SEC Loves IC

Interview by Rich Karlgaard

Commissioner Steven Wallman sees a future for IC reporting.

Tall, broad-shouldered, and absolutely bald, Steven Wallman looks like an ex-Olympic butterfly swimmer. Editor Rich Karlgaard talked to Wallman about IC disclosure at his SEC office in Washington.

ASAP: Why do you advocate the reporting of intangibles? The capital markets already build it into their assumptions.

Wallman: They absolutely do. You could argue that we don't need financial statements at all, because without them you'd still find a way. But, in fact, financial statements do end up being the thing that keeps the discussion of information and exposure of information honest. Financial statements provide that kind of integrity check. If we start to get further afield so that the financial statements become less and less useful and are measuring less and less of what it is that is truly valuable in a company, then we start to eliminate the ability of that scoreboard—that integrity check—to be as useful as it has been. Because of this uncertainty, in the knowledge sector you see tremendous volatility.

A: Why is that bad? Tech stocks have always been volatile. That hasn't stopped people from investing in them.

W: Clearly what volatility does is increase perceived risks. The investor demands a higher return. If you demand a higher return, you increase the cost of capital. It creates an increased cost of capital for that whole sector. The question is, Can you reduce that cost of capital by reducing the volatility, by reducing the perceived risk, by allowing companies to provide better disclosures that will—when you go through this whole cycle—reduce their cost of raising capital? That's critical. If you can reduce the cost of capital, you can have more jobs, you can pay better, you can have more customers, with products that you sell at a lower cost.

A: Where would you like your agency to start?

W: I think the appropriate next step is more research. Then supplemental disclosure that makes it clear that this is different from a disclosure that relates to $100 coming in through the door. We are already at the point where certain measures are reasonably credible enough so they can be disclosed today, which will be quite helpful and useful in showing drivers of value. But I don't think that is the same kind of thing that you would expect necessarily to be on a balance sheet.

A: What are some examples of your new measures?

W: One clear driver of wealth production in a company is customer satisfaction. People have found that if you have higher levels of customer satisfaction, you have higher retention level, you can also charge more, and you've got more loyalty. Lots of things flow through high levels of customer satisfaction. Firms like J. D. Power and others are capable of measuring that in surveys.

A: Yes, but their measurements are relative, not absolute.

W: Well, it's both. Next, they would have to come up with credible measures of customer satisfaction, at least within certain industry sectors. You want absolute customer satisfaction and you also want relative satisfaction, so that you have a competitive understanding of how it plays out. Both of those can be obtained. J. D. Power can do industry wide surveys, and they can do relative and absolute levels.

A: What else would you like to see?

W: Employee satisfaction measures are also starting to come to the fore. People are starting to feel reasonably comfortable with a number of those. These can be anything from very objective, simple measures, like how many days of absenteeism are there, to measures that relate to more psychologically gratifying issues of how happy people are at work and things like that.

A: Happiness tests? Who would conduct such surveys—third parties like J. D. Power, or...perish the thought!...would the government get involved?

W: Not the government, for a couple of reasons. The government is not necessarily the greatest at coming up with new innovations with regard to measures of this type. The government, I think, has a valid role to play in standard-setting, enforcing appropriate disclosures, eliminating externalities, ensuring antifraud, and things of that nature. You don't want somebody saying J. D. Power is not grading right. We're quite good at that kind of thing. We're not very good at coming up with the measures, designing new tests, and implementing them ourselves.

A: Do you foresee a day when we can apply hard numbers to intangible assets?

W: Yeah, sure. I think that Baruch Lev is working on it. What you'll see over the next two, three, four years is the development of new methods, new theories, new constructs, where some will gain currency and some won't. The ones that gain currency eventually will find their way into exposure.

A: Steve, I worry about false assumptions. Take R&D. Everyone in the intellectual capital movement assumes it is a good thing. But Harvard's Michael Jensen claims it ain't so. He says most big companies get negative return from R&D. They squander it.

W: I am not actually convinced by Professor Jensen's work and the results that he had. For every example it's easy to come up with a counterexample where R&D has paid off wonderfully. But leaving aside that debate, what we are talking about here is measuring. Investors know this and can decide whether or not they want to provide premiums or discounts to that company's stock, given that it is engaging in a certain kind of R&D or not. Once you give shareholders the knowledge [about] what it is that the company is doing, and they decide that R&D spending by a company is not a good thing, they can put pressure on the company to come up with some other way of doing R&D, or give it back to shareholders and let shareholders invest in small startup companies. That's fine. What we're talking about is providing that kind of information.

A: But again, why bother? The markets are chugging along fine without it now.

W: There are people who say that right now you can't do it well enough, so therefore it's not worth trying. That's equivalent to going back 15 years and saying right now we don't have computers that are fast enough to do things. Therefore, don't worry about trying to come up with software or trying to make it better. It's silly. We can see a vision of a world out there where we can measure these things better.

A: What does the Web make possible in terms of disclosure?

W: I can envision something in the future, but it is still 5 or 10 years away, where you'd have a very different kind of financial reporting system. We have today a lot of disaggregated information being compiled and aggregated by accountants, then categorized and presented in a financial statement, which, as you say, the analysts then take and spend a lot of time disaggregating, trying to get back to the basics. So you end up with this sort of discounted process. Disaggregated information being aggregated just so people can spend all their time trying to disaggregate it again. This was necessary before electronic delivery. But if you extend this out, as you think about it in 5 years or 10 years—as we get better database technology, faster and more powerful computers, and greater bandwidth to disclose information through the Internet and through other kinds of communication networks—then you are in a position where you can imagine not going through the aggregation process at all. You could see having the auditor function, certifying the information going into a database, certifying whether cash was received on a certain day. But after that, people like you or me or an institution would then have our own application program we could buy off the shelf. Microsoft would sell it.

A: To do what? Create our own financial statement?

W: Exactly. You could access a database and create your own kind of financial statement. Based on your preferences and kinds of things you look for. The things you care about may be different from the [profile] I create. But we'd all be basically working off the same database. You can imagine something like that.

A: How does this play into the subject of intangibles?

W: You, as an investor, might value employee satisfaction or customer satisfaction. I might value brand integrity and patents. Another person might value the financial incentive of managers as defined by the number of options they hold and the strike price. I might value some intangibles more highly than you might, or less highly, or not at all. But at least I would have access to it, and be able to place it into my own grid and assign some multiple that made sense to me.    

Steven Wallman, an SEC commissioner since 1994, directed a major symposium on the accounting of intangible assets last April. Prior to his SEC appointment, Wallman served as a partner at Covington and Burling's Washington law office. commissionerwallman@sec.gov

Illustration by Don Arday
Photography by Max Aguilera-Hellweg

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