Spend some time watching the members of the Financial Accounting Standards Board in action, and it's hard not to think of them as heroes. Seriously. Beset by conniving earnings-manipulating corporations, betrayed by spineless Big Six accounting firms, these seven brave Defenders of Our Nation's Accounting Principles do battle on behalf of investors who need the numbers on financial reports to mean something. At least, that's how it looks from close up, especially during the board's recent bitter struggle to make corporations report the cost of the stock options they give out.

The FASB's valiant efforts over the years may, however, have been largely an exercise in missing the point. Financial statements--in particular the earnings numbers they produce--have actually become less reliable as a measure of corporate performance and value. One study on the topic, by New York University accounting professor Baruch Lev, documents a sharp drop during the past few decades in the statistical correlation between reported earnings and stock returns. This may simply mean investors have gone nuts, but Lev offers other explanations. The most compelling: The Generally Accepted Accounting Principles, set by FASB, don't allow for some of the prime drivers of corporate success--investments in intangible assets such as know-how, patents, brands, and customer loyalty.

The great strength of modern accounting is that it leads managers and investors to draw links between a company's wealth (assets) and the income it derives from that wealth--thus focusing their attention on return on investment and leading them to attempt to maximize that return. Accounting also links spending and revenue over time, so the cost of building a plant that will produce earnings for 20 years is counted as an asset and charged to earnings over 20 years, not all at once. Leaving the most important assets off the balance sheet, and counting money spent on them as immediate expenses, gives readers of financial reports--including company executives--a distorted picture of how a company makes money.

No one disputes that current accounting practice misrepresents reality. "There are arguments that balance sheets ignore certain intangibles," acknowledges former FASB chairman Donald Kirk. "But the reporting issues of trying to recognize them are, in my mind, insurmountable." The concern of many accountants is that companies will try to classify virtually every expenditure as an asset in an attempt to jack up book value and defer expenses. Financial analysts express similar worries--and point to America Online, which, until backing down in October, capitalized most of the costs of recruiting new subscribers as assets, even though it couldn't claim with any confidence that those customers would stick around. But successful established companies often do just the opposite. Microsoft, for example, despite its massive investment in know-how, claims no significant intangible assets. A special FASB rule tells software companies to capitalize some R&D spending, but Microsoft says intangibles are just too hard to keep track of. The company's no-intangibles accounting policy also happens to make its earnings growth look even more impressive, and gives it a truly spectacular return-on-assets number.

Between AOL's overreaching and Microsoft's hauteur, however, are (as has been documented in this magazine) more and more companies whose executives realize that to manage their resources properly, they need to keep track of intangible assets and the returns on those assets. Securities and Exchange Commissioner Steven Wallman is convinced that some of these measures, such as R&D spending and customer satisfaction indexes, are becoming reliable enough to be included as supplements to companies' annual reports. "Not only am I confident that there is a way to do it right," Wallman says, "I'm overwhelmingly confident that we have to do it, because right now we know that the answers we've got are wrong." Lev, who in October founded the Intangibles Research Center at NYU, believes that measurements of R&D spending are already reliable enough to be included as an asset on the balance sheet.

All these measures are, of course, inexact. But so are many of the numbers one now finds on corporate balance sheets. To argue that intangibles don't belong in financial reports is to argue that it's more important for those reports to follow accounting tradition than to reflect economic reality. Which is fine for the professional analysts, whose trade group offers a course on Finding Reality in Reported Earnings. But for the rest of us, as long as companies reporting intangible assets have to follow some consistent rules, what's wrong with earnings numbers that actually bear a resemblance to reality?