Interviewer: Are you familiar with the economic theory of the bootleggers and the baptists? It explains the notion of why prohibition was able to last as long as it did. Bootleggers wanted it to continue because they were making all of this money. The baptists wanted to do it for moral reasons.
I’m wondering if there’s a similar coalition going on right now with our regulatory structure, with the accountants serving the role of the bootleggers in a sense because they’re making a lot of money producing these reports [i.e., financial statements]. And then of course the SEC and the regulators are in the role of the baptists, saying “we need to keep everybody on the straight and narrow.” It’s this reinforcing loop.
Baruch Lev: This is a brilliant thing. You’re perfectly right. The reason that this goes on [i.e., traditional financial statements that haven’t changed in over 100 years] is that there are some very strong vested interest…
The bootleggers aren’t just accountants. It took me years to understand, there are very highly connected and deep pocketed investors who are thriving from the lack of clarity in financial reports, because that’s where their ability with research staff comes in to overcome this. Some thrive on lack of transparency.
That was the wise Baruch Lev on The Soul of Enterprise podcast discussing his book, The End of Accounting. Lev’s basic premise is that the rise of intangible asset creation (e.g., product design, software, databases, patents, brands, company culture, supply chains) is making traditional accounting based on tangible assets (e.g., facilities, inventory, current revenues) irrelevant.
Indeed, Lev and his co-author found that found that the value of tangible assets and earnings explained more than 80% of companies’ value when entering the stock market from 1950 to 1959, whereas the figure over the period 2000 to 2013 is just over 20% (2016). EverEdge reports that intangibles comprise 87% of all company value, and is much higher still for tech companies. This is why Facebook bought WhatsApp for $22 billion when they only had $10 million in revenue, and why Tesla has such a high valuation when they report losses year after year.
The rise of intangibles makes cost accounting data difficult to interpret. The amount of labor, capital, and raw materials that go into the production process no longer signals the value being generated in that process. When companies made known things by known methods, there wasn’t much room for creating big value or losing lots of money. But when companies are primarily in innovation and information technology, the money spent on inputs does not create much signal as to the value of outputs. This is true not just for valuing a company as a whole, but for putting prices on individual products/services.
The reality of intangible assets is a challenge to the valuation process, which must rely on strategic information. Here’s Lev on the real long term objective of businesses:
It’s not to beat the consensus next quarter, but to achieve sustained competitive advantage. To beat your competitors over the long term.
One signal of sustained competitive advantage is relatively large profits, which is what we’re seeing out of some tech companies. If competitors were catching up to the leading firm, then they would be able to drive down the profits of the leader. What is assumed as market power is often a competitive advantage derived from intangible assets that create a great deal of value for consumers. For example, Twilio — which is an API company automating calls/texts that was very difficult for developers — has had gross profit margins at 50-60%. Many other examples exist.
These realities in the 21st century are not well reflected by government policies in which prices are based on accounting costs plus a small consideration for profit.
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