Is 'Real Value' Escaping Board Oversight?

Agenda Week
By Tony Chapelle July 29, 2019

The great majority of corporate value — nearly 90%, by some accounts — isn’t noted in company books due to accounting rules that keep intangibles such as knowledge assets off of balance sheets in most cases.

Critics say the rules can leave intangible assets undervalued, underutilized or poorly protected. But directors, consultants and risk managers disagree on what to do about the situation.

Cynthia Todd Jamison, chairman at Tractor Supply and an audit committee member at Office DepotDarden Restaurants and Big Lots, explains that as long as generally accepted accounting principles (GAAP) prevent companies from increasing the value of intangible assets such as goodwill or intellectual property after acquiring them, they’ll never be able to report intangible hikes on the balance sheet even when they actually appreciate.

“I believe directors and senior management are aware that there is real value there. The conundrum comes in trying to honestly describe that value while complying with the accounting rules,” writes Jamison in an e-mail.

“I’m not sure how much can be done about this from a management or board point of view. It is not discretionary. Until GAAP accounting changes, this will continue to be a murky area in terms of communicating true value to investors.”

Intangible assets include a range of physical and intellectual holdings such as data, content, lines of software code, brands, trade secrets, customer relationships, patents, design rights and other knowledge assets.

The U.K. Treasury reported late last year that intangibles account for between 52% and 84% of public company value. That report suggests that the world’s five most valuable companies are worth a combined £3.5 trillion. Yet their balance sheets only report tangible assets, valued at £172 billion, according to the research.

Meanwhile, a 2015 study of S&P 500 companies by Ocean Tomo, a merchant bank for intellectual property assets, concluded that intangible assets made up 85% of the market value of the index firms. Ocean Tomo calculated the figure by starting with the total market cap of the 500 companies, then subtracting all fixed assets and cash.

Paul Adams, CEO of management consulting firm EverEdge, estimates that only 10% to 20% of Fortune 500 companies understand their intangible assets, account for them, and secure and insure them. Yet he says that it’s important for any company to understand the value of its intangible portfolio when it comes to raising capital, paying its tax obligation, putting itself on the market or just being sure officers are managing the assets well.

Therefore, he’s big on managers’ and boards’ assigning value to intangible assets and tracking them on the fixed-asset register and risk register. Without those, “it’s like flying a plane; you get wrong information and you make wrong decisions,” Adam explains.

But others aren’t as worried.

“Intangible assets have always been top of mind for many of the executives that I have consulted with from a strategic risk perspective,” says Michael Yip, senior vice president at Marsh Risk Consulting, a subsidiary of the insurance brokerage Marsh.

Yip says that major Fortune 500 firms almost always identify the value of certain intangibles such as their brands’ reputation, and the innovations that they protect through copyrights and trademarks.

Yip says many major company executives and boards indirectly communicate to investors how important it is for them to protect and manage key intangible assets, such as brand reputation, as part of the recent trend toward “organizational resiliency.”

That overarching set of best practices includes initiatives such as corporate social responsibility (CSR) and environmental, social and governance (ESG) programs. Resilient companies also have robust enterprise risk management, crisis management and business continuity frameworks.

To be sure, insiders admit that reporting values for intangibles is difficult.

“The general accounting rule of thumb is that if I [actively] create an intangible asset, I shouldn’t report [its value] on my balance sheet. But if I go out and buy it, that should be listed on my balance sheet,” says a venture capital investor in companies that often create patents. The investor, who asked to remain anonymous, said the reasoning behind this is that it’s considered too subjective to assign a price to one’s own creation absent the objective process of a purchase price.

The venture capitalist doesn’t, however, consider intangibles to be at risk just because their values aren’t reported in the corporate accounts.

Jennie Hwang, a director at Canadian company 5N Plus and CEO of manufacturing company H-Technologies Group, also believes it’s more pragmatic to predicate value on what an actual buyer is willing to pay. Someday, however, she says, she’d like a system that could valuate intangible asset categories for companies and analysts. But Hwang disagrees with the notion that company officers don’t perceive the significance of their intangible assets.

