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Financial Reporting Brief
This month’s article 'Corporate Balance Sheets – The Full Picture?' considers the factors underlying major differences between market capitalisation and balance sheet value, with particular reference to intangible asset value.
Corporate Balance Sheets – The Full Picture?
A major question about financial reporting, under current accounting standards, is whether the balance sheet properly reflects the value of a business. In many cases, there are very significant differences between the net equity position, or net asset value, as presented in the financial statements and the market capitalisation of a business. This indicates that much of what investors perceive as being business value is intangible and not capable of being accounted for within the constraints of a framework which, with few exceptions, is largely based on historic cost.
In recent years, innovation and various other developments in the global market place have seen a very substantial increase in corporate intangible values with much of it included on balance sheet but perhaps even more not recognised but being factored by investors and analysts into market capitalisation.
An indicative measure of this is a study carried out by Standard & Poors – the S&P 500. The S&P 500 Study shows intangible assets at 84% of total value shown on balance sheet, more than doubled in the last twenty years. The S&P 500 represents 75% of the American Equity Market by capitalisation.
A survey of UK companies shows that intangible assets amount to 70% of the modern day corporate balance sheets and 53% of the total value of the FTSE 100. Businesses such as Uber and Air B&B are prime examples of taking a traditional business and partnering it with modern technology to give rise to substantial intangible value.
Many business leaders are of the view that the value of intangible assets is being undervalued or overlooked. They see it as being largely due to (a) a lack of acceptance at board level of the value of intangible assets such as IP rights, but rather it is perceived as being a potential significant cost to the business, and (b) a lack of understanding of what an intangible asset is and what it means to the value of the business. Identifying certain intangible assets and attributing a value to them, and maintaining a reliable inventory of them, is complex and difficult to manage.
The examples cited of Uber and Airbnb highlight that value may be created by being first to the marketplace, and/ or having a strong commercial arrangement . Development of a ‘brand’, with securing of the name and protecting it by registration and enforcement of rights, all contribute to the value of the intangible asset.
Two recent publications in the area of intangible value are:
- A Consultation launched by the UK Financial Reporting Council (FRC) – ‘Business Reporting of Intangibles: Realistic Proposals’
- Joint Report by Deloitte and the Association of Chartered Certified Accountants (ACCA) – ‘The Capitalisation Debate: R&D expenditure, disclosure content and quantity, and stakeholder views’
FRC Consultation Paper
The FRC Consultation Paper is in response to frequent calls to reform the accounting for intangible assets, arising at least in part from the move to a knowledge-based economy. The Paper considers the case for radical change to the accounting for intangible assets and the likelihood of such change being made in the near future.
There are concerns that financial statements have lost relevance for investment decisions, citing the divergence between the accounting value of equity (net assets) and market capitalisation, suggesting that this is due to the failure to recognise the value of intangibles in financial statements.
The objectives of the FRC Paper are:
- To explore the reasons why intangibles cannot be more fully reflected in financial statements without radical change;
- To develop practical proposals for improvement in business reporting that can be expected to be implemented in the near future.
Examples of intangibles are diverse – a license to operate has little in common with a supplier relationship, except that neither is tangible, and that a business with both is more valuable than one that lacks either. Only items that meet both the definition and the recognition criteria can be included in financial statements without radical change to the accounting framework (IASB or equivalent).
The immediate priority is to identify how practical proposals can enhance the relevance and quality of information that is conveyed by financial reporting. A way forward may be Narrative Reporting.
Narrative reporting should be integrated into any pertinent information in financial statements. The narrative reporting, included in such reports as ‘Management Commentary’ or ‘Strategic Report’ should therefore not only be consistent, but also the relationship between information in the financial statements and narrative disclosures should be clear. The focus of the narrative reporting should be on those intangibles that are most relevant to the entity’s business model, including both those reported in the financial statements and those not.
