In today’s economy, the relevance of intangible resources in value creation processes is widely recognized. Over the past few decades, investments in these assets have taken on increasingly greater weight, proof that they serve as drivers of growth and economic development. In fact, according to a 2017 report by the European Commission, over the past twenty years investments in intangibles have outpaced investments in tangible resources by far, escalating by 130% in the US and 87% in the EU, compared to a growth rate of 70% and 30% respectively in tangible assets.
But despite this rising relevance (also due to an ever more technology- and service-based economy), today most intangible assets cannot be seen on corporate balance sheets. The reason in part is that international accounting standards lay down strict rules on entering investments in intangibles on the asset side of the balance sheet. IAS 38, for example, allows companies to recognize only intangibles acquired externally; development costs are the lone exception, but only if they meet specific criteria. Even more stringent are the US GAAP rules, which only permit reporting acquired intangibles as assets. As a result, resources such as patents, brands, copyright, reputation, relationship capital and so forth, if produced in-house, are not entered as assets on the balance sheet.
The prevailing opinion among preparers and users of financial statements is that accounting standards have not evolved to keep up with the changing times, so now more than ever before they must be reexamined. Indeed, beyond the limits as regards recognizing the intangibles mentioned above, consider the new generation of this asset class, such as cloud computing, emission rights, crypto currencies, and more. As we can easily imagine, applying the rules dictated by current accounting standards is anything but straightforward for these intangibles.
Bolstering the growing demands for revised rules that go farther to recognize intangibles on the balance sheet, several empirical studies show that investors have been finding financial statement results far less useful in the past few decades (what’s called value relevance), in particular for companies with a higher intensity of intangibles. The source of waning value relevance is the fact that it is impossible to capitalize the costs incurred internally to develop intangible resources. This means that there is little correlation between costs and revenues in periods of growth or decline, which in turn leads to over/underestimating performance indicators like ROE and ROA. Another motivation is the limited comparability between the balance sheets of companies with internally-developed intangibles versus those with externally-acquired ones. All this makes the work of analyzing financial statements particularly challenging (and in some cases not very helpful) for users. Other studies focus on the real effects deriving from different regimes for reporting intangibles on balance sheets. This body of research shows that the possibility of capitalizing on investments in research and development is reflected in a greater propensity among managers to undertake innovative investments, while in contrast, immediately expensing these costs tends to dampen the incentive to invest in intangible resources.
But while many are clamoring for change, nay-sayers are voicing their opinion as well. Beyond the fear that greater flexibility in terms of capitalization might make room for opportunistic accounting policies, a number of experts believe that the excessive uncertainty typical of internally-developed intangibles would translate into greater uncertainty and possible distortion of results in later accounting periods, results which would be impacted by conjecture stemming from complex calculations for amortization and depreciation. Also on the no side of the question are people (mainly company representatives) who worry that greater information transparency on intangibles would mean revealing sensitive information, which would have negative repercussions on competitiveness.
Standard setters do not have an easy job with regard to intangible assets. Demands come from all sides to strike the right balance between satisfying different information needs while minimizing potential risks. The issue of intangibles was recently added to the agenda of the International Accounting Standards Board (IASB) for 2024. Meanwhile, the European Financial Reporting Advisory Group (EFRAG) has published, “Better Information on Intangibles. Which is the Best Way to go?” In this Discussion Paper, EFRAG acknowledged the need to rethink and revamp accounting principles on intangibles. The Group also advanced a series of possible solutions, and is currently in the process of collecting feedback and comments. The discussion that EFRAG has opened up centers on three main solutions: a revision of the reporting and measuring criteria for intangibles produced internally; new rules on disclosure for key intangibles; future-oriented information on operating costs. With regard to criteria for reporting and measuring intangibles, the detailed solutions on the table range from recognizing all intangibles generated internally, to recognizing only those that meet certain conditions (i.e. starting from the moment when they do so), to barring the recognition of any and all internally-produced intangibles on the balance sheet. As an alternative to a different reporting model for intangibles, EFRAG also invites practitioners to assess an approach based on fuller disclosure, in particular on intangibles that are classed as especially relevant to the company’s business model. By doing so, users would get the chance to evaluate how said assets contribute to the company’s value creation process, even though they are not recognized the balance sheet. Last of all, a third option under consideration involves requiring detailed information on the costs associated with intangibles. Although such costs would be entered in the income statement, they may represent future benefits; at the same time, information should also be provided on risk factors and opportunities that can impact the realization of said benefits.
The pros and cons of each solution enumerated above are myriad, and none seems capable of reconciling the various needs of users and preparers of financial statements. Almost certainly different solutions for different types of intangibles will be needed. Complicating matters further is the fact that each possible solution must also take into account recent advances on the topic of sustainability reporting, which inevitably intersects with the question at hand. In fact, any number of intangibles come under the umbrella of sustainability: just think, for example, of intellectual capital, human capital, or social and relational capital. One of the questions that standard setters will find themselves asking is how to decide which intangibles will fall within the perimeter of financial reporting, and which in sustainability reporting, where areas of overlap are clearly evident.
The debate goes on, more heated than ever before. Proposals from the ASB are also forthcoming as work is getting underway, but due to the complexity of the issue, it will likely take several years before we see any revision of the standards. In the meantime, all we can do is wait, and if possible, add our voices to the ongoing debate.