Nir Kossovsky is chief executive of Steel City Re, a company that insures companies’ and board directors’ reputations. He was once executive secretary of a now-defunct group called the Intangible Asset Finance Society. Kossosvky states that most corporate leaders recognize the importance of intangibles on corporate value.

In fact, Kossovsky explains that companies are increasingly expressing the value of all intangible assets in annual reports where they disclose how “intangible assets underpin their competitive advantage” and how failures involving these assets would impair their overall value.

EverEdge’s Adams cites an example from recent history where a shareholder figured out the value of an intangible asset that was underreported and underutilized.

In 2011, a patent monetizer notified the hedge fund Starboard Value that the patent portfolio at AOL was significantly undervalued. In time, it would be clear that the Internet company was reporting the portfolio’s net value at a mere $9.8 million on the balance sheet. Starboard soon acquired a 5.3% stake in AOL. Jeffrey Smith, the Starboard co-founder and CEO, notified the AOL board in a February 2012 letter that the company’s more than 800 patents were “non-core, extremely valuable, and should be monetized…[because they] could produce in excess of $1 billion of licensing income.”

By April of 2012, AOL had agreed to sell Microsoft its portfolio — until then valued at less than $10 million — for $1.056 billion in cash. The price was 107 times its previously reported worth.

Adams says that after engaging with dozens of client companies, he has spotted five common key risks at companies that don’t monitor their intangible assets.

One, he says, is that some companies leak confidential info. Another is that some companies can’t prove they own their intangible assets. A third problem is that companies don’t manage their brands properly. Fourth, companies that don’t manage intangible assets can’t prove ownership of open-source code they acquire from the Internet. That open source also could create exposure to hackers. Finally, Adams says that companies with poor intangible management face potential risk for litigation over their information technology if they fail to check their patent and trademark rights before developing new products.

The consultant says that before seeking capital, in addition to producing numbers to show the other side, the company should valuate its intangibles by hiring a consultant to create a narrative that describes how the full operation depends upon the intangible asset to leverage the company’s full value. The result, he explains, should be a valuation report that features more prose and analysis to accompany the quantitative research that provides a reliable numerical value.

To get serious about identifying, leveraging and mitigating risk to their intangible assets, Adams recommends that boards and management teams ask for and identify their intangible assets, ask about the impact of those assets on business and how they drive economic benefit, and understand the risks the enterprise is exposed to through those assets.

By identifying the major potential risks faced by their business, boards can understand how managers can mitigate these issues before they suffer a significant negative impact on the business.

Aside from protection from the patent office, the experts said it’s difficult to actually insure large categories of intangibles.

For one thing, says Kossovsky, who calculates that intangible assets account for 91% of the value of an average S&P 500 company, traditional accounting does not support actuarial calculations of frequency and severity of loss that are the foundations of insurance. But there’s a growing market of liability and risk transfer solutions for intangibles such as reputation that use a parametric strategy in lieu of traditional accounting.

Sergio Trindade, president of energy and climate change consulting firm SE2T International, says that boards should always demand transparency. “Some companies may want to be opaque to protect from the competition. But it’s always best to value a company as close to possible to the real value.”

Trindade, co-winner of the 2007 Nobel Peace Prize, once advised International Fuel Technology, Inc. on how to protect its intellectual property rights. He speculates that many companies are glad to keep some intangible assets off the books. A company that owns millions of lines of software code may not want it to be obvious to competitors that it holds such valuable goods.

Generally, however, Trindade says, the board of a public corporation should ask its public accountants for clear numbers and answers on the bottom-line financial impact of its intangible assets. “So, you devolve the problem to the accountants,” he says.

But the complex accounting treatment for intangibles could change before long.

This month, the Financial Accounting Standards Board, the private sector nonprofit that sets accounting rules, announced an upcoming study with public companies to look at the accounting of “certain identifiable intangible assets” that get acquired in mergers.

One aspect of the study will be to determine whether these assets should be classified as goodwill. The comment period is expected to last until Oct. 7.

Jamison is optimistic. “Maybe there is hope that some of this will be addressed in the coming years,” she says.