Superb Businesses
Capital Structure, Strength and Economic Performance
I will argue in this post that company Income Statements and Balance Sheets have almost entirely lost their relevance for investors. Further, those responsible for addressing the problem, the FASB (Financial Accounting Standards Board and the IASB (International Accounting Standards Board) with input from the CFA Institute Research and Policy Centre (Certified Financial Analysts) are probably not on the road to solving the problem. The CFA Institute aims to promote standards in ethics, education, and professional excellence in the global investment services industry.
In practical terms, the only thing investors have to work with is the Cash Flow Statement. When all you have is corn meal, you make your bread with corn meal and call it Johnny Cake. For me the Cash Flow statement is the corn meal and investors’ use of it is the Johnny Cake.
The source of the problem
The following chart illustrates how, over a span of 50 years, companies went from being valued for their tangible assets to being valued for their intangible assets. In the last ten years the percent for intangibles has only increased.
The problem is that GAAP accounting rules are completely inadequate to deal with intangibles.
First, accounting rules require companies to expense much of their intangible investments even though huge amounts of those investments are creating intangible assets of lasting value. This undermines the relevance of the income statement.
Second, accounting rules restrict the inclusion in the financial statements of internally developed intangible assets, such as brands or software that have been developed at high cost. IAS 38 requires an entity to recognize an intangible asset, whether purchased or self-created (at cost) if, and only if it is probable that the future economic benefits that are attributable to the asset will flow to the entity; and the cost of the asset can be measured reliably. This undermines the relevance of the balance sheet.
The problem has been recognized for years
I started this blog in 2019. One of the first posts was titled The fading usefulness of book value. The post explained: “Book Value – Ain’t what it used to be – With the rise of company investment in intangibles, book value is losing its relevance.”
It went on: “Something over 80% of the market capitalization of the S&P 500 is made up of intangibles. Only a fraction of that appears on balance sheets.”
Since then, I have written a number of posts about intangibles –see here,
including:
The emergence of a new model of capitalism
Value investing in the age of the Magnificent Seven, networks, intangibles, AI and all that
A deep dive into price earnings ratios
Investment in intangibles has wreaked havoc on the meaning of multiples
Is there a fix in sight?
At the May 8, 2024 Board meeting, FASB Chair Richard R. Jones announced that the staff is working on an Invitation to Comment (ITC) related to the research project on Accounting for and Disclosure of Intangibles. See here.
My comment: I suppose better late than never. Financial statements are used by various stakeholders. Amongst others, Management use them. Boards of directors use them. The U.S. Internal Revenue Service (IRS) uses them. And, investors use them. Each uses and relies on them in different ways. The priorities for investors are quite a bit different than those for, say, management.
My concern is that changes will be made that serve the needs of management and boards but not the needs of investors.
As of May 2024, the IASB has started a project to comprehensively review the accounting requirements for intangibles. The project will assess whether the requirements of IAS 38 remain relevant and continue to fairly reflect current business models or whether the IASB should improve the requirements. See here.
My comment. Same as for FASB.
Investor input to these initiatives
Here’s the critical part. Unless there is a concerted effort to advocate for the interests of investors, any changes made to the accounting rules will do nothing for these stakeholders.
The CFA Institute is a key organization that must fight for investors’ interests. It has recently fielded a survey of its members in their portfolio management and investment analyst roles to gain their perspectives on intangibles broadly and on the accounting for and disclosures of intangibles more specifically. They asked 30 questions of their members for their views on the usefulness of the existing accounting model, the initial recognition and subsequent measurement of internally generated and acquired intangibles, and the relevant disclosures. See here and here.
Survey results
In a nutshell here is the key conclusion from the CFA Survey which sums up the attitude of the chartered financial analysts’ community: “Financial Statements Risk Losing Relevance without Action, but Little Appetite for Radical Change” (Emphasis Added)
The CFA Institute explains it this way: “Many survey respondents want internally generated, identifiable intangibles to be recognized on the balance sheet, supporting a single model for internally generated and acquired intangibles. A significant plurality disagrees, however, seeing the potential for earnings management and because deferred recognition and amortization may not provide any more useful information than immediate expensing.” (Emphasis Added)
The CFA Survey spends some time on Balance Sheets and almost no time on Income Statements. And, of course, irrelevance of Balance Sheets undermines things like Price to Book ratios and irrelevance of Income Statements undermines things like Price/Earnings ratios.
My take
People seem to have a hard time getting their minds around the concept of intangible assets. Tangible assets you can essentially touch and feel although some may be quite ephemeral. Intangible assets are simply the result of company investment in intangibles that have lasting value.
A list of intangibles is set out below. Cash invested by companies on these items are intangibles investments:
Digital intangibles
- proprietary and patented technology,
- computer software,
- data and databases
- technology
- platforms
- networks
Innovation, discovery, creation
- trade secrets
- know-how
- ideas
- knowledge
- recipes
- process design
- service design
- product design
- trademarks, trade dress, newspaper mastheads, internet domains
- copyrighted literary and other works
- artwork
- video and audiovisual material
- media and entertainment production including motion pictures and television programmes
- aesthetic content
Business competencies
- organizational capabilities, internal structures, supply chains
- staff training and human capital
- customer lists
- subscribers
- mortgage servicing rights
- licensing, royalty and standstill agreements
- import quotas
- franchise agreements
- distribution agreements
- customer and supplier relationships (including customer lists)
- marketing rights
- market research
- brands
- goodwill
Of course, some intangible assets are less enduring than others. Subscribers may be costly to acquire and the subscriptions may be sticky enough that the company does not face high churn rates. Or the subscribers may be distressingly disloyal. The same sorts of comments could be made about all intangible assets. Of course, the same can be said about many tangible assets as well. They can become functionally obsolete in a heartbeat.
For the life of me I can’t see why it is so problematic to treat investment in intangibles of lasting value the same as investment in tangibles. A company might buy a printing press and capitalize its cost and depreciate it over time. The original cost is not expensed. The printing press might wear out in time. It might also become obsolete because paper communication is being replaced by digital. The same thing happens with intangibles.
Where things stand
The treatment of intangible assets on Balance Sheets is currently a confused and misleading mess. Goodwill is Accounting Goodwill and should really be classed as a form of Economic Goodwill. See my post: Buffett’s concept of economic goodwill vs accounting goodwill
Economic Goodwill is simply an intangible asset.
Conclusion
The way things are, the only numbers of use to an investor from a Balance Sheet relate to debt. The expensing of investments in intangibles of lasting value creates a distortion that completely undermines the use of the Income Statement. Reported earnings are not only useless for investors but also misleading for the unwary.
I would go so far as to say that millions of investors are seriously harmed by relying on Price/Earnings ratios and Price to Book ratios. To which we can add others like Return on Equity, Return on Invested Capital and even Return on Tangible Common Equity. This latter one is a favorite of banks seeking to exaggerate their returns. So called Value Stocks are one product of this deception.
I have very little confidence that the current initiatives of the FASB and the IASB (with input from the CFA Institute Research and Policy Center) will lead to ratios like the Price/Earnings ratios and Price to Book ratios becoming useful again. As well, the current initiatives are about 30 years late in arriving on the scene.
The only good news is that once you know a company’s debt structure, the Statement of Cash Flows is extremely useful for assessing a company’s capital structure, strength and economic performance. As I say, the Statement of Cash Flows is my corn meal and I use it to make my Johnny Cake. You make do with what you have.
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I’m also on Twitter @rodneylksmith
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