Wednesday, April 25, 2007

Knowledge Accounting: Inventory, Capital, Depreciation

Rummaging through my files, I came across a white paper dated Feb. 10, 1981, while I was at Xerox PARC. Some of the ideas in it still intrigue me, and I've never gotten much feedback on them. I've resisted the temptation to update the memo here, or explain the Xerox internal references from that distant time.

I have long been troubled by the fact that accountants regard Research as a "cost center," rather than a "profit center," but I had no reasonable alternative to offer.

* * *
Paul Strassman's talk last Thursday--with its discussion of the characteristics of Tribal, Agricultural, Industrial, and Information Societies--reminded me of something I read a long time ago about the conditions that enabled the emergence of industrial society.

THE CLAIM WAS that a key enabling factor in the "invention" of the industrial firm was the development of modern (double-entry) bookkeeping, particularly the understanding of the key concepts of inventory, capital, and depreciation.

- Prior to double-entry booking, accounting was essentially on a "cash flow" basis (much like we use for our personal checkbooks). There was no way to record the differing effects of differing forms of expenditure. E.g., cash spent to purchase assets showed up as a "loss"; later sales showed up as pure "profit," unconnected with that "loss."

- Without the intermediate concepts of inventory and capital, accounting cannot trace the connection between an expenditure and the income it generates. The books will always look worse in periods of net investment, and better during periods of "living off capital." There is just no way to do rational evaluation of planning of investment (expenditure in one period in the expectation of increased income in a future period) within such an accounting scheme.

- The distinction between inventory and capital is equally important. Imagine GM trying to evaluate its financial position while accounting for sheet metal and metal presses on the same basis. Inventory gets "used up," while capital gets "used." Of course, capital goods don't last forever; the concept of depreciation accounts for their finite lifetime.

- The bookkeeping of assets neither "creates" nor "destroys" money, it merely helps to keep track of its flow, and the relation of cause and effect. For a firm in steady state (or if we integrate over the entire lifetime of a firm) there is no particular difference between the financial position determined by cash flow accounting and by double-entry bookkeeping; however, in dynamic situations the latter gives a far more meaningful evaluation.

- Of course, the "net book value" of an asset (either inventory or capital) is only a first approximation to its actual value, which may be difficult to measure or even intangible. However, book value provides an adequate starting point for more sophisticated analyses, such as Return on Investment or Payback Interval.

* * *
A KEY FACTOR in the development of an information society may well be the adoption of accounting methods that treat knowledge as an asset with a "book value," just like industrial goods or real estate. High-technology firms are precursors of this society because they have already reached the point where a significant portion of their assets is not represented in their balance sheets.

- Trying to budget rationally for knowledge acquisition with present accounting techniques is as frustrating as trying to budget for the acquisition of a new industrial plant on a cash flow basis. The entire expenditure is accounted as an expense, and the result does not appear on the balance sheet at all. Since there is no measure of a firm's real assets, evaluation and planning are ad hoc.

- With present accounting methods, investment in knowledge acquisition will always appear less profitable than draining down existing knowledge capital. This emphasizes short-term results over investment, such as product development or research.

- No firm can totally ignore investment in knowledge. Since "profit and loss" is so misleading in the short term, firms use arbitrary budgetary guidelines instead. (E.g., spend 5% of gross revenues on research and development.) These make no more sense than corresponding guidelines for capital investment. (E.g., spend 8% of sales on investment in plant.)

- The basic problem is not the lack of a tangible "knowledge base," (consider patents, trade secrets, designs, formulae, software, accounting records), but rather the failure to treat this knowledge base as a valuable asset.
[This can lead to substantial anomalies: E.g., Xerox could afford to "invest" millions in speech recognition technology (by purchasing Kurzweil--certainly not for the book value of its assets) at the same time it could not afford the "expense" of a major speech recognition research program.]
- As long as a firm's knowledge assets are fairly static (or can be treated as proportional to other assets), knowledge accounting will not significantly change the picture. However, if they are dynamic (e.g., if the firm is investing in new technology or relying on technology with a finite lifetime), then the picture can be significantly distorted by any accounting method that ignores them.
* * *
BOTH AS a high-technology firm, and as a hopeful purveyor of the systems that will form the basis of the Information Society, Xerox should be in the vanguard in treating knowledge as an accountable asset, and developing the appropriate bookkeeping techniques.

- To start, there must be a distinction between single-use knowledge (inventory) and knowledge capital (which must be depreciated over its expected useful lifetime).

- Such accounting techniques could provide a starting point for the study of the productivity of "knowledge workers." Until it is recognized that they produce something of value, this is hard to do. Just as the "value added" by a production line is the difference betwen the price of the input and the price of the output, the "value added" by an office is the difference between the price of its knowledge input and the price of its knowledge output. A production line or an office is profitable to the extent tht its value added exceeds its cost of labor plus its depreciation.

- Just as internal "transfer prices" must be established for goods flowing among different profit centers within a firm, there must be transfer prices for knowledge flowing among different profit centers. The accuracy required depends both on the amount of net flow and the extent to which the various center are to be evaluated separately.

