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Is there a case for Intangible Expense Reporting?
I had recently blogged about the need for publicly listed firms to embrace IC Reporting as a tool for providing their current and prospective investors with more incisive information about their business. A handful of businesses around the world have already adopted this practice but the vast majority is yet to start, perhaps they are awaiting industry or regulatory guidance in this matter. Meanwhile there is another school of thought among the IC community that suggests that a more practical and less stringent approach would be to have businesses report their expenses incurred on developing intangible assets along with their statement of accounts. The logic behind this suggestion is that businesses already keep track of their operating expenses and capital expenditures. Hence it should not be too difficult to keep track of specific expenses incurred on developing intangible assets. Let’s try and dissect this approach and try to understand its pros and cons.
Let’s set the ground rules first. Let us agree that we are only considering the interest of investors here. There are other stakeholders that could also benefit from an Intangible report on the firm such as employees, suppliers and partners, yet we are not addressing their concerns here because these stakeholders have a direct access to the business through which they can get reliable information about the business that is useful to them. Investors however do not have access to any such direct channels and have to rely solely on the formal communication from the business as the only authoritative source of reliable information about the business.
Next, let us think about what investors are interested in. Very simply they are interested in Return on their Investment or ROI. ROI is the bottom-line interest of every investor. Yet it is not enough for the management to commit a particular ROI to investors which they will accept at face value. Investors also need to see the proof of why their investment in the business will be a multi-bagger.
An astute investor will choose to invest in those industries whose products and services will be in great demand in the coming years. Within that industry, the investor will then choose to invest in that specific firm which is best geared up for catering to the forecasted demand of the industry. Choosing the industry whose products and services will be in demand in the future requires a thorough understanding of the macro-economic environment of the geography where the industry is located. Investors rely on a variety of research reports and other inputs for deciding the industry of their choice. But once an investor has decided on the industry that he wants to invest in, all that remains to be done is choosing the firm that is best equipped to meet the demand for products and services of that industry.
At this point investors will start looking at performance of the various firms in the industry, one at a time. And all they will have for doing so is the published financials of the business. Since investors know that more than 70% of the value of any business is generated by intangible assets, this is what they will try to figure out from the financial statements, but will fall woefully short. Let us assume here for the sake of argument that the published financials for the business also include the expenses specifically made for developing intangible assets. Is this a good assumption? Will this really work in practice? Technically it is very easy for accountants to ‘group’ intangible expenses and publish the same along with their financials. However, let us look this situation from the point of view of the company’s managers, the people who will be responsible for publishing this information in the first place. What is their objective? Clearly they are motivated by making the most amount of operating profit for the business, since that will fetch them the maximum compensation (assuming their compensation is linked to operating profits). And how is operating profit calculated – simply by deducting all operating expenses from all operating income. If managers now have an avenue of categorizing some operating expenses as capital expenses, what do you think they are going to do? They will clearly reduce operating expenses and increase capital expenses, which in turn will directly inflate profits in the current period at the cost of deflating profit in future periods since all capital expenses need to be depreciated in the future. This will directly benefit managers when their performance is reviewed for the current period but it will hurt investors who will be left with reduced profits in the future. A discounted cash flow analysis of the business will show that the value of the business is less now. Therefore what is good for managers will turn out to be not so good for investors. It is exactly this behavior of managers that is curbed by accounting guidelines that have strict rules for determining the expenses that can be capitalized in the statement of accounts.
The above argument against reporting of expenses incurred on intangibles is in the best case – that is when all such expenses are actually incurred on developing intangible assets. However, since accounting principles in this matter are not yet evolved, frivolous practices may soon kick in around expenses that center on the ‘grey’ area. For instance, all or part of employee wages may be shown as expenses incurred on developing human capital. Expenses incurred on annual maintenance of information technology assets such as computers, video conferencing equipment, etc. may be shown as expenses incurred on developing structural capital. And routine expenses incurred by salespeople for soliciting customers may be shown as expenses on developing customer capital. These and other such ‘creative’ accounting practices will flourish to the point where operating expenses will be negligible. Is this a desirable state? You may say it is desirable for managers but investors will be worse off than they are now.
The conclusion I am arriving at therefore is that whereas the suggestion for reporting of intangible expenses is a noble thought, in practice it will only lead to obfuscation, deceit and chicanery. Instead what we need is an Intellectual Capital Report of the business that is drafted by an independent IC professional. This report should be published along with the statement of accounts and it should be audited by external IC professionals in the same manner that the accounting statements are audited by external accounting professionals.
I invite fellow IC professionals to submit their own point of view to this discussion.
