The KEI Network begins its September series, In Search of the Future Economy, with a basic question: are we still measuring the economy we actually have?

Traditional accounting was built for an industrial age dominated by factories, machinery and physical assets. Today, much of economic value is created by knowledge, software, data, artificial intelligence, intellectual property, customer relationships and human capital. 

In “Exposing the Hidden Economy” Robert McGarvey argues that accounting’s conservatism now leaves many of these modern assets invisible to managers, investors and lenders. “The Hidden Economy” broadens the issue, citing Statistics Canada research suggesting that recognizing more intangible investment would reveal substantially more economic activity than conventional measures currently show.

This matters especially for SMEs, whose real strengths often lie in capabilities rather than collateral. If Canada is to finance, manage and grow its future economy, it must first learn to recognize the assets already driving it.

Exposing The Hidden Economy: Why Accounting for Intangible Assets Matters

    – By Robert McGarvey

Capitalism is in the midst of another major asset revolution. We have not witnessed a paradigm shift on this scale since the Industrial Revolution two centuries ago. Value creation today has been transformed, driven by the growth of intelligent technology and a modern networked-based digital infrastructure. The value drivers of this new economy are vastly different from the tangible assets of the industrial era. As valuable as plant, equipment and machinery are, newer intangibles like software, artificial intelligent algorithms, Big Data, and global networks-of-value (e.g. social media) have eclipsed them. The hard reality is the economy has changed in fundamental ways, but the Science of Economics and Accounting Standards remain unmoved. Their basic assumptions remain stuck in industrial mode, creating both a measurement problem and potentially a significant arbitrage opportunity.

It is hard to imagine a more esteemed profession than Accounting. Accountants are considered by many to be – ok, a bit boring – but reliable, accurate and solidly technocratic. And yet, there is trouble in the accounting paradise. In plain speaking, there is a giant and growing rift between economic reality and what accountants are prepared to measure. How can this be? 

Well it seems that accounting great strength (its conservatism) is also its most profound  weakness. It appears that Accounting is in complete denial about the profound transition that has taken place in modern capitalism. Over the past 50 years, the economy has been fundamentally transformed from an industrial factory-based economy, dominated by physical assets to a new digital knowledge-based economy dominated by intangibles.

How is it possible to miss such an obvious development? The problem is, modern Accounting became fixed-in-stone in the early 20th century. This was the period when factory-based manufacturing began to develop, and accounting began to establish Standards and formalized approaches to account properly for tangible assets like land, plant, equipment and machinery – the physical value drivers of the industrial economy.

Accounting needs to modernize. The gap in GAAP (Generally Accepted Accounting Principles)  is potentially dangerous due to the fact that accounting does not recognize or account properly for modern value creation. The vast majority of revenue-generating assets today are intangible (upward of 90%, source S&P 500).. These value sources not only drive the majority of revenues in the modern economy but they are also vital from a management point of view. Intangibles are literally the source of corporate competitive advantage; yet they remain undocumented, absent on financial statements, which means they’re essentially invisible to management, investors, and the public.

Accounting for intangibles has real life implications. For example, banks and other financial markets have almost completely abandoned the SME (small to medium-sized enterprise) sector, by far the most important economic sector in most developed economies today. Why? The fact is most of the exciting new growth opportunities today are in the ‘new’ economy, and their assets are intangible. These non-traditional assets are most often not capitalized on SME company balance sheets. Regrettably SME’s are not the only victims; the gap in GAAP is undervaluing corporations large and small throughout our economy.

The kinds of changes needed today are more in conformity with pre-industrial accounting. Frederic Cronhelm, writing early in the 19th century, emphasized the equivalence between total capital and its constituent parts, arguing that the purpose of bookkeeping is to “show the owner at all times the value of his whole capital and every part of it.”

Measuring value accurately in capitalism is one of the keys to fully unlocking a new economy. For example, the 19th century Industrial Revolution of mechanized factory-based production was remarkable, but it was not until J.P. Morgan, the banker, revolutionized accounting, aggressively capitalizing industrial class assets that 20th century industrial capitalism finally reached it full potential. Not only is it important to measure value properly from a corporate point of view. Accounting reform is also vital as Canada seeks to accelerate economic growth in its quest to renew Canada and escape the predatory embrace of our close neighbours to the South. 

The Hidden Economy: Why Accounting for Intangible Assets Matters. For more than a century, accounting has been one of the world’s most trusted professions. Investors, lenders, governments, and businesses rely upon financial statements because they are built on principles of consistency, transparency, and reliability. Those principles have served the global 
economy remarkably well. Yet there is growing evidence that accounting now faces a challenge unlike any in its history. The economy it was designed to measure has fundamentally changed. 

The accounting standards that underpin modern financial reporting were developed during the
Industrial Revolution, when factories, machinery, buildings, inventories, and other tangible assets generated most corporate wealth. Today, however, economic value increasingly comes from assets that cannot be seen or touched: knowledge, software, data, artificial intelligence, intellectual property, customer relationships, organizational capability, brands, and the skills of employees. The economy has evolved. Accounting has evolved far more slowly. 

