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Even with new accounting treatments, financial systems don't allow companies to say much about their intangible assets. Finance chiefs are finding ways to address this conundrum.
Ben McLannahan, CFO Europe Magazine
December 30, 2003
Intangible assets are at the core of what we do," says Steve Ruffini, CFO of HIT Entertainment. "Our business is owning and managing intellectual property."
But as anyone who has observed the growing gap between the market and book values of knowledge-intensive companies will testify, getting an idea of the real value of HIT's business isn't easy. Poring over the balance sheets of the small London-listed children's entertainment company certainly won't help.
The frustration now is that even after new international financial reporting standards (IFRS) go into effect next year, HIT's financial statements still won't be able to convey the value of its biggest assets—the brand ownership of Bob the Builder, Barney the Dinosaur, Angelina Ballerina and a host of other characters popular among pre-school children around the world.
HIT's situation is by no means unique. Increasingly, intangibles—ranging from intellectual property and brands to licences and R&D pipelines—dwarf the tangible book assets of all sorts of companies in all sorts of industries. That's left many CFOs in a bind. Most finance chiefs agree that the new accounting standards will not help them supply the depth and breadth of information that the investor community is clamouring for.
Reporting above and beyond the book assets appearing in financial statements "should be a critical exercise for every company wholly or partly dependent on intangibles for its value creation," says Marie-Ange Andrieux, a partner at accounting firm Mazars in Paris. CFOs should be "at the forefront of this process, using their skills in measurement and control to provide additional information to the financial markets to allow them to judge companies more precisely."
But can finance chiefs rise to the challenge to bring intangibles into sharper focus? The jury is out, amid plenty of debate within finance circles on how—and even whether—it can be done.
One thing is for sure, the debate will heat up soon. Starting next year, new rules on accounting for business combinations from the International Accounting Standards Board (IASB) will bring the issue of intangibles reporting to the fore. According to Stuart Whitwell, a partner at Intangible Business, a London-based consultancy, the proposed standards "will focus the minds of management, forcing them to manage brands and other intangibles as they would manage any other type of asset."
On the evidence of the exposure draft and subsequent announcements, the IASB's line of thinking is very similar to two US standards approved in 2001—FAS 141 on business combinations and FAS 142 on goodwill and other intangible assets. As in the US standards, there are three changes under discussion—the abolition of merger accounting, otherwise known as pooling of interests; the non-amortisation of goodwill; and a new impairment test for goodwill and other intangible assets. The latest word from the IASB is that the new standards— revising IAS 22 on business combinations, IAS 36 on asset impairment and IAS 38 on intangible assets—will be in place by the end of the first quarter 2004.
Among CFOs the reaction has been mixed. One of the three changes in particular—the impairment test—is drawing a lot of fire. As far as Kurt Bock, CFO of BASF, the German chemicals giant, is concerned, the tests promise to be "a very cumbersome and laborious process."
If the IASB has its way, companies will have to undertake impairment tests at least once a year. First, all goodwill and intangibles with an indefinite useful life acquired in an acquisition must be allocated to a company's smallest individual cash-generating unit—which is something that most companies are not accustomed to doing. The fair value of the reporting unit must then be calculated and compared to its book value. If the fair value is less than the book, the fair value of each of the assets and liabilities of the reporting unit must be calculated, including internally-generated intangible assets that are not recorded on the balance sheet and therefore may never have been valued before.
This doesn't sit well with Bock. "How is it possible to value intangibles in a consistent way across companies and countries, and in a way that a third party can claim is a due process and really works correctly?" Bock asks. "The lack of a theoretical foundation cannot be overcome—it exposes accounting to a grey area of guesswork and speculation, and that's probably the last thing we need right now." For the time being, Bock says BASF, which carried around €3.5 billion of intangibles on its balance sheet as of December last year—or around 10% of the firm's total asset base—is content not to capitalise anything "unless we really have to."
Ruffini of HIT shares Bock's concerns—to a point. HIT, currently reporting under UK GAAP, is "saddled with taking a goodwill charge, which our US competitors don't have in their earnings per share," he says.
