Accountancy can save the world: the prequel

Intangible assets have swiftly become a major consideration for investors, making up 90% of all enterprise value on the S&P 500. Yet our accounting system, which lies at the heart of how we allocate scarce resources, has failed to adapt, with implications for the decisions that could affect sustainability. Our columnist – on a mission to make accountancy part of the social value solution – proposes a (relatively) simple fix.

Accountancy is part of the problem when it comes to social and environmental crises but is also a key part of the solution. Sadly, this is being ignored by both non-accountants (understandably) and by many accountants, specifically those responsible for accounting standards.

One solution is to stop allocating resources to activities that make things worse. This means accountancy should provide information that leads to resource allocation decisions that generate financial returns and contribute to sustainability. All the articles in this series so far have focused on what needs to change so that investment decisions contribute to sustainability. This is easy enough as it simply means changing the information needs of users from ‘assessing expected financial returns’ to ‘assessing financial returns for the investor and the consequences for others (also known as impact).’

 

Read: Will accountants save the world? and more articles in Jeremy's Nicholls & Dimes series 

 

But what about assessing the financial returns, based on expected future cashflows, based on understanding of the resources of the enterprise (the balance sheet) and the stewardship of those resources (the profit and loss account)?

There is a big problem here that also needs fixing – the issue of intangibles – and it can largely be fixed within existing accounting standards.

 

Intangible – and invisible

Previously I argued that accountants are well placed to save the world, using their understanding of useful information to support the development of sustainability and impact reporting and to speed the integration into one system. There is, though, another issue that needs to be addressed, that is related but separate. Separate as it is more about getting the house in order; related as it is also about using the financial statements wherever possible. Only then should we explore the need for any non-financial reporting.

The problem is highlighted in the table below from consulting firm Ocean Tomo.

In just 43 years, intangibles have evolved from a supporting asset into a major consideration for investors – today, they make up 90% of all enterprise value on the S&P 500, a massive increase from just 17% in 1975. And yet they don’t appear on the balance sheet – because they are intangible.

Financial accounts are not designed to show the value of a reporting entity. They are designed to provide information on an entity’s resources and calls on those resources, and on a manager’s stewardship of those resources – in order to assess potential future cash inflows in the expectation of financial returns. Fair enough. But historically, financial accounts provided a pretty big clue as to the value of the entity, and for any entity which does not have significant ‘intangibles’, they still do.

Historically, financial accounts provided a pretty big clue as to the value of the entity, and for any entity which does not have significant ‘intangibles’, they still do

In the International Accounting Standards Board’s (IASB’s) Conceptual Framework for Financial Reporting makes this clear in paragraph 1.7:

General purpose financial reports are not designed to show the value of a reporting entity; but they provide information to help existing and potential investors, lenders and other creditors to estimate the value of the reporting entity.

But the above was first stated in 2011. Rather than address the problem so that balance sheet values continued to be close to market valuations, the solution was simply to state that – since accounts were not designed to show the value – there isn’t a problem.

 

 

Risk of suboptimal decisions

But it is a problem. If the accounts are intended to provide useful information, then they need to provide information on these intangible assets, since these are the assets that are increasingly driving future cashflows and so expected returns. If they are not in the accounts, then there is also no information on management’s stewardship of these assets. Investors and investment managers have to backfill this information from their own sources, and the risk of making suboptimal decisions has gone up. Surely it would be better for management and the directors to provide some information on these assets and how they have been managed? Investment managers can assess this, in the context of other information, and then make their decisions.

The problem has of course been recognised. IASB is revising the management commentary, the report that complements an entity’s financial statements to provide management’s insights into factors that have affected the entity’s financial performance and financial position and factors that could affect the entity’s ability to create value and generate cash flows in the future. This is not mandatory for IFRS (the body that oversees global accounting standards) but could be required by other regulatory bodies. One of the concerns raised in the current IFRS exposure draft on the management commentary is that existing commentaries do not always provide investors and creditors with the information they need, including providing insufficient information about matters that increasingly affect the entity’s ability to create value and generate cash flows, and are matters of increasing interest to investors and creditors—for example, information about intangible resources and relationships and ESG matters.