Let’s set the ground rules first. Let us agree that we are only considering the interest of investors here. There are other stakeholders that could also benefit from an Intangible report on the firm such as employees, suppliers and partners, yet we are not addressing their concerns here because these stakeholders have a direct access to the business through which they can get reliable information about the business that is useful to them. Investors however do not have access to any such direct channels and have to rely solely on the formal communication from the business as the only authoritative source of reliable information about the business.
Next, let us think about what investors are interested in. Very simply they are interested in Return on their Investment or ROI. ROI is the bottom-line interest of every investor. Yet it is not enough for the management to commit a particular ROI to investors which they will accept at face value. Investors also need to see the proof of why their investment in the business will be a multi-bagger.
An astute investor will choose to invest in those industries whose products and services will be in great demand in the coming years. Within that industry, the investor will then choose to invest in that specific firm which is best geared up for catering to the forecasted demand of the industry. Choosing the industry whose products and services will be in demand in the future requires a thorough understanding of the macro-economic environment of the geography where the industry is located. Investors rely on a variety of research reports and other inputs for deciding the industry of their choice. But once an investor has decided on the industry that he wants to invest in, all that remains to be done is choosing the firm that is best equipped to meet the demand for products and services of that industry.
At this point investors will start looking at performance of the various firms in the industry, one at a time. And all they will have for doing so is the published financials of the business. Since investors know that more than 70% of the value of any business is generated by intangible assets, this is what they will try to figure out from the financial statements, but will fall woefully short. Let us assume here for the sake of argument that the published financials for the business also include the expenses specifically made for developing intangible assets. Is this a good assumption? Will this really work in practice? Technically it is very easy for accountants to ‘group’ intangible expenses and publish the same along with their financials. However, let us look this situation from the point of view of the company’s managers, the people who will be responsible for publishing this information in the first place. What is their objective? Clearly they are motivated by making the most amount of operating profit for the business, since that will fetch them the maximum compensation (assuming their compensation is linked to operating profits). And how is operating profit calculated – simply by deducting all operating expenses from all operating income. If managers now have an avenue of categorizing some operating expenses as capital expenses, what do you think they are going to do? They will clearly reduce operating expenses and increase capital expenses, which in turn will directly inflate profits in the current period at the cost of deflating profit in future periods since all capital expenses need to be depreciated in the future. This will directly benefit managers when their performance is reviewed for the current period but it will hurt investors who will be left with reduced profits in the future. A discounted cash flow analysis of the business will show that the value of the business is less now. Therefore what is good for managers will turn out to be not so good for investors. It is exactly this behavior of managers that is curbed by accounting guidelines that have strict rules for determining the expenses that can be capitalized in the statement of accounts.
The above argument against reporting of expenses incurred on intangibles is in the best case – that is when all such expenses are actually incurred on developing intangible assets. However, since accounting principles in this matter are not yet evolved, frivolous practices may soon kick in around expenses that center on the ‘grey’ area. For instance, all or part of employee wages may be shown as expenses incurred on developing human capital. Expenses incurred on annual maintenance of information technology assets such as computers, video conferencing equipment, etc. may be shown as expenses incurred on developing structural capital. And routine expenses incurred by salespeople for soliciting customers may be shown as expenses on developing customer capital. These and other such ‘creative’ accounting practices will flourish to the point where operating expenses will be negligible. Is this a desirable state? You may say it is desirable for managers but investors will be worse off than they are now.
The conclusion I am arriving at therefore is that whereas the suggestion for reporting of intangible expenses is a noble thought, in practice it will only lead to obfuscation, deceit and chicanery. Instead what we need is an Intellectual Capital Report of the business that is drafted by an independent IC professional. This report should be published along with the statement of accounts and it should be audited by external IC professionals in the same manner that the accounting statements are audited by external accounting professionals.
I invite fellow IC professionals to submit their own point of view to this discussion.
Tags: IC, Intangible, Reporting, eprense, reporting
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Replies to This Discussion
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Permalink Reply by Mary Adams on
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Abhijt- Thanks for opening up this discussion. I know that this is in response to my comment on your post about the Need for IC Reporting.
In my experience in the U.S., most investors do not understand that 70% of corporate value is intangible. They are annoyed when they see this crop up in M&A. And they don't understand that the gap exists in all companies. Is it different in India and other countries? I know that many governments in Europe and Asia are investing in education around this.
I do not think that we should view financial and nonfinancial IC reporting as mutually exclusive. In our new book (hitting the market any day now), we call for triangulating IC earnings potential using investment, assessment and performance measurement. Another way of describing this is financial, qualitative and quantitative indicators. A good example of this approach is PwC's Value Analysis Statement. I think that the IC community has made such an effective argument for the fact that financial information isn't enough to capture the essence and performance of intangible--that we have ignored the fact that there is a financial story to tell about intangibles.
