Dark accounting matter – Legal Aggregate

(Originally published by the Harvard Law School Forum on Corporate Governance on July 9, 2024)

Editor’s note: Colleen Honigsberg is associate dean of students and professor of law at Stanford Law School. This post is based on her recent work.

Physicists believe that about 85% of the matter in the universe is “dark matter,” which “does not absorb, reflect, or emit electromagnetic radiation and is therefore difficult to detect.” The S&P 500 currently trades at a price-to-book ratio of 4.2, which suggests that book value is less than 20% of the S&P 500’s market value. The remaining 80% does not appear anywhere on the balance sheets of these companies – it is invisible to modern accounting techniques and represents “dark accounting matter.”

In a recent article, I explain that dark accounting matter has become a significant limitation on the relevance of financial data reported under generally accepted accounting principles (GAAP). As I explain, part of the “dark accounting matter” consists specifically of factors that are commonly described as components of “ESG.” Human capital, for example, is an intangible asset that is not listed on balance sheets and is commonly categorized under the S in ESG. Therefore, rather than creating separate disclosure regimes, I propose a unified approach to disclosing valuable intangible assets—whether those assets fall under “ESG” or reflect traditional intangible assets such as intellectual property. More specifically, I propose that issuers be required to describe and discuss factors that contribute to the difference between their market and book value, and provide tailored disclosures that attempt to shed light on that difference.

The article begins by highlighting the importance of dark accounting matter for stock prices. Recent research shows that the long-standing and very significant relationship between stock prices and GAAP financials is beginning to fade, and the growth of off-balance sheet intangible assets is one reason for this change. Dark accounting matter arises because internally developed intangible assets (e.g., an internally developed patent) are typically valued at zero under GAAP. This means that these intangible assets are removed from the balance sheet, resulting in the value of the assets being systematically underrepresented on the balance sheet. This accounting treatment also leads to differences in accounting rules for investments, because investments in internally developed intangible assets are typically expensed, while investments in physical property are capitalized.

Four key trends illustrate that this accounting approach is reducing the relevance of GAAP financial data in a market that is increasingly accounting obscure. First, off-balance sheet intangible assets have grown substantially over the past few decades, in line with changing economic patterns and growth in high-intangible industries such as health care and information technology. Second, as intangible assets have grown, the difference between market value and book value has also grown substantially. Third, the number of firms reporting a net loss under GAAP has risen sharply; nearly 50% of publicly traded firms report negative net income. Fourth, reporting of “non-GAAP” measures has exploded, and many investors rely more heavily on these non-GAAP measures than on GAAP measures.

The increasing obsolescence of GAAP financial data creates challenges for investors, managers and market participants who rely on quantitative materiality measures. Investors will not have the information they need to conduct fundamental analysis. Managers will have to rethink how they communicate with the market and likely face poor incentives from inconsistencies in accounting rules. And market participants who try to rely on quantitative materiality measures, such as auditors, will find themselves at an impasse. For example, how can one assess materiality using the commonly used standard of 5% of GAAP pretax profit when pretax profit is negative?

I argue that the rise in opaque accounting matters provides a helpful lens through which to view the recent evolution of ESG-related disclosures. As the value of off-balance sheet assets has increased, investors have understandably demanded more information about these assets. Finally, they must seek to understand and value these off-balance sheet assets. Notably, some of these off-balance sheet intangible assets fall under what is generally considered ESG.

Consider, for example, a company’s human capital. Managers often claim that their employees are their most valuable asset, and research provides many reasons to believe that human capital contributes to company value. However, no “human capital” is reported as an asset on the balance sheet, and accounting rules require very little disclosure about a company’s workforce. Given this background, it is not surprising that investors are increasingly demanding information about human capital. The question is not why investors want this information, but why it should be treated differently than other intangible assets that are not reported on the balance sheet but are included in market capitalization.

In my article, I propose new disclosures that provide more general information about intangible assets, whether those intangible assets are traditional, internally developed intangible assets (e.g., patents) or ESG-related intangible assets (e.g., human capital). My proposal would eliminate the need for a separate ESG disclosure system and capture many of the intangible assets omitted under GAAP. In addition, it would be tailored to each company and would account for the wide differences in intangible assets across companies and industries.

Specifically, I propose that managers be required to disclose what they believe causes the difference between market value and book value, and to report information about the key intangible assets that cause that difference, using standardized templates. For example, if a company has a book value of $200 million and a market value of $1 billion, the company’s managers would be required to disclose what they believe causes that $800 million difference. If the company states that it believes its human capital and patent portfolio cause the difference, it would be required to provide standardized disclosures about its human capital and patent portfolio.

As explained in the article, my proposal includes features designed to ensure consistency and comparability across issuers while minimising costs. However, there are of course potential points of criticism and I welcome feedback from interested parties.