This week, we explore a new way to think about value investing, and the ways that traditional metrics fail to capture critical aspects of modern businesses. To complement that piece, which can be read here, we look at the difficulties of accounting intangible assets - the non-physical parts of a business that are often the motors of growth.
Investors can attempt to re-interpret reported numbers to make sense of how intangibles are accounted for. But that still leaves two glaring questions: how might accounting standards change to solve the problem, and why is this not happening?
Last year, Stern School of Business accounting and finance professor Baruch Lev presented the case for change in financial reporting in an article published in the European Accounting Review titled 'Ending the Accounting-for-Intangibles Status Quo'. Lev is the author of several books on the subject, including The End of Accounting. He also writes the highly readable End of Accounting blog. He reckons the problem is significant, change is long overdue and that some of the biggest problems with accounting standards could be fixed relatively simply.
Lev argues that the scant information provided about a company’s intangible investments in accounts is harmful to investors and the economy, and makes little sense. He says there is "no way, for example, for investors to know how much did the firm spend on employee training or IT, or whether the brand value is maintained or left to atrophy", and considers it absurd that "the major value creators of modern businesses”, including research and development or tech investment, are treated as having no future benefits, whereas the ‘commoditised’ fixed assets – described as marginal value creators because they are available to all competitors – are capitalised.
While many commentators see the stock market success of lossmaking companies as a worrying reflection of overexuberance, Lev offers a different perspective: reported losses are more often a failure of accounts to reflect reality. Between 2016 and 2017 when the economy was booming, close to 70 per cent of high-tech public companies were lossmaking. "Such massive and pervasive ‘losses’ obviously don’t reflect the real performance of these companies,” he explains. “For almost half of the high-tech and science-based firms the ‘loss’ was caused by the expensing of intangible investments.”
Lev does acknowledge that there are specific risks relating to intangible investments, including development risk or patent infringement, which need to be understood differently. However, these characteristics do little to explain why the value of internally-generated intangibles should be ignored by balance sheets. “The one thing that accountants can definitely do to decrease investors’ uncertainty and the consequent cost of capital is to enhance the information investors have about intangibles.” He feels the issue is particularly damaging to smaller businesses, which may not be fronted by leaders charismatic enough to deflect investors' focus from large reported losses, such as Amazon founder Jeff Bezos.
While current accounting rules may appear disadvantageous for investors, and potentially for society, Lev argues that there are also those who have an interest in preserving the status quo. “These investments vanish from investors’ and directors’ memories when they are expensed. Managers are all too happy to erase the trace of intangible investments from the books to avoid embarrassing questions when those investments are impaired, or fail outright.”
He believes many fall for the red herring that capitalising intangibles requires companies to value the investments in order to put them on the balance sheet. All it actually involves is recording the cost of investments and periodically assessing whether it was money well spent.
Expensing of intangibles also presents the danger of encouraging bad actors, which Lev also believes is an underappreciated issue. “Only few realise that the current intangibles’ expensing rule provides a powerful real manipulation tool for managers: a dollar cut from R&D, for example, raises reported earnings by a dollar.”
To encourage better capital allocation decisions, Lev believes it is vital to bring these investments out into the light. “Capitalisation forces managers and auditors to periodically assess the economic viability of the most important expenditures of modern businesses (patents, brands, artistic products) and alert investors to impairment or value disruption of these investments. No long-term investment, tangible or intangible, should escape investors’ monitoring.”
The most significant elements of the accounting solution proposed by Lev are in fact very straightforward. What’s more, the multi-year experience with existing rules for testing goodwill impairment and for amortising acquired intangible assets would, he argues, significantly aid implementation. He suggests that internally-generated intangibles should be capitalised if the company has legal ownership of the asset it has developed; the asset created is scarce and cannot be easily imitated by rivals; the asset is likely to generate a benefit; and the spending on the asset can be identified and completed.
These intangible assets would then be amortised over their useful or legal life and be subject to an annual impairment test.
For Lev, change is long overdue. “It’s hard to find more outdated and harming accounting and reporting rules than those pertaining to intangible investments... This could have been somehow tolerated if intangibles were a fad, or a passing phenomenon. But they are not.”
