In the UK today, most people work in service-based and knowledge-based industries. These are industries which deal in intangible assets such as intellectual property: knowledge and know-how, patents, trademarks, copyrights and brands.
This wasn’t always the case, but the pace of change has been accelerating. It’s only in the last fifty years that these industries, deriving most of their value from intangible assets, have really begun to dominate stock exchanges in terms of total market capitalisation. The archaic system of accounting that we have in place today hasn’t been able to keep up, and has lost a lot of its meaning and relevance in the context of these tertiary industries.
When it comes to counting the beans, the traditional primary and secondary sector industries are more straightforward. The latter comprises processing and manufacturing activities secondary to the former, the (primary) extraction and production of raw materials. If you grow fibre crops, or produce textiles from them, a relatively liquid market for these will give you a pretty good idea of what these tangible assets are worth to your business.
In such traditional sector industries, capital investments get you better machinery and bring you economies of scale, so you can produce more goods at a lower average cost. The markets will also give you a fairly accurate idea of such machinery’s asset value to your business. Between the goods which a business owns to buy or to sell, and those that form its plant and machinery, businesses in these sectors preside primarily over tangible assets whose value can be readily approximated. These businesses’ values will be much closer to their net asset values (total assets less total liabilities).
What about intangible assets?
What sets the knowledge and service-based industries apart is that their value and competitive advantage is powered to a greater degree by their intangible assets – and that this is where most investment goes. This investment is in people, in ideas, in training, in knowledge, and in image; in ‘human capital’ and intellectual property.
Why can the Kraft Heinz company, for example, sell you a can of baked beans for three times the price of a supermarket’s own equivalent when they’re both equally as full of beans?
While Kraft Heinz may appear to be a typical secondary-sector firm, it’s really more of a higher-tiered hybrid. When you buy Heinz beans, you’re being sold more than a can of beans. You’re also buying (read: paying for) more than a can of beans.
Clearly, it’s worth something to the firm and its investors. But how do we account for ‘brand’? Well, according to most accountants, it shouldn’t exist as an asset on a company’s financial statements: it’s too hard to measure, value, and track the change of over time. But it is an asset, isn’t it? It’s something the company owns, and which it can exploit for value.
Can you put a value on a brand?
Enough about the beans for a bit. More than just being assets, things like branding, trademarks, and copyright are long-term assets. However, marketing and advertising costs associated with developing these are treated wholly as operating expenditure (expenses that reduce profits), rather than as capital expenditure (investments that don’t directly affect profits, but reflect the value invested in the business). Why is that the case when the latter is closer to economic reality, and the former violates accounting’s matching principle*?
*The matching principle stipulates that expenses should be reported in the same period as the revenues which their incurrence generated. If you pay for a three-year lease on your place of business upfront for example, you’ll still spread the cost over three years’ worth of accounts. If you don’t, the first-year profits will be understated and your second- and third-year profits will be overstated – not an acceptable way to defer tax on your profits.
The problem goes much deeper. Consider the giants of the pharmaceutical, software, and tech industries. Their billions invested in R&D each year create internally generated intangible assets in the form of intellectual property, the most obviously valuable of which are patents for products with regulatory approval. However, this investment also serves to expand the know-how and current expertise of its people – even if no patents are generated.
Intangible assets which are internally generated are rarely reported on company balance sheets. In fact, most intangible assets that do appear on a company’s balance sheet are acquired by transaction with a third party, at which point many accountants are suddenly happier to bestow a numerical existence upon them.
Software development is one example where thousands of people might be working on developing an intangible asset, but rather than treat the software in progress as an investment by treating some costs as capital expenditure, we often expense the development costs now and report any income generated later. Revenues, when they do then occur, are not matched properly to their corresponding costs.
Not capitalising at least the relevant portion of this expenditure means that there is no way to tell from looking at the accounts whether a company’s spend is a cost or an investment.
