Subcommittee on Securities

Hearing on Adapting a 1930's Financial Reporting Model to the 21^st Century

Introduction

Thank you for the opportunity to discuss with you one of the most critical issues facing investors and corporate stakeholders, as well as one that fundamentally affects the future of my profession in serving clients. That subject is the challenge of ensuring the relevance, timeliness, reliability, consistency and comparability of information and its impact on the ability to truly measure the value of an enterprise in the New Economy. To this point, Peter Drucker, noted management guru, has said that the next Information Revolution will be led not by the technologists, but by the accountants who will identify the information needs required by companies and investors to make more informed decisions about their future.

With the emergence of the New Economy, there is a much greater risk that organizations simply do not have adequate information for making strategic, operational and financial decisions. The capital markets, too, suffer from a dearth of information needed to place reasonably well-supported valuations on companies, and hence for making optimal investment decisions. Nor is there a filter to deal with the potential for the largely irrelevant "information overload" caused by the Internet. We really seem to be "drowning in information while starving for knowledge."

As a result, my testimony today addresses two areas of challenge to business and government. First and foremost in connection with today’s hearing, I will address the importance of improving our current measurement and reporting system, both internal and external to the organization, because it misclassifies or overlooks entirely significant sources of value. Second, I would be remiss, in light of the recently proposed SEC rule that would limit the scope of practice of accounting firms, if I did not also briefly address the impact of this proposal on the accounting profession and its future ability to serve investors and clients. Ironically, at precisely the moment when we need to be developing specialized competencies and new ways to systematically account for emerging sources of value in a rapidly changing world, this rule would, if adopted, prevent us from doing just that.

From our perspective at Arthur Andersen, the New Economy is very real. Advances in technology and the Internet, of course, have played a key role. But so too have globalization, the war for talent and the growing importance of intangible assets like knowledge and innovation. The New Economy is replete with economic and business anomalies, and nowhere is that more apparent than in attempts to value businesses. The following examples illustrate the point:

• Tangible assets no longer seem valuable: BMW, the German automaker, sold its U.K. Rover car business this year to a group of British investors for approximately $16 after Rover posted a major loss in 1999. Despite book assets that included a factory and inventory, the Rover car business was valued in this sale at almost nothing.

• Companies are shedding manufacturing activities: Rambus, Inc. – the chipmaker that markets RDRAM to accelerate PCs – posted a four to one stock split at mid-June in the midst of the NASDAQ doldrums. Founded in 1990, the company’s stock price rose 342 percent in the last year. Unlike Rover, the company develops and licenses technology, but outsources manufacturing, in this way reducing its investment in book assets like manufacturing plants.

• The future seems to be in services and intangible assets: Charles Schwab revolutionized financial services by selling its own and competitor products and services. Its stock price at mid-year was off 35 percent from a March high, but the company is projected to triple its customer assets in the next five years to about $3 trillion. Its stock sells at a price-to-earnings ratio of 41. That is a hefty P/E ratio, but then consider that the company is expected to grow by 46 percent in 2000 alone. Is the stock over- or under-priced?

These examples speak to an important question. How much is each of these companies really worth?

The plain truth is that we cannot readily answer that question because our current measurement and reporting systems in the United States do not capture emerging sources of value. The measurements we use don’t reflect all the ways that companies create or destroy value in the New Economy. Nor do they produce accurate information about companies like Rambus, Schwab, AOL or Cisco, which are breaking ground with new business models, many of which rely almost exclusively on intangible assets like knowledge and innovation, eschewing investments in facilities and other physical assets altogether.

There are clear ramifications in the marketplace, as a result. The current measurement and reporting system can exacerbate business risk and stock volatility. Consider the fact that the number of days that the S&P 500 traded by over 1 percent in the early 90's was 45 percent whereas last year it was 79 percent and this year 93 percent.

Five years ago, Arthur Andersen undertook an initiative with the goal of investigating changes in how companies create value, including analysis of financial market trends over a 20-year period. This testimony reflects insights and findings from that initiative, including the development of new frameworks as a guide for understanding value creation. We believe the core question to be addressed is:

What information do policy makers, business leaders, investors, financial analysts and investors need to make the best judgments about value creation and realization?

