How to Spotlight "Dark Matter" in Accounting

A professor of law and Co-Chair of the Securities and Exchange Commission Working Group on Human Capital Accounting Disclosure offers a practical way to better account for the significant amount of organizational value unaccounted for under traditional accounting practices.

The Increasing Irrelevance of GAAP in Accounting
A Potential Starting Point
A Tailored Approach
The Striking Demand for ESG Disclosures

“Dark Accounting Matter,” a working paper by Colleen Honigsburg, Associate Dean of Curriculum and Professor of Law at Stanford Law School, addresses an issue that continues to vex accounting and financial experts around the world:

“The S&P 500 currently trades at a price to book value of 4.2, suggesting that book value accounts for less than 20% of the S&P 500’s market value. The remaining 80% appears nowhere in these firms’ balance sheets—it is invisible to contemporary accounting techniques and constitutes ‘dark accounting matter,’” she writes.

She continues, “Some ‘dark accounting matter’ is composed of factors commonly described as components of ESG (environmental, social, governance.) Human capital, for example, is an intangible asset omitted from balance sheets, and is commonly categorized under the S in ESG. Other intangible assets do, however, appear on the balance sheet. This asymmetric treatment is increasingly difficult to defend as the divergence between book and market value increases, especially as some intangible assets, such as intellectual property, may or may not appear on the balance sheet depending on how they were financed.”

The Increasing Irrelevance of GAAP in Accounting

In the paper, Honigsberg highlights “the increasing irrelevance of traditional Generally Accepted Accounting Principles (GAAP) requires that accounting practice and policy expand to capture at least some factors contributing to dark accounting matter. More precisely, issuers can be asked to describe and discuss factors that contribute to the difference between their market and book values, and to provide tailored disclosures that seek to shed light on that difference.”

She says that “Perhaps the best example is information about a company’s human capital. Managers commonly proclaim that their employees are their most valuable asset, and research provides much reason to believe that human capital contributes to firm value. However, there is no human capital asset on the balance sheet, and accounting rules require very little disclosure about a firm’s workforce. Viewed this way, it is not surprising that investors have become increasingly vocal in their demands for information about human capital. A growing number of investment firms now incorporate human capital strategies in their investment criteria, and research finds that human-capital focused investment strategies generate abnormal returns. Thus, the question may be not why investors want this type of information, but rather why it should be treated differently than the other intangible assets that currently comprise accounting dark matter.”

She goes on to explain that “The growth in internally developed intangibles—which, as mentioned previously, are typically not reported on the balance sheet—is thought to drive the disconnect between market value and book value. Whereas market value represents the market’s estimate of equity value (i.e., the present value of all cash flows that will be available to the equity-holders), book value under GAAP equals total assets minus total liabilities. In theory, it represents the value that shareholders would receive if the firm were to be liquidated.”

However, research and development (R&D) expenses “will not create a corresponding asset because, as mentioned previously, internally developed intangibles are generally valued at zero. As such, a company that invests heavily in R&D may appear to have minimal assets and negative net income—but may actually have substantial intangible assets that are omitted under GAAP. This inconsistency in accounting for investment is likely a factor in the nearly 50% of listed companies that report negative net income but have a positive market capitalization.”

Despite this growing interest in human capital, it seems unlikely that its value is fully priced into the market, she asserts. “For example, recent work found that an investment strategy built on firms’ human capital investments yields abnormal returns from 3.5 to 7.8%. Given the value of this ESG information, it is no surprise that investors increasingly demand that issuers provide them with human capital disclosure.”

A Potential Starting Point

Given the many challenges of establishing a concrete valuation of intangibles, she proposes “that managers be required to disclose what they believe drives the difference between market value and book value, and to report information on the key intangible assets driving that differential using standardized templates. For example, if a firm has a book value of $200 million and a market value of $1 billion, the firm’s managers would be asked to disclose what they believe drives that $800 million difference.”

She continues: “Consider a firm with a book value of $100 billion but a market value of $400 billion. My proposal would require managers to disclose what drives that $300 billion differential. Should the managers believe that differential is driven by the firm’s patent portfolio, human capital, and brand value, the managers would be required to disclose information on those intangibles using standardized disclosure templates.”

To Honigsberg, the solution is not to capitalize off-balance sheet intangibles. Instead, “she proposes giving investors key information on those assets—and allowing them to incorporate the information into financial analyses as each investor sees fit. For example, a standardized template for human capital could include information such as headcount (broken into full-time, part-time, and contingent), total labor costs (broken down by type of compensation), and turnover. These disclosures would allow investors to incorporate human capital into their own valuation through, for example, adjusting the cost of capital or capitalizing a portion of compensation.”

A Tailored Approach

In her view, “the set of disclosures will be tailored to each company. I am not the first to suggest this type of disclosure regime. For example, the Sustainability Accounting Standards Board (SASB) requires different disclosures by industry precisely because there is so much variation in what drives value across different industries. Key for investors, however, is that the proposed disclosures be sufficiently standardized to allow for comparability. Investors have noted time and again that such comparability is necessary. To this end, I anticipate that peer companies will have similar intangibles and thus provide similar disclosures, allowing for cross-company comparability. Further, to allow for within-company comparability, I suggest that issuers be required to disclose a minimum of three years of data for each intangible. This will permit time-series analysis, and the requirement for three years of data is consistent with the current requirement that the income statement provide three years of data for each issuer.”

The Striking Demand for ESG Disclosures

Her proposal relies on a “disclosure-only approach. In other words, I suggest that investors receive select information that can allow them to better understand the value of an asset, but I do not ask managers to attempt to quantify the value of inherently subjective assets. This approach allows investors to better incorporate the value of intangible assets in their own valuation—and to ask better questions—but will not affect the reliability of the reported financials under GAAP.”

She asserts that the challenges ‘dark accounting matter’ poses in valuation helps explain the “striking investor demand for ESG disclosures. In essence, as intangible assets have created a growing black hole on firms’ financial statements, investors have requested additional sources of information that could give them insight on those intangibles.”

Human capital management perhaps fits best with this paradigm, she suggests. “Commonly classified under the S in ESG, interest in the workforce is sometimes viewed from a humanist perspective that expresses concern for the rights of those who provide labor to the company (i.e., employees and independent contractors). However, human capital (defined as the knowledge, skills, competencies, and attributes of the workforce that enable the firm to earn higher operating and stock-based returns) is commonly viewed from a financial perspective, where it represents an intangible asset that firms must manage and develop.”

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