Dark Accounting Matter

Dark Accounting Matter Colleen Honigsberg* ABSTRACT 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.” 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. Other intangible assets do, however, appear on the balance sheet. This asymmetric treatment is increasingly difficult to defend as the divergence between book and market value increases, especially as some intangible assets, such as intellectual property, may or may not appear on the balance sheet depending on how they were financed. This Article seeks to stimulate discussion about how accounting and disclosure rules apply to ESG and other intangibles. I highlight the increasing irrelevance of traditional Generally Accepted Accounting Principles and urge that accounting practice and policy expand to capture at least some factors contributing to dark accounting matter. More precisely, issuers can 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. * Colleen Honigsberg is a Professor of Law at Stanford Law School. I thank Adam Badawi, Bobby Bartlett, Albert Choi, Joe Grundfest, Jim Hines, Rob Jackson, Amelia Miazad, Frank Partnoy, Elizabth Pollman, Adam Pritchard, Gabe Rauterberg, and participants at the Berkeley ESG Conference, Berle Symposium, and Michigan Law & Economics Workshop for helpful comments and suggestions. I can be reached at . 383 384 Seattle University Law Review [Vol. 48:383 CONTENTS INTRODUCTION ......................................................................................385 I. THE ROLE OF ACCOUNTING IN SECURITIES MARKETS ......................388 A. Importance of Financial Reporting in Securities Markets. ...........389 B. Growing Obsolescence of GAAP. .................................................390 1. Key Trends. ...............................................................................390 a. Growth of Intangible Assets. .................................................390 b. Ratio of Market Value to Book Value. ...................................393 c. Increasing Number of Net-Loss Firms. .................................394 d. Use and Reliance on Non-GAAP Financials.........................396 2. Problems Caused by Growing Disconnect. ...............................398 a. Difficulties with Fundamental Analysis.................................399 b. Challenges for Managers. .....................................................400 c. Materiality Assessments in Securities Litigation. ..................402 3. Explanations for Standard-Setters’ Failure to Update. ..............403 a. FASB’s Prioritization of Its Projects. ....................................404 b. The FASB’s Time-Consuming Process. .................................406 II. OVERLAP BETWEEN ESG FACTORS AND INTANGIBLE ASSETS........407 III. IMPLICATIONS ..................................................................................410 A. Proposed Disclosure. ....................................................................410 B. Similar Disclosure Regimes. .........................................................411 1. Tailored but Comparable Disclosures. ......................................412 2. Disclosure-Only Accounting Rules. ..........................................413 C. Objections. ....................................................................................414 1. Cost to Issuers............................................................................414 2. Variation in Types of Intangibles That Precludes Comparability. ...............................................................................415 3. One-Size-Fits-All Standardization. ...........................................416 CONCLUSION..........................................................................................416 2025] Dark Accounting Matter 385 INTRODUCTION Just as much matter is difficult to see, so is the value now attributed to modern corporations.1 The past decades have seen significant growth in (internally-developed) intangible assets that are omitted from the balance sheet—assets that I call “dark accounting matter.” By some estimates, 90% of the value of S&P 500 firms in 2020 was derived from intangible assets—a far cry from the estimated 17% that was derived from intangibles in 1975.2 This estimate is generally consistent with the S&P 500’s current price to book ratio of 4.2, which suggests that roughly 80% of the value of the firms in that index is not captured by book value.3 In this Article, I explain that dark accounting matter has become a significant limitation on the relevance of financials reported under Generally Accepted Accounting Principles (GAAP). Indeed, despite the longstanding and highly significant relationship between stock prices and GAAP financials—and the underlying theory explaining this finding—recent research shows that this relationship has begun to fade.4 This Article identifies dark accounting matter as one reason for the increasing irrelevance of GAAP financials for investors, managers, and regulators. It also provides a path forward for policymakers interested in ensuring that financial statements remain useful to the constituents they were designed to serve. 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.5 The principle underlying this accounting treatment also causes differences in the accounting rules for investment because investments in internally-developed intangibles are typically expensed while investments in physical property are capitalized.6 1. See generally, Virginia Trimble, Existence and Nature of Dark Matter in the Universe, 25 ANN. REV. ASTRON. & ASTROPHYSICS 425 (1987). 2. See infra Part I.B. 3. S&P 500 Price To Book Ratio (I:SP500PBR): 4.191 For Q2 2023, YCHARTS, https://ycharts.com/indicators/sp_500_price_to_book_ratio (last visited Feb. 6, 2024) (showing a price to book ratio of 4.191 for the S&P 500 in Q2 2023). 4. See infra Part I.B. 5. An additional concern is that, because these intangibles are not included on the balance shee (...truncated)