Compare a whiskey distiller and a software developer. Both invest in producing a long-term asset that neither might make money from for years to come. The difference in the accounts being that the distiller’s will show the maturing barrelled whiskey as an asset, whereas the software developer’s show nothing except for employment costs. Looking at the software developer’s balance sheet you might be forgiven for thinking that these show a whole lot of sunk costs with nothing much to show for them.
Albeit a crude measure, subtracting net tangible asset value from market capitalisation leads to the conclusion that 90% of S&P 500 companies’ market value is intangible, driven by the likes of Apple, Microsoft, Amazon, Facebook, and Tesla. The story in Europe isn’t much different: the S&P Europe 350 index shows that intangibles account for 75% of the index firms’ market cap.
So, what’s going on here? We could of course be in the midst of a giant intangible economic bubble, and there might exist some other factor(s) that we need to consider. Another explanation though, is that our contemporary inability to represent investment into intangibles in a coherent and meaningful way is a shortcoming of our accounting systems which is becoming quite difficult now to ignore. We believe the latter of these three to provide the greatest share of the explanation.
Few things highlight our system’s current shortcomings with respect to the reporting of intangibles as well as does one of accounting’s most absurd and enduring anachronisms: the notion of ‘goodwill’.
Goodwill simultaneously acknowledges the influence of uncapitalised intangibles on a company’s value, whilst completely failing to contend with their existence in any meaningful way.
Historically, in the 1800’s and early 1900’s, this was perhaps less of a problem because the tangibles-dominated primary and secondary-sector industries encompassed almost the whole working economy. Given the shift to today’s intangibles-dominated service-based economy however, the accounting mistreatment of intangibles, as epitomised by goodwill, is a problem of ever-increasing significance.
The apparent absurdity of goodwill is blunted by the nature of its general acceptance into modern accounting orthodoxy, which falsely legitimises it. Its absurdity, however, is increasingly problematic and increasingly warrants highlighting.
How to think about goodwill
It’s quite similar to the imaginary unit (i), the mathematical placeholder invented to answer the question: “How can you find the square root of a negative number?”. As abstract as it may seem though, i opened up the maths of imaginary and complex numbers which has important real-world problem-solving value in fields such as engineering and physics. It works, so we kept it.
In much the same way, negative numbers allowed us to answer the question: “How can you have less than nothing of a something?”. Today, we use the negatives routinely and they can be useful for describing relationships mathematically: negative money is a debt, negative acceleration is deceleration, and a negative score relative to par describes a good golfer. Negative numbers tend to be useful – they work, so we kept them.
In fact, the whole of maths is abstract. It’s only the bits that we’re used to and familiar with that don’t seem absurd. Today, negatives seem an obvious extension of the number-line, and every ten-year-old is familiarised with them. You only need to go as far back as the 18th century though, to find a time when they were considered absurd by the western mathematical mainstream and when their proponents were considered mavericks at best, or charlatans at worst. In fact, accountants might be using positive and negative numbers rather than debits and credits, had the negatives been more widely accepted when modern bookkeeping was invented.
You could say, then, that we derive the imaginaries’ and the negatives’ existence from their function. If they didn’t serve a useful function, the mainstream probably wouldn’t bother to entertain their existence. Goodwill, in contrast, takes its form from a near-to useless fiction (rather than as a consequence of any useful function) and so its functional existence shouldn’t warrant entertaining.
Shared fictions cease to be useful when they no longer serve us, and especially when they work against us, at which point the entertainment of their existence might more aptly be termed a delusion. Goodwill, we argue, should be consigned to this category. If it doesn’t work, why do we keep it?
How does goodwill arise, and what does it mean?
When a company acquires another, the excess above the net asset value might be shown as ‘goodwill’ in the accounts of the emergent entity. In this regard, goodwill is a placeholder asset of a precisely specified value. It balances the acquirer’s books without specifying what the figure represents, patching the difference between the reported balance sheet value of the acquired business and its supposed fair market value.
Just as i and the negatives were invented as placeholders in maths, so was goodwill invented as a placeholder in accounting. It answered the question: “How do you account for the difference between what was received and what was paid when one company buys another for more than the other’s books say it is worth?”.