What are the characteristics of the New Economy?

It’s tempting to disregard fundamental changes in how value is created in today’s economy, given the financial market volatility this past spring and the stampede of capital out of the dot.com sector. But it would be unwise not to look more deeply at the currents reshaping value creation and destruction.

Our view is that the U.S. economy is built on the shoulders of change that is both real and of extraordinary depth. The Internet has achieved what has never occurred in human history – a ubiquitous global network that supports rich multimedia exchanges of information. By enabling information to be packaged, distributed and consumed in digital form, the Internet breaks the economic bottleneck imposed by physical goods production and, in the process, introduces a discontinuity into the business landscape. Our economy is also shaped by the increasing pace of globalization (itself hastened by faster and cheaper communications); the impact of the war for talent and changing attitudes to the work place; and the increasing importance of intangibles such as knowledge and relationships, along with research innovations, speed and connectivity as change enablers. How is this reflected in the economy and marketplace? Clearly, those issues are complex:

• New business models are emerging for organizations based on customer relationships, supply chain relationships and other intangible relationships.

• New business risks are being created as a consequence, and the information for decision-making risk is ever more critical right now as these new models push the boundaries of traditional control.

• New processes are being implemented and require understanding as a result of these new models.

• And finally, new tools, skills and competencies are required to understand, analyze and interpret the changes that are going on in the market, and to help meet the needs of the market itself.

In all these developments, the role of information is central, and therefore what I will label "Information for decision-making risk" is ever more critical right now as these new models push the boundaries of traditional control.

An example of two companies that compete in retail illustrates the points above dramatically. One company competes with traditional shopping malls and the other as a pioneer in the "virtual mall."

• Mr. Chairman, being from Minnesota, you’re no doubt familiar with the Mall of America, which is owned by Simon Properties. Simon is the largest mall owner in the United States and also the largest publicly traded real estate investment group – or REIT. Simon, until recently, has defined its business model primarily in terms of physical assets. The company owns or has an interest in 255 properties and reports mall visits of some 2.2 billion each year. Simon’s market value was $4.3 billion as of mid-July, 2000. The company’s ratio of market value to book value was 0.4 as of March 31, 2000.

• In contrast, consider America OnLine, the world’s largest provider of online services. At mid-July, the company had a $142.7 billion market cap – about 10 tens that of Simon – but owns only eight properties. AOL’s value reflects its 23 million customers, its global brand and a highly scalable electronic platform, which continues to produce major growth. In 1999, for example, AOL posted a sales growth of 83.7 percent. AOL’s market value to book value ratio was 4.3 as of March 31, 2000.

AOL has fewer customers than Simon Property, fewer locations (primarily its Dulles, Virginia, headquarters), and less capital invested. But AOL has a growth rate based on the scalability of its electronic infrastructure and potential access to an almost unlimited audience. In contrast, a traditional mall’s access to customers is rooted in physical locations, which makes it less easily scalable than the customer assets and electronic offerings of a company like AOL.

It’s instructive to note that Simon Property has recognized the changing competition in the marketplace and taken action, becoming a pioneer in a new business model described as "clicks and bricks." Simon established a new subsidiary to offer Web-based services (Clixnmortar.com or clix). And its Simon Brand Ventures formed in 1997 uses Simon’s large customer base to implement mall marketing initiatives, including marketing and technology alliances.

How are companies creating value in the new economy?

Nevertheless, our measurement and reporting system continues to reflect industrial age value creation, when physical and financial assets were of paramount significance. And Wall Street has failed to clamor loudly enough for more relevant information, despite claims of an era of investor capitalism.

How does the measurement system distort value?

The balance sheet (reporting "stocks" at a particular point in time), income statement and statement of cash flows (reporting "flows" over a period of time) form the backbone of today’s accounting system. But that system does not always capture significant sources of value in our economy. The balance sheet accounts for physical assets like buildings and financial capital as assets - sources of value. In contrast, employees are treated solely as expenses in the income statement, and customers are nowhere to be found as assets. They are simply the byproduct of product and service sales – also tracked in the income statement.

