The reason for this conference can be illustrated with an example from real life.

Between 1994 and 1996, America Online undertook an innovative and risky effort to create a subscriber base for its online service. Online computer services like AOL are the classic network industry, where the value of the service to each individual subscriber increases with the number of subscribers. Accordingly, the larger its subscriber base, the more valuable AOL would be as a company.

Recognizing this, AOL began to send out large numbers of floppy disks, unsolicited, to households throughout the United States-an enormously costly effort, in addition to television and print advertising, to create a subscriber base.

Once created, AOL’s subscriber base would have been considered a productive asset under conventional accounting theory. Subscribers paid for time they were connected to the company’s servers, and the company was able to sell advertising to others eager to reach the company’s subscribers. Thus, AOL’s subscriber base was directly responsible for the production of the company’s revenue, and therefore met the test to be considered a productive asset, with a place on the company’s balance sheet, under generally accepted accounting principles (GAAP).

In the years 1994 through 1996, AOL followed this logic. It capitalized the costs of advertising and sending out computer disks-the costs that created this asset. In economic and practical terms, the only difference between these costs and the costs of plant and machinery for a widget manufacturer is that AOL’s asset was intangible and was produced internally rather than purchased from an outside supplier. In accounting terms, then, one might think the treatment should also be the same-since AOL’s subscriber base performed the same function for AOL as plant and equipment performed for the widget manufacturer.

However, the SEC objected to AOL’s accounting treatment. It argued that if AOL had written off its advertising and promotion costs in the years 1994 through 1996, it would have shown losses for those years. Instead, by capitalizing these costs it showed profits. Incidentally, this was more than just an abstract accounting debate; AOL was eventually forced to restate its financial statements for these three years, and was fined $3 million for issuing misleading financial reports. The SEC seemed to regard the company’s treatment of its promotional costs as a deliberate effort to boost its earnings.

But was this fair, or even correct?

Let’s look at the question from the standpoint of investors. There is no question that AOL was creating an asset with its promotional activities. For a company in the online computer business, a large subscriber base was potentially the most important asset it might have. If its subscribers used AOL’s services and were responsive to its advertisers, the company would be very profitable. However, by requiring AOL to write off its promotional expenses, the SEC had removed this asset from the company’s balance sheet.

In addition, of course, when the company restated its financial statements for the years 1994 through 1996, it showed losses for those years. Investors, who took these losses seriously, were likely to have sold the stock. All this occurred at a time when there was great debate about AOL’s prospects, and the restatement probably convinced large numbers of investors that the company’s prospects were poor. Many of these investors may not have been aware that the company was in the process of creating an off-balance-sheet asset that had the potential to make it very profitable in the future.

On the other hand, investors who were sophisticated enough to understand that the company was creating an off-balance-sheet asset-and believed that this asset could be valuable-stayed with the company despite its reported losses. They were rewarded with substantial increases in the price of AOL’s stock until the market break in the year 2000. One of the reasons for this profitability was that the company’s profits during the years subsequent to 1996 were not reduced by depreciation of its subscriber base, the costs of which had already been written off at the SEC’s insistence.

In light of this, what was the correct treatment-AOL’s original approach, or the SEC’s? The answer is that there is no way to know, and that is the nub of the problem we will be discussing today.

AOL’s expenditures in creating a subscriber base could have been a very successful investment. On the other hand, these expenditures could have been a waste of money. It all depended on whether its subscribers stayed with the company over an extended period after trying it out, used the company’s services extensively or only infrequently, and responded to the advertising they received.

Investors who were intent on finding the answers to these questions received no useful information. The information they did receive was not helpful in judging the real value of the company. The company’s accounting method, which capitalized its promotional costs, put a number on the balance sheet but provided no information as to the real value of this investment. The SEC’s approach, by causing the company to write off its promotional expenditures and show losses for the three-year period, discounted the idea that the company’s promotional costs created a valuable asset.

