There is a clear and succinct post at WSJ I recommend called Shift to Valuations, Estimates Challenges Auditors  that talks about the challenges auditors face in their evaluation of corporate financial statements. Emily Chanson summarizes a speech by Jay Hanson of the Public Company Accounting Oversight Board (PCAOB):

estimates and measurements are one of the most frequently identified trouble spots by the U.S. auditor watchdog, as managers and accountants have to spend more time focusing on the fair value of financial instruments, goodwill impairments and intangible assets in the new economy.

I had this same discussion a number of times over the years with my father. He was a CPA and CIA (Certified Internal Auditor, a little more settled than the espionage types). In the first half of his career he was an auditor at Exxon then was an independent auditor with his own practice and ultimately served one term as the State Auditor of New Mexico. He’s gone now but he and I used to have long conversations about changing financial standards and the challenges that intangibles create for accountants.

You see, accounting has the unenviable challenge of applying a tool set designed for the tangible economy to the rapidly-changing and radically-different intangible economy. These standards favor tangible assets and generally recognize spending on intangible assets as operating expenses. This approach has failed to measure or capture the enormous value in the knowledge, ideas and connections that companies have been able to build using information technology and the internet over the last 30 years. These intangible knowledge and collaboration assets are the key drivers of revenues and profits in almost every company today. But since they exist outside the balance sheet, the tangible net worth of the average public company in the U.S. is equal to just 20% of its total corporate value. The rest is., well, intangible and generally not well-understood.

The accounting profession is trying to adapt to this changing world by focusing more intensely on fair value rather than historic costs. But the truth is that accounting (as it is conceived today) will never be able to fully account for many of the intangibles in a business. Many intangibles like people, relationships and culture are not owned assets that can be isolated and quantified on a balance sheet. But they are critical to the competitive (and collaborative) advantage of every company.

This is why we are advocating the promulgation of ICounting. It is a separate skill set that is complementary to Accounting. It is less worried about resources that are owned and controlled and more about resources that are available and connected to an enterprise. Accounting uses financial transactions as a way of measuring financial health and success of an organization. ICounting uses value transactions (the exchange of knowledge, trust and solutions) as a way to understand the health and success f an organization. Each has its place.

Mr. Hanson explains that the PCAOB finds that

auditors fail to check the reasonableness of management assumptions, don’t weigh valuation risk properly, and don’t appropriately consider positive and contradictory evidence in evaluating estimates

How to check "reasonableness and risk," how to "evaluate estimates" in today’s business without understanding the intangibles? Even the Accountants will have to learn ICounting.

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Tags: Accounting, ICounting, PCAOB, fair value, goodwill impairments, intangible assets, intangible capital

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