Dr. Janice Denoncourt, a Senior Lecturer at Nottingham Law School, has
authored the following guest post concerning updating accounting standards for intangibles. Notably, her comments tie together contributions from her recently published book [Intellectual
Property, Finance and Corporate Governance (2018) is available from Routledge as part of the
Research in IP Series here], which was discussed in her previous IP Finance post, here, and the recent UK Financial
Reporting Council's consultation on Business
Reporting of Intangibles: Realistic proposals.
‘The difficulty lies not so much in
developing new ideas as in escaping from old ones.’
John
Maynard Keynes (1883-1946)
Accounting
sanctions particular distributions of wealth and legitimises commercial
relationships. How the accounting international
financial reporting standards (IFRS) and international accounting standards
(IAS) treat intangibles, a wide category which includes IP rights, is an important
corporate governance concern, especially for large and listed IP-centric
companies. Accounting and financial
statements, such as the balance sheet and profit and loss account, act as a
kind of internal control for investors, shareholders, financiers, suppliers and
other stakeholders who engage with the company.
While the evolution of the credit and debit matching system has been
indispensable to the efficiency and material prosperity of the modern economy,
accounting for intangibles needs to be updated and advanced – particularly for
internally generated corporate IP assets. The problem is that IP is largely invisible in
traditional financial accounts as they are ‘off balance’ sheet when IAS 38
Intangibles is applied. Many knowledge-based intangibles do not meet
the accounting definition of an ‘asset, nor the recognition criteria set out in
the prevailing accounting standards. The
UK FRC recognise that this important corporate governance challenge – namely, the
inadequacy of traditional accounting methodology to deal with the future value
creation potential of intangibles and monopolistic IP rights. However, an understanding of the deeply
ingrained accounting principles is needed to better understand the accounting
and reporting issues at the heart of the consultation.
A
lesson from the Merchants of Venice on the history of accounting
In Chapter Four of my research monograph Intellectual Property, Finance and Corporate Governance (2018) I examined
the deeper reasons rooted in the history of double entry book keeping why
accounting for intangibles and IP is so difficult. Briefly, the ideas that revolutionised the
way Europeans counted and accounted for their assets were introduced by the
Italian Renaissance mathematician, Leonardo of Fibonacci in his ground breaking
book Liber Abaci, ‘The Book of
Calculations’ published in 1202.
Fibonacci introduced the concept of present value (the discounted value
today of a future revenue stream). Historically, the double-entry book keeping
system, which forms the basis for modern accounting principles and is globally
accepted, was simply a tool to track and document the exchange of tangible
items and prevent embezzlement. In other
words, it is an ‘error detection tool’ making it a record of historical
transactions. In the case of error, each
debit and credit can be traced back to a journal and transaction source
document, thus preserving the audit trail.
The double entry book keeping system was originally designed to prevent
fraud and misappropriation by employees of the Renaissance merchants of
Venice. The root of the problem with the
modern accounting for IP rights developed by a company internally (rather than
acquired from someone else) is that these assets do not fit the socio-historic
evolution of accounting as there is no historical transaction to record. For example, when a patent is applied for it
becomes a property asset of the company and thus a form of currency. At this point, there will be no historical market
transaction to record in the accounts if the patent was developed internally,
as opposed to acquired from a third party at arm’s length (no purchase price of
the asset to record). However, the
expenditure to internally develop the innovation to the patent filing stage IS usually
recorded. Thus from an accounting point
of view, part of the equation is missing in the balance sheet. Arguably, there is also a basic question as
to the integrity of the accounts. The
entry is a debit expense, with no equivalent asset (credit) recognised due to the
uncertain future value of the patented invention.
Modern
accrual accounting and the GAAP
The next significant step in the history of accounting was the
‘accrual’ method which essentially relies on six key principles: (1) revenue
principle; expense principle; matching principle; cost principle, objectivity
principle and the prudence principle. The ‘matching principle’ correlates the
revenue and the expense principles. The
nature of R&D, innovation, filing patent applications (which may be granted
several years later) does not map well onto the accrual method of recording
historical transactions at arm’s length either.
These assumptions and principles have become known as the Generally
Accepted Accounting Practice (GAAP). The
GAAP shape a perception of the quantitative value of intangibles and
monopolistic IP rights. Arguably, the
GAAP accounting principles shackle the fullest use of corporate IP assets as
their value is simply not captured and reported publicly. In summary, the internationally harmonised accounting
principles have traditionally relied on two inherent assumptions. First that
tangibles rather than intangibles contribute to business performance and
second, that business depends largely on an arm’s length transaction between a
willing buyer and a seller (in contrast to in-house development).
