The Unbalanced Balance Sheet: Make Intangibles Count

Change and uncertainty are a feature of our world alongside innovations in our fast-changing economy. Investments in new business models and intangible assets — such as brands, technology and customer relationships — are increasingly key to driving value creation as companies research new technologies, cultivate customer relationships, manage their workforce and more. But information related to these important assets is often limited in the financial information reported by companies to stakeholders.

Intangibles are often unique, but that doesn’t mean it’s impossible to integrate intangible assets in reporting efforts. The lens through which we view a company affects how we measure success. A more complete picture contributes to a more unified understanding of value and, when used wisely, can act as a clear signal for action.

So what is the current state of affairs, and what can be done to improve things?

Why accounting lags behind

Accounting standards have historically treated investments in plant and equipment or financial assets very differently than investments in intangibles. As a result, investments in internally generated intangible assets are generally not recognized on balance sheets. This may have been OK at a time when companies created value through the deployment of vast collections of tangible assets, but today, most companies generate much of their value through intangible assets. The absence of most intangibles from financial statements and footnotes can result in a large gap between the book value of the company and its market capitalization, as well as a GAAP earnings metric that does not reflect a complete measure of return on investment.

Approach intangible assets with the rigor of financial reporting

To enhance the relevance of financial reporting, it needs to provide greater insight into intangible investments. Communicating this information as part of the financial reporting process, rather than through other avenues, subjects it to the rigor of the financial reporting ecosystem. Including information on internally generated intangibles, in addition to any acquired intangibles, can help incorporate some measure of intangible assets’ value into a company's financial statements.

Don’t stand still on ESG while things change around you

Investors are increasingly focused on a company’s environmental, social and governance (ESG) strategy, which highlights management’s stewardship of certain intangibles, such as human capital. ESG is a lens to help understand the operational and financial measures of impact and value creation. Operational and financial dimensions are linked — use both perspectives for a more comprehensive view of performance. ESG strategies and high-quality data can help you understand the impact of activities, and trigger decisions, change and financial outcomes. Stakeholders today are seeing a greater connection between ESG strategies and long-term value creation, and rewarding it. Strategies and commitments need milestones and a well-considered selection of high-quality ESG measures to communicate performance. This ESG data often includes operational insights (such as customer retention rates) that translate into value (valuation of customer intangibles).

Standardized disclosure guidelines will help

Transformational changes to financial statements, such as recording and disclosing all or some internally generated intangibles, will help the financial reporting process keep pace with business innovation and remain relevant. Thankfully, FASB and IASB recognize the need for action in this area. FASB is in the early stages of a project, and the IASB is seeking feedback from stakeholders on adding one. In the meantime, it’s critical for boards to engage all stakeholders — from the C-suite to regulators, auditors and users — to gather each of their unique perspectives on how financial reporting can best capture the value created through intangible assets.

Ultimately, ensuring that stakeholders have visibility into management’s stewardship over intangible assets is critical if financial reporting is to remain relevant in an intangible-dominated world. While the best approach may not be one-size-fits-all, any reliable effort to incorporate valuable intangible assets will benefit businesses in the long run.

(Source:  AccountingToday Audit & Accounting – Voices – March 1, 2021)