As a result, certain types of accounting treatments need to be enhanced with new innovative measures in today’s economy. We depreciate the costs of a factory on the basis that its value should be amortized over its useful life. But the same principle as easily applies to intangibles like training employees, research and development or marketing, which have value well beyond the year these investments were made. Amazon.com reported a loss of $720 million in 1999. But its financial picture would look dramatically different if the company were able to capitalize (or somehow reflect the value of) its massive investments in such areas as brand- and customer-building, advertising and marketing as it builds a global e-tailing capability. And the most successful companies today are aggressively seeking to build customer assets and knowledge workers. Indeed, relationships of all types - including the information about them and the intellectual capital they create - are as surely assets as any factory or government bond.

Understanding value in the new economy, as a result, goes far beyond questions regarding the appropriate pricing of Internet stocks. Our view at Arthur Andersen is that the formal measurement and reporting system largely overlooks many sources of intangible value, which range from the quality of a company’s leadership to its brands, employee know-how, capacity to innovate, intellectual property, systems and processes, and relationships with customers. Intangible assets, of course, are not easy to measure, and that is the historical reason for their absence from the measurement system.

Why is measuring value in the new economy so important?

Although most companies recognize the growing importance of intangible assets, few businesses have formal processes and systems to manage these assets and the risks they create. For management, we can sum up the need for change in the measurement system in this way:

Organizations effectively manage only what they measure. That’s true for government agencies, private and public companies, and even families accounting for their assets and liabilities.

There is a clear risk that leaders and managers will make uninformed decisions about the use of scarce resources – time and money. Here’s what that looks like in various spheres:

• Government as a whole, as well as public agencies, allocate resources in ways supported by what is defined as valuable in the measurement system, rather than what may have value in today’s society. Government also tracks economic indices based on an industrial age economy. Why not track semiconductor production or employment of knowledge workers, for example, as indicators of economic health?

• Business leadership develops strategy and invests resources in the absence of more comprehensive information about what creates value. We see that in industries in which management puts more money in physical assets, eventually stranding them, because our measurement system showcases them as value-creators in the balance sheet. Investments in intangibles are made – or not made - without clear recognition of their value.

• Because so many underlying sources of value are overlooked in the traditional measurement and reporting system, investors and analysts are compelled to apply a variety of less-than-exact analytical methods and "guesstimates" to value companies. Investors need to understand all of the sources of value and how well management exploits them. The increasing volatility in the daily highs and lows of the NASDAQ index itself demonstrates the need for better information about all the assets that matter. Clearly, the investment community does not fully understand the key drivers of value in the New Economy. Without a better understanding of what creates value, and better information about those drivers of value, the volatility in the financial markets will only continue.

New models are emerging - A new value framework

We believe that companies create and destroy value depending on how they assemble assets into business models. But what assets? Leading companies of the new economy have created unique and powerful business models. The underlying rise in the NASDAQ index, still some 50 percent up on its value twelve months ago, reflects the emergence of new business models based on new combinations of tangible and intangible assets. Many of the winners in the stock market in the last decade --companies like Dell Computer, Cisco Systems and Charles Schwab & Company -- are deriving the majority of their value from their intangible assets – their relationships with customers, suppliers and employees, as well as building and using web-based technologies to link them together.

As a guide for companies, we have developed the Value Dynamics Frameworkä as a way to identify and classify these sources of value in five classes of assets. To the balance sheet categories of financial and physical assets, we need to add three new groupings, as well as identifying the most significant asset in each:

• Customer assets (customers, distribution channels and alliances).
• Employee & Supplier assets (the skills, knowledge and attitudes of the workforce, as well as suppliers and partners).
• Organization assets (leadership, strategy, structure, culture and values, as well as intellectual assets such as knowledge, innovation, systems and processes, and intellectual property).

