Oversight Hearing on "Accounting and Investor Protection Issues
Raised by Enron and Other Public Companies."

Prepared Statement of Mr. Peter J. Wallison
Resident Fellow and Co-Director
Financial Deregulation Project
American Enterprise Institute

10:00 a.m., Thursday, March 14, 2002 - Dirksen 538

Mr. Chairman and members of the Committee:

I very much appreciate the invitation to appear before you today to talk about the important accounting issues confronting this Committee—as well as investors, companies, accounting firms and the Securities and Exchange Commission—in the wake of the collapse of Enron Corporation. Robert Litan has covered very comprehensively in his formal statement the various issues that are now the focus of public attention, and in general I can associate myself with the views he expressed.

My testimony today, however, will look to the future, in large part because I believe that much of the current debate about the adequacy of Generally Accepted Accounting Principles—and whether they were properly applied or disregarded in the Enron case—may be beside the point. The fact is that GAAP accounting is becoming increasingly irrelevant for financial disclosure, and we must begin working on supplements and alternatives. I will attempt to explain why this is so, and discuss some of the ideas that seem necessary if we are to bring financial disclosure into alignment with where our economy is today. The accounting industry has foreseen this development, and has been working for years on how to address it. Much of what the industry has done, and much of what I will say today, is covered in a monograph, The GAAP Gap: Corporate Disclosure in the Age of the Internet, of which Bob Litan and I are the co-authors, published in 2000 by the AEI-Brookings Joint Center for Regulatory Studies.

If there is any good that can be said to have come out of the Enron collapse it may be the sudden attention now being paid to the adequacy of GAAP accounting, and the possibility it creates that a better system of financial disclosure will emerge from this review. But if this is to happen, it is necessary that this Committee, policymakers generally, companies and investors, and especially the SEC, understand that in tinkering with GAAP they are in a real sense fighting the last war. Just as we are now realigning our military force structure to deal with terrorism instead of an attack by the Soviet Union in central Europe, there is a need to get started on the process of revising our financial disclosure system to deal with major changes in our economy.

We are all very proud—and deservedly so—of the quality of our capital markets. The ease with which companies can obtain capital financing is one of the reasons we have the most powerful and successful economy in the world, and why ambitious and skilled people from all over the world want to come here to take advantage of the opportunities our economy offers.

The importance of Information

But it is clear that our capital markets would not function nearly as well if investors did not have the information they need. Without information, investors are simply guessing, and when they do that they demand higher premiums or rewards to cover the additional risk they incur. This makes capital more expensive, and poor information reduces the efficiency with which capital is allocated among competing uses. Good information, on the other hand, reduces the uncertainty associated with making investments, and thus reduces one element of investment risk. Reduced investment risk in turn reduces the cost of capital. Lower capital costs generally means that more capital will be available for companies that need it, that capital will be allocated more efficiently, that we will have faster and broader-based economic growth, and that the welfare of all Americans will be enhanced.

But despite the importance of information, and the legal structure we have erected in the United States to assure its disclosure, recent changes in the economy have made it difficult for investors to get the information they need for evaluating companies. This is not because companies are withholding anything they are otherwise required to disclose, or that existing laws and regulations are not being vigorously enforced. It is because the nature of the assets on which most public companies now rely to generate cash flows and profits have changed so radically in the last quarter century that we literally do not have the skills or means to describe their value.

Intangible Assets

According to some estimates, about 80 percent of the value of companies listed in the S&P 500 is attributable to their intangible assets. This represents an important change in how our economic system creates value, but it requires a momentous change in how we account for, report on and disclose the financial significance of that value.

What are intangible assets, how do they differ from tangible assets, and what is the significance for financial disclosure of their coming to dominate the assets of American companies?

We have all heard of the so-called "post-Industrial economy," the "information economy" and the "knowledge economy." These by now clichéd terms refer to something real and undeniable—that the US economy has moved from an industrial or manufacturing economy to one that creates value through services and the productive use of knowledge and information. Computer software and pharmaceuticals are two examples of products that are in one sense manufactured but in a more important sense are the products of human knowledge and skill rather than machinery or equipment. In other words, the value of these products is the knowledge and skill that went into creating them, not the few cents worth of plastic in each disk or the insignificant cost of the chemicals in each pill.

