When Company X, which is in the steel business, spends Rs.100 crore every year towards factories, it charges around Rs.3 crore towards depreciation for the next thirty years to write off the asset. Meanwhile, assuming 7% annual inflation, the replacement value of the asset after 30 years would be an astounding Rs.760 crore!
Compare this with Company Y, which is in the consumer products business spending Rs.100 crore every year towards advertisement, promotion and brand building of its products. It charges off the Rs.100 crore to its revenue accounts and steadily builds up an intangible hidden asset, the brand, on its books.
Whose profits are real?
New technologies have fundamentally changed the way we do business. Ask any CEO and he will point out dozens of ways business is conducted differently from just a decade ago. But while so much else has undergone a seismic shift, the way business continues to account for profits remain frozen in a time zone. Reported profits have become increasingly meaningless. Basically, profits measure the rate of change in a company’s assets. Increase assets by Rs.10 crore and you report Rs.10 crore more profits. Write down inventory by Rs.15 crore, profits decrease correspondingly.
Double entry bookkeeping, developed by Luca Pacioli in 1494, lets businesses keep track of changes in asset base. But this system, still in use today, deals primarily with tangible assets such as inventories, debtors, cash, and factories. It ignores intangibles: goodwill, human resources, management quality, customer relationships, information infrastructure, business designs, brands, patents, distribution networks etc. What companies report are “Old profits” based on changes in tangible assets. But any meaningful measure of profits would have to include the rate of change in the total asset base – both tangible and intangible.
In the industrial revolution and advent of mass-production system, this distinction was not important. Worker skills were considered as interchangeable as equipment parts. Remember Charlie Chaplin in “Modern Times”? Clearly, intellectual assets were not an issue. And as intangible assets were not of significant value, it made little sense to include them in the calculation of profits.
But this method of measuring profits is misleading now. In the industrial age, 80% of the important assets were tangible; today, this ratio is probably reversed. Information age companies generate a great deal of revenue using fewer physical assets, but many more intangible ones. They have far less invested in factories and inventories than in talent. While conventional accounting might show a company making large “old profits”, its intangibles may be losing value. By the time these losses begin to show, a company may already be non-competitive.
Managements get what they measure. If the management systems are wrong, management is certain to devote its energies to producing wrong results. The problem is that accountants don’t know how to value most intangible assets. The stock markets, however, have a fair idea of their worth. Companies like Amazon, Microsoft and Google in the USA and Hindustan Lever and TCS in India, loaded with valuable intangibles, have market capitalization far in excess of their book value. But those with poor market positions, bad supplier and customer relationships, poor business designs and demoralized employees often trade at close to or below book values.
Accountants should admit that their measurement tools are flawed and take a first step in setting it right. Obviously, information age accountants are faced with a difficult challenge: live with the old system and distort the truth or develop a new system fraught with the dangers of measuring intangibles. “Old profits” don’t matter, but we can’t accurately compute “New profits”. What we need is a totally different system of measuring business.
Milan Sangani Milan is a veteran stock market investor and educator on equity investing. Connect with him on email@example.com