In the UK today, most people work in service-based and knowledge-based industries. These are industries which deal in intangible assets such as intellectual property: knowledge and know-how, patents, trademarks, copyrights and brands.
This wasn’t always the case, but the pace of change has been accelerating. It’s only in the last fifty years that these industries, deriving most of their value from intangible assets, have really begun to dominate stock exchanges in terms of total market capitalisation. The archaic system of accounting that we have in place today hasn’t been able to keep up, and has lost a lot of its meaning and relevance in the context of these tertiary industries.
When it comes to counting the beans, the traditional primary and secondary sector industries are more straightforward. The latter comprises processing and manufacturing activities secondary to the former, the (primary) extraction and production of raw materials. If you grow fibre crops, or produce textiles from them, a relatively liquid market for these will give you a pretty good idea of what these tangible assets are worth to your business.
In such traditional sector industries, capital investments get you better machinery and bring you economies of scale, so you can produce more goods at a lower average cost. The markets will also give you a fairly accurate idea of such machinery’s asset value to your business. Between the goods which a business owns to buy or to sell, and those that form its plant and machinery, businesses in these sectors preside primarily over tangible assets whose value can be readily approximated. These businesses’ values will be much closer to their net asset values (total assets less total liabilities).
What about intangible assets?
What sets the knowledge and service-based industries apart is that their value and competitive advantage is powered by their intangible assets – and that this is where most investment goes. This investment is in people, in ideas, and in knowledge; in ‘human capital’ and intellectual property.
Why can the Kraft Heinz company, for example, sell you a can of baked beans for three times the price of a supermarket’s own equivalent when they’re both equally as full of beans as our former Health Secretary, Matt Hancock? (Although he turned out to be more sauce than beans).
Easy point-scoring aside, the answer, in this case, is: for the most part, its brand.
While Kraft Heinz may appear to be a typical secondary-sector firm, it’s really more of a higher-tiered hybrid. When you buy Heinz beans, you’re being sold more than a can of beans. You’re also buying (read: paying for) more than a can of beans.
Clearly, it’s worth something to the firm and its investors. But how do we account for ‘brand’? Well, according to most accountants, it shouldn’t exist as an asset on a company’s financial statements: it’s too hard to measure, value, and track the change of over time. But it is an asset, isn’t it? It’s something the company owns, and which it can exploit for value.
Can you put a value on a brand?
Enough about beans for now though. More than just being an asset, things like branding, trademarks, and copyright are long-term assets. However, marketing and advertising costs associated with developing these are treated wholly as operating expenditure (expenses that reduce profits), rather than as capital expenditure (investments that don’t directly affect profits, but reflect the value invested in the business). Why is that the case when the latter is closer to economic reality, and the former violates accounting’s matching principle?
The problem goes much deeper. Consider the giants of the pharmaceutical, software, and tech industries. Their billions invested in R&D each year create internally generated intangible assets in the form of intellectual property, the most obviously valuable of which are patents for products with regulatory approval. However, this investment also serves to expand the know-how and expertise of its people – even if no patents are generated.
Intangible assets which are internally generated are rarely reported on company balance sheets. In fact, most intangible assets that do appear on a company’s balance sheet are acquired by transaction with a third party, at which point many accountants are suddenly happier to bestow a numerical existence upon them.
When a company acquires another, the excess above the net asset value might be shown as ‘goodwill’ in the accounts of the emergent entity. This simultaneously acknowledges the influence of intangibles on a company’s value, whilst completely failing to contend with their existence in any meaningful way.
What is goodwill in accounting?
Goodwill is a fuzzy falsehood, which covers up for accounting’s current inability to give information on investments in intangible assets and intellectual property in a manner that reflects the last 150 years’ economic developments. These developments have been huge.
Software development is one example where thousands of people might be working on developing an intangible asset, but rather than treat the software in progress as an investment by treating some costs as capital expenditure, we just expense the development costs now and report any income generated later. Revenues, when they do then occur, are not matched properly to their corresponding costs.
Not capitalising at least the relevant portion of this expenditure means that there is no way to tell from looking at the accounts, whether a company’s spend is a cost or an investment.
Compare a whiskey distiller and a software developer. Both invest in producing a long-term asset that neither might make money from for years to come. The difference in the accounts being that the distiller’s will show the maturing barrelled whiskey as an asset, whereas the software developer’s show nothing except for employment costs. Looking at the software developer’s balance sheet you might be forgiven for thinking that these show a whole lot of sunk costs with nothing much to show for them.
Albeit a crude measure, subtracting net tangible asset value from market capitalisation leads to the conclusion that 90% of S&P 500 companies’ market value is intangible, driven by the likes of Apple, Microsoft, Amazon, Facebook, and Tesla. The story in Europe isn’t much different: the S&P Europe 350 index shows that intangibles account for 75% of the index firms’ market cap.
So we’re either in a giant intangible economic bubble, there are some other factor(s) that we need to consider, or our inability to represent investments in intangibles on financial statements in a coherent and meaningful way is a shortcoming of our accounting systems which is becoming quite difficult now to ignore. We believe that the latter of these three provides the greatest share of the explanation.
So, what’s the rub? Why don’t accounts show us this information?
There are a lot of factors at play here. Honest and accurate financial reporting is vital to maintaining investor trust and a healthy economy. However, with all the benefits of international harmonisation of accounting standards, there comes the danger that the system becomes too clunky and too rigid to adapt to the times. New rules keep being added to the system, and if old ones aren’t taken out, the system becomes too complex for most people to contend with.
There is a clear need for processes that ensure that the system continues to serve the purposes for which it was intended. A focus on principles-based accounting, as opposed to rules-based accounting, is a movement in the right direction. The accounting world may also need to rethink what the prudence (conservatism) principle means in the age of intangibles, now that ignoring them is becoming less feasible.
We shouldn’t shy away from intangible assets. After all, intangible assets are no more ‘imaginary’ than the ‘imaginary’ value of money; a legal and social fiction that we collectively entertain.
We’re not saying let’s pluck numbers from thin air. Estimates can be dangerous and add unnecessary noise to accounting information. But the least we could do is to begin to report investments in intangibles and intellectual property at original cost, reflecting their capital value where it likely exists, and begin treating them sensibly. We really just don’t want to see “goodwill” in the accounts.
If you want to read more about the poor state of accounting due to intangibles, check out this page by Baruch Lev. For a more rigorous analysis of the issues we’ve mentioned take a look at Lev and Gu’s: “The End of Accounting and the Path Forward for Investors and Managers”.