Introduction

It is a pleasure to take part in this hearing on removing barriers to the New Economy.    I greatly appreciate the Joint Economic Committee's leadership in creating this opportunity for government and industry to focus together on how we can encourage our nation's continued technological and economic leadership.

My remarks today will focus on a top priority of the technology industries: the role of knowledge and intangible assets in the New Economy.  For the companies that make up the New Economy, nothing is more crucial to success than the ability to attract capital for investment in new technologies, new products and new ways of delivering those products. Unlike the traditional economy, however, today's technology-driven economy is built not on hard assets or physical products, but on mindshare. It is therefore essential that accounting standards recognize the role that intangibles and knowledge-based assets play in the New Economy.  Although accounting rules and the work of the Financial Accounting Standards Board are seemingly arcane, they currently threaten to undermine the factors driving the New Economy.  Old approaches to the valuation of intangible assets and financial reporting of those assets represent genuine barriers to realizing the full potential of the New Economy.

Let me take a few moments to tell you about EMusic.  Since it was founded in January 1998, EMusic has established itself at the forefront of how new music will be discovered, delivered and enjoyed in the next decade.  In addition to having the Internet's largest catalog of downloadable MP3 music available for purchase, EMusic operates one of the Web's most popular families of music-oriented Web sites -- including RollingStone.com, EMusic.com, DownBeatJazz.com, and IUMA.  The company is based in Redwood City, California, with regional offices in Chicago, Los Angeles, New York and Nashville.

EMusic.com is the Web’s leading site for sampling and purchasing music in the MP3 format, which has become the standard in the digital distribution of music. Through direct relationships with leading artists and exclusive licensing agreements with over 650 independent record labels, EMusic.com offers music fans an expanding collection of more than 100,000 tracks for purchase -- individual tracks for 99 cents each or entire downloadable albums for $8.99.  EMusic.com features top artists in all popular musical genres, such as Alternative (Bush, Kid Rock, They Might Be Giants, Frank Black), Punk (Blink-182, The Offspring, Pennywise), Jazz (Duke Ellington, Dizzy Gillespie, Louis Armstrong, Concord Records), Blues (John Lee Hooker, B.B. King, Buddy Guy), Hip Hop (Kool Keith, The Coup), Country (Willie Nelson, Merle Haggard, Patsy Cline), Rock (Phish, Goo Goo Dolls, David Crosby), World (Nusrat Fateh Ali Kahn, Lee “Scratch” Perry) and Vintage Pop (Liza Minnelli, Eartha Kitt, Judy Garland).

To give you an idea of how fast the downloadable music industry is growing, the company has now sold over 1 million songs in the popular MP3 format since its launch.  This total includes single-track sales as well as tracks included as a part of albums and special collections.  In addition, EMusic.com's catalog has grown to offer more than 100,000 high-quality MP3s for sale from over 650 independent labels.

EMusic is part of the New Economy, both culturally and technologically.  At twenty-four years old, I am the youngest CEO in NASDAQ.  I am one of those freaks of nature in the high tech world – but in a very good sense.  I am very proud of the fact that I have taken ideas and created companies with my friends and with many new people that I have been fortunate to meet along my journey.  EMusic is my third company.  My first, PrivNet, I created while in college.  I sold it to PGP, Inc., and went to work for PGP.  PGP was sold in 1997 to Network Associates.  While at EMusic I have bought four companies.  Creating companies, jobs, and economic wealth – all depend on sound accounting principles supported by well thought-out public policy.   EMusic is a young company that has grown by acquisition.  So far EMusic has done purchase transactions because we are not poolable.  This is one aspect of the impact of accounting rules on the New Economy.  I will come back to that point shortly.

It is important to understand that EMusic represents significant intangible assets.  Many companies in the New Economy do not and will not have any physical assets.  Their value is either between the ears of their employees or on the hard drives of their computers and networks.  EMusic digitally delivers music to consumers.

So far my earnings are not too significant; they are increasing however.  EMusic currently reports a loss.  I can tell you that our intangible losses are much more significant than my cash base losses because we write down a lot of intangibles.  Purchase accounting requires that we write down our intangibles as if they were wasting away.  And I assure you that if these assets that I have acquired are in fact wasting away, EMusic’s shareholders will soon make me Nasdaq’s youngest ex-CEO.

Accounting and Economics

 Growth and improvements in information technology have, as Treasury Secretary Lawrence Summers said recently, “a great deal to do with our current economic success.”  “But,” he cautioned, “it would be a grave mistake to assume that it all goes forward automatically.”  While the accountants at the Financial Accounting Standards Board say that they do not look at economics, and some economists might say that accounting isn’t relevant to economic decisions, the facts on the ground in the New Economy say that they are closely related.  Financial numbers are the language that investors must be able to read in order to make good decisions.  Accounting rules are the syntax and grammar of this language.  These rules can make the language either clear or incomprehensible to the individual investor and to the markets as a whole.  I can tell you right now, when it comes to accounting for goodwill and other intangible assets, the rules obscure rather than clarify.

This is important to the whole economy, not just the New Economy.  As Treasury Secretary Summers said, one fundamental change at the heart of the New Economy is  “the move from an economy based on the production of physical goods to an economy based on the production and application of knowledge” – and, at the risk of seeming biased, I would add: “production and distribution of music”!