Alongside this the European Financial Reporting Advisory Group, that reports to the European Commission, is currently working on a project on better information on intangibles which started in 2018 and has established an advisory group on intangibles. There is concern that uncertainty and inconsistency in the valuation and inclusion of intangibles becomes a risk for investors, as has been highlighted in some merger and acquisition deals where the purchaser has discovered that assets were overvalued. Not that anyone complains when they discover they were undervalued. But so long as the uncertainty relating to valuation of any intangibles becoming tangible is transparent, investors can be expected to be reasonable investors and be able to consider this in making their decisions.

So long as the uncertainty relating to valuation of any intangibles becoming tangible is transparent, investors can consider this in making their decisions

These will help, but the challenge for investors will still be to understand the trade-offs that management has made between an entity’s own investment options and between creating value from intangible as well as tangible assets. This would require the information to be included in the financial statements. Increasingly we have three tiers in that part of the financial statements represented by the balance sheet – profit and loss account and cashflow statements, the notes statements, and the management commentary. And soon there will be requirements to disclose sustainability information. All adding complexity.

Surely if the information is material to an investor’s decision (to provide resources to an entity, based on the resources of that entity and management’s stewardship of those resources) the information should be in the financial statements? Perhaps the best place for disclosure is in the notes but the information should still be in the financial statements. The notes are an important part of the financial statements that have generally been used to disclose information about the balances in the profit and loss and the balance sheet. Perhaps we need a specific set of notes that relate to information that didn’t quite make it into disclosure – in other words, anything that’s in the management commentary that relates to management’s historical decisions. This information would still need to meet the requirements for information to be relevant and to be faithfully represented. But these requirements cover three types of uncertainty: existence, outcome and measurement. If uncertainty is too high for disclosure it could be included in the notes, if too high for the notes, it might make it to the management commentary or not be reported at all. We need to reassess the level of uncertainty that makes disclosure possible and provide appropriate caveats for the users.

The challenge for investors is knowing whether the management commentary is complete. At least in respect of historical information, this challenge would be significantly reduced if the information was included in the notes because the notes are part of the information that is audited for the risk of material misstatement.

 

 

Increasing acceptable uncertainty

The diagram below shows that information that is material and could be included in the financial statements exists in a continuum from low to high uncertainty where uncertainty depends on a mix of three types of uncertainty: existence (does it exist), outcome (will it happen) and measurement (can it be measured). Inevitably a line has to be drawn somewhere. Information to the left of the line becomes tangible, to the right it becomes intangible. But where the line is drawn arises from historical practice. If we want to move it, and so long as investors are aware of the increased uncertainty, we can.

Jeremy Nicholls - Increasing disclosure of intangible assets

The information that would be included as a result of an increase in acceptable uncertainty could be separately reported, for example in the notes, even as a parallel set of financial statements. This is the approach being taken by Rethinking Capital which is pioneering a normative accounting approach. Either way, a change to accounting standards isn’t required. Just a change to the disclosure threshold.

These approaches could close the gap between balance sheet values and market values and protect the usefulness of the financial statements.

A lot can be done with some small changes 

Although I have been arguing for a change to the basis of financial accounting to reflect investors’ (current and potential) information needs more accurately, a lot can be done with some small changes (though with big implications). Where the consequences of a business operations result in assets for other people they are not controlled by the entity and so the requirement for control would need to be adapted. Where the consequences result in costs for other people these do not become obligations because of the big get-out-of-jail card in IFRS standards – is there practical ability to avoid the obligation? If there is, the obligation does not need to be disclosed. ‘Practical’ would need to be adapted so that being responsible would make it impractical to avoid the obligation.      

It may still seem weird, but accountancy lies at the heart of the way in which society allocates scarce and often very limited resources to activities – an approach that was once thought the best way of meeting social needs and meeting the wider public interest. With these changes, and alongside a few others, accountancy can go a long way to saving and even regenerating the world.

Thanks for reading Pioneers Post. As an entrepreneur or investor yourself, you'll know that producing quality work doesn't come free. We rely on our subscribers to sustain our journalism – so if you think it's worth having an independent, specialist media platform that covers social enterprise stories, please consider subscribing. You'll also be buying social: Pioneers Post is a social enterprise itself, reinvesting all our profits into helping you do good business, better.