The important point to note is that there was no way to tell which treatment was correct without knowing what would happen in the future. If the subscriber base AOL was developing turned out to be a good investment, capitalizing the costs would be the right treatment; the company had created a valuable asset. On the other hand, if it turned out that subscribers did not stay with the company, or did not use its services, or did not respond to advertising on AOL’s website, the company’s promotional costs were properly written off. Obviously, an accounting system that depends crucially on what happens in the future could not be of much use to investors.

Nor would it be true to say that the SEC’s treatment was more "conservative." At the time the promotional costs were written off, to be sure, this treatment caused the company to show losses, which was arguably a more conservative treatment. But if the costs produced a valuable asset, the fact that the costs were written off in advance would increase the profits the company would show later from the exploitation of this asset, and this would not be a conservative treatment. In fact, the most conservative treatment, following the underlying theory of GAAP accounting, would have been to treat the subscriber base as an asset-as the company did-and to depreciate it over time. After all, the underlying principle of GAAP accounting is that costs and revenues should be accounted for in the same reporting period if the profitability of an enterprise is to be accurately assessed.

Indeed, it can be argued that the SEC’s treatment of AOL’s intangible assets was responsible for the huge price/earnings ratios that appeared during the dot-com boom of the late 1990s. Most of the assets that the dot-coms were creating were intangible assets just like AOL’s subscriber base. These assets were software for such things as Internet auctions, search engines, information databases, and computer applications of every kind-all of which were intangible assets created by employees of the dot-coms involved. Under the theory the SEC followed in requiring AOL to write off its promotional costs, the dot-coms were required to write off the employee salaries and other costs that were responsible for the creation of these assets.

Thus, although immediate profitability suffered, the dot-coms were creating off-balance-sheet intangible assets that might have real value. Investors attempting to assess the value of these hidden assets were, in effect, reconstructing the profit and loss statements of the dot-coms so as to treat their salary and other costs-which were being written off under GAAP-as investments that should have been capitalized. When they did this, current earnings were increased, and price/earnings ratios came closer to approximating historic norms. Viewed with reference to published earnings calculated under GAAP, the extraordinarily high P/Es looked to many like a bubble, but this might have been in substantial part because the dot-coms were writing off, currently, investments that other companies were permitted to capitalize and depreciate over time.

Reconstructing balance sheets and income statements, however, could get investors only so far. It gave them a more accurate picture of the dot-coms’ profits or losses, but there was no way to determine the value of the off-balance sheet assets these fledgling companies were creating, and it was the quality of these assets that would determine their success or failure over the long term. The information necessary to make this judgment was simply not available to investors.

That’s where nonfinancial indicators-the subject of today’s conference-assume some importance. These are measures of how well a company is doing in adding value for its shareholders, and if properly structured, can provide investors with information about the value of specific intangible assets that simply cannot be determined from GAAP financial statements.

Returning to the AOL case, imagine how helpful it might have been for investors in 1996 to know the length of time that AOL’s subscribers stayed with the company after trying out its services; how much time they were connected to the company’s servers; or their overall satisfaction. These would have been indicators of the actual health of the company’s principal asset, whether or not it appeared on the balance sheet under GAAP.

Metrics or indicators such as this are what this conference is about. Although GAAP financial statements attempt to measure the going concern value of business entities, these results are highly inferential and derivative. Nonfinancial indicators, sometimes also called business indicators or business performance measures, are intended more directly to describe the health of the underlying business. The people who will discuss nonfinancial indicators today are some of the leaders in thinking about this subject, and in some cases have been successful in using these indicators to assess the value of intangible assets.

The accounting profession-which has long recognized the deficiencies of GAAP for intangible assets-has been studying and developing nonfinancial indicators for almost 15 years, but with little interest from the SEC, financial analysts, or the business community. There are reasons in each case why no one in any of these groups has made an effort to bring nonfinancial indicators into general use, but none of them-even the SEC-seems to be looking at the issue from the perspective of investors.

Hopefully, this conference will draw more attention to this important subject, and the valuable information it can provide to investors.