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| The accounting world has barely changed since double-entry bookkeeping was invented about 500 years ago. But it will have to change soon. The basic issue is that computing prices have been falling exponentially—50% every 18 months—for the past 30 years and will probably stay on that curve for another couple of decades. Yet, for convenience, accounting treats the plunge as a steady, straight line. All assets, including computers, are depreciated as though they lose the same small fraction of their value each year. Accounting inaccuracies, allowed to accumulate for years, can lead to spasms of disruptive activity, such as occurred a decade ago when corporate raiders bought dozens of companies that had undervalued their real-estate assets. The balance-sheet error meant the companies' stock was artificially low, so raiders roared in to scoop up bargains and liquidate the businesses they acquired. In many industries, the difference between information-technology accounting and I/T reality has been allowed to go on so long that we're going to face the same kind of violent correction. To think about accounting, it's useful to return briefly to first principles. The value of an asset should be its ability to contribute to future earnings. Predicting that value is very hard, so companies generally try to use the replacement cost of, say, a computer as the asset's appropriate value. But even if companies did a better job of carrying computers on their books at replacement cost—by shifting to exponential depreciation—they'd still be missing extremely important issues. For instance, say you're a company with stores where people can use computers to print signs. You carry your computers on your books at a modest discount to their purchase price, based on a plan to depreciate them over five years. But the rapid decline in computer prices (as described in Moore's Law) means a new competitor could enter your market—probably with better software—at much lower cost simply by waiting a bit. The value of your computer assets should drop well below their replacement costs because your computers would leave you at a competitive disadvantage. Another example: Oxford Health said late last year that earnings would be much lower than it had been led to believe by its computerized financial reporting systems, and its stock value plunged 60%. But I'm sure the company hasn't taken a write-down on the value of those computer systems, even though the crippled systems are clearly worth less than the company thought. (I realize that utilities refer to closed nuclear power plants as "stranded assets," but they live in a world of regulatory doublespeak; in real life, a liability needs to be called a liability.) Part of the reason that few companies have to take startling write-downs on their information systems is that, while they overvalue computer hardware, they undervalue software. They sometimes get the right answer for the wrong reasons. Software is generally expensed when it's purchased. Similarly, the full cost of internally developed software is usually taken as a charge immediately, as the salaries of those who produced it. Yet software has a much longer useful life than hardware, as we see in the Year 2000 crisis—where software that took a shortcut on handling dates was expected to go out of use years or decades ago but is still around to haunt us. So, how to get the values right? And what happens if you don't? To get your balance sheet right, you need to focus more on the context in which your assets operate. Information systems used to be relevant mostly internally—in accounting, process control, knowledge management, etc.But now the systems' valuations are based on their ability to help you with external issues—determining customer needs, advertising offerings, locating new raw materials. So, external factors can also radically change the value of your assets, as in the example of the sign maker. Local phone companies show what can happen when values are badly wrong. Fundamentally, the local telecommunications industry is suffering from an accumulation of technological inefficiency that has been preserved and covered up by an accounting method that does not account for innovation. The industry may now suffer the consequences as competitors position themselves to make inroads into the local market. Here's what has happened so far: For the past 30 years, Moore's Law has guaranteed that the switches that compute and process signals have plunged in price. Yet local phone companies have depreciated switches slowly, because their monopolistic positions and skill at regulatory politics gave them the freedom to defer the pain. As a result, when phone companies look at new ways of handling communications, they make their calculations based on balance sheets that assume signal processing is 1,000 times more expensive than it really is. If the computer industry operated in the same way as the telecommunications world, we'd all still be using, and depreciating, IBM 360-model mainframes, which were introduced more than 30 years ago and which have less processing power than the typical calculator of today. At the same time as this depreciation disparity was developing, technology made it easier for new competitors with new, hyper-effective business models to enter the market. While the phone companies assume that they need to have switches that provide lots of intelligence at the core of their networks—to move calls, handle call waiting, and so on—a new style of communications has developed that assumes no intelligence in the network. Instead, this style—which is the approach that drives the Internet—assumes the intelligence on the ends of the network, in my phone and yours. One result is that users can finance new entrants into this kind of telecommunications market, by buying intelligent phone-like devices, in much the way they've financed the progress in the computer industry over the past two decades by buying personal computers. New phone companies don't need to raise risk capital and invest billions of dollars in central office switches to compete with AT&T. The local telephone companies could well have to replace their old switching technology to keep up with newer competitors that have a more efficient approach. Such replacements, while cheap to buy, would entail huge write-offs, given that existing switches are almost worthless and yet are carried on the books at fantastic sums. The central office switches and line cards of the phone companies could become the nuclear power plants (the "stranded assets") of the telecommunications industry. We could wind up with a debacle on the order of the S&L problem that led to such an enormous federal bailout—a bailout that some local phone companies are beginning to lobby for, under the misguided notion that politicians will nostalgically support their monopoly position against new, more competitive entrants. We could also end up with similar, smaller problems in lots of industries unless we start addressing now the issue that accounting in the age of Moore's Law is very different from what's been practiced for the past several centuries. Mr. Reed, formerly chief scientist at Lotus Development, currently consults on computer and telecommunications issues. He can be reached at dpreed@reed.com. |
