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Accounting for the invisible asset

10/07/2017

By David Herbinet, Global Audit Leader, Mazars

Intangibles do not have physical presence not only by definition but under current accounting requirements they are also often ‘invisible’ from financial reporting unless they are acquired separately or in the context of the acquisition of a business. 

As businesses in the global economy have generally shifted away from conventional manufacturing towards being more service and technology orientated in nature, so has the importance shifted regarding the nature of assets of these businesses from tangible to now primarily intangible assets. Recent studies have indicated that for listed companies that over 80% of their market capitalisation is intangible in nature. These intangibles inter-alia include brands, customer relations, human capital, patents, know-how and other technology based intangibles. 

The importance of intangible assets to the overall value of many listed companies is perhaps not surprising given, for example, the significance of know-how for modern technology companies or the importance of brands in the consumer product industry in today’s global economy. What is surprising is the failure in financial reporting, given the importance of brands and intangibles in general to the value of companies, to be able to report effectively for these assets. As a result, this is probably the single most important threat to the relevance of accountancy in modern times. 

One of the main qualitative characteristics of useful financial information is ‘comparability’. The justification for recognising acquired brands but not ‘home grown’ ones is very weak. Further, for intangibles, accounting standards only allow the subsequent revaluation where there is an active market. Given it is uncommon for an active market to exist, revaluation in practice is currently extremely rare. 

Since accountants and auditors must get themselves comfortable with valuations of intangibles that are acquired as part of a business combination then instinctively they should also be able to get comfortable with valuation of internally generated intangibles. Whilst accepting to the non-specialist, intangible asset valuation might appear rather daunting, and accepting that it includes judgement and therefore is a statement of opinion not fact, it still seems that having valuation information on these assets is at the very least useful information that would be welcomed by users of financial statements. 

Furthermore, it is hard in the modern age of accounting to ignore the reporting for brands, and other intangibles simply because these issues fell into the ‘too difficult’ box. Applying traditional assumptions based on the accounting world of yesterday where physical assets dominated can surely no longer be justified. Accounting for intangibles has been the forgotten issue of financial reporting as standard setters have primarily focused on leasing, another invisible ‘right of use’ asset that will eventually be recognised on the balance sheet and also financial instrument projects which have received a disproportionate amount of time and effort compared to other areas of accounting. 

Whilst standard setters are understandably nervous about recognising brands on the balance sheet when you need to consider the reliability of measurement for assets, the current alternative of showing nothing is equally unacceptable. If a valuation of a brand is a “best estimate” and if the reporting entity has properly applied an appropriate process, properly described the estimate and explained any uncertainties that significantly affect the estimate, then this should be able to be understood by users of financial statements. If there is no alternative representation that is more faithful, that estimate should provide the best available information. Either through recognition, or at the very least disclosure, financial reporting needs to narrow the reporting gap between market value and balance sheet value so that financial statements are truly fit for purpose.

The ‘true and fair’ concept has been a part of English law and central to accounting and auditing practice in the UK for many decades and assurance needs to be provided on the performance and position of the business under this concept. The non-recognition of many intangibles arguably undermines the level of assurance that is actually provided to stakeholders. 

The lessons learnt from over 10 years of valuations of acquired intangibles in business combinations under both IFRS 3 and US GAAP requirements in ASC 805 has put the accounting profession in a better position to now move to the next level with regard to reporting for brands and other intangibles. However, perhaps even these standards are too restrictive by not recognising certain key intangibles such as human capital and corporate culture. 

Conclusions 

To compete, businesses must actively develop and leverage their brands and intangible assets. Understanding the value of these assets is therefore critical. In order to get a proper representation of an entity’s net asset position you need financial reporting requirements that are both robust and transparent. 

Improved financial reporting on brands and intangibles is essential and with appropriate valuation methodologies it is no longer as controversial as in earlier years. The recognition and/or disclosure of these ‘invisible assets’ is surely necessary in order to provide investors with the information they need on brands and other intangibles. Auditors, standard setters and investors need to work together to determine the way ahead on this issue which is surely an evolution worthy of consideration. 

What a balance sheet currently shows is interesting, but what it hides is often more crucial! 

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This is one of the opinion pieces published in Brand Finance GIFT™ 2017 report.

The Brand Finance Global Intangible Finance Tracker (GIFT™) is the world’s most extensive annual research exercise into intangible assets, covering over 57,000 companies (with a total value of US$92 trillion) across more than 170 jurisdictions.  The report provides detailed insight into intangible value reporting by company, sector, and country along with leading accounting organisations sharing their views. 

You can see our previous feature here​ and you can expect further coverage in future Praxity communications.  If you would like to share your views or contribute to discussions, please contact our copywriter Simon Tyrrell on styrrell@praxity.com.

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