Yet, what's troubling Ruffini is that the new IFRS standards still won't enable companies to capitalise the costs of creating and developing their own intangible assets in the same way that they do with home-grown tangible assets such as software. The new rules alone, he concludes, aren't able to provide the "full picture" of how a company is creating value from its intangibles.
So Ruffini is taking a route that other CFOs are being forced down—moving beyond the realm of accounting standards to share with external stakeholders the impact that specific intangibles have on earnings. This, of course, is easier said than done, particularly if a CFO has trouble extracting credible, consistent numbers from business units about their intangibles.
The task was made a bit easier for Ruffini after the firm bought UK-based Gullane Entertainment last year. After that deal, which added Thomas the Tank Engine, Sooty and Captain Pugwash to HIT's brand portfolio, the firm decided it needed to improve the way specific intangibles—namely its brands—are managed. On the advice of international brand experts from rivals Mattel and Disney, HIT is no longer organised along general business divisions, such as home entertainment and consumer products. Instead the firm is divided into "brand teams" within its core territories (the US, Canada, Europe and Japan), each with its own P&L and five-year plan.
"Before, home entertainment did what was best for Bob and Barney, while consumer products did what it thought was best," says Ruffini. "It became apparent after the Gullane deal that we really needed brand champions who focus specifically on co-ordinating efforts between products, home entertainment and marketing."
A big benefit of the reorganisation for Ruffini: he now has greater visibility into the performance of each brand, which he's been able to demonstrate to investors and analysts.
In its annual report for the latest fiscal year ending July 31st, the company provided not only data on revenues and growth plans for each of the firm's core territories, but also "softer" information such as brand awareness and customer loyalty. HIT is considering further disclosures, too, in response to requests from analysts to break down footnotes by brand, rather than by division.
In an industry dominated by the US home entertainment giants Disney and Viacom, Ruffini reckons HIT's intangibles disclosure puts it in a league of its own. "I'm a big believer in benchmarking, but these big boys are so large and so vertically integrated that I can't tell a darned thing when I look at their financials," he says.
But even Ruffini concedes there are limits to how much HIT wants to disclose publicly. "From a commercial standpoint, our competitors might benefit if we were to disclose very specific brand information," he says. There are also trading partners like Wal-Mart, the US retail giant, who wouldn't mind finding out what percentage of sales they were driving. "Not that they won't try anyway, but I certainly wouldn't want to give them audited financial information to strengthen their bargaining power," says Ruffini.
Competitive sensitivities are also always at the back of Carsten Lønfeldt's mind when intangibles reports are prepared at Coloplast, the DKr5.6 billion (€753m) medical products provider where he's CFO. But that certainly hasn't stopped the company going further than conventional reporting requirements.
According to Per Nikolaj Bukh, professor of accounting at the Aarhus School of Business, Coloplast's reporting outstrips anything that regulatory models require. And that's by the high standards of Denmark, which last year became the first country in Europe to require companies to disclose an "intellectual capital" statement in addition to traditional financial reports. The Danish Financial Statements Act, which came into effect last year, requires two new additions to management's review: a description of the intangible assets of the company, "if they are of special importance to future earnings," and a description of the company's impact on the environment and measures for the prevention, reduction or remedy of environmental damage.
But as Lønfeldt recalls, Coloplast didn't wait for mandates from regulators to launch its intangibles reporting. Its foray into the area began in 1997, when the company was asked to join 19 other Danish firms in a project examining corporate intellectual capital sponsored by the Ministry of Industry. But while Coloplast was enthusiastic about the project and its results, Lønfeldt recalls with bemusement that when he announced to investors that the company would begin publishing intellectual capital reports alongside its financial statements, "you could literally see some of them rolling their eyes to the skies," he says.
With good reason. For the most part, the investor community tends collectively to cringe if they hear of any attempt to mix tangible assets with intangible assets on a balance sheet. "You can't express intangibles in monetary terms," contends Bernard Marr, a professor at Cranfield School of Management in the UK and head of the intellectual capital group of the Performance Measurement Association. "The best way to do this is to try and create a narrative for intellectual capital."
