Are outdated accounting standards hurting innovation?

Good R&D needs to know what's truly valuable, and what's not

Could innovation be supercharged if accounting standards better understood how to value intangible assets? It's a good question.  

Innovation certainly seems to be slowing down. According to the UNESCO Science Report, global R&D expenditure growth slowed from an average of around 4% per year in the early 2000s to 1.7% in 2019.

The World Intellectual Property Organisation (WIPO) also reported that the growth rate of global patent applications slowed to 1.5% in 2019, compared to an average growth rate of 5% per year in the previous decade.

Many reasons have been proffered for this slowdown in ideas, some more likely than others. But it’s worth considering if the way accountants are stuck using outdated valuation mechanisms means companies often don’t know where their real value is.

Any decent growth strategy would start with “where is the best return on investment?” But if a company doesn’t know that its intangible assets are its most valuable assets, how can it be expected to invest properly?

Changing Marketplace

It wasn’t too long ago that everyone imagined the word “marketplace” as somewhere you go, a physical place on a physical road in the middle of a town.

This marketplace was filled with big stalls where merchants showcased their tangible products. To succeed, companies would strive to out-manufacture their competitors, each vying for the biggest and flashiest shop to attract customers who trundled by.

But aside from a few shopping malls that now mainly serve as watering holes for groups of sulking teenagers, most people now imagine the word “marketplace” as being entirely in the digital realm.

What brought about this transformation?

The Covid-19 pandemic certainly acted as a turbocharger, propelling us into this digital era at an unprecedented speed. But the trend away from brick-and-mortar stores (a bit of jargon from the industry) towards e-commerce as the primary model has been happening for the better part of a decade.

Official statistics show what’s been going on. According to the US Department of Commerce, US e-commerce sales reached $US1.03 trillion in 2022, passing $US1 trillion for the first time ever. E-commerce’s share of total retail growth in 2022 was 23.8% year over year, which was still well below the record-setting share of 84.2% during the Covid-19 pandemic in 2020.

Consider that only a decade ago in 2012, online sales in the US totalled $US231.4 billion. The latest data from the US government also shows that in the last decade, annual US e-commerce sales multiplied by nearly five times, rising at an average annual growth rate of 16.4%.

Here are a few more intriguing stats:

• Sales in online stores will reach 22% of global retail sales by 2023, compared to 14.1% in 2019;

• It is estimated that by 2024, digital wallets will account for over half of total e-commerce payment volumes, with slight declines in credit cards (to 20.8%) and debit cards;

• Amazon coordinated 39.5% of all US retail e-commerce sales in 2022, or nearly $2 in $5 spent online. Altogether, the next 14 biggest digital retailers will make up just 31.0%.

In this new digital landscape, it makes sense that the true gems of economic growth are no longer physical objects but intangible assets. Modern businesses thrive by leveraging intangible assets like intellectual property, cutting-edge software, vast data insights and even the intangible aura of a trusted brand. Intangible assets have become the currency of success in this new digital-first world.

Intangible Innovation

As a result of this changing marketplace, intangible assets have emerged as a key factor in e-commerce innovation as well.

At the heart of innovation lies intellectual property (IP). Through patents, trademarks and copyrights, innovators have nurtured a culture of risk-taking in the digital world, encouraging developers to push the boundaries of what is possible (and to maximise the existing models that were transposed into the online world).

Data, the lifeblood of the digital age, is also unlocking unparalleled insights into consumer behaviour. By deploying deep analytics, e-commerce platforms know more about their customers than their customers know about themselves. This wealth of information enables online businesses to create personalised experiences, tailor-made product recommendations and creepily targeted marketing campaigns.

Software provides the tools and infrastructure for e-commerce companies to optimise supply chains and enhance user experiences in ways never before possible with brick-and-mortar store models.

Finally, the design of e-commerce platforms is an often-overlooked factor in digital innovation, but it plays an indispensable role. After all, aesthetically pleasing and user-centric design makes it easier for users to find what they’re looking for.

Simply put, intangible assets compel e-commerce entrepreneurs to dream big, understand their customers at deeper levels and create experiences that reshape the way we shop.

Today, these assets – anything you can’t drop on your foot – account for about 90% of all company value and drive nearly all earnings and profit growth. Only 40 years ago, intangible assets barely touched 17% of the average company’s value, according to Ocean Tomo research.

It’s hard to name a company that doesn’t carry some digital layer within its operations, so the idea that intangible assets are the biggest part of modern businesses is easy to understand.

Even the smallest SME will have accounting software and customer data. But they will also boast plenty of industry expertise, confidential information, approvals and certifications, innovations (perhaps one or two, maybe more), patents, copyright, trademarks and relationships with suppliers or customers. These are all intangible assets, and it’s hard to say which is more important than the other.

In fact, the very definition of a “pre-revenue” start-up business is that its value is almost entirely intangible. A start-up’s desks, chairs and laptops aren’t worth anywhere near as much relative to the founder’s vision, ideas and perhaps the research that investors chose to support with their hard-earned money.

Language of Business

As logical as this all sounds, businesses still don’t really know how to see – let alone value – their intangible assets.

It strikes me that this oversight is mainly because global accounting standards have no formal way to track, measure or value these assets. Warren Buffet once said that “accounting is the language of business.” But intangible assets are either left off the balance sheet, lost under the amorphous term “goodwill” or if they do make the balance sheet, they are recorded at cost.

Although slow to update (as all bureaucracies and industry bodies tend to be), accounting standards are being updated to consider intangible assets.

For example, the International Accounting Standard (IAS) 38 sets out the criteria for recognising intangible assets separately from other assets and specifies the methods for measuring their carrying amount. Likewise, the International Financial Reporting Standard (IFRS) 3 requires identifiable intangible assets to be recognised separately from goodwill.

A lot of companies simply don’t care what the accounting standards say. They know their data, content, networks and patents are valuable, so their strategy is to seek out consultants or valuers who do understand intangible assets, sometimes bypassing accountants completely. There are plenty of such advisors around, and many are available for astoundingly low fees considering the potential return on investment from their services.

Meanwhile, the inability of accountants to measure or even discuss intangible assets correctly, the discipline of accounting is essentially speaking an outdated language in this modern, digital world. In the process, the true value of businesses is often lost in the cacophony.

To extend Buffett’s analogy further, it’s as though an Ancient Roman citizen were transported to 2023. After he recovers from his shock at things like aluminium drink bottles and movie theatres, the Roman time traveller would probably quickly pick up a decent percentage of modern English words due to their shared Latin roots. But he wouldn’t be conversant, at all. Rome to 2023 New York. That’s how far behind accounting is today.

Obviously, the slowing rate of innovation across sectors and industries isn’t the direct fault of outdated accounting standards. I wouldn’t be so bold to say something like that. But as I pointed out earlier if a company doesn’t know how to value 90% of its assets, how can it be expected to funnel the correct number of resources to the most promising and profitable goals?