Monday, May 10, 2010

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.

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