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This is a summary of an article published in Mundo Contable, digital magazine of the University of San Andrés, Buenos Aires, Argentina in June of 2023.

Business activity and the value of a business entity increasingly depend on intangible assets. This is reflected in the growing valuation of goodwill occurring from mergers and acquisitions. It also contributes to a growing gap between market values and book values.

Under the IFRS accounting standards, the financial statements do not reflect all the resources that an entity invests in. The International Integrated Reporting Framework was developed to draw attention to the different types of capitals (or resources) that an entity uses, classifying them into six types: financial, manufactured, intellectual, human, social and relationship, and natural.

However, the relationship between the actions carried relative to the different capitals and the cash flow applied for it is not visible. We propose an expense-based approach with no change to existing reporting standards to recognize and increase visibility of certain intangibles, that are not accounted for in the financial statements.

Where is the money?

When intangibles are created internally, they are generally not treated as assets (with a few exceptions). They fail to meet the criteria stated in IAS 38. It is a conservative approach in that the money spent is written off – gone – charged against current revenues.

Historically, a large portion of the work that people were being paid for was related to their work in converting inputs to outputs that would then be sold to customers resulting in current revenues. Charging these costs (operating machines, buying, receiving, moving, and managing materials, maintaining equipment, and administering activities related to current revenue generation) against current revenues made logical sense. It also met the accounting expectation of matching costs and revenues.

But as the nature of work changed, an increasing portion of peoples’ activity was no longer involved in current revenue generation but shifted to designing and building system capability. Charging these disbursements against current revenues in the period incurred is no longer logical.

Essentially, accounting standards do not track the cash invested to create intangible capabilities. There is a lack of information on the investment made on the creation of those intangible capabilities so users of financial statements have no visibility into intangible asset creation or impairment of future capacity. However, this investment and conversion of financial resources into intangible assets, providing capacity and capability, is in reality building an invisible balance sheet. Investor equity and organizational value are increasing, and should the business be sold, merged, or acquired, a large portion of these invisible assets will become crystallized again on the balance sheet.

The concept of non-financial capitals

The concept of the six capitals embraces all of the resources that an organization uses as inputs for its business model. This model takes inputs and processes these through activities to create outputs, which then collectively become the organizational outcomes. Outcomes reflect one or more of the six capitals.

If the total resource inputs to an organization's business model were all included within these six capitals, then it would follow that tangible and intangible assets would be part of and included within these.

The market view or economic value of an organization reflects how the market views the effectiveness with which management has brought together and uses all its resources, to create the desired outcomes, which include the ability to create a return for shareholders and create and protect value for other stakeholders. The goal of management is to leverage its resources in such a way as to optimize value creation over time.

Given monetary sums invested into building intangible capabilities, these costs and the resulting assets have become material in terms of an organization as a going concern and its resilience. The intangibles not recognized for accounting purposes are closely linked to the capitals mentioned by the International <IR> Framework even though they are not shown in the financial statements.

The underlying resources are reflected by the six capitals, and management’s ability to leverage these to create value. The growing gap between book value and market value seems to suggest that the cash being diverted to future-oriented expenses or sustaining expenses reflects the changing model. Therefore, providing greater visibility to the cash being invested into intangibles, even though accounting may be treating them as expenses, provides a better understanding of the enterprise value of the business .

Proposed reporting of future-oriented expenditures

We build on the EFRAG Discussion Paper "Better information of Intangibles: which is the best way to go?” published in August 2021 which identifies three different approaches for better information on intangibles:

  1. Amending recognition and measurement requirements for intangibles
  2. Providing information on specific intangibles
  3. Providing information on future-oriented expenditures (or future-oriented intangibles) and risk/opportunities factor that may affect future performance

While we believe that the three approaches are not mutually exclusive and can be combined, our proposal focuses on supporting the third approach to advance a significant improvement in the quality and integrity of decision-useful information. It will also allow both the accounting profession and the users of reports to gain experience on the identification and monitoring of future-oriented expenses and the process of generating intangible resources, which will be useful at the time any change in the recognition criteria could be implemented.

We also think that a solution based on improving financial reporting is much more likely to be implemented more quickly. The key features of our proposal are:

  1. We don´t propose any change in the traditional recognition criteria for intangibles, at least initially.
  2. We support the idea of presenting complementary information on sustaining expenses or future-oriented expenses. More specifically, we consider it convenient to present accumulated information on this pool of investments in intangibles. This information should be presented in a note or annex to the financial statements.
  3. We also support the idea of presenting information on risks/opportunities in relation to unrecognized intangibles that may affect future performance. This information should be presented in a note to the financial statements.
  4. Regarding the information on sustaining expenses or future-oriented expenses that represent investments on intangibles, we consider that entities should be asked to present separately expenses that according to the management relate to the current and past earnings and those incurred to generate earnings in a future period. Although this will imply some level of subjectivity, it is not too different from what is required to present certain information that is already presented in the financial statements today. On the other hand, like the rest of the information contained in the financial statements, this information should be subject to audit examination.
  5. The newly submitted note or annex should have these characteristics:
    1. Reproduce the Statement of Financial Performance or Income Statement and for each line of this statement indicate how the reported balance is opened between "current or past earnings" and "future-oriented expenses" or "related to earnings in future periods" or what we called “sustaining expenses”. In turn, the latter should be opened by each of the capitals: human, social and relationship, intellectual and natural.
    2. Consist of accumulated information, that is: starting from the final accumulated balance at the end of the previous period, showing the increases and, where appropriate, decreases, and the balance at the end of the new period.
    3. Include more detailed information on the additions of the period to the pool of future-oriented expenses or sustaining expenses.

