Intangibles

The UK Financial Reporting Council earlier this year issued a discussion paper titled Business Reporting of Intangibles: Realistic Proposals, of interest to intellectual property scholars. The FRC states

 The FRC issued a Research consultation in 2018 to gather stakeholder views on potential research projects; stakeholders supported further research on intangibles. The topic has also been identified internationally by other accounting standard-setters as a key area of research. 

Objective 

2. The objective of this paper, “Business Reporting of Intangibles: Realistic proposals” is to add to the international debate, gather views and influence the IASB and its future work agenda. 

3. The FRC is requesting comments by 30 April 2019. Comments are invited on all issues relating to possible improvements to the business reporting of intangibles. Comments are sought on the questions below. ...  

Section 1 Introduction 

6. This section sets out the objectives of this paper, which are to explore reasons why many intangibles are not fully reflected in the financial statements and to develop practical proposals for improving business reporting of intangibles. 

Question 1 Do you agree that it is important to improve the business reporting of intangibles? 

Section 2 Which intangibles should be reported as assets? 

7. This section reviews the implication of the IASB’s Conceptual Framework’s requirements that an intangible can only be recognised as an asset in financial statements if it meets the definition of an asset; and recognition provides relevant information about the asset and a faithful representation of it. 

8. The main proposals made in this section are: (i)An intangible should be recognised at cost only where: –the costs to be incurred on development of an intangible asset can be estimated at the time when a project to develop an intangible is undertaken. The amount capitalised should not exceed these estimated costs in view of the difficulty of establishing the future economic benefits; and –the economic benefits to be derived from the intangible can be specified when the costs are first incurred, and hence a relevant method of amortisation or monitoring for impairment can be established. (ii)For many intangibles the measurement uncertainty of fair value is so great as to call into question whether it could provide a representationally faithful depiction. (iii)The requirements of existing accounting standards should be reviewed in light of these conclusions. 

Question 2 Do you agree that an intangible should be recognised at cost under the two conditions set out above in (i)? 

Question 3 Do you agree with the assumptions the paper makes regarding measurement uncertainty of intangibles? 

Question 4 Do you agree that existing accounting standards should be revisited with the aim of improving the accounting for intangibles? 

Section 3 Disclosure of expenditure on intangibles 

9. The main proposals made in this section are: (i) There is a case for specific disclosure requirements of the amount and nature of investments in unrecognised intangibles that are treated as an expense in the period, particularly those that are incurred with a view to generating benefit in subsequent accounting periods (“future-oriented intangibles”). These should be clearly differentiated from expenses that unambiguously relate to the period. (ii) The cumulative amount of future-oriented expenditure that is expected to benefit future periods, and movements in it, should be disclosed. 

Question 5 Do you agree with the above proposals relating to expenditure on intangibles? 

Section 4 Narrative reporting 

10. This section discusses how narrative reporting might usefully complement the information provided in financial statements, both as regards recognised and unrecognised intangibles. The main proposals are: (i) Management should select the intangibles that are discussed in narrative reporting, by reference to those that are most relevant to the entity’s business model. (ii) Narrative reporting should include metrics relating to intangibles. It is questionable whether an estimate of the value of intangibles will be useful, but other metrics should provide information that is helpful to investors in making their own assessment of intangibles and their impact on financial performance. (iii) Metrics should be reported for several reporting periods, so that the trend is clear. (iv) Management should comment on the factors that have caused a change in metrics and compare the reported metrics with their realistic targets. (v) The definition and calculation of metrics might be standardised within specific industries. 

Question 6 Do you agree with the proposals aimed at improving the quality of information on recognised and unrecognised intangibles in narrative reporting? 

Section 5 Implementation 

11. This section suggests ways in which participants in the business reporting process could improve the reporting of intangibles. Question 7 What are your views about how the various participants involved in business reporting could or should contribute to the implementation of the proposals made in the paper? Further questions Question 8 Do you use additional information other than the financial statements when assessing and valuing intangibles? If so, can you please specify what additional information you use. 

Question 9 Do you have any suggestions, other than those put forward in this paper, as to how improving the business reporting of intangibles might be achieved? 

1 Introduction 

Objectives 

1.1 “Over the last 15 years or so there have been a number of calls for accounting reforms, with claims that the traditional historical cost approach has outlived its usefulness. One of the claims made in this debate is that the economy has changed in fundamental ways, that business is now fundamentally “knowledge based” rather than industrial, and that “intangibles” are the new drivers of economic activity. Based on those claims, commentators contend that one of the key problems faced by financial reporting is that financial statements fail to recognise many of the most important knowledge-based intangibles, such as intellectual capital, and that this has adversely affected investment in intangibles. This has led to calls for accounting-standard setters to re-evaluate how intangibles are accounted for and to make reforms.” 

