Intangibles – The big white elephant in the room!

Intangibles - The big white elephant in the room!

Intangibles - The big white elephant in the room!

The article discusses the growing importance of intangible assets in the era of globalisation and recent technological advancements.

I refer to intangibles as the “big white elephant in the room of accounting and finance”, everyone knows it’s there but what do we do about it? But one thing is true, we cannot avoid it much longer and that is why I found the piece in the WSJ very interesting and worth sharing http://www.wsj.com/articles/accountings-21st-century-challenge-how-to-value-intangible-assets-1458605126.

The article discusses the growing importance of intangible assets in the era of globalisation and recent technological advancements. We have moved from shortwave radios to television to smartphones all within a span of a generation (or two). Traditional business models have been usurped by upstarts; consider for instance the recent phenomena of Uber and Deliveroo which have spread the globe in viral proportions in such a short space of time and so quickly shutting the door on its traditional Jurassic rivals. In some cases, the success of such businesses has been akin to violent volcanic eruptions and even caused political rifts between governments. http://www.socialistparty.org.uk/issue/906/22997/14-06-2016/uber-drivers-strike-against-unfair-fares.

These companies balance sheets are pregnant with intangibles and will only be recognised if the owners eventually choose to spin or sell off their businesses which we are now starting to see. I would also include business valuations from the sale of Chapter 11 corporations.

The WSJ article borrows on some data from New York University, the Fed and an economist, it is estimated that currently half the $18 trillion market cap of the S&P 500 is made up of intangibles. This still discounts any further intangibles which may arise from business combinations yet to take place. Intangibles now represent around 14.3%of the private sector GDP; tangibles are 9.5%, a complete about face when compared to forty years ago.

The last major upheaval in accounting for intangibles was brought about by the frenzy of M&A activity and eventually lead to the issuance of SFAS 141 in June 2001 after a period of five years of work by the accountants at the FASB, replacing and updating a lot of the material in the original Opinion 16 of the APB from 1970. Now, the FASB is faced with another mammoth challenge of how to measure, depreciate and amortise internally generated intangibles. Currently, the US GAAP only allows for capitalisation of costs in certain instances but it completely ignores the value of items such as brands, algorithms and big data.

Intangibles are valued using established methods. The cost method looks at cost of reconstruction of identical or replacement of similar assets, however, it does not account for future economic benefits that flow to the business from the use of the asset but does provide a useful baseline. The market method relies on identifying the asset in a market of same or comparable and readily tradable assets with multiple buyers and sellers.

The income method uses DCF methods applied on incremental cash flows as a result of employing the asset which necessitates a detailed understanding of the business. In some cases, it is possible to use bench marking to arrive cash flows such as royalties or license fees obtained from comparable assets, use of the relief from royalty model. The future cash flows are discounted at the appropriate risk premium for the duration of the anticipated cash flows. The CAPM model is applied in the case of a diversified portfolio which has no unsystematic risk and therefore it is of little use in the evaluation of a single asset, arguably income method is more useful for strategic planning than as an evaluation tool. Where measurement gets really fuzzy is in the valuation of fin-tech start ups, all the assumptions which underpin valuation techniques carry a health warning.

Intangibles

On the point of publishing companies, I had a brief look at the financial statements for Reed Elsevier for December 2015 and some interesting but unsurprising facts emerge about the “big white elephant”. RELX, up until last year was known as Reed Elsevier, is an international publishing company providing information and data analytics to the professional, academic and business community.  RELX owns the brands Elsevier, LexisNexis and Reed Business Information through its subsidiaries.  Its key revenue reporting segments are scientific, technical and medical; risk and business analytical; and legal.  Its current annual report shows net assets, excluding goodwill and intangible, as negative -£6.2 bn.  Goodwill and intangible are £8.3 bn.  The market cap is around £15.2B on 1.175 bn of shares.  The difference £21.4bn must, therefore, be attributed to the intangible and goodwill.  Subscriptions account for 52% of the £5bn global revenue of which 70% is in electronic format and only 15% is in print format.  Contrast this with 15 years ago when 64% was in print format.  RELX state that their turnover of £5bn accounts for only 1% of their customers cost base, making the point that they are delivering real value to their customers and I suppose, their ability to pinch even more revenue.

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Article written by Haroon Rafique (Principal, Meer & Co Chartered Accountants and Tax Consultants)

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