"Reporting intangible assets is an issue the accounting profession has walked away from." Thus spoke Peter Fritz, referring to one of the biggest conundrums of the impending rollout of the International Financial Reporting Standards (IFRS) in Australia - the reporting of internally generated assets such as brands, mastheads, knowledge and relationship assets, and internationally generated goodwill. Add software and information assets to the mix, and the ’minor’ issue of interpreting the new standards throws valuation and reporting of up to 70 per cent of organisational investment up in the air.
Last month, the Australian Financial Review reported that "potential conflicts between the international and local [regulatory] boards have left companies uncertain as to how and when to recognise tens of billions of dollars of intangibles and goodwill when they restructure or merge". One estimate suggests the actual impact on Australian organisations could be as high as A$40 billion, and the implications for internal IT investment, such as the cost of application development, customisation and delivery of non-revenue generating IT products and services, could be enormous.
To Fritz, chair of the Australian Government Consultative Committee on Knowledge Capital (AGCCKC), however, the issue goes a lot deeper than the immediate need to deal with a different way of reporting what the AGCCKC believes to be the majority of all organisational assets. He says it is an entirely wrong world-view for the 21st century.
"Two-entry accounting is only 450 years old," Fritz quips. "It was an innovation that gave Venice and trading cities around Europe advantage in measuring tangible economies of manufacturing. But it is a wrong way of dealing with the modern world. We cannot afford to rely on a methodology that is not created for the world we live in."
An AGCCKC paper on knowledge capital and the management of intangibles, written by Chris Liell-Cock and Dr Ken Standfield, estimates approximately 70 per cent of the employment in advanced economies and 70 per cent of GDP created in those economies is attributable to the services sector. Yet, the models used to manage and govern the knowledge and services-based economy are, in the words of US Federal Reserve Board chairman Alan Greenspan, not tracking the investment in those assets.
This is what Fritz means when he accuses accountants of "walking away" - the accounting tools they have equipped information and knowledge-based economies with are simply not evolving with the times. Historically, examples and analogies illustrating Fritz’s point are easy to find.
"Until the 1960s, there was almost no investment in mining in Australia because there was no way of assessing the risk of investing in a hole in the ground," he offers. "We now need to create one that will assess risk in information and knowledge economy.
Enter the Fritz-chaired AGCCKC, a consultative body comprising public and private interests whose agenda is to increase recognition of the concept of knowledge capital and establish a standard for evaluating intangibles through the knowledge capital process. Part of a global network of organisations battling for representation and valuation of intangibles, the AGCCKC has built its framework around former NASA chief technology officer and long-term knowledge capital advocate Paul Strassmann’s simple definition of knowledge capital as the net difference between the market value of a corporation and its tangible asset.
Defining intangibles The crux of the problem of valuing this difference, according to Liell-Cock and Standfield, lies not only in the discrepancy of the outdated accounting tools used in operational management and investment, but in the general misunderstanding of the term ’intangible’.
"There are two types of intangibles: hard intangibles (information protected by law, such as trademarks or non-accounting value evidenced by financial transactions such as goodwill); and soft intangibles (knowledge assets - ’what people know’, relationship assets - ’who people know’, emotional assets - ’motivation levels’, and time assets - ’effectiveness levels’)," they explain.
"Currently, people are aware of hard intangibles and often fail to understand soft intangibles exist. That is even more problematic when 90 per cent of intangibles are soft intangibles."
Despite the lack of appropriate tools, Strassmann has been measuring knowledge capital for almost a decade. "I calculate economic value-added, showing what customers are willing to pay for a firm’s goods and services," he told Knowledge Management Magazine back in 1999. "I calculate the price for additional capital, benchmarking prices paid for comparable mergers and acquisitions.
I calculate economic value-added dollars discounted over the life-cycle of the proposed knowledge investment, which yields a dollar estimate of a firm’s knowledge capital. I examine head count, calculating knowledge capital per employee compared with salary. Where compensation is greater than the knowledge capital of employees, the company is paying for value-detractors."
