting externally on IC is the risk that such information may be competitively harmful to the reporting company. However, imposing such reporting on all publicly traded companies would probably reduce this risk considerably. This is because such companies will be reporting the same type of information under the same standards, and will thus be subject to the same consistent and comparable measures. In fact the increasing voluntary disclosures made by companies to report on their IC in annual reports, in the United States and Europe, reflects their dissatisfaction with the existing reporting model to communicate their real value to stakeholders. But voluntary disclosure alone cannot be the solution, particularly when the comparability of such disclosures is negligible.


Indeed, it seems that the risks created by not reporting on IC outweigh by far the risks posed to the competitive position of the company. Consider this situation for an example. Companies have bitterly found how their stock prices can suffer if they miss their price/earning ratio's projections even slightly. This happens despite the fact that they may be doing extremely well given the market conditions. The reason behind this is not that investors are emotional, but simply that in the absence of better measures, investors and some analysts take that slightest miss to mean a weakness in the company's competitive position and management ability. If analysts and investors had better indicators of the company's future earning potential then they would be in a better position to make more informed decisions, and thus not merely react to short term results.


There is no doubt that reporting on the critical intellectual drivers of value is of utmost importance to both the company and the economy as a whole. One of the major hurdles hampering the development of IC reporting, however, is the mystification surrounding the subject. In the United States, both the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB)2 examined and confirmed the need for IC reporting.3 Both have concluded, however, that before setting any standards, time should be allowed for IC reporting models to develop beyond their current rudimentary state. The case is very similar in other developed economies, and despite the large number of studies and reports on the subject to date no standardized model has emerged. Part of the mystification is caused by the divergent accounting approaches that developed to deal with IC reporting. Not only have two divergent approaches emerged to deal with IC reporting but there are variances in dealing with different types of IC under each of the approaches.



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