The Reliability Question. The principal reason traditionally offered for excluding most intangible assets from financial statements has been reliability. Unlike a building or a piece of equipment, how does one objectively value a company’s accumulated expertise, proprietary algorithms, customer loyalty, corporate culture, or innovation capability? These concerns are legitimate. Financial reporting depends upon standards that are objective, verifiable, and comparable across organizations. Investors must have confidence that reported values are supported by evidence rather than optimism. But this objection becomes far less persuasive if reliable methodologies now exist.

Robert McGarvey and his colleagues have spent years developing standardized principles for 
identifying, classifying, measuring, and reporting intangible assets in a transparent, consistent,  and auditable manner. While no valuation methodology eliminates professional judgment entirely, neither do many existing accounting practices. Depreciation schedules, pension obligations, impairment testing, deferred taxes, and contingent liabilities all require estimates made within standardized frameworks.

Reliability has never meant perfect precision. It has meant disciplined measurement using accepted standards. If standardized methodologies can produce reliable and comparable measures of intangible capital, then the principal obstacle is no longer technical. It is institutional.

When Conservatism Becomes a Constraint. Accounting’s conservatism has long been one of its greatest strengths. It protects investors from overstated earnings and inflated asset values. It encourages prudence and promotes confidence in financial markets. But every strength can become a weakness when circumstances change. Today, the greater danger may no longer be overstating corporate value, but systematically understating it. Financial statements continue to record the assets of the industrial age while omitting many of the assets that generate value in the knowledge economy. Investors receive only a partial picture of corporate performance. Banks continue to undervalue knowledge-based businesses, particularly small and medium-sized enterprises. Management often lacks standardized measures of the very capabilities—innovation, organizational knowledge, customer relationships, data, artificial intelligence, and human capital—that determine long-term competitiveness.

The debate is therefore no longer simply about reliability. It is about relevance. Financial reporting should faithfully represent the economy it is intended to describe. When intangible assets increasingly drive corporate performance, excluding them makes financial statements progressively less representative of economic reality.

The Hidden Economy. The implications extend well beyond corporate balance sheets. Statistics Canada has undertaken pioneering work to estimate the economic significance of intangible investment. Its research suggests that if a broader range of intangible investments—including organizational capital, employee training, data assets, branding, and other knowledge -based investments—were recognized, nominal business-sector GDP would have been approximately 8 to 9 percent higher over the 2000–2019 period. Applied cautiously to the Canadian economy as a whole, this suggests that Canada’s measured GDP today could be approximately 6 to 8 percent higher, representing roughly $180 billion to $240 billion in additional annual economic activity. This does not mean accounting reform would suddenly create hundreds of billions of dollars of new wealth. That wealth already exists. Rather, much of what businesses currently record as operating expenses would instead be recognized as long-term investments that create value over many years. The difference is profound. Canada would not become wealthier overnight. It would simply begin measuring its wealth more accurately.

A Better Measure of National Strength. The greatest benefit of recognizing intangible assets may not be a higher GDP. It is a better understanding of where Canada’s productive capacity actually resides. Statistics Canada estimates that intangible investment has contributed significantly to Canada’s productivity growth over the past two decades. Yet Canada continues to invest less in intangible capital than many of its leading competitors, particularly the United States. Without better measurement, these trends remain largely hidden. Governments risk under-investing in innovation.

Financial institutions continue to favour collateral over capability. Investors undervalue firms built upon knowledge rather than machinery. Managers often struggle to measure the assets  that matter most. In short, we cannot effectively manage what we do not adequately measure.

The Next Evolution of Accounting. Accounting has never been static. It has evolved  continuously alongside commerce itself—from Renaissance merchants, to the factories of the Industrial Revolution, to the multinational corporations of the twentieth century. Each transformation required new accounting principles to measure emerging forms of value. The transition to a digital, knowledge-based economy represents the next great evolution. The question before the profession is no longer whether intangible assets matter. Few would dispute that they now represent the primary drivers of corporate value and competitive advantage. Nor is the question whether they can be measured. Increasingly sophisticated and standardized methodologies are demonstrating that they can. The remaining question is whether accounting standards are prepared to evolve. The greatest risk may not be that accounting changes too quickly.

It may be that it changes too slowly, leaving investors, lenders, managers, and policymakers to make decisions using an increasingly incomplete picture of economic reality. Far from abandoning the principles that have made accounting one of the world’s most respected professions, recognizing intangible assets would extend those principles into the twenty-first century. It would preserve accounting’s commitment to objectivity while restoring its equally important responsibility: faithfully measuring the assets that increasingly drive productivity, innovation, competitiveness, and national prosperity. The challenge facing accounting today is not whether to protect reliability or embrace relevance. It is to achieve both.