The assets used to produce these disks and pills are classic intangible assets—they exist only as ideas and concepts in the brains of the scientists and technologists who conceived and developed them. They cannot be touched, and in many cases they cannot even be sold. Stranger still, because they consist of the skills, knowledge, education and imagination of a company’s employees, they are not even owned by the companies which receive the cash flows from the sale of the goods or services these knowledge assets have produced. For this reason, the assets that are responsible for the cash flows of many—perhaps most—US public companies do not and cannot appear on their balance sheets.

In addition, the productive assets of many companies include patents, trade secrets, formulas, computer programs and other items that embody ideas or knowledge—and belong to the company—but were internally generated within the company and have values in terms of their revenue generation potential that far exceed their development costs. One of the unique characteristics of the knowledge economy is that companies develop their productive assets themselves, internally, rather than purchasing these assets the way industrial companies purchase machinery and equipment. Because there is no purchase involved, the cost as well as the value of internally developed knowledge assets is inherently uncertain.

We can also go one step further: most companies depend for their success on their reputation—the views that their customers and suppliers hold concerning the quality of their products or services and the honesty of their dealings. In other words, whether such a company is able to generate revenues may depend on the views of others about it and not on anything we can actually see or touch. Obviously, the views of others are not recorded on a company’s balance sheet.

eBay, the online auction system, is a good example of a knowledge economy company. It has a market value of about $14 billion and a book value of $1.4 billion. What is the driver of eBay’s value? It has no inventory, warehouses or sales force. The only thing it has is the reputation it has built among the public, linked to a sophisticated and specially designed computer software system—neither of which can be valued fully by referring to their cost. That’s why eBay’s market value is so much larger than its balance sheet net worth.

Even Enron can be analyzed in these terms. For all the financial and accounting chicanery that may have occurred in the Enron case, the company’s collapse to virtually nothing was the result of a massive loss of confidence in the honesty of its management. As a trading company, the company relied on reputational assets to remain in business, and when this asset was dissipated there was virtually nothing of value left.

Since both eBay today, and Enron when it functioned, consisted of little more than a collection of intangible assets, the question a prospective investor might ask about both of them is how one might be able to tell, at any point in time, whether its intangible assets are increasing or decreasing in value?

Now we are getting close to the issue. If you were an investor, and were considering the purchase or sale of a company’s shares, you would want to know not just what the company had done in the past but what it was likely to do in the future. In fact, since your investment is all about the future, you would want to know as much as possible about what was producing the earnings or cash flows that are recorded in its financial statements, and whether those assets are likely to continue to produce those cash flows.

The effect of intangible assets on balance sheet values

To find this information, you certainly wouldn’t look at the balance sheets of companies like eBay, because few of the assets that are generating its cash flows—the knowledge embedded in the software it uses, or the degree to which its services are valued by its customers, for two examples—are on its balance sheet. These intangible assets—the real source of its earnings and cash flows—are not captured by GAAP accounting, or for that matter by the International Accounting Standards that some regard as an alternative to GAAP. In Enron’s case, the question would have been—as it is with all trading firms—whether they were building confidence and reputation in the market or depleting it.

In other words, in an economy where the principal assets that generate revenues and cash flows for companies are intangible assets, GAAP financial statements are useless to provide the information that investors really need—information about the quality or value of the assets that will produce these revenues and cash flows in the future.

It is important to understand that this is something new. When a company decides to build automobiles, it purchases the land, the factory and the equipment. These have a cost that can be readily ascertained and recorded on financial statements. This meant that the cost of the assets on a company’s balance sheet were a reasonably good reflection of the company’s actual value—since one could simply reproduce the same company by purchasing the same inputs. In theory, a company could be liquidated for the book value reflected on its balance sheet.

That is not true of companies that rely on knowledge. One can’t simply reproduce Microsoft or Merck by buying their offices, research labs and other facilities. They are collections of employees—biological scientists, computer specialists and chemists—whose knowledge and skill create the values of these companies. And although research and development costs might appear on a corporate balance sheet, those costs do not include the actual value of the education, imagination or resourcefulness of their employees and management—all of which continue to belong to these individual employees.

So when some sources estimate that 80 percent of the assets of the S&P 500 are intangible assets that’s a fairly significant statement. It means that perhaps 80 percent of the assets that produce the cash flows and earnings of these companies will not appear—indeed can never appear—on their balance sheets.