 There is a microeconomic and a macroeconomic impact from the inability of investors to discern the actual financial condition of intangible-laden businesses from their financial reports.   First, if the company’s GAAP financial reports misstate the business’ condition by obscuring the value of its intangibles, the company’s cost of equity capital will rise.  This is especially true for newer, smaller companies that do not have dozens of analysts following them and performing separate, non-GAAP, analyses of their financials.

 Second, from all these individual investment decisions, based on poor or misleading information, there is a high likelihood that capital will be misallocated.  This is a barrier to the continued advance of the New Economy.

Purchase vs. Pooling

As you may know, there is a debate raging about accounting for mergers and acquisitions.  The Financial Accounting Standards Board (“FASB”) has a plan to eliminate pooling accounting and to force all business combinations to be accounted for as though one company purchased the other.  Purchase accounting is the method that Emusic has had to use up until now and purchase accounting forces EMusic to amortize and deduct the value of the intangible assets I described earlier.  Therefore, unless FASB makes significant changes to purchase accounting before it moves to eliminate pooling, investors will continue to receive distorted information about New Economy companies.  FASB’s plan to eliminate pooling accounting misses two fundamental points that I want to leave with you.

I don’t think good public policy here should make this an either-or discussion.  There are problems with both purchase and pooling accounting.  So my first point is, FASB needs to fix purchase accounting first before it goes after pooling.

There is a large problem in the high tech community: the growing disparity between book value and market value. The problem can be traced to the fact that much of the value of these companies is in intangible assets.  So my second point is that we really need a better method for measuring intangibles.

As more economic wealth moves into intangibles, accounting methods and their supporting public policy have to keep up.  By not fixing purchase accounting and by eliminating pooling accounting, FASB threatens the New Economy.  Moreover, there will be no improvement in the flow of information about companies to markets and investors.   As we all know the past few years have enabled more Americans to directly invest in the stock market and individual companies.  Many Americans do so via the Internet; many have stock from their employers; many have their retirements and investments in stocks and mutual funds.  Just as transparency and the flow of information are critical to the success of democracy, it is critical in the increasingly democratic, egalitarian and participatory stock markets.

The Entrepreneur’s Dilemma: An Example of Accounting and Economics

 As an entrepreneur I have two options to perform a transaction.  I can utilize the purchase accounting method, under which I have to take an EPS impact in the future, or I can do a pooling, which obviously has positive benefits for my company as a high tech company and an intangible asset company.  Those companies that have built their intangible assets from the ground up don’t have that hit against their earnings, frankly, because those intangible assets have never been valued.  But when I buy a company and am required to value and amortize its intellectual property assets (i.e., its intangible assets) that work against my business decision to acquire.

Frankly, these valuations are not black and white.  A company can see the value of its assets increase without doing anything.  For example, an artist such as Madonna can perform an old song and increase its value even though a company unrelated to Madonna and her record label owns the song.  The problem is that valuation is confusing, and if it is confusing to companies in the business that know or should know as much as there is to know about valuing intangibles, then where does this leave the individual and institutional investors?  One of my biggest concerns here is how intangible assets are valued because I am not sure that the public really knows what stated assets are really worth or are not worth.  Institutional investors may be able to get into the details and ascertain from their own perspective what value may be, but the average Josephine is not likely to decipher what is and what is not included in a company’s pro forma presentation of earnings before she makes her personal investment.  Notwithstanding the great amount of information available to individual investors via the Internet, the average individual investor simply does not have access to the analysis that companies and institutions do.

This touches upon an even larger public policy issue.  And this issue underscores why it is so important for the Congress to increase its oversight of FASB and how it changes accounting rules.  This larger public policy issue is a matter of who gets the information, in what form and when.  Individuals may not get all the information at all, in a useable form, or they may get it at the last moment after others have seen it and made their move in the market.  This is an increasing market inefficiency given the expanding amount of capital flowing into the market from individuals and the growth of margin debt.
Conclusion.

When so much of the value of the American economy is tied up in intangibles assets, how these assets are perceived is really the driver of value.  If the market is being driven more by perception than by the principles and rules that government, industry and professionals have set out, then effective governance no longer works and the anarchy of the market has taken over.  This is not fair to individuals and is not reflective of our nation’s democratic values.  Intellectual property is an extremely important part of our nation’s export economy.

Whether it is Hollywood in southern California or Silicon Valley in northern California, ideas and intellectual property are drivers of our nation’s economic growth and international economic influence.  Valuation of intangibles like intellectual property must be grounded on sound public policy and democratic values.

In closing, I want to leave a clear impression with you.  The current process is flawed and FASB needs to fix purchase accounting first before they do anything with regard to pooling or other rules.  The big problem for high tech companies is the fact that current purchase rules do not provide investors with better or more useful information.  The high tech community has been engaged on this issue through organizations such as TechNet but to date the feed back from FASB has been less than satisfactory.  While I am not in favor of any new governmental role here or in any new body charged with setting accounting standards, we do need to work together in a new way to develop a better method for measuring intangibles such as intellectual property.

FASB’s proposal to require all companies to use purchase accounting will only make these issues worse and will not improve the flow of information to investors, especially the individual.  I am pleased that Congress has chosen to exercise its proper oversight over the FASB process on this important economic issue and look forward to working with the Congress in the future on this issue.