Although intangibles are different (almost magical) in that they can have infinite value, the work of a manager in a business is still straightforward: make investments in productive capacity in order to make a return. Corporations have been investing intensively in intangibles for three decades. But no one has tracked that investment because it is "intangible." We are caught in this circular logic that we need to break. Just because it is intangible under current accounting standards does not make intangible capital investment irrelevant.
And this story is directly related to ROI. You speak convincingly of investor interest in ROI. How can ROI be calculated if the true I/investment is not identified?
At some point, this will need to be addressed in accounting standards. But we are a long way from that. The answer, in my view, is management accounting. It is here that businesses use accounting data to inform their managerial and strategic decisions. When I advise companies to track their intangible capital expenditures (i-capex), it is in the form of a management report.
What should go on that report? Investments that are expected to have value beyond the current year. This is a distinction that accountants make every day. Some kinds of expenditures on tangible assets, for example, are considered maintenance (current year expenses) or improvements (capitalized expenses). This is not a creative exercise, it is a logical and accepted way of thinking about spending. This logic can be applied to intangibles as well. In almost all cases, wages are not an investment, they are the cost of keeping an employee in the operation. But investment in process development and, some R&D would be considered an investment.
Of course, it is not enough to just examine investments to understand the working of corporate IC. For that, IC Reporting is critical. But IC Reporting without i-capex misses an important opportunity to show the direct link between financials and IC. The 70% of intangible value did not appear out of thin air. It is the result of decades of careful investment. Isn't it time that we in the IC community helped make this link?
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Permalink Reply by Abhijit Talukdar on -
Mary - I am aware that within the IC community there is a pervasive feeling that IC Reporting is an instrument for that only contains intangible indicator values. This is OK. Since our community is in an evolutionary phase, we can consider an IC Report containing only indicator values a a first generation IC report.
However, I entirely agree with you that a really useful IC report is one that provides a monetary value on the value of the intangible assets. The IC Report that I profess starts off with the first generation IC report above, then links those intangibles into the core competencies of the business and finally values those competencies using bottom-up and top-down valuation algorithms. Such an IC report not only gives a view into the intangible nuts and bults so to speak, but also their dollar value. What's more every year the original IC Report can be audited and the worth of the intangibles be valued once again. This way readers get to know clearly which way the business is moving.
The point I made to being with is that this kind of Report cannot be created by the managers of the business, since they will have a natural tendency to fudge information. It is much like asking a teenage school going kid to evaluate his own exams! Would anyone be surprised if his results are good, then?
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Abhijt- I would like to distinguish between accounting for cost and estimating value. I agree that a management team should not estimate value because of the need to have certified third parties to perform valuations.
However, I do believe that it would be good for every management team to have a clearer idea of how much they are investing in intangible "capacity." No one knows the answer to this because accounting mixes intangibles investments together with operating costs on the income statement. This kind of reporting should be done for now for internal management accounting. But I see it as an important step that will:
1. Get the true extent of intangibles investment on the management agenda
2. Provide data to better understand the cause and effect of different kinds of investments
3. Provide a learning base that can be tapped in the long term to come up with more permanent solutions to the very valid reasons that keep intangibles off of balance sheets.
Most businesspeople still think that intangibles have a very fleeting value. I maintain that the value of intangibles like processes, data and competencies are actually more lasting than a lot of tangible assets. A company may throw away a computer but they do not throw away the software and processes that run on that computer.
So I think we are doing the IC field and business in general a disservice if we continue to insist on the separation between accounting and IC...
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Permalink Reply by Thomas Mathiasen on -
Abhijit and Mary - this is a very good discussion, with rather many good points to take off from. The crucial point for me in Intangible Expense Reporting is to enable the enterprise to follow the ROI of the particularly Intangible issue. That is, a control point for evaluating and following the IC Strategy laid out previously. So, mostly for internal purpose. The need for accounting statements is very much external, e.g. for taxation purposes.
From my point of view, the need for an Intellectual Capital Report of the business that is drafted by an independent IC professional, is mostly to ensure that the process and the report do reflect the conditions in the company. Not that the IC Report is to be audited by external IC professionals.
One group of externals would be interested in the expenses used to generate future potential, that is the shareholders. So they, as a group, might have a need for the Intangible Expense Reporting.
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I think that all stakeholders are interested in the financial picture. If we can use IC financial, quantitative and qualitative reporting in combination, we are going to rocket into the mainstream business conversation.
© 2012 Created by Mary Adams.