The reason for this is that conventional (GAAP) accounting establishes value with reference to costs; it has no effective means for recording the value of the intangible assets internally generated by companies. To be sure, these have a cost of some kind—salaries, laboratory equipment and the like—but these costs do not capture the real value of the assets that are being put to work. Before the advent of the knowledge economy, when goods rolled off factory assembly lines, it was possible to get a good sense of an industrial company’s value by looking at its balance sheet. One would know, within certain limitations, that if the company ultimately became bankrupt because of mismanagement its assets still had value, since they could still be used to produce goods and could be sold to someone who would use them more effectively. Indeed, until the 1970s, the market values of companies did not depart significantly from their balance sheet values. But as the knowledge economy developed, the ratio of market value to book value of public companies began to grow, so that in 2000 it had reached 6-to-1. Obviously, investors were valuing something other than what appears on balance sheets, and it seems reasonably clear that they were placing a value on intangible assets of these companies, even though these did not for the most part appear on their balance sheets.

The effect of intangible assets on income statements and Price/Earnings ratios

Now, it might be objected that balance sheet values don’t really matter anyway—that in the knowledge economy what investors are looking at is earnings, and the price/earnings (P/E) ratios of public companies are what is important. Let’s leave aside for the moment the question of how an investor can have confidence that a company will earn in the future what it has earned in the past—something that comes from an assets of its productive assets and of course cannot be determined from an income statement. Instead, let’s focus on what the GAAP income statement reports. Why is that statement not sufficient to give investors the information they need about companies in the knowledge economy?

The answer is that, once again, the inability to value intangible assets internally generated by companies creates distortions in income statements, making price/earnings ratios and other similar comparisons also unreliable.

A very good example of this problem is furnished by AOL’s settlement several years ago of an SEC charge that, in capitalizing its customer acquisition costs during the years 1994 through 1996, it adopted a misleading accounting treatment. Many of us saw evidence of the enormous amount AOL was spending on customer acquisition in those years, because we received unsolicited disks in the mail with which we could sign on to AOL and try its services. When a company capitalizes a cost like this, it means that it is treating the cost as though it were an investment rather than an expense. In GAAP accounting, of course, cash spent on an investment has no impact on earnings except through depreciation over a subsequent period of years. In capitalizing its customer acquisition costs, AOL claimed in effect that these costs were producing an intangible asset—customers who would use its services in the future—and that the proper accounting treatment would be to capitalize them when they occurred, and to amortize or depreciate them against the earnings from these customers in future years.

The SEC disagreed. It argued that by capitalizing these very large costs AOL showed earnings in 1994 through 1996, when—if it had written off these costs as incurred—it would have shown losses for those years. In 1997, under pressure from the SEC, AOL changed its accounting treatment, so that it expensed its customer acquisition costs.

Was this the right treatment? The answer—in light of later developments—is clearly no. AOL, as we all know, turned out to be a great success, largely because it accumulated a huge number of customers before anyone else. This is a network phenomenon, now well-known, in which each additional customer adds value to those already on the network and the network itself becomes more valuable as it acquires new subscribers. In other words, AOL’s customer acquisition costs really were investments, since they produced a very large, profitable and ultimately market-dominating customer base. But because these costs were—at the SEC’s insistence—written off (expensed) as they were incurred, AOL’s current earnings were in effect understated for the years in which this accounting treatment was required.

Let’s stop for a moment and consider what effect this had on the price/earnings ratio for AOL’s shares. Before the write-down required by the SEC, let’s say AOL had a P/E of 50—very high by historical standards. After the restatement of its earnings—because it now showed losses in each of the three years—it had a P/E for those years that was essentially infinite. Market commentators and analysts who looked at AOL’s GAAP earnings (or lack thereof) would conclude that it was vastly overvalued based on this enormous P/E.

But as it turned out, AOL’s original treatment was correct. It was making an investment when it spent so much to gain customers. We can see that now. But if an investor at the time recognized the value of what AOL was doing, he or she might have been willing to pay quite a lot for the company even though it was showing losses. In other words that perceptive investor would have realized that AOL was creating an intangible asset that had considerable value because it would generate enormous profits in the future. In fact, the cost of building this asset, because it was reducing current earnings, actually made the company look worse, probably lowering the market price at which our savvy investor could acquire shares.

