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Do Current Accounting Systems Inhibit Innovation?

Innovation thought leaders and industry experts emphatically harp that if you want to stay afloat (and ultimately thrive) in today’s hyper-competitive business environment, innovation is not optional—it’s absolutely imperative for survival and success. Your customers demand it; and if you can’t innovate, your competitors will consistently outflank and outperform you.

Yet, even if you follow all the “rules” and imperatives to innovate and thrive in this competitive marketplace, build a company culture to sustain the creation of new ideas, and take action to promote actual implementation of innovation, success is never guaranteed. In some cases, the numbers and figures churned out by today’s generally accepted accounting systems can create an insurmountable roadblock to new idea creation and the implementation of innovation.

“When companies base their internal performance measurement systems solely on short-term profits or traditional GAAP-approved accounting returns—the results can be dangerously skewed.”

The corporate big-wigs, the board of directors, the investors, private and public funders, shareholders, and the like—they often render the make-or-break decisions about the fate of your business and the future of funding for your big idea based on the four square walls of your basic accounting financial statements. What’s the bottom line? What’s your ROI? Your cash asset ratio? Your net profit margin? (And a whole other stew of esoteric accounting terms and an alphabet soup of financial acronyms.)

When companies base their internal performance measurement systems solely on short-term profits or traditional GAAP-approved accounting returns—the results can be dangerously skewed, causing premature or inappropriate decisions about the fate of new innovations and R&D funding.

Dale Halling, a patent attorney specializing in high technology companies, discusses in both his book The Source of Economic Growth and blog post Accounting Inhibits R&D how current accounting rules may inhibit R&D and innovation and ultimately may be bad for society and business as a whole. Major takeaways from Halling’s work include:

If you invent something without obtaining legal title to it (i.e., through obtaining a patent on the invention), the economic value of the invention is substantially reduced since, without legal title, you can’t license, sell, or finance the invention.

According to their site the current accounting rules, both the cost for creating an invention and obtaining legal title to that invention dictate an immediate expensing of these costs. Why are these costs expensed rather than capitalized? The accounting board’s rationale (as nonsensical and counter-productive as it can often appear) is due to the uncertainty in identifying the amount and time of the future benefits of these expenditures. Since they are classified as intangible assets, the current accounting rules say they should not be classified as assets on the company’s balance sheet.

Halling says, “Our present accounting systems never show [that] internally funded inventions produce any value.”[1] To illustrate this point, he uses the example of a new cell phone that has come about due to millions of dollars worth of investments in numerous inventions. Even though most of the phone’s profits are based on its inventions and not on the manufacturing process, present accounting systems “only allocate a return for the manufacturing of the phone and nothing for the inventions that made the phone possible.”[2] This seems perverse as the massive difference in price between the latest and greatest cell phone and one with old and outdated technology is due to the inventions in the new phone, not to manufacturing.

This flawed accounting system makes it appear that the expenses associated with creating inventions appear to have no return, which in turn causes substantial under-investment in invention. Additionally, this flawed accounting system also causes companies to overvalue their manufacturing processes. With no realistic idea of what the actual return on manufacturing processes is, companies cannot make well-informed, smart decisions on whether to manufacture a product using their inventions or to license the technology to another external entity. [3]

How can this be fixed?
It’s becoming increasingly obvious that our accounting systems need to be modified. After all, many of today’s current companies have 75% of their value stemming from intangible assets. These assets may not appear on the company’s balance sheet, but doesn’t it seem grossly negligent to completely ignore them during the company’s valuation process? It would be impossible to effectuate a major change in our present accounting systems, although they could more accurately track the value or inventions and other intangible assets like patents or other forms of intellectual property, companies would hopefully become less wasteful and make more educated decisions about whether to keep or sell their inventions and licenses. This ideally would encourage a surge of inventions and innovations in businesses that enrich our lives in both monetary and non-monetary ways.

However, knowing internally what the real value of the company’s inventions is will allow management to determine if they should buy or develop the technology, whether they should manufacture or outsource manufacturing or license their technology. Today, most CEO’s think they make money with manufacturing, not inventing. Most companies do not have a significant advantage in manufacturing, and the real value of their products and services comes from inventions in their products and services.







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