The FRC suggests that:
- Relevant and useful information could be provided without the need to recognise more intangible assets in companies’ balance sheets
- Such information could cover a range of factors, broader than the definition of intangible assets in accounting standards that are relevant to the generation of value
- Improvements could be made on a voluntary basis within current reporting frameworks, such as the strategic report
- Participants in the reporting supply chain could collaborate to bring about improvements
Joint Deloitte/ACCA Report
The Report, published jointly by Deloitte, also expresses the view held by many that financial statements no longer reflect the underpinning drivers of value in modern business, with particular consideration of accounting for intangibles. This includes research and development costs with research costs being expensed while, under IFRS, development costs should be capitalised if they meet the six criteria specified in the accounting standard. Similar requirements apply under Irish/UK standards.
Financial statement users primarily rely on companies’ voluntary/narrative R&D disclosure decisions for understanding the value and future benefits arising from capitalised development expenditure. Mandatory disclosures in IFRS are limited to the amounts capitalised and/or expensed being disclosed separately.
There is an inconsistency within accounting standards insofar as development expenditure as part of acquisitions will be upheld whereas the standard on R&D supports capitalisation where criteria are met but those criteria are very restrictive and make it very difficult to do so. Possibly, a simplification of criteria could lead to a more consistent approach being taken to capitalisation.
There are strongly held views that there needs to be a change in culture from an emphasis on ‘prudence’ to more ‘faithful representation’, and that there should be more disclosures to assist transparency and the associated decision-usefulness of financial statements. This would inevitably lead to more transparent disclosure of key judgements or assumptions made in deciding on capitalising or expensing development costs.
The Report is here.
Indicative surveys show that 75% of the purchase price in merger & acquisition (M&A) deals is represented by goodwill and intangible assets. This highlights the importance of identifying and measuring the value of intangible assets to support the rationale of an acquisition. Valuing intangibles pre-transaction has three main benefits:
- It can support the acquisition price and investment case, particularly where the acquirer is in a new sector or the business being acquired is at a valuation which appears outside of their usual parameters
- In the event of a future warranty claim, demonstrating there has been a diminution in the value of the intangible assets that comprised the majority of the purchase price can be important evidence
- The valuation can be used for the purchase price allocation in the financial statements, rather than carrying out the exercise retrospectively.
Recognition of and accounting for intangibles is an increasing challenge with many concerned that financial statements fail to properly recognise important intangibles, such as intellectual capital, and that this may adversely affect investment in intangibles.
Standard setters are being called on to re-evaluate how intangibles are accounted for. Changes to accounting measurement and recognition will not be easily made within current frameworks. It seems much more likely that there will be changing requirements for disclosure and a much greater insight into intangible value and its significance to the market value of a business.
While it may be of more significance to certain business classes and corporate structures than others, for many it is an area where thinking may need to be refreshed in anticipation of change.
What's New? Monthly Reporting Pack – April 2019
Irish/UK GAAP & Related Developments
IFRS & Related Developments
Legal & Regulatory Developments
Previous Financial Reporting Briefs
- April 2019: Sustainable Development – A Goal for All
- Quarterly Financial Reporting Brief: April 2019
- March 2019: Reporting on Success - Getting the Balance Right?
- February 2019: Corporate Communication – More than the Financials
- Quarterly Financial Reporting Brief: January 2019
- January 2019: Smaller Companies - Sharpen up Reporting!
- December 2018: Corporate Reporting – Guidance from the Enforcers
- November 2018: Financial Instruments – A More Workable Solution?
- Quarterly Financial Reporting Brief: October 2018
- October 2018: European Financial Reporting – is Europe fit?
- September 2018: New Governance Code – More Robust Measures
- August 2018: Financial Reporting – Understanding the Concepts
- Quarterly Financial Reporting Brief: July 2018
- July 2018 - History – Repeat Mistakes or Learn the Lessons
- June 2018: Corporate Reporting – An Integrated Approach
- May 2018: The Activities of the Enforcers – ESMA Report
- Quarterly Financial Reporting Brief: April 2018
- April 2018: IFRS 15 Revenue Recognition – Already Here!