Value Dynamics redefines assets as potential sources of future economic benefit that have the capacity to contribute to a company’s overall value. This expands the usual accounting definition of assets contained in the balance sheet – financial capital and physical assets. The definition also includes sources of value both within a company’s control and outside it. This goes beyond conventional accounting definitions of assets are based on concepts of control and exclusivity. The pace of industry mergers and consolidations, formation of strategic alliances and partnerships, significant business process outsourcing, etc., suggests that considerable "organizational morphing" is occurring. Organizations are increasingly permeable, relying to a growing extent on supply chain and outsourcing partners, market alliances and other relationships that make up the extended enterprise

Emerging business models demand commensurate strategy and new processes to cope with associated risks. In contrast, the traditional measurement and reporting system is better suited to closed, tightly knit, command-and-control organizations. We need a different measurement and reporting system to reflect these new realities

In this connection, consider Ashby’s Law of Requisite Variety from the field of systems and cybernetics. In its simplest form, Ashby’s Law maintains that "a model system or controller can only model or control something to the extent that it has sufficient internal variety to represent it." In other words, to capture and portray complex systems and behaviors, we need a model that is commensurately sophisticated in its design and representation. Thus, it is not surprising to observe that the accounting and consulting firms over the years have naturally evolved to possess an array of specialized competencies and skills that are necessary to understand, explain, and predict business phenomena, measure and manage risks, and install sophisticated systems and processes. Consistent with Ashby’s Law, in a dynamic environment featuring open systems and permeable organizations, a whole new range of specializations is necessary to recognize and exploit business opportunities, while managing the associated risks, and create and realize value.

This view reflects a systems view of value creation. As business theorist Peter Senge has argued, it’s important to see the forest and the trees. Looking at an organization and its environment as a whole system allows us to see through complexity to the underlying structure. So too with the dynamics of value creation. It is the complex interaction of a company’s mix of assets — its economic DNA if you will — that creates or destroys value.

New risks are being created requiring new processes

New business risks are clearly emerging as new business models push the boundaries of traditional controls. Management must recognize risks that include ebusiness, partnering, channel effectiveness, knowledge capital, human resources, technology innovation, asset stranding, and product development.

Three types of risks (i.e., environment, process & information for decision making) can thwart organizations from achieving their goals and objectives. Environment scanning and diagnostic systems need to furnish relevant, reliable and timely information for strategic decision making. Without such capabilities, decision makers at all levels (within and outside organizations) are exposed to the paramount "information for decision making risk." Of course, we simultaneously need filtering mechanisms to minimize the possibility of information overload. Information at the aggregate level (forest) and detail level (trees) is required on a timely basis.

New tools, competencies and skills are necessary to survive and thrive

The demand for relevant information from global capital markets, the emergence of new, sophisticated measurement tools and technologies, and the development of online auction markets, contribute to an ever-increasing trend of reliable, fair-value information about more intangible assets becoming available. Innovative measurement tools and methodologies are being developed (e.g., neural networks for data mining and customer relationship management; online auction sites furnishing fair value approximations for selected intangibles; Nielsen-type, Media Metrix ratings for Web traffic measurements). These innovations will enable us to capture and reflect the impact of key value drivers. We can also expect revolutionary changes in the business environment - presaging a dramatic shift in the types of skills and competencies that accountants, auditors and other information services professionals will routinely need in the future.

The large accounting and consulting firms have been tracking this for some time and have developed broad capabilities in risk-based assurance services, as well as in a multitude of complementary service line offerings. In many cases this allows more effective assurance to be provided on complex assurance engagements. In other words, the market's needs have been logically and appropriately mirrored in the organizational structures of the major accounting firms (hence their explosive growth in the provision of assurance and consulting services). Unfortunately, the needed interdisciplinary perspectives and fusion of academic fields have not occurred in the educational sector, resulting in a more intensified "war for talent" for the most qualified and competent recruits.

Wall Street suffers from a dearth of relevant information to make proper business valuations. The massive fluctuations in the valuations of both "Old" and "New" economy companies (e.g., Proctor & Gamble and Amazon.com respectively) suggest that uncertainty about the future is rampant. But significant skills in business valuation - and in the measurement and management of intellectual capital and other intangibles - are going to be needed going forward. Auditors should especially take note of these developments because assurance services, by providing credibility to decision-relevant information disclosed by listed companies, play a crucial role in efficient capital allocation and in maintaining public confidence.

The future of accounting – a flawed proposal from the SEC

In the midst of these challenges, the SEC has proposed to broadly limit the scope of practice for accounting firms – just as we need to take an even more active role in making needed changes in the measurement and reporting system in support of better information for decision-making by corporations, investors and government.

