Glenn Miller and Frank Sinatra may have popularized the concept in the 1940s; 'that old black magic has me in its spell, that old black magic that you weave so well...' but they had nothing on today's accounting profession.
The issue is the valuation of what are euphemistically referred to as 'hard to price assets,' - like brands, customer lists, employee retention percentages. Even somewhat more tangible figures like pension fund values and 'private investments.'
The challenge, alas, has nothing to do with magic and everything to do with a refusal to acknowledge that accounting conventions developed 500 years ago, then standardized during the height of the industrial revolution might no longer provide the degree of specificity required in a post-industrial economy dependent on the exchange of ideas, concepts, theories and related ephemera.
The global economy is increasingly driven by intangibles not found on balance sheets and income statements. Not because they dont have value - but because the powers that be can not agree on a set of comparable factors and methods acceptable to all those to whom they may apply. Institutionalization of these notions might hurt the energy industry and help the software industry - or vice versa - not that anyone is trying very hard to find common ground. And the accounting profession is perfectly happy to play along because they can make money from the confusion.
The reality is that intangibles now account, conservatively, for upwards of 70% of most global corporations market value. The amounts are too large to be ignored and the factors too basic to be sloughed off as immeasurable. This is the present and the future of business value creation. That regulators are beginning to shine an unwelcome light on the dark recesses of the obscure practices that govern these processes suggests the time is well past for companies themselves to take more responsibility for providing solutions. Given the tarnished recent history of attempts to value 'easy to price' assets, new impetus from outside the intellectual confines imposed by the current gate-keepers may be both welcome and salutary. JL
Emily Chasan reports in the Wall Street Journal:
As many companies kick off their annual audits this month, they are taking great pains to document how they arrive at the values they put on their books for hard-to-price assets like thinly traded securities, pension-fund assets and customer lists.
That’s because regulators have warned that companies and their auditors have been relying too heavily on figures provided by third-party valuation advisers and pricing services without fully understanding how they were calculated. Since the financial crisis, when markets for complex securities froze, making it hard to determine what they might fetch if sold, the Securities and Exchange Commission and the Public Company Accounting Oversight Board have been worried about the accuracy of the values companies claim for such assets.
PCAOB inspection reports released in the past two years found a threefold increase in valuation-related audit problems, spurring securities and audit regulators to alert managers and auditors that they are personally responsible for understanding the assumptions that underlie third-party value estimates.
“Anybody doing financial reporting is going to have to learn a lot more, spend a little more money, and make sure these values are right,” said Verne Scazzero, chief executive of Harvest Investments Ltd. in Chicago, which helps companies review the value of their investments.
“The challenge for a CFO, or anyone in a financial reporting group, is that suddenly they are being asked to talk about investments as if they were a lifelong specialist in this category,” he added.
The PCAOB hasn’t completed its latest round of inspections, but the accounting watchdog has been finding fewer pricing and valuation-related deficiencies lately, said a person familiar with the inspection process.
A PCAOB spokeswoman declined to comment.
For its part, the SEC is satisfied with many of the changes it is seeing from companies, auditors and valuation firms. “They got the message,” said Jenifer Minke-Girard, the agency’s senior associate chief accountant.
Investors may never see the mountains of paperwork auditors and companies are generating, but the results of the process will show up “on the very face of the balance sheet,” where valuations for investment assets should be more accurate than in the past, said Mr. Scazzero of Harvest Investments.
The PCAOB organized a task force to examine the issue and has held a series of public and private meetings with it over the past two years. The SEC’s staff, meanwhile, has asked companies including Charles Schwab Corp. KeyCorp Piper Jaffray Cos. and BB&T Corp. to explain how they were using pricing services, and what actions they took when there were discrepancies between one pricing source and another. Each company, in its publicly filed response, agreed to provide more details of its processes in future disclosures.
As accounting rule makers have tightened requirements for companies to carry assets on their books at market prices, companies have come to rely more on outside services that use computer modeling to help them appraise their most-esoteric assets, such as structured financial products, auction-rate securities and pension investments. Now, companies want to know more about those models.
“Everyone is looking to beef up their documentation,” said P.J. Patel, managing director at Valuation Research Corp. in New Jersey. “We do the valuation work and have an internal review, then the client and its auditors review it, then ultimately the PCAOB and SEC.”
Corporate auditors have grown more likely to consult with their national offices on tricky valuations, and many have hired additional advisers to get a second opinion. “Auditors are going to be asking a lot more,” questions about how values were determined, said John Keyser, national director of assurance services at accounting firm McGladrey & Pullen LLP. “The work is exponential.”
Pricing firms historically have been hesitant to fully explain their models because of competitive concerns, but regulatory pressure is prompting some, like Interactive Data Corp, to reveal more information. IDC, which says it comes up with fair values for 2.8 million securities a day, has rolled out software over the past year that lets corporate managers see the data and assumptions behind its valuations.
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