The average company’s balance sheet understates its value by 80 percent, according to Sarah Tomolonius, co-founder of the Sustainability Investment Leadership Council. Why? Intangible assets are not recorded on the balance sheet under U.S. Generally Accepted Accounting Principles (GAAP), unless they are acquired from a third party.
Instead, GAAP generally calls for the costs associated with creating and maintaining these valuable assets to be expensed as they are incurred — even though they provide future economic benefits.
Eye on intangibles
Many companies rely on intangible assets to generate revenue, and they often contribute significant value to the companies that own them. Examples of identifiable intangibles include:
- Patents
- Brands & trademarks
- Customer lists
- Proprietary software
- A trained & knowledgeable workforce
In a business combination, acquired intangible assets are reported at fair value. When a company is purchased, any excess purchase price that is not allocated to identifiable tangible and intangible assets and liabilities is allocated to goodwill.
Acquired goodwill and other indefinite-lived intangibles are tested at least annually for impairment under GAAP. But private companies may elect to amortize them over a period not to exceed 10 years. Impairment testing also may be required when a triggering event happens, such as the loss of a major customer or introduction of new technology that makes the company’s offerings obsolete.
Inquiring minds want to know
Investors are interested in the fair value of acquired goodwill because it enables them to see how a business combination fared in the long run. But what about intangibles that are developed in-house?
At a sustainability conference earlier in May, Tomolonius said that businesses are more sustainable when they are guided by a complete understanding of their assets, both tangible and intangible. Assigning values to internally generated intangibles can be useful in various decision-making scenarios, including obtaining financing, entering into licensing and joint venture arrangements, negotiating mergers and acquisitions, and settling shareholder disputes.
Calls for change
For more than a decade, there have been calls for accounting reforms related to intangible assets, with claims that internally generated intangibles are the new drivers of economic activity and should be reflected in balance sheets. Proponents of changing the rules argue that keeping these assets off the balance sheet forces investors to rely more on nonfinancial tools to assess a company’s value and sustainability.
It is unlikely that the accounting rules for reporting internally generated intangibles will change anytime soon, however. In a quarterly report released in August, Financial Accounting Standards Board member Gary Buesser pointed to challenges the issue would pose, including the difficulty of recognizing and measuring the assets, costs to companies, and limited usefulness of the resulting information to investors. Buesser explained that, “the information would be highly subjective, require forward looking estimates, and would probably not be comparable across companies.”
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