Now is a good time to address the fundamental issue of intangibles description and definition, believes Martin Brassell.
If you’re looking for a book to add to your Christmas (or New Year) list, you might find Capitalism without Capital (Haskel and Westlake, Princeton, 2017) an interesting read. Written by two experts who have been intimately acquainted with the challenges of identifying intangible asset investment over many years, and well reviewed in national media, it shines a fresh light on the ‘hidden capital’ we all know companies have, and what it means for the economy.
Along the way, the book notes that statutory financial statements don’t generally make a great job of articulating the intangible assets companies create that often drive business value. This is hardly a controversial statement, but neither is it an easy problem to solve. Some of these assets are not readily separable from the entities that have created them; as for the remainder, there are very few asset types for which there can honestly be said to be a transparent, ready market where their value can be realised.
It’s therefore encouraging to see that the draft guidelines for the company strategic report, currently being formulated by the Financial Reporting Council, do include a specific reference to intangibles. The latest draft to be released puts it this way:
The strategic report should also include information relating to sources of value that have not been recognised in the financial statements and how those sources of value are managed, sustained and developed, for example a highly trained workforce, intellectual property or internally generated intangible assets, as these are relevant to an understanding of the entity’s development, performance, position or impact of its activity.
The concept of ‘value sources’ has something in common with the Integrated Reporting (IR) framework, another initiative aimed to address the information gaps that financial statements leave behind. IR sees intellectual capital as one of a number of ‘stocks’ that are transformed by the business’s operations into value.
Intangible assets are different
Both the changes to strategic reports and the increasing interest in IR are encouraging developments. However, one of the points made in Capitalism without Capital is that intangible assets are different, and behave differently, from tangible ones. It is difficult to build an inventory of things you can’t see, especially when you don’t have the right language to describe them.
For either strategic reports or IR to address the information gap that currently exists in relation to value-producing intangibles, in a way that provides stakeholders and investors with relevant points of comparison between firms, it is by definition necessary to agree what the common types of intangible are, and how they can be described clearly.
This point comes into sharp focus when one considers that reporting requirements, initially applied to large and quoted entities, have a habit of trickling down to smaller companies. Recent updates to UK GAAP, specifically the provisions of FRS 102, provide a good example of this. By changing the rules regarding the treatment of goodwill in acquisitions, this has brought small companies broadly into line with the international standards set out in IFRS 3. But despite now having a requirement to find the ‘identifiable intangible assets’ that have been acquired, guidance for accounting professionals on what they should be looking for is quite limited.
These identifiable intangibles are not trivial: they can be expected to account for a substantial proportion of the purchase price. Previous research by Deloitte (2007) and KPMG (2010), among others, highlights that when post-purchase accounting is concluded, they regularly account for between one-third and one-half of the amount paid. This is the ‘magic’ that happens when businesses are bought; the capital residing in a company that it couldn’t previously explain suddenly ‘materialises’ on the acquirer’s balance sheet.
Impact of FRS 102
As it happens, FRS 102 might also encourage more businesses to capitalise permitted development costs. It replaces the previous SSAP 13 provisions on R&D, which previously covered this aspect. Many technically advanced firms have rather weak balance sheets, and it would not be surprising to see an increasing trend towards amortisation of intangible investment in the future – especially where companies spend a lot on these assets.
Whatever the reporting framework chosen, anyone looking at a company will appreciate having better ways to understand where their value really lies. This includes how and why a firm is making investments in assets whose value cannot be shown in its financial statements. Whatever mapping is chosen, it would make sense to make this compatible with the headings recognised in growth accounting (R&D, design, software, branding, training, organisational development and original copyright works).
Difficult to finance
Lastly, Capitalism without Capital also points out that as well as being hard to recognise, intangible investment is also difficult to finance. The Autumn 2017 Budget included a commitment to look at finding ways to address this, particularly for IP-rich companies with good growth prospects. However, if companies aren’t equipped to explain what assets they own, lenders will find it difficult to respond to them. For many reasons, then, now would be a good time to address the fundamental issue of intangibles description and definition.
Martin Brassell FRSA is CEO of Inngot. He is co-author of two ACCA reports: Innovation, intangibles and Integrated Reporting (2015) and Accounting for innovation (2016). His recent report (with Dr Jackie Maguire) for the UK Intellectual Property Office on IP valuation has just been published as Hidden Value. Martin is also co-author of Economic Approaches to Intellectual Property (Oxford University Press, 2016).