[A-List] Financial regulatory crisis

[Keaney Michael]

Putting a finger on corporate intangibles
New US rules about disclosing assets such as brands, customer lists and
technology could benefit investors. But managers have some reservations,
writes Simon London
Financial Times: March 5 2002

US financial reporting has crossed the Rubicon. The Financial Accounting
Standards Board is working on rules that will require US companies to
disclose, for the first time, information regarding intangible assets
such as brands, customer lists and technology.

In normal times the announcement would have caused a stir in accounting
and investment circles and among corporations. But times are far from
normal: shock waves from the collapse of Enron meant that FASB's
announcement passed almost unnoticed.

Do not be fooled. Regulations that make companies reveal more about
their investment in intangible assets could have a greater impact, in
the long run, than anything likely to emerge from the Enron saga.

First, giving investors information about intangibles should help them
value companies more accurately. This applies to companies in "old"
industries such as chemicals and engineering as well as software and
services companies.

Second, according to the old adage that management follows measurement,
disclosure could start to change the way companies are run.

Moreover, this may start to be felt sooner rather than later. FASB says
it hopes to have an exposure draft ready for publication by the autumn.
A new accounting standard could be in force by this time next year.

But the standard-setters are likely to proceed in small steps. Do not
expect companies to be required soon to value brands, customer
relationships or other intangibles on the balance sheet.

More likely, FASB will call for disclosure in the notes to the accounts
of metrics and ratios from which investors can draw their own
conclusions.

It is no secret that the conventional balance sheet gives investors very
little useful information about intangibles. While investment in
tangible assets - the physical plant and machinery employed in a
business - is capitalised on the balance sheet, investment in
intangibles is treated as an expense against revenue.

US companies are required to reveal how much they spend on research and
development. So there is nothing to stop investors recasting the
accounts to count this as an investment. But other intangibles -
advertising, marketing, training, etc - are usually lumped together
under the heading of "selling, general and administrative expenses".
They are not broken down.

Yet academic studies have found consistent correlations between
investment in intangibles and future profits. "Spending on advertising
and [research and development] can be viewed as a form of investment in
intangible assets with predictably positive effects on future cash
flows," concluded a recent paper in Financial Management, the academic
journal.

On this view, the distinction between tangible and intangible assets
makes no sense: both represent future eco nomic benefits for a company,
based on past transactions or events. Both deserve a place on the
balance sheet.

The problem for the accounting profession is that intangible assets are
very difficult - impossible, say traditionalists - to measure with any
accuracy. "There is always a tension between relevance and reliability.
We all know that intangibles are relevant but the argument has always
been that they can't be measured reliably," says Mary Barth, accounting
professor at Stanford Business School.

Now FASB is edging away from that position. Its new project marks a
recognition that intangible assets can no longer be ignored. More
information is required.

How will companies respond? Many will be fearful. "Anything you reveal
to shareholders you also reveal to competitors. I expect many companies
to push hard to keep disclosure to a minimum," says Gordon Petrash, a
senior executive at Delphion, which produces software to help companies
manage their intellectual property.

For example, disclosure of marketing spending and gross margins for
every brand would help investors better to understand Procter & Gamble.
But this information could also be useful to competitors.

Fear of being sued is another factor. The Securities and Exchange
Commission, the top US regulator, last year set up a task force on
intangibles led by Jeffrey Garten, dean of Yale School of Management. It
called for legislation to make it more difficult for investors to sue
over allegedly inaccurate information. This was necessary, it argued,
before companies would willingly disclose more about their intangibles.

Companies hoping to place large valuations on the skills of their
workforce or similar fuzzy assets will also be disappointed. Halsey
Bullen, project manager at FASB, says any new standard is likely to
stick to the narrow definition of intangibles contained in its standards
on mergers and acquisitions (see box). This will rule out "employees" as
an intangible because they are not controlled by the company.

FASB will spend the next few months trying to reconcile these
conflicting pressures.

Prof Barth points out that the standards-setter will find it hard to
follow the detailed, prescriptive approach for which US accounting
standards are renowned. The metrics that investors may find useful will
vary enormously between industries.

"It is difficult to see how FASB will be able to say: 'these are the two
or three ratios we think are important for your company'. The board will
have to take a more general approach," she says.

Baruch Lev, accounting professor at the Stern School of Business at New
York University, says the FASB should ask companies to disclose detailed
information about everything from staff training and turnover to
investment in information technology. He wants to see disclosure of both
inputs - the amount of money spent on training, for example - and
outputs, such as staff turnover.

Such metrics would be revealing. When a company downsizes, for example,
it usually takes a one-time charge and promises annualised cost savings.
But investors are left in the dark about the potential impact on staff
morale, customer loyalty and other intangibles.

It is unlikely that FASB will go this far. It has every incentive to
proceed with caution. But now the standard-setter has recognised that
intangible assets have a legitimate place in the accounts, there is no
turning back.

Full article at:
http://news.ft.com/ft/gx.cgi/ftc?pagename=View&c=Article&cid=FT3LY3XLEYC
&live=true

Michael Keaney
Mercuria Business School
Martinlaaksontie 36
01620 Vantaa
Finland

michael.keaney at mbs.fi