1.2 The above paragraph introduced a paper[1] first published in 2008. The only revision that is required today is to replace “over the last 15 years or so” with “over the last quarter century or so”. Criticisms that financial reporting fails to provide relevant information about intangibles continues. For many years Baruch Lev has been one of the leaders of this criticism: he has recently published a book (co-authored with Feng Gu) memorably titled “The End of Accounting”. Those who take the view that the shift to the new economy has caused financial statements to lose much of their relevance for investment decisions often cite the divergence between the accounting value of equity (net assets) and companies’ market capitalisation. They suggest that this is due to the failure to recognise the value of intangibles in financial statements. There are, however, reasons to be sceptical about this argument. Although financial statements may be expected to provide information that is useful to an assessment of the value of a company’s equity, they have never pretended to provide that value directly. This has most recently been confirmed in the IASB’S Conceptual Framework (IASB 2018, paragraph 1.7). 

Many items in financial statements are reported at historical cost rather than fair value, which would be indefensible if the objective were to report the value of the company. Essentially, financial statements are a record of past transactions. They reflect the extent to which past transactions have resulted in assets to the extent they might provide future cash inflows (and, of course, liabilities to the extent they might require future cash outflows). In contrast, the market value of equity reflects an assessment of future cash flows. But even if all assets and liabilities were recognised and reported at fair value, differences between reported equity and market capitalisation might be expected. 

A long-standing puzzle in the finance literature is why shares in funds, such as investment trusts, often trade at a discount (and occasionally at a premium) to their net asset values, despite the regular reporting of the fair value of their net assets. For a discussion of this puzzle, see Shleifer (2000, Chapter 3). Some researchers dispute the claim that financial statements have lost relevance despite the advent of the new economy—for example, Penman (2007), and Skinner (2008). A particularly thorough recent study is Barth, Li and McLure (2018) which suggests that “our findings reveal a more nuanced, but not declining, relation between share price and accounting information that reflects the new economy”. 

1.3 The objectives of this paper are: •to explore the reasons why intangibles cannot be more fully reflected in financial statements without radical change; and •to develop practical proposals for improvement in business reporting that can be expected to be implemented in the near future. 

1.4 Examples of intangibles include: patents, copyrights, trademarks, knowledge, skills, permits, licenses, computer software, customer lists, relationships, business processes, and dynamic capabilities (such as the ability to adapt to new working methods). Clearly this is not an exhaustive list. It is also obvious that the examples are diverse: a license to operate has little in common with a supplier relationship, except that neither is tangible, and that a business that has a license to operate and good supplier relationships is more valuable than one that lacks either. 

1.5 The IASB’s Conceptual Framework (IASB 2018), which has recently been revised, sets out definitions of assets and recognition criteria. Only items that both meet the definition and the recognition criteria can be included in financial statements without radical change. While the possibility of radical change cannot be discounted, it undoubtedly will not be achieved in the near future. The immediate priority is to identify how, within the current financial reporting framework, practical proposals can enhance the relevance and quality of information that is conveyed by financial reporting. 

1.6 Within the current Conceptual Framework, financial statements can only deal with those intangibles that meet the definition of assets and satisfy the recognition criteria, as set out in the IASB’s Conceptual Framework. However, it seems unlikely that this will be sufficient: it is also necessary to consider how financial reporting of those intangibles that do not meet either the definition of assets or the recognition criteria might be improved. This might be by narrative reporting rather than within the financial statements. That is why our title for the project is “intangibles” rather than “intangible assets”. 

1.7 Our working definition of “intangibles” is: “Intangible factors that are important to an entity in its creation of value, whether or not they are secured by legal means and whether or not they meet the current definition of “assets”.” 

Scope of project 

1.8 However, to restrict its proposals to maintain focus, some limitations on the scope of this paper are necessary. So, this paper focuses on “business reporting” which excludes: •reporting by entities in the public and not-for-profit sectors; and •reporting to meet the needs of stakeholders other than those defined as the primary users of financial reporting in the Conceptual Framework (that is, existing and potential investors, lenders and other creditors). 

1.9 These topics are not excluded because they are unimportant, or because this paper’s proposals are necessarily irrelevant to future initiatives to address them. But it acknowledges that, in considering extending the proposals to these areas, it may be necessary to modify or adapt them. 

However, as mentioned above all forms of business reporting, including the management commentary, are addressed in this paper. It is not confined to the financial statements but discusses other forms of business reporting such as in the management commentary. 

1.11 Financial reporting of goodwill and its impairment are also not addressed in this Discussion Paper. The IASB plans to issue a Discussion Paper or Exposure Draft on Goodwill and Impairment in the second half of 2019, and EFRAG has recently completed research on the same subject. Revisiting goodwill and its impairment within this project would therefore duplicate the work of others. 

Structure of this paper 

1.12 The remainder of this paper is structured as follows:

• Section 2 discusses the implications of the Conceptual Framework for the reporting of intangibles. It relates its conclusions to the economic features of intangibles that are identified in the literature. 

• Section 3 considers possible improvements to the reporting of expenses incurred to develop intangibles that cannot be capitalised in financial statements but are expected to benefit future periods (“future-oriented intangibles”). 

• Section 4 discusses how narrative reporting, including the use of metrics, might be used to provide better information for investors on intangibles. 

• Section 5 notes that further consideration is required of the implementation of the suggestions made in the paper and the role of preparers, investors, and standard-setters in that process.