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Italy’s decree on intangible assets should serve as a cue

In August 2020, the Italian government declared that Italy’s domestic firms could and should declare their intangible assets in full on their financial statements. The immediate motivation for this move was the rapidly-eroding share values of Italian firms on stock markets in the midst of the covid pandemic, which rendered many of them very attractive as cheap takeover targets. Without any other accepted indicator of the true worth of these firms, the market was the sole arbiter of their value. With the inclusion of their intangible assets, however, their actual intrinsic value is what prospective buyers would now have to negotiate against.

While this was a much-needed tactical response by a government to the asset risks posed by a global crisis, the move has far- reaching implications for the management of the world economy at large. We intuitively know that the intrinsic value of a successful 21st century business entity cannot be the sum of its tangible assets. So, will this spread across other developed economies that depend heavily on intangible assets? The US, France and Germany, all derive significant value from the ‘reputations’ and ‘recipes’ of their businesses. Even if we were to extend this logic to startups, the more sanely constructed of them, think of how much value (or return on capital if you will) would be based on intangible assets.

We are very conscious now that losing a brand is nothing less than a body blow to any business. An erosion in intellectual property (IP) is not a superficial wound. Imagine if you could no longer use the word Caterpillar even in a largely spec-driven B2B business like earth movers; would it survive? Imagine if 3M closed down its innovations cell. Or if the Tata Group declared that its Tata Code of Conduct is no longer mandatory. Will any of these business entities have legs to stand on?

So what might the world economy of 2025 look like from this perspective? Of course, we will all need a physical device to watch Netflix on. But what are we paying for? And where exactly does Netflix’s value reside? Of course we need a phone to order an Uber cab and a car to take us to our destination. But what are we actually paying Uber for? The best universities in the world are already offering full-length online options for educational degrees.

In 1975, the contribution of intangibles to an average S&P 500 firm was 17%. In 2020, that number was a shade under 90%. The equivalent figure for the eurozone was 75%. The value-creating competitive advantages of most product and service categories will increasingly turn intangible. And consequently, the value lying in tangible assets could get eclipsed over time. What will it take for legal, accounting and governance protocols to recognize this and catch up with market reality?

Consider these:

Legal: Can IP law adequately ring-fence all intangible assets?

Accounting: Shouldn’t our financial statements recognize and declare the value of these assets?

Governance: Are business leaderships able to manage the risks attached to their intangible assets?

Performance: Will ‘return on capital’ metrics include intangible capital as well?

For over a century, we have managed to keep a watchful eye on shareholder interests, with robust mechanisms that oversaw precious shareholder capital residing largely in tangible assets. This level of oversight unfortunately has not extended quite so smoothly to intangible assets, which can no longer be relegated to ‘goodwill’.

Surprisingly, this is not the shiny new thing of this decade. As far back as the 1960s, economists like Machlup and Griliches had started questioning the allocation of research and development budgets as intermediate inputs. At the turn of the millennium, Corrado, Hulten and Schisel had begun to create classifications for intangible assets.

In the Italian case that we began with, many firms would have been swallowed for a song had it not been for the government’s decree. Their intangible assets would have been meaningless contributions to their valuations in such a stock-market environment.

Today, private equity tends to ‘price’ a firm rather than ‘value’ it. Investor demand for such a business in the current capital market determines the value that is paid. This often has little or nothing to do with the intrinsic value of all its assets. It’s a bit like saying that the value of an airline’s jets should be calculated based on the state of the travel industry. Would that be acceptable under current accounting norms?

Westlake and Haskel, in their defining work Capitalism Without Capital, argue that one of the biggest social risks of not recognizing intangibles is the widening of already-yawning gaps in wealth creation. The synergies and spillovers that intangibles create make it easier for intangible-rich companies to attract talent with the education and skills needed to work in knowledge-based industries, and to pay them higher wages.

Clearly, irrespective of the lens through the which we view the issue, intangibles can no longer be the subject of endless debate on whether or how to capture it, leaving it opaque for all stakeholders. The time for ideological oneupmanship and posturing is over. As in the case of tangible accounting standards put in place about a century ago, sophistication will evolve with time. But we must make a beginning.

It would be ridiculous to stay in denial of the elephant in the room only because we can’t agree on how to describe it.

Ramesh Jude Thomas is president and chief knowledge officer, Equitor Value Advisory

 

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About the author

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Pioneer Jury is a qualified writer and a blogger, who loves to dabble with and write about technology. While focusing on and writing on tech topics, his varied skills and experience enable him to write on any topic related to tech which may interest him. [email protected]

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