This example shows that in a knowledge economy seemingly sophisticated commentary about companies or a whole market being "overvalued" because price/earnings ratios are high by historic standards can be quite misplaced. Investors, as in the case of AOL, may be placing values on internally generated intangible assets the costs of which are being written off as incurred under prevailing GAAP accounting. This treatment both reduces earnings—thus increasing P/Es—and hides from investors with less sophistication the development of an asset that will be responsible for large cash flows in the future.

It is important to mention here that there is no cure for this problem in GAAP accounting. If AOL had turned out to be a failure, the accounting treatment demanded by the SEC might have been seen as the right one. The asset that AOL thought it was building was not worth the cost. The losses from 1994 through 1996 were real losses, and to the extent that investors were warned off the company by these losses they would have been saved some losses of their own.

How can investors tell the difference? They probably can’t in any precise way. They may be guessing, but overall—given the wide divergence between market values and book values, and the historically high P/E ratios in today’s markets—they are seeing something in companies that conventional accounting is not recording.

This situation is not the result of a deficiency in the skills or imagination of the accounting profession. There is simply no reliable way to place a value on internally generated intangible assets—to measure the value of the asset AOL was building through its customer acquisition costs. There is no market for most intangibles, especially those that are unique to the company that created them, so there is no known way to establish their value for balance sheet purposes.

This is not a healthy situation. If financial statements do not allow investors to understand the real value of a company, if investors are left to guess, they are taking risks. Risk, as I noted above, raises the cost of capital, promotes volatility, and ultimately distorts the allocation of capital.

In other words, the almost 60 year effort to create a more efficient market—in large part by making sure that investors have the information they need—has been at least partially defeated by the advent of changes in our economy. These changes have made intangible assets the real drivers of company value, but this has happened before we have had an opportunity to develop the means to assess and communicate what these assets are actually worth. The result is an increasing discrepancy between what financial statements are telling us and what the market sees—and hence more uncertainty, more volatility, higher than necessary capital costs, and less efficiency in the allocation of capital in our economy.

Data elements and real time financial reporting

There are also other inherent problems with financial statements that are worth noting. For one thing, they are inherently backward-looking. They tell us what happened to the company over the last quarter, or the last year, but not much about what will happen in the future. In fact, under some circumstances financial statements can be actively misleading about the future.

Take the case of Xerox Corporation. While Xerox was exploiting its patent—from the mid-50s through roughly the mid-70s—it was a very profitable company. Unfortunately, however, the copiers the company was producing, while in high demand because of their unique features, were highly unreliable and frequently needed repair. The company found that by selling the copiers instead of renting them it could make even more money—first on the sale, and then by charging for repair services. So until its patent expired, Xerox showed increasing earnings.

However, as soon as competitors were able to use its technology, Xerox was nearly driven out of business. The poor quality of its copiers had infuriated customers, and as soon as they had a choice they changed brands. In other words, even though its financial statements were showing healthy and profitable growth, the company was hollowing out. Investors who relied on Xerox’s financial statements, and did not know the degree of its customer dissatisfaction, were in for a shock.

Here again, we encounter an intangible asset—customer satisfaction—that does not appear on a balance sheet and yet can be more important for predicting the future than what does. In other words, financial statements, because they are backward-looking, are inherently deficient in the information that investors want most to know about—the company’s future. What is needed is information that supplements the financial statements—that provides some indication of the company’s prospects.

Finally, financial statements suffer from one other inherent deficiency. They are issued periodically—quarterly or annually. Between these reports, the market is full of speculation about what they will contain. This speculation adds to uncertainty and volatility, and therefore to risk. The way financial statements are prepared—involving decisions by management and the aggregation of many different items into a relatively few lines—this delay is probably unavoidable. But that should not necessarily mean that all data on a company’s operations has to be issued at periodic intervals.

In the past, when it took a while to assemble financial and other data, periodic releases were unavoidable. Today, however, when a good deal of information is available to management in real time, there is a question whether some of it could not be released more quickly. In fact, the delayed release of financial data may be leading to earnings management—where companies coach analysts to reach conclusions concerning the company’s earnings, and then companies come forth with earnings that slightly beat these estimates. If this is happening, it further suggests that investors’ lack of confidence in financial statements is well founded.