And that's precisely what Coloplast set out to do. Its intangibles reports aim to tailor its information to four groups—shareholders, customers, employees and customers. In its latest annual report for the fiscal year ended October 31st 2002, 18 pages out of a total of 55 were devoted to a range of metrics for each of those groups, providing five years of data on, among other things, product and service performance, customer satisfaction, new products brought to market and patent licensing. In addition, the firm served up data on employee satisfaction measurements, job rotations, managerial positions filled internally, absence rates and other human resources related information.
As for the CFO's concern about giving away too much data to competitors, the firm withholds "sensitive information" on co-operation with customers and user-groups, preferring, for example, to give certain data in indexes rather than absolute numbers.
Seeing Is Believing
Not all CFOs are keen to go to the same lengths as Lønfeldt of Coloplast. But given the limitations of accounting structures, CFOs should aim to "present the fullest picture possible of their companies, so that investors can see the firm through the eyes of management," says Thibault de Tersant, CFO of Dassault Systèmes, the €774m French software maker. For his part, de Tersant is adamant that intangibles don't belong on the balance sheet.
The Nasdaq-listed firm, which designs software to facilitate the design, simulation and production of complex goods such as cars and aircraft, is intensely R&D-focused—between 28% and 30% of the firm's annual revenues are reinvested in R&D, compared to the typical industry range of between 10% and 15%. And yet de Tersant doesn't rely on the balance sheet to tell this story—since R&D costs are such a nightmare to capitalise, his policy is to run them through the P&L, while "aggressively" amortising the firm's acquired goodwill and technology.
De Tersant claims the market is "quite happy" that the firm doesn't have huge amounts of intangibles on its balance sheet—the firm has €11m of intangibles in a total asset base of €867m. "From a theoretical standpoint, we have far more assets than those that appear on the balance sheet, but when dealing with investors, I always stress that everything they see is real," he notes.
While the balance sheet won't, or can't, provide the insights into intangibles that investors might want, the CFO says more and more presentations and meetings are devoted to disseminating information that aims to give shareholders a better understanding of the business behind the numbers.
"If you look at our presentations to investors, we spend at least half our time talking about product innovations, rather than focusing on backward-looking financials," he says. Put another way, the firm's financial statements are nothing more than "a point of departure."
All the talk of intangible reporting is fine in theory, but does a greater focus on non-financial metrics benefit a company financially? According to Carsten Lønfeldt, there's compelling evidence that it does. In August this year, the CFO of Coloplast, a Danish medical products maker that began intangibles reporting in the late 1990s, recently took part in an experiment conducted jointly by Schroders, a London-based fund manager, and accountants PricewaterhouseCoopers (PwC).
Taking Coloplast's annual report from 2002, PwC stripped out all of the quantified non-financial data. The final document complied with Danish GAAP, and included the narrative provided in the front of the report and accounts, but excluded Coloplast's own metrics relating operational performance to economic outcomes.
Armed with two versions—a complete document along with the abridged one, both with the name of the firm concealed—PwC gave each investment manager at Schroders who was participating in the exercise one of the two versions of the report. The managers were asked to come up with forecasts of revenue and earnings for the next two years and decide on a recommendation for the stock based on the document they were given. They had two hours to complete the task—no conferring with other participants or access to external sources was allowed.
According to Lønfeldt, the results were "startling." More often than not, the participants with the full set of supporting intangible measures generated a lower, but much tighter, range of estimates than those who used financial performance information only. Moreover, the group with the undoctored report were overwhelmingly in favour of buying the stock. Those with the incomplete information set were less enthusiastic about the company—nearly 80% gave a sell recommendation.
"That tells us that this extra transparency is a good thing, since it leads to a much better understanding of the company," says Lønfeldt. "Higher earnings estimates with a bigger variance are not as attractive as a more consistent view on the value of the company." To Lønfeldt—a CFO with five years of intangibles reporting under his belt—the results were "vindication of our approach."