- Most present "cost centers" will become "profit centers" when it is recognized that they are adding value to the firm's knowledge assets. (See the note later on about paperclips and the cost of accounting for small knowledge transactions.)
* * *
[Constructed by myself for rhetorical purposes.]

1. We lack accurate measures of what knowledge is really worth.

A. Nor do we always have accurate measures of the value of other assets. We can adopt the same accounting basis for knowledge: Use the cost of acquisition as the initial book value.

- Even nominal values would provide a starting point for a rational analysis of expected Return on Investment for different research areas, for planning Technology Investment Profiles, and estimating the value of various types of technology transfer within the firm.

2. We don't have accurate measures of when (and for how long) knowledge will pay off.

A. Again, we don't always have them for traditional assets. Single-use knowledge can be accounted as inventory, and charged out when used. We can assign nominal depreciation rates for broad categories of capital knowledge.

Comments: Research generally depreciates less rapidly than development; it may be appropriate to depreciate basic and applied research at different rates.

- One problem with traditional accounting methods is that product development is an "up front" expense; the better the firm's capital of emerging products, the worse its balance sheet is likely to look.

- Product development should be depreciated according to expected product lifetime. Present accounting methods do not adequately distinguish between long-life products (e.g., 8-12 years for reprographics) and short-life products (e.g., 3-5 years for electronic systems).
[This may explain some of the leisurely corporate pace in exploiting the knowledge capital acquired by PARC. Business planners might have acted differently three years ago had the books shown that the technology demonstrated at Boca Raton was depreciating at $10,000,000 a year.]
3. Knowledge isn't destroyed or lost by being used.

A. Neither is metal press. However, in both cases, one can project a finite useful lifetime, as a basis for depreciation. (Note that depreciation is generally independent of use.)

4. The cost of knowledge may have little relationship to its value. The most surprising things can pay off handsomely, while "sure things" can turn out disappointingly.

A. The same problem exists with traditional assets. Changes in plans or market conditions may leave a firm with capital (plant, goods, or knowledge) that is no longer relevant to its needs, or that is unexpectedly valuable. "Good business judgement" is the ability to ensure that the latter situation predominates.

- Accountants have learned to cope with changes in the value of assets. "Net book value" is a useful baseline, and there are established mechanisms for adjusting it when it is SIGNIFICANTLY out of line. (Many small errors will tend to cancel out.)

- Firms that consistently manage to extract values exceeding costs prosper; those that persist in acquiring goods or knowledge at costs exceeding their business value tend to go bankrupt.

5. There are so many knowledge transactions that the cost of keeping track of them could exceed the value of doing so.

A. This is the "paperclip" argument. There are well-established mechanisms for accounting for large quantitites of industrial goods with low unit value (e.g., charge them in aggregate to overhead, estimate charges on the basis of a statistical sample, aggregate charges through the "petty cash" mechanism).

- Just as it may make sense to charge the cost of the paper in a telephone directory to overhead, rather than charging for each book individually, so it may make sense to charge the cost of the knowledge in the directory to overhead; that does not make it "free," just differently accounted.

- Overhead goods tend to be supplied centrally, and consumed throughout the firm. In many cases, overhead knowledge transations are in the other direction: the knowledge is supplied throughout the firm, and consumed centrally. At present, those who consume knowledge that comes from outside their immediate area may have no idea how much it costs to provide it.

- Accounting records are themselves knowledge assets. Accounting them as such would give us (at last!) a rational method for determining the value of recording various kinds of transactions. "Unprofitable" accounting could be identified and dropped, just like other unprofitable operations.

- As more knowledge transactions are mediated electronically, the cost of automatically recording them will drop dramatically.

6. But a lot of knowledge is carried around in people's heads.

A. Exactly. A significant portion of the firm's knowledge capital is associated with individual employees. (How many times have you heard "Our people are our greatest asset"? How often have you seen this asset on the balance sheet?)

- This would make it convenient to account rationally for a variety of good practices:

Employee education can be treated as a capital expense.

The cost of losing an employee will show up on the books; the cost of employee benefits can then be compared rationally with the value of expected reductions in employee turnover.

When an employee moves between profit centers within a firm, his "book value" provides a reasonable estimate of the "transfer price" that should be associated with the transaction.

- Annual employee "appraisals" can take on an entirely new significance.

7. What about taxes?

A. Legal tax avoidance already creates an accounting tension between accurately reflecting the firm's financial position and minimizing taxes. (Consider accelerated depreciation schedules for investment tax credit.) If present accounting methods are understating the corporation's assets, and net income before taxes, by 20%, then the tax consequences should be thoroughly understood before converting to more accurate methods.

8. Such a deviation from established accounting practice would never be tolerated by auditors, the SEC, etc.

A. The benefits are huge compared to the cost of a research grant to a respectable management school or consulting firm to develop a complete, workable accounting method that includes knowledge assets.

9. This sounds too sensible to ever be adopted.

A. What can I say?

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