The accounting profession has been developing ways for companies to make financial disclosures on a more timely basis—in some cases virtually in real time—and this subject is covered in The GAAP Gap and in the formal testimony of my colleague Bob Litan.

Possible solutions and the obstacles they face

It seems clear then that our economy—as it comes to rely increasingly on intangible assets as the source of company values—must have some way to assess the quality of these assets. We must recognize that GAAP accounting can never do this, and may in fact distort perceptions of value.

The inherent deficiencies in financial statements have drawn the attention of the accounting profession. As early as 1991, the Financial Accounting Standards Board (FASB) issued a report—now known as the Jenkins report—concluding that information furnished by companies should be forward-looking and user-driven. As the problems associated with intangible assets became more pronounced, accounting firms themselves began developing ideas for ways in which companies might communicate the value of their intangible assets and how they were meeting their goals.

On an official level, the Organization for Economic Cooperation and Development (OECD), which is a program supported by many of the major industrialized nations, has begun an intensive effort to find and develop nonfinancial indicators or measures that would permit investors to assess the prospects of companies or the value of their intangible assets. The indicators are nonfinancial in the sense that they involve information that does not appear in financial statements.

To take the AOL and Xerox examples, the hope would be that nonfinancial indicators or measures could be developed that would have allowed investors and analysts to get a better picture of whether AOL’s customer acquisition costs were likely to pay off in the future, or that Xerox was incurring customer enmity rather than fostering customer satisfaction. In both cases, a great deal of uncertainty would have been eliminated, investors would have a better sense of how to value the intangible assets of both companies, and the securities markets would have functioned more efficiently.

Thus, many groups see the need for making useful nonfinancial information available to investors. But up to now progress has been slow.

First , there is really no comprehensive theoretical framework for the development of this information. There hasn’t been any significant testing of the efficacy of various indicators, there are no universal indicators that could be applied to all businesses, and there are very few for specific industries or activities. In research for The GAAP Gap, I came across a number of suggestions for indicators, and I have attached a list to this testimony, but as far as I know none of these indicators is now being used by a US public company as part of its regular disclosures to investors.

Second, there is concern among companies in proceeding down this road. Companies say that they are concerned that the information they will have to disclose will be helpful to their competitors, or that disclosures will result in legal liability. There is some merit in these concerns, but they may be somewhat exaggerated.

Third, many companies see no value to them in taking the trouble to develop indicators, or the information that the indicators would require them to disclose.

On the other hand, there are several areas where businesses are already cooperating in activities that are closely related to the development of indicators that would be useful for investors. First, many industries participate in a process called "benchmarking," in which they seek to develop the best practices by exchanging information about the way they conduct certain kinds of operations, such as employee recruitment and training. Testing whether these practices are effective involves statistical comparison of indicators.

Second, a number of industries are currently developing supply chain standardization, so that they can save procurement costs by creating accepted definitions for commonly used parts and services. This would enable a manufacturer, for example, to solicit bids for a particular part from a world-wide group of potential suppliers—all of whom would understand the specifications the manufacturer desires without having to meet and discuss them. The definitional problems associated with this activity is not far removed from what would be required to develop common measures or indicators.

Finally, for a number of years businesses have been developing, for internal use, indicators that tell management whether and how well a company is achieving its goals. These indicators are not shared outside the company, but they could be . In fact, a few companies do make some of their internal indicators public. Skandia International Insurance Company, a large Swedish insurer with a world-wide financial services business, has for almost 10 years been making public, in time series, the indicators it uses to measure the success of some of its subsidiaries.

To be sure, even if these internal indicators were made public they would still not permit the comparisons across competing companies that would be most useful to investors. Before this might be possible, certain indicators would have to gain industry-wide acceptance. Nevertheless, making public the results of company-specific indicators, in time series, would be a good start. It’s important to remember that Generally Accepted Accounting Principles—on which we rely today to make comparisons among companies—hardly existed as late as the 1950s. Financial accounting is hundreds of years old, and for most of that time individual firms, and then whole industries, had unique ways of accounting and reporting their results. Although we don’t have hundreds of years—or even half a century—to develop the indicators that are necessary to supplement financial statements, a good place to start might be with companies making public the indicators they use themselves.