This is a fatally flawed proposal in many respects. For example, the most recent comprehensive examination of audit quality and scope of practice – conducted by the Public Oversight Board’s Panel on Audit Effectiveness and completed in the past two months – found no instances in which non-audit services impaired audit quality and, in fact, found in a quarter of the audits studied that non-audit services enhanced audit quality. This finding is completely consistent with our own extensive experience that non-audit services benefit audit quality because the more one knows about a client and the business risks they face, the better the audit. In our view:

The proposal would prevent the accounting profession from being able to provide assurance on exactly the kinds of information and data that investors and the marketplace must have and will demand in the New Economy.

Simply put, we need to be able to understand the "gap in GAAP." We need to assist in the identification and measurement of the emerging sources of value.

Today, in the New Economy, as we’ve noted above, the most important sources of value are not measured and reported. As a result, as Ashby’s Law would demand, the accounting profession needs to continue to develop broad skills and competencies to understand and measure these sources of value - ultimately providing assurance on them.

The proposed SEC rule also flies in the face of the traditional services offered by the accounting profession, which has historically provided a broad scope of practice for clients. Our founder – Mr. Arthur Andersen himself - plainly contemplated that scope when he established the firm in 1913. In describing how our firm could serve our clients, he listed: "periodical audits, including the preparation of balance sheets and statements of profits and an analysis and interpretation thereof (as well as) the designing and installing of new systems of financial and cost accounting and organization, or the modernizing of existing systems." (Emphasis added.)

Even as we sit here today, new sources of value and technologies are emerging. As they emerge, the skills and competencies that the accounting profession will need to bring to audit and assurance will change. The policy question raised by the SEC’s proposed rule is no less fundamental than this: Will the accounting profession be allowed to evolve and to serve investors as these new sources of value emerge? Or will we be locked into a bygone era, and a measurement and reporting system on which fewer and fewer investors rely?

The proposed SEC rulemaking on scope of practice would place the accounting profession in an Old Economy model at exactly the moment when, in our view, policymakers ought to be examining how to develop a New Economy model that "assures," if you will, the relevance of auditing and assurance for investors in the 21^st Century. The SEC rule – coming at this time – would be analogous to a return to manual typewriters, rotary phones and teletype machines just when high-speed laptops, cell phones and digital data transmission became a necessity. We hope you agree that a broad scope of practice is critical to protect investors and to promote audit quality in the 21^st Century.

The future of measurement and reporting

Our view is that accounting firms must be allowed to provide leadership and insights into developing standards and processes relating to information required to support investors, business leaders and policy-makers. The provision of more relevant and reliable information about intangible assets is essential to reduce business uncertainty, and by making possible more consistent market expectations, also reduce stock volatility.

In addition, we expect that the next generation of information management technology to integrate internal and external information, as these digital tools provide streams of information from asset markets that approach real-time. These markets and the information that drives them are being organized at a rapid pace, as new market-makers and "infomediaries" (many of them now on-line) restructure and improve access to them.

As a result, we believe that it will be possible in the future to develop measurement and reporting information that far exceeds today’s standards. Our prophecy is as follows:

In the New Economy, companies will need to continuously measure and report all assets at fair value to all users.

Clearly, this will not occur overnight. There are significant challenges in replacing legacy systems, complying with today’s regulatory requirements, and developing the tools required for hard-to-measure intangible assets. Nevertheless, a "fair value" standard directly links assets to their value in current markets. This stands in contrast to today’s measurement system, which accounts principally for financial capital and tangible assets at historic costs. Companies, in effect, use a "rear-view mirror" to make decisions about their present or future course. Certainly that’s not the best approach in a highly dynamic and volatile market. Where fair market values are not available or cannot be determined, we believe companies must look to innovative ways to measure the performance of their intangible assets.

Consider Cisco Systems, a company that can close its books 365 days a year and can file a registration statement any day. The company has created an electronic infrastructure that shares all financial data almost instantly. Sales figures, product margins, high-cost structures in a given geographic region—everything is visible in real time. Called the "virtual close," Cisco has built the capability of closing its financial books on an hour’s notice.