Goodwill then, implicitly represents the sum value-impact of every possible internal or external factor which might influence the acquired business’ value, minus the reported balance sheet value. Incidentally, it also includes the margin of error by which the reported balance-sheet value and the business’ assumed fair market value might be incorrect.
Where a business’ value is primarily derived from its capitalised tangible assets, an immaterial amount of goodwill becomes a tolerable minor indiscretion. This is a situation that might have been acceptable as the status quo 150 years ago. Today though, in instances such as those where misrepresented or underrepresented investments in intangibles commonly result in material amounts of goodwill, we need to ask ourselves whether the system that we’ve put in place is still serving us to our benefit, or whether we are entertaining it to our detriment.
In its misstep beyond the remit of accountancy, goodwill is like a sponge which soaks up and hides potentially useful accounting information. We should be clear though that goodwill is a symptom, and not a cause, of the accounting world’s inability to deal with the increasingly intangible-heavy modern economy.
Goodwill merely serves to highlight the widening gap between assets recognised by the market as being valuable, and those whose recognition is permissible under modern financial reporting standards. Why should a company which has grown organically have a tenth of the balance sheet value of an equivalent firm whose growth is fuelled by acquisitions, if these firms are otherwise identical in every way? Not that they will be identical, but that is another story.
So, what’s the rub? Why don’t accounts show us this information?
Honest and accurate financial reporting is vital to maintaining investor trust and a healthy economy, but there are a lot of factors at play here that make change difficult to achieve.
With all the benefits of movements such as the international harmonisation of accounting standards, there comes the danger that our systems become too clunky and too rigid to adapt to the times. New rules keep being added, and if old ones aren’t adequately reviewed, then the system has a tendency to grow too complex and unwieldy for most people to contend with.
This complexity doesn’t just apply to accounting systems, but also to our legal and tax systems. Complexity can create artificial economies of administrative scale, unfairly tilting the playing field in favour of larger firms and making it harder for smaller businesses to compete. To the latter, specialist accountants’, tax advisers’, and lawyers’ fees might not be worth the few percent that they could save in tax, for example. To the former, a few percent is a lot of money, in view of which the concoction of a double-Irish with a Dutch sandwich begins to sound quite appetising indeed.
Note how that, if your firm acquired a large company that was making efficient use of some newfangled double-Irish arrangement, the value of its being able to do so would appear as goodwill in your firm’s accounts. As hesitant as they can be to allow the recognition of investments in internally-developed intellectual property as such, our current accountancy standards will gladly permit the implicit ascription of value to an externally-acquired company’s relative ability to avoid tax by the recognition of this ability as a phantom asset: ‘goodwill’.
This phantom asset masks the true value of factors such as a good workplace culture, uncapitalised in-house R&D, loyal customer relationships, or a team with decades’ worth of relevant experience.
There is a clear need for processes that ensure that the accounting and tax system continues to serve the purposes for which it was intended. A focus on principles-based accounting, as opposed to rules-based accounting, is a movement in the right direction. The accounting world may also need to rethink what the prudence (conservatism) principle means in the age of intangibles, now that ignoring them is becoming less feasible.
We shouldn’t shy away from intangible assets. After all, intangible assets are no more ‘imaginary’ than the ‘imaginary’ value of money; a legal and social fiction that we collectively entertain.
We’re not saying let’s pluck numbers from thin air; estimates can be dangerous and add unnecessary noise to accounting information. But the least we could do is to begin to report investments in intangibles and intellectual property at original cost, reflecting their capital value where it likely exists, and begin treating them sensibly.
It’s unlikely that the debate surrounding the capitalisation of intangibles will be resolved anytime soon, but we really don’t want to see “goodwill” in the accounts in the meantime.
If you want to read more about the poor state of accounting due to intangibles, check out this page by Baruch Lev. For a more rigorous analysis of the issues we’ve mentioned take a look at Lev and Gu’s: “The End of Accounting and the Path Forward for Investors and Managers”.
If you’re interested in how businesses with the right culture can use a partnership (LLP) model to get better returns on their intangible capital, check out our partnerships page, knowledge base, and FAQs.