His methodology, however, has fallen on deaf ears with the international regulators, whose obtuse standards of intangibles reporting - driven by the US Federal Accounting Standards Board (FASB) - are far from universally endorsed.
According to Professor Zoltan Matolcsy from University of Technology Sydney’s Faculty of Business, the global standard, which has been brewing for over a decade now, simply doesn’t recognise the need to align the reporting standards with the change in the nature of corporate investment.
Shifting market values
"In the 1980s, market value of companies was generally lower than the value of assets held by a company. Back then, companies made money through asset stripping," Matolcsy explains. "Today, the market value of most companies exceeds their asset value and a lot of that intangible value will have to be written off the corporate balance sheets under the new standards."
Although the new global standards took effect on 1 January, 2005, there is little evidence that the rollout is going to happen according to schedule as companies battle confusion over how exactly they should be interpreting the changes.
Patricia McBride, policy adviser at CPA Australia (The Australian Society of Certified Practicing Accountants), is quick to point out that not much has changed in reality. "We haven’t changed the way we work, just the way we report things," she says.
But things have changed and the implications for investment in intangibles are very tangible. Certain internally generated intangibles, such as mastheads and brands, will be prohibited from internal recognition as assets, while others can be recognised but cannot be revalued if a company’s assets are traded in an active market.
In practical terms, this means that some cost of investment in intangibles - including investment in information technology - will indeed have to be written off.
"Until you analyse the nature of intangibles - what has been acquired as opposed to what has been developed internally - you will not know what the impact of the new rules will be on your balance sheet," McBride explains. "In Australia, it will depend on an individual organisation, on how they accounted for it before the new standards were introduced, and how they develop software."
Capitalising on IT The question of internal development or customisation of software, while not common, is certainly one of the areas the IFRS may have an impact on.
"In Australia, IT was optional to capitalise, so I would think the reporting on IT development is all over the place. For those who have been capitalising it, the big write-offs would occur if they were re-valuing that investment, which I doubt they would," says McBride.
Under the new standards, however, a company will not be able to start capitalising investment in IT until that investment delivers incremental benefits to the company. So, if a company builds a web site, which is used simply for marketing and communication purposes, the company will not be able to capitalise the cost of development. However, if the site is developed to provide services or sell products or services, then its cost can be capitalised once the site is close to completion, ie. close to the point at which it will start to deliver incremental benefits to the company.
The IFRS general rule of thumb on IT investment is going to work in favour of IT vendors and investment through acquisition, rather than internal IT departments and investment through in-house development. Local IT vendors, such as Microsoft Australia’s chief Steve Vamos, readily admit to this, acknowledging that the proper accounting and valuation of intangibles is going to be good for the IT industry as a whole. How and if the new rules will change the nature of corporate IT investment, on the other hand, remains to be seen.
One answer to the current confusion of managing both intangibles and the related IT investment, says Phil Cronin, general manager of Intel Australia and New Zealand, could be in getting CIOs back on company boards "where they were at the end of the 1990s". Evidence from the US, however, suggests that it is the chief knowledge officers (CKOs) who are given preferential treatment when it comes to corporate boards seeking advice on ways of managing, measuring and valuing knowledge capital. In Australia, where CKOs are few and far between, the onus is back on the CIO to permeate the accounting framework and influence the way the intangibles are reported on a micro-level.
In the meantime, organisations like AGCCKC are racing against time to deliver what they hope will be a more suitable and valuable set of standards to deal with the economy of intangibles. Fritz says several projects have already been initiated by the Federal Treasury and Department of Finance, including evaluating reporting standards used by environmental industries, which could possibly be applied in a wider economic context. The issues, of course, are wide and varied, and some may be resolved over the next six months, when the new regime will start to apply to all companies. The related question of knowledge capital, however, will remain open for some time.
"We have been living without reporting the intangibles for 40 years and this process will speed up the introduction and valuation techniques to deal with the issue," offers Fritz.
"The accountants think they can stop the world, but they can’t stop things from evolving and they can certainly not stop the world."