Dark Accounting Matter

Physicists calculate that approximately 85% of the matter in the universe is composed of “dark matter” that “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 value of 4.2, suggesting that book value accounts for less than 20% of the S&P 500’s market value. The remaining 80%, appears nowhere in these firms’ balance sheets—it is invisible to contemporary accounting techniques and constitutes “dark accounting matter.”

In a recent article, I explain that dark accounting matter has become a significant limitation on the relevance of financials reported under Generally Accepted Accounting Principles (GAAP). Notably, as I explain, some “dark accounting matter” is composed of factors commonly described as components of “ESG.” Human capital, for example, is an intangible asset omitted from balance sheets, and is commonly categorized under the S in ESG. Therefore, rather than create separate disclosure regimes, I suggest a unified approach for disclosure of valuable intangible assets—regardless of whether those assets fall under “ESG” or reflect traditional intangible assets such as intellectual property. More precisely, I suggest that issuers be asked to describe and discuss factors that contribute to the difference between their market and book values, and to provide tailored disclosures that seek to shed light on that difference.

The Article begins by highlighting the importance of dark accounting matter to equity prices. Recent research shows that the longstanding and highly significant relationship between stock prices and GAAP financials has begun to fade, and the growth of off-balance sheet intangible assets is one reason for this change. Dark accounting matter arises because internally-developed intangibles (e.g., an internally developed patent) are typically valued at zero under GAAP. This means that these intangibles are omitted from the balance sheet, causing the value of assets on the balance sheet to be systematically underrepresented. This accounting treatment leads to differences in the accounting rules for investment as well, as investments in internally-developed intangibles are typically expensed while investments in physical property are capitalized.

As highlighted by four key trends, this accounting treatment reduces the relevance of GAAP financials in a market increasingly made up of dark accounting matter. First, off-balance sheet intangible assets have grown considerably over the past decades, in line with changing patterns in the economy and growth in high-intangible industries such as healthcare and information technology. Second, consistent with the growth in intangibles, the difference between market value and book value has also grown considerably. Third, the number of firms that report a net loss under GAAP has greatly increased; nearly 50% of listed firms report negative net income. Fourth, there has been an explosion in reporting of “non-GAAP” measures, and many investors rely on these non-GAAP measures more than GAAP measures.

The growing obsolescence of GAAP financials leads to challenges for investors, managers, and market participants who rely on quantitative measures of materiality. Investors do not have the information they need for fundamental analysis. Managers must reconsider how to communicate with the market and arguably face poor incentives created by inconsistencies in accounting rules. And market participants who attempt to rely on quantitative measures of materiality, such as auditors, will find themselves stymied. How, for example, can one assess materiality on the commonly used standard of 5% of pretax GAAP income if pretax income is negative?

I argue that the growth in dark accounting matter provides a helpful lens through which to view the recent emergence of disclosures related to ESG. As the value of off-balance sheet assets has increased, investors have understandably demanded more information about those assets. After all, they must attempt to understand and value these off-balance sheet assets. Notably, some of these off-balance sheet intangible assets fall under what is commonly considered to be ESG.

Consider, for example, a company’s human capital. Managers commonly proclaim that their employees are their most valuable asset, and research provides much reason to believe that human capital contributes to firm value. However, there is no “human capital” asset on the balance sheet, and accounting rules require very little disclosure about a firm’s workforce. Viewed this way, it is not surprising that investors have become increasingly vocal in their demands for information about human capital. The question is not why investors want this information, but rather why it should be treated differently than other intangible assets that are excluded from the balance sheet but included in market capitalization.

In my Article, I propose new disclosures that will provide information on intangible assets more generally, whether those intangibles are traditional internally-developed intangible assets (e.g., patents) or ESG-related intangibles (e.g., human capital). My proposal would negate the need for a separate ESG disclosure regime and would capture many of the intangibles that have been omitted under GAAP. Moreover, it would be tailored to each firm, accommodating the wide variation in intangibles across firms and industries.

Specifically, I propose that managers be required to disclose what they believe drives the difference between market value and book value, and to report information on the key intangible assets driving that differential using standardized templates. For example, if a firm has a book value of $200 million and a market value of $1 billion, the firm’s managers would be asked to disclose what they believe drives that $800 million difference. If the firm stated that it believes its human capital and patent portfolio drive the difference, it would need to report standardized disclosures on its human capital and patent portfolio.

As explained in the Article, my proposal includes features designed to provide consistency and comparability across issuers while minimizing costs. However, there are of course potential criticisms, and I welcome feedback from interested parties.