At Arthur Andersen, we specifically advocate a gradual approach that ultimately will bring the needed change in two important areas:

• Corporate Information for Decision-Making. We support radical change in the measurement system that begins with corporate management developing interim methods of measuring sources of value, including development of key performance indicators. Our view is that innovation is this area will be well rewarded. Many businesses will benefit from making major changes in their internal measurement systems to reflect the value of investment in intangible assets that range from employee training, innovation, development of intellectual capital and its codification in patents and software. As management better understands the sources of value in their organizations, changes in how those assets are managed also must take place. Clear accountability for value in terms of tangible and intangible assets will produce important change in management practices.

• Measurement and Reporting System. The regulatory system requiring public companies to measure and report performance has a long history and slow evolution. Nevertheless, we have called for gradual and concerted action to examine changes that are required to match the new, wealth-creating capabilities. Regulators, standard-setters, academic researchers, and business leaders and corporate boards need to forge a collaboration designed to understand the new economy, and respond with new and thoughtful approaches to measurement and reporting.

What is required is a concerted action by many constituencies. In our recent book on value creation – Cracking the Value Code – we issued a call to action on these issues:

• Management must strive to obtain complete, real-time information about the fair value of all their assets so that they can set strategy, master risk, and measure and report on the entire value creation process.

• Boards of directors need information about all the assets that drive value so that they can properly discharge their duties of stewardship and governance.

• Investors should demand information transparency so that they direct resources where they will create the most value.

• Employees should actively participate in open, two-way communication with employers to enhance their ability to create value for themselves and others.

• Customers should seek out organizations that understand and address their needs so that they and their suppliers will prosper.

• Standard-setters and regulators should encourage the development of new measurement and reporting systems that enhance information transparency.

• Finally, policy-makers should promote the measurement and reporting of all sources of value to all stakeholders so that they have a sound basis for developing monetary, fiscal and social policies.

In summary, we believe that it is important for policy-makers, standard-setters, regulators, business leaders and others to envision a new reporting model to develop rules on fair value measurement and key performance indicator disclosures. Such disclosures will help ensure relevance, timeliness, reliability, consistency and comparability. For the markets to have confidence in these disclosures, they must also be "auditable" -- so that assurance can be provided about them. And given the increasing complexity of the global business environment in the New Economy, accounting firms need to possess a smorgasbord of deep competencies to remain relevant and add value, and for which a "broad scope of practice" is essential.

ANNEXURE

The issues involved with measuring value in the new economy are complex. The following questions are intended to help the Securities Subcommittee of the Senate Banking Committee focus on key issues going forward. First, we need to understand how financial analysts and others go about factoring intangibles in their valuations of companies. The next steps are to identify these key value drivers, come up with reliable ways of measuring them, and begin experimenting with innovations in internal reporting with the expectation that these advances will eventually spill over into external reporting. Bringing about these changes in business reporting, however, implies the promulgation of new measurement and reporting standards, which in turn would require all stakeholders to engage in a constructive debate and propose acceptable solutions.

Questions

1. Financial Analyst Needs: How do analysts use traditional accounting information in valuing new economy companies, which are developing new business models? What other non-financial information do they use in their business valuation models? (A survey of financial analysts to understand how they value Internet companies may be useful)
2. Measuring and Reporting on Key Value Drivers: What are the key drivers of value for companies today? To the extent traditional measurement and reporting does not provide value-relevant information, how do we go about expanding the information set? How can we establish a process by which innovations in internal measurement and reporting for strategic decision-making percolate to external business reporting?
3. Measurement Methodologies: What measurement tools and technologies are necessary to produce reliable measurements and/or key performance indicators for difficult-to-measure intangible assets? What new measures are needed to suit an e-commerce setting? How will these measures be validated? (Again, surveys of existing measurement methodologies, e.g., Web traffic measurements made by Media Metrix, and emerging online auction sites serving as markets supporting fair value determination, e.g., Pl-x.com for intellectual property, would be very useful)
4. Encouraging High-Level Debate: How do we draw the attention of practitioners, standard- setters, policy makers, regulators and academics to this significant matter and promote a productive dialogue? Ultimately, we believe Congress should consider changes to the 20^th century regulatory framework, in order to modernize it for the New Economy.

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