Finally, and perhaps most important, there is data indicating that increased disclosure can have the effect of lowering capital costs. This stands to reason—since more information reduces uncertainty and hence volatility and risk. If this can be demonstrated to the satisfaction of companies—either through analytical work or by observing experience of others—a virtuous circle could result, in which successful companies disclose extensive amounts of nonfinancial information in order to achieve lower capital costs, and others must follow suit in order to remain competitive. A lot of value could accrue to the first mover.

Thus far, I have discussed indicators that are derived or interpreted from operating or other data of public companies. But there is also a class of information that might be called data elements. These are raw financial or nonfinancial facts that generally do not require any interpretation or compilation. As I suggested above, the number of patent citations would not be an example of such an indicator, since it requires the distillation of information from a number of sources. On the other hand, a data element might be a company’s daily sales. This is the basic information a company uses to prepare its financial statements. Data elements can also be nonfinancial information, such as the number of employees—assuming that the term "employees" is suitably and precisely defined.

This data can also be disclosed, some or all of it in real time. The development of the Internet makes instantaneous communication, at virtually no communication cost, entirely feasible. In part, this would address the problem of periodicity in financial statements. If the market were to have access to significant information in real time it would put to rest a lot of speculation between quarters.

But developments involving the Internet enable us to go a step further with this kind of quantitative raw data. A new Internet language known as eXtensible Markup Language, or XML, is now coming into common use. Up to now, information on the Internet has been stated in a language known as Hyper Text Markup Language, or HTML. HTML is basically a set of instructions to a display mechanism—a monitor or a printer—on how to display the document as a whole. It does not generally permit individual items of data to be identified and extracted from a document. XML, on the other hand, permits the tagging of individual items of data with definitions and context, so that they can be extracted from the document in which they are imbedded. The word "bank" in a document, for example, would be tagged with a definition that would distinguish its meaning as a financial institution from its meaning as the side of a river, allowing documents on the Internet to be word-searched and data to be extracted for other uses. The accounting profession has begun to develop an accounting application of XML, known as XBRL. The details of this innovation are covered extensively in The GAAP Gap and in Bob Litan’s formal testimony today.

Clearly, the disclosure of data elements in real time is far different from the use of indicators. For one thing, companies would simply be disclosing factual information. Assuming it is accurate, there should be little if any legal liability associated with disclosures of this kind. Moreover, it is far less costly to develop this information than to develop the information used in indicators, since by and large it is information that companies maintain anyway—either to prepare their financial statements or for other business purposes.

There is still the issue of providing useful information to competitors, but the question would be whether any of this data would provide as much useful information to competitors as the many things companies have to do "in the clear"—such as building plants, making acquisitions, or hiring skilled personnel. In any event, whether information will be of use to competitors is a matter to be worked out in considering specific information, not a reason to reject the whole idea out of hand.

The role of policymakers

The issue for policymakers is how to stimulate the development of indicators and more attention to the disclosure of information in real time. The SEC has thus far taken no serious steps in promoting alternative or supplemental forms of disclosure, although under its new chairman there appear to be slight stirrings of interest. Nevertheless, SEC humility in this area would be well-advised. Companies, accountants and analysts can take the lead, and should.

Indeed, SEC mandates of any kind would be highly counterproductive. As we have seen in the past, SEC requirements quickly produce boilerplate disclosures and stifle innovation. There are sufficient potential benefits for companies in the form of lower capital costs to believe that once the best companies start disclosing additional information—and seeing these benefits—others will feel compelled to follow suit.

On the other hand, the SEC could perform a valuable role without issuing mandates. It could encourage voluntary action—convening groups of companies, dealing with objections, seeking solutions that attract support, emphasizing that investors need information in order to make rational choices. In my experience, companies are highly responsive to requests from the government for new thinking; what they don’t want to do is waste the time of their executives.

In summary, then, there is clearly a current and growing need for information that supplements conventional GAAP financial statements. Indeed, the continued efficiency of our economic system depends on developing this supplementary information. Through the Internet, there are now inexpensive ways that this information could be made available to investors, and a strong basis to believe that both companies and investors will be benefited by such disclosure. What is needed, however, is the will among policy makers and businesses to proceed. This Committee could do much to encourage more attention to this question by the SEC.

Mr. Chairman, that concludes my testimony. Thank you for the opportunity to present these views.

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