Recently, I had the pleasure of chairing a panel exploring how we could improve the fundamental analysis of companies, by focusing on intangibles disclosures provided in the annual reporting package.
The information that companies provide about intangible resources – or ‘intangibles reporting’ – has been a hot topic for many years and has long interested people directly involved in financial reporting and analysis, such as investors, accountants and corporates.
Given this background, we wanted to examine intangibles reporting at our June IFRS Foundation Conference, with a panel comprising of investors, a regulator, a CRUF UK member, an academic and a member of the International Accounting Standards Board (Board).
The complexities of intangibles reporting are beyond the scope of this blog. Instead, my modest aim is to examine some concepts discussed in the workshop and to share some notable comments and insights from the panellists.
How do we define intangibles?
Broadly, ‘intangibles’ lack physical substance and help a company to create value, whether or not they are secured by legal means, or meet the definition of assets in the current accounting framework. Intangible assets as defined in IAS 38 Intangible Assets, form a subset of the broader set of intangible resources (or, more simply, ‘intangibles’).
Investors generally want to know about all items that may potentially produce future cash flows and growth. So, investors may want to use both information about intangible assets that must be formally recognised and measured in a company’s financial statements as well as information about unrecognised intangibles.
The rising role of intangibles
Overwhelming evidence suggests that companies today derive significantly greater value from intangibles than was the case 20–30 years ago. We asked the workshop’s participants whether the rising importance of intangibles suggested that the Board should amend any IFRS Standards. A significant number of workshop participants indicated that some change would be beneficial, while about half said that IFRS Standards should be amended to recognise and measure more intangibles, as well as to introduce new disclosure requirements outside a company’s financial statements for intangibles.
Participants discussed the recognition and measurement of intangibles in the current accounting framework and compared the narrow definition and system of classification for intangibles in IFRS Standards to other more wide-ranging approaches. The preparer on the panel argued that the Standards provide insufficient clarity on how different intangibles may be classified, particularly in relation to business combinations – a view echoed by many conference participants.
We examined a few intangibles: human capital, brands and knowledge. Some approaches measure and value these intangibles – but few participants suggested they be recognised in financial statements. Investors on the panel commented that such recognition would have little analytical value i.e. improving ability to forecast future profits, or improve accuracy of valuation estimates. Another panellist, a preparer from a pharmaceuticals company, indicated that the analysts following their company found interactions with scientists to be useful in understanding the company’s value drivers. Such anecdotes illustrate that, in many cases, investors may already access information about a company’s intangibles from sources other than its financial statements.
In our discussion of these intangibles:
- A majority of participants, 75%, reported that measuring human capital would be of limited use to investors; and
- Just 45% of participants said that knowledge should not be reported in a company’s financial statements.
The intangibles information gap
Panellists also discussed the usefulness of information that investors receive on intangibles in a company’s financial statements and in other parts of its annual reporting package.
Many global economic policymakers, regulators and academics have expressed concerns about the perceived information gap on intangibles. For instance, Gu and Lev (2016) viewed the current accounting treatment of intangibles to be linked to the declining relevance of earnings to company value. Others assert that the failure to recognise many internally generated intangibles in a company’s financial statements has adverse consequences for investment analysis and governance. Evidence suggests that earnings have become less important in explaining share-price movements: in the opinion of Barth and others cash flows have taken their place. A majority of participants (54%) agreed that to close the perceived gap on information about intangibles, companies should provide more information outside of the financial statements on ‘value drivers’ and their associated intangibles; on the management of and strategy behind intangibles; and on the value of intangibles.
Using intangibles in investment analysis
Our workshop also covered some analytical approaches for intangibles used in investment analysis. We discussed an approach proposed by Damodaran that capitalises certain expenses and amortises the resulting assets using reasonable amortisable-life assumptions. These are expenses such as R&D in pharma companies, advertising in consumer goods companies, and training in consulting companies. Using this approach is believed to produce more consistency between the inputs in discounted cash flow models (such as growth rates, and reinvestment rates and return ratios).
We also discussed a qualitative approach that incorporates information on intangibles into a relative valuation framework. The fundamental idea here is that investors can develop scorecards to help them assess the performance of a company’s intangibles. A company achieving a higher score in such a framework may warrant being valued using a higher price multiple when its intrinsic value is estimated.
An investor on the panel said that many investors already use sophisticated approaches to incorporate information on intangibles into their analysis and valuation of companies.
A majority of workshop participants – 63% – said investors can best analyse intangibles using capitalisation techniques and non-financial information on the risks and return potential of intangibles.
Inconsistency in accounting for intangible assets
Participants also discussed inconsistent accounting treatment for internally generated intangibles as opposed to those identified in a business combination – an issue which investors have repeatedly raised in recent years. The investors on the panel found this inconsistency unhelpful, because it diminishes comparability between companies that acquire companies with those that grow organically. The preparer on the panel also criticised the inconsistency and thought that the need to identify acquired intangibles (as required by IFRS 3 Business Combinations) was costly and largely unhelpful. Furthermore, 86% of the participants in the workshop agreed that the Board should require more consistency in accounting for intangibles.
Narrative reporting on intangibles
In principle, investors and other stakeholders broadly accept that the perceived information gap on intangibles can be addressed in narrative reporting. The panel discussed related reporting frameworks, including the work of national and international standard-setters. We provided evidence of limited adoption of the national frameworks on intangibles by listed companies.
Of the workshop participants, 65% agreed that an absence of harmony in current requirements was the greatest obstacle hindering progress towards global adoption of intangibles reporting frameworks.
We highlighted the Board’s Management Commentary Practice Statement project, which will, in part, look to develop guidance on narrative reporting on intangibles. In this regard, a majority of workshop participants – 55% – said rather than to require specification, the Board should take a ‘principles driven’ approach to intangibles for narrative reporting.
Key Performance Indicators (KPIs) also featured in the workshop; investors report that KPIs are useful for analysing companies. The World Intellectual Capital has developed a framework emphasising innovation and value creation through explicit links to KPIs. We examined how different ‘value drivers’, such as customers, competitive position and employees, are linked to respective intangibles such as loyalty, market share and skills. For each of these value drivers, KPIs can be ascribed to track the performance of the associated intangibles – for example, the repeat-customer ratio can be used to assess customer loyalty. Of workshop participants, 51% said the Board should allow market forces to determine the development of KPIs (compared to 49% who would prefer the Board to support the development of KPIs either at a high level or at a sectoral level).
To conclude, intangibles represent complex investments for which single measures of value are unlikely to provide all relevant information. Instead, a narrative discussion on ‘value drivers’ and associated KPIs could be a useful way for companies to communicate with investors.
In relation to intangibles, the Board is currently addressing the information needs of investors via its Management Commentary project and we welcome feedback on the project’s exposure draft which the Board expects to publish in the second half of 2020.
Sid Kumar, is part of the IASB technical team and supports the IASB in its efforts to improve the knowledge of IFRS Standards. He also works with the IASB technical staff to develop educational materials for the investment community.
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Disclaimer: The views expressed in the blog are those of the author and do not necessarily represent the views of CRUF participants.