Using the categories for “non-financial capitals” identified as a foundation of integrated reporting will start to bridge financial expenditures and the creation of intangibles.   

Some aspects of this proposal were included in the UK Financial Reporting Council’s consultation,  Business reporting of intangibles: realistic proposals, The following objections arose in the consultation:

  • The inherent subjectivity in the distinction of expenditures between period expenses and "future-oriented expenses"
  • The difficulty of executing this distinction in a consistent and non-arbitrary way
  • The possibility of manipulation by management

We agree that these are challenges. However, the same objections apply, to a large extent, to many of the estimates that are currently made and accepted in the preparation of financial statements.

The key question is, what is the line for determining when an expenditure is not a current expense and can be considered as a future-oriented expense or sustaining expense? Is it possible to have sufficiently clear criteria to carry out this classification?

We consider that it is possible and would help provide decision-useful information.

The impairment challenge

It also makes sense to consider a mechanism to check if the accumulated investment correlates to the creation of intangibles for the entity and, where appropriate, reduce that accumulated investment.

For some investments in future intangibles, in which there is a previous project and a clear idea of the asset to be achieved and how that asset will be consumed, it is possible to consider monitoring. However, in other cases "keeping track" of the evolution of these internally generated intangibles in an individualized manner may be excessively complex.

Given this complexity, we think that global monitoring may be preferable. The challenge is to demonstrate the relationship between accumulated investment and the total amount of unrecorded intangibles.

Generally, the difference between the market value of the entity and the book value is represented by three elements:

  • the highest market value of the assets recorded in respect of their historical cost,
  • the value of unrecorded assets, mainly identifiable intangibles that were created over time but were not recognized for accounting purposes, and
  • the goodwill.

The first element is not related to investments made in intangibles. Therefore, what should be ensured is that the accumulated investment in intangibles does not exceed the sum of the other two: unrecorded identifiable intangibles and goodwill.

Identifiable intangibles can be measured. Therefore, what remains is to check that the amount of goodwill necessary to support the accumulated investment does not exceed the actual goodwill or at least is recoverable by applying the criteria established in IAS 36.

The actual goodwill could be estimated considering the market value. One reason that many sustaining expenditures are not classified as intangible assets is because of uncertainty related to identifiability, the power to obtain future benefit, and the actual impact of that benefit. However, goodwill exhibits many of these characteristics but it has to be recognized in the case of mergers or acquisitions as it is created in monetary terms once asset and liability classification has been exhausted.

A similar approach might be taken annually by looking at the market value of the business entity as a basis for “non-impairment” of identified future-oriented expenditures that are being carried forward. A possible criticism of this approach would be that the market value could be influenced by the cumulative amount of investments in intangibles disclosed in the financial statements.

Another possible approach would be to consider the amount of accumulated investments in intangibles, net of identifiable intangibles measured at market value, and add this amount to the goodwill impairment test.

This is not a perfect solution. We therefore think that this issue should be the subject of analysis and research in search of the best possible solution. What would not be convenient is to abandon the rest of the disclosure proposal while waiting for that perfect solution.

Man with glasses
Nick A. Shepherd

With over 50 years of diverse experience, Nick began as a UK engineer before becoming a professional accountant. After a decade in the UK, he moved to Canada, reaching VP Finance in a major technology company and later becoming President of a significant industrial distribution company. From 1989 to 2017, Nick ran his consulting firm, focusing on corporate cultures, organizational sustainability, human capital, and integrated reporting across multiple countries. Officially retired, he remains active in research and writing.

Nick is a Fellow of the UK Chartered Certified Accountants and the Canadian Chartered Professional Accountants, as well as a Fellow of the Certified Management Consultants. Elected as a Fellow of the Royal Society for the Arts (UK) in 2023, he is also a member of MENSA and a past member of the American Society for Quality. As an author, his recent work includes "The Workplace Battlefield: where great talent goes to die," along with professional papers and guidelines on management accounting topics like values, ethics, intangibles, and sustainability.

Fermin del Valle, head and shoulders smiling at the camera
Fermín del Valle

Fermín del Valle is a Public Accountant. He is Director of the Accounting Career in Universidad de San Andrés in Buenos Aires, Argentina and former President of IFAC. He is a retired partner at Deloitte Argentina.