The Questions Every Director Should Be Asking About Value & Risk

As companies in countries such as New Zealand and Singapore move towards their financial year end – and Australian companies enter their last quarter – many management teams and Boards are taking a close look at their financial reports and reflecting on (positive and negative) differences between targets set 12-months ago and what they have actually achieved.

For more sophisticated companies (and investors) it is increasingly clear that the primary yard sticks of performance and company health – the P&L and the Balance Sheet – are no longer accurate reflections of company value. To understand company value today, management and investors increasingly need to look beyond traditional company accounts, as these generally fail to take into account the primary drivers of company value: the enterprises’ intangible assets.

Today, it is estimated that 90% of company value of the S&P500 is driven by intangible assets (such as data, brands, content, code, trade secrets, patents, design rights, and industrial know-how). Unfortunately, modern accounting standards completely obscure the impact of intangible assets as these assets are typically either off the balance sheet entirely, lost under “good will” or listed at cost.

Cost ≠ Value

The last point raised here is one of the most problematic as there is often no correlation between the cost and the actual value of an intangible asset. However, where assets are recorded at cost on the balance sheet, it can lead you to the erroneous conclusion that this figure is correct, potentially hiding significant risks and opportunities.

A stark example of this can be seen in when Nortel filed for bankruptcy in 2009. Nortel sold various business units and tangible assets and raised $3.2 billion. The last assets to be sold were the company’s 6000 patents, which were recorded on Nortel’s balance sheet at cost: $31 million.  While the frothiest market estimate of their value was $1 billion, most analyst estimates were far south of this.

These intangible assets were eventually sold for $4.5 billion – 145X the value recorded on the balance sheet and the patents ultimately were worth more than the value of the entire rest of the company. A great result for the company’s creditors, but you have to ask whether Nortel would have entered bankruptcy at all if its directors and management team had recognized the actual value of these assets and actively managed this portfolio, rather than taking the figures on the balance sheet at face value…

Performance issues

Although many recognize the limitations of the Balance Sheet, there seems to be a general consensus that somehow the P&L is more ‘honest’ and a better reflection of true company performance. However, if you look beneath the surface you realize that P&L can lead you to erroneous conclusions as well.

A simple example from Baruch Lev, Professor of Accounting and Finance at New York University’s Stern School of Business, illustrates just one facet of the problem, which relates to the accounting treatment of R&D on the P&L. Imagine two companies who both $10M and both want to be able to manufacture product X. ‘Company A’ spends $10m on R&D (R&D being the generation of intangible assets) and ends up being able to manufacture product ‘X’.

Meanwhile, ‘Company B’ takes a different path and uses its $10M to purchase intangible assets (or a company that owns intangible assets) that enable it to manufacture product X. Both companies end in the same place: they have alienated $10M from themselves and both can now manufacture product X.

However, in the case of Company A this activity is most likely to show up as an expense on the P&L, depressing earnings. In the case of Company B this transaction would result in these assets showing up as an asset in the balance sheet, thereby enhancing company value.

Now from an investment perspective, Company A looks like it’s underperforming relative to Company B but in reality, it’s not – they are in fact identical. The issue is that from an account standards perspective they look very different due to the treatment of their intangible assets.

The language of business

As Warren Buffet says, ‘accounting is the language of business.’ It defines how we think about business. This is important because accounting standards drive company reporting, which in turn drives capital flows, regulatory frameworks, governance, and management behavior.

If current accounting standards create an environment where opportunities and risk are hidden, then Boards, management teams and investors need to recognize the issues faced and look beyond the balance sheet and P&L when assessing value.

For investors, this means for example taking a closer look at the costs associated with R&D and the development of intangible assets (which may depress earnings), to assess the likely current and value of the assets being created.

For directors, it means getting a better understanding of the company’s intangible assets and intellectual capital and how the value and risks associated with these assets – which are likely to be off-balance sheet – can be accounted for and reported in the company’s accounts.

And finally, for management teams, it is important to look at how the accounting treatment of intangible assets can drive behavior. If management teams are paid as a function of the EBITDA that the company generates, then there is less incentive to undertake R&D in-house and to instead employ more of an acquisition strategy to artificially inflate earnings.

So what can companies do?

Research has consistently shown that companies that focus on intangible assets consistently outperform their peers and industry benchmarks. As management teams and Directors assess their financial performance for the 2020/21 year, a better understanding of the company’s intangible assets will help to provide a more rounded view of the growth potential, risk profile and likely current and future value of the company.

To do this, here are ten questions for management teams and Directors to ask in relation to their intangible assets:

  1. What are our intangible assets?
  2. How do these assets drive economic and strategic value for our business?
  3. How much are these assets worth?
  4. How does the real value of these intangible assets differ from the accounting treatment and how does this drive our behavior?
  5. How can we unlock additional value from our intangible assets?
  6. Are we actively managing these assets?
  7. Do our employees and management teams understand how important these assets are?
  8. What are our primary intangible asset risks?
  9. What systems and processes do we have in place to manage and mitigate these risks?
  10. How are we articulating the value and risks related to our intangible assets in our company reporting?

Addressing these questions will help companies take a more measured view of how to manage and utilize their intangible assets.  It will also help management teams and Directors to identify which intangible assets are the business assets that actually drive value and profitability, (regardless of what accounting standards might say).

 

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