Calls
for reform to business reporting of intangibles
Fortunately, over the past decades, there have been frequent calls to
reform the accounting (quantitative) and narrative reporting (qualitative) of intangible
assets. This has been largely in
response to the move to a knowledge-based economy and the greater store of
corporate value which resides in intangibles. Accounting, narrative reports (annual
reports, directors strategic reports) and actual events support
‘triangulation’, a powerful technique that facilitates validation of data
through cross verification from three or more sources applying several
methodologies to the same phenomenon.
The UK FRC’s Consultation
On 6 February 2019, the UK Financial Reporting Council took
the bold step of launching a consultation on Business Reporting of
Intangibles: Realistic proposals. Possible
improvements to the reporting of factors important to a business’ generation of
value are set out in the Discussion Paper prepared by FRC staff. The FRC’s paper considers the case
for radical change to the accounting for intangible assets and the
likelihood of such change being made in the near future. It suggests that:
(1) relevant and useful information could be
provided without the need to recognise more intangible assets in companies’
balance sheets;
(2) such information could cover a range of
factors, broader than the definition of intangible assets in accounting
standards, that are relevant to the generation of value;
(3) improvements could be made on a voluntary
basis within current reporting frameworks (such as the strategic report); and
(4) participants in the reporting supply chain
could collaborate to bring about improvements.
The FRC’s
Executive Director for Corporate Governance and Reporting, Paul George states:
“It is
unrealistic to expect the value of a business to be fully represented in its
balance sheet; there is always likely to be a gap between the balance sheet
total and the market capitalisation of a company. The paper suggests several
ideas for expanding the information provided, both quantitative and
qualitative, to improve users’ assessment of corporate value.”
The research in my book and derived from my PhD
thesis (2015) underpins the detailed response I made to the FRC consultation, which closed on 30 April 2019, and is
published, here.
In summary, everyone essentially agrees that existing accounting standards should be
advanced, updated and modernised to take greater account of intangibles and IP
assets. The question is how and to what extent. To this end, I made several practical suggestions
that could be implemented with relative ease including the greater use of notes
to the accounts as well as the use of the well-established technology readiness
level (TRL) system to facilitate investment in technologies.
Technology Readiness Levels
The TRL system, for those not familiar with it, is a
well-established method of estimating the maturity of critical technology
elements on a scale of one to nine, with nine being the most mature
technology. The TRL system was
originally developed by the US National Aeronautics and Space Agency (NASA) in
the 1980s to assist with the allocation of public funding and is now widely
used in public finance.
The use of TRLs enables consistent uniform discussions
of technical maturity across different types of technology. It is also an entrenched measurement tool to
support the assessment of investment and funding risks in publicly finance
technology, but in my view could be more widely used in private finance and
corporate reporting. The TRL system
facilitates cross-sector communication regarding technology and could help to
improve transparency and disclosure of intangibles in business reporting.
My further recommendations include the need to keep
accessible accounting records for intangibles and IP assets, even if they are
consider ‘off-balance sheet items’ under
accounting standards to ensure the integrity and traceability of the accounts
in the future e.g. when the business and/or IP is sold.
I also firmly hold the view that there is a need for a
minimum level of intangibles and IP business reporting by large of
listed companies who own substantial IP portfolios. An annual IP audit and formally reporting who
is responsible for managing and control of corporate intangibles and IP assets
would be good practice and may give rise to a greater role for IP professionals
in corporate reporting and governance. In
my view, adopting the above would expressly increase the level of transparency
and disclosure of corporate intangibles in the public interest.
However,
there are a variety of views on the subject and some areas of disagreement. The FRC Discussion Paper and all 18 responses
(CPA Ireland, UKSA Office, CPA Australia, Grant Thornton UK LLP, Ernst
&Young, SEAG, The 100 Group, WCI, Wellcome Trust, Christopher de Nahlik,
ACC, EAA, RICS, QCA, IR Society, Mazars and ICAS) are published, here.
No doubt the range of
submissions, reflections and ideas submitted will influence the international debate and the
International Accounting Standards Board (IASB) on the matter. However, the discussion paper does not cover
the reporting of goodwill and its subsequent impairment which may be a future
project.
