Mark Hynes - thoughts on corporate disclosure

Opinions on changing rules, changing best practices, and their effect on investor relations officers.

Friday, July 08, 2005

Intangibles need formal reporting structure – enter the EBRC

The formal processes of financial disclosure have not kept pace with the needs of investors. Research shows that only about 25% of a company’s market value can be attributed to accounting book value, as captured by the existing GAAP model. The remaining 75% of market value is based upon “value drivers” - intangibles such as strategy, product innovation, people and customer loyalty, which are often NOT reported under disclosure requirements.
In early noughties (000’s), a casualty of the “changing fortunes” in tech stocks was the idea of these intangible business assets.
Amid bitter investor cynicism, soft items such as research and development, software, employee training and the power of brands were less likely to be counted as real assets on corporate balance sheets, alongside such traditional ‘old economy’ assets as factories, stocks and equipment. With stock prices falling in 2000, and some companies cooking the books, some investors – unsurprisingly - were asking what was real and what not. As a result unfortunately, a useful debate about this aspect of investor communication was put on hold.
At their worst, the promoters of Internet stocks wanted to have it both ways: to deduct such business expenses as R&D and advertising, whilst at the same time wanting investors to believe that these and other intangible investments should be counted as assets, not routine expenses as required by generally accepted accounting principles.
However, intangibles are recognised as assets when a company is acquired and the buyer pays more than so-called book value, which is based on the cost of tangible assets. If you bought AOL, for example, you would have to pay a lot more than the cost of the company's physical operations. You would have to pay for the AOL brand, which the company cannot count as an asset on its balance sheet, despite having spent significant money in building it.
In this more sober investment era, it is time revisit intangible business investments and the role they play in generating long-term profits. One organisation addressing this is the Enhanced Business Reporting Consortium, which is working toward consensus on an internationally recognized framework of voluntary guidelines for reporting that would make it easier to compare these intangibles.

The idea is that this framework would have internationally accepted definitions and measurements for industry-specific key performance indicators. There would be voluntary disclosure guidelines for information about opportunities, risks, strategies and plans, and about the quality, sustainability and variability of cash flows and earnings.

In the UK, the new OFR requirements recognise the importance of disclosing, business strategy, value drivers, risks and opportunities as a compliment to the financial statements. Enhanced Business Reporting aims to provide greater structure for these reports, making them easier for investors to use.

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