Environmental, social, and governance (ESG) issues are omnipresent in the business press, especially following the March 2022 watershed climate disclosure proposal from the U.S. Securities & Exchange Commission. Many tout ESG risks and opportunities as critical information for investors, but, in reality, what’s been shared to date has largely been focused on risks, not opportunities.
Yet opportunities abound. Investors care about ESG because it can make a company more resilient and, therefore, more valuable. Business leaders are responsible for creating value. Yet one asset class that adds value through sound stewardship doesn’t get its fair share of attention in the financial statements: intangibles.
In a knowledge economy, the most valuable assets that a company owns are often intangible. The portion of intangible value as a percentage of S&P 500 market value has grown exponentially. In 1975, intangible value was about 17% of total company value. According to the intellectual property specialists at Ocean Tomo, it was 90% by 2020.
Managers make investments that create intangibles or enhance their value, and often those actions are key to the companies’ strategies. They may, for example:
- Research new technologies,
- Cultivate relationships with existing and new customers or service providers that complement in-house capabilities,
- Advertise to enhance product recognition and brand affinity, or
- Identify, hire, and nurture a workforce that can deliver on the company’s value proposition.
This list shows that there are many different intangibles and that they vary in the degree to which they meet the Generally Accepted Accounting Principles (GAAP) definition of an asset on their own, but most are used by management in these and other ways to drive value creation. They can be considered in categories: customer intangibles, brands, intellectual property, and human capital.
INTANGIBLES IN FINANCIAL STATEMENTS
There’s little information about intangible assets in the financial statements. As GAAP was developed in an age when companies created value by building new plants, intangibles are only recorded in limited circumstances. They’re generally only recognized as assets in a business combination and are sometimes lumped in with goodwill. In most other cases, cash spent on intangibles is expensed immediately, just like the electric bill, even if the outlay was more of an investment intended to enhance the value of an intangible.
Let’s dive deeper into one example: a campaign to build a brand, which involves expenditures that would likely fall into the general bucket of operating expenses. But there’s limited disclosure of operating expenses, and it may be difficult based on current disclosures to discern which operating expenses are actually investments that create value. Sharing information about these economic assets—really thinking of them as investments—could enhance company value.
Another example of particular interest lately is human capital. It’s part of the “S” in ESG and, for many companies, a significant part of their strategy. Human capital is particularly important in knowledge-intensive businesses because employee knowledge and skill drive the production of services, products, and new projects.
Consider a car manufacturer that has migrated much of its production to electric cars. Doing so would likely have involved upskilling its workforce with the know-how to make electric cars rather than gas-powered cars. But this investment isn’t typically transparent in the financial statements. The idea that human capital is an asset, and that value can be created by investing in it, stands in contrast to the historical perspective of labor as a cost that needs to be tightly managed to create value.
Unlike financial statements, ESG reports include a lot of information on certain intangibles, including human capital. ESG reporting is often investor-oriented and supports the thesis that human capital is an asset, not an expense. To level the playing field, even when GAAP doesn’t require disclosure, it makes sense to enhance disclosure in the financial statements, or ESG reporting will eclipse GAAP reporting on the relevance meter.
WHERE TO BEGIN?
Start with highlighting the investment you’ve made in intangibles, rather than just disclosing outlays that are the cost of doing business. Along with disclosure of, say, total salary expense, consider disclosing the amount the company has invested in training or upskilling its employees. Other disclosures to consider are the approximate time horizon for an investment to materialize and the key inputs to the value of each intangible. Customer turnover affects the value of the customer base. Employee engagement affects the value of the workforce. And so on.
Of course, there’s a trade-off between more disclosure and sharing proprietary information. For example, detailed information on employee recruiting may reveal strategic information on a company’s expansion plan. But this concern can be addressed in various ways, such as using ranges rather than point disclosures.
Both the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) are evaluating projects to consider whether to recognize or disclose more information on certain intangibles based on feedback received on their agenda consultations last year. The European Financial Reporting Advisory Group (EFRAG) issued a paper in August 2021 that provides various approaches for capturing the value of intangible assets in the financial statements.
When it comes to investments in intangibles, disclosing ahead of any requirements may put your company ahead of the pack. As a result of the nonrecognition of many intangibles, the company value created by investing in them is only observable to stakeholders in an indirect, lagging way (for example, through growing revenues or expanding margins). Disclosure could alleviate that information gap and ultimately enhance your company’s valuation.
May 2022
