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Accounting column – Taking control of intangibles.

For decades, on both sides of the Atlantic, those with an interest in financial reporting have grappled with both the ‘what’ of measurement (I’m not interested in last year’s figures, I want projections of what you will do over the next 12 months), and the ‘how’ (should my building be in at cost or at market value?).

Over the last year or so, the emphasis has moved away from the financial and – through the gateway of intangibles – has instead turned to measuring and disclosing items which would not have appeared in any traditional accountancy text book. Debates are now starting over imponderables such as the size of an organisation’s human or reputational capital.

These issues have been highlighted most by the growth in the new economy, where the crucial, defining, wealth-creating characteristics of companies are knowledge, technology, information and intangible assets, along with that increasingly controversial notion – globalisation. In this sort of business environment the information currently provided for investors and creditors in annual reports and accounts seems unconnected with the real business drivers.

It is clearly unsatisfactory that the difference between the owners’ valuation of a company – usually measured by market capitalisation – and the book value should be attributed to one ill-defined lump called intangibles.

This has led to a justified search for relevance in financial and business reporting.

The seriousness of the questions facing corporate reporting is underlined by the publication of a report* from the US Financial Accounting Standards Board (FASB), which looks at the challenges presented by the new economy.

The FASB reckons the notion of reporting for new economy companies in a different way to old economy companies is unhelpful. Instead, it focuses on the definition of an asset, and claims that control is one of the essential characteristics of all assets.

By saying control is at the heart of the matter, the FASB has started to define which items can be described as assets. So, as an example, the FASB would argue that customer satisfaction could never satisfy the definition of an asset, because it can only be managed, not controlled. At the same time, the control definition does not preclude related items, such as customer databases, from being recognised in the balance sheet.

The FASB argues that there are two gaps that frustrate attempts to recognise intangible assets in financial statements. First is the time gap. Vast amounts of time and money may be needed to create an asset before the final product can be demonstrated to have probable future benefits. This has been seen with the internet revolution, in which it has taken longer and cost more than was first predicted to persuade us all to do our shopping and banking over the internet than the (with hindsight) over-optimistic predictions said it would. But this is not a new problem – the same could be said of the building of the railways in the 19th century. Business pioneers who need massive investment always run the risk of being stuck by financial arrows.

The second gap is a so-called “correlation gap”. This means that the general relationship between the cost incurred and the value of future benefits (which works or has worked for the railways and other tangible assets) does not exist for intangible assets. This is a tough one: if there is such uncertainly, why should anyone in their right mind invest in intangible-dominated businesses?

To address these gaps the FASB reckons FDs are going to have to grapple with three areas that result from the emergence of the new economy. First, internally generated intangible assets are going to be have to be recognised and measured. Secondly, whether FDs like it or not, there is going to be expanded and systematic use of non-financial performance metrics. Eventually, more forward-looking information will be disseminated.

This strategy may well be both the realistic and sensible future for corporate reporting. But how much it has been driven by the needs of investors pouring billions into hopeful internet ideas, and how much has happened as a result of pressure for better corporate governance and improved risk management – movements which apply equally in old and new economy companies – is a matter of debate.

Versailles FD faces writs

Fred Clough, FD of the collapsed Versailles group, faces over #60m in writs. PricewaterhouseCoopers has indicted him for #50m, while Carl Cushnie, former chairman of the company, has issued a #13m claim after discovering #12.8m was missing from the accounts of Marrlist, a company that had Cushnie and Clough on the payroll.

Risky business

‘Loss of reputation’ is now the greatest business risk for large corporations, closely followed by ‘failure to change’. But an AON survey found that 14% of organisations have not yet carried out risk identification as part of corporate governance.

* Business and Financial Reporting, Challenges from the New Economy can be downloaded from the website

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