Sunday, 17 August 2014

Financial reporting for intangibles: why IP intangibles remain invisible

Last week's guest post, by Efrat Kasznik, "Financial reporting for intangibles: The Case of the Invisible Assets", has attracted considerable interest, with some perceptive comments being posted by readers. It has also attracted the following comment from Janice Denoncourt (Senior Lecturer, Nottingham Trent University), who writes:
Your post has raised an important question. Companies don't rush into voluntarily disclosing the value of their IP. The question then is, why?” 
There are two forms of mandatory corporate disclosure regimes in play and each is designed with a different purpose in mind.
First, Anglo-American national corporate reporting regimes and corporate governance principles are aimed at ensuring that directors have complied with the requirements of the relevant company legislation in that jurisdiction. Corporate disclosure is made via the annual report or quarterly reports, which include the financial statements and a narrative directors’ report, confirmed by the auditors as providing a true and fair view of the company’s business. The purpose is to monitor the directors’ stewardship of company assets and prevent moral hazards such as a director's conflict between his or her private interests and those of the company. If the company’s intangibles assets are a significant element of the business strategy, then they should feature in the Directors’ Report.

In the UK, reporting on corporate assets should also be reflective of the value they provide to the business in the medium to long term. The sustainability of the organisation and the long term view is enshrined in section 172 of the UK’s Companies Act 2006 (CA 2006) via the concept of ‘enlightened shareholder value’ which provides that directors have a duty to promote the success of the company. Core intangible assets clearly have the potential to contribute to profitability, long term growth and ultimately the success of the business. To comply with the mandatory s.172 CA 2006 legal requirement, both private (unless exempt) and public UK companies would supplement their traditional quantitative financial statements (which provide very little relevant qualitative information about significant intangible assets resulting in information asymmetry) with narrative disclosures.

Secondly, in addition to the above, companies listed on the London Stock Exchange (LSX) for example also subscribe to mandatory disclosure via the Disclosure and Transparency Rules (DTR). The DTR are designed to promote prompt and fair disclosure of relevant information to the public investor market. According to the LSX, “This helps to encourage investor confidence and maintain Europe’s deepest pool of capital”. In this respect I agree with Ken Jarboe’s comments that 
“Investors should have information on intangibles which allow them to come to their own valuation judgements”. 
Relevant information is ‘price-sensitive’ information that would be likely to have a significant effect on the share price in the short term. This relates to Efrat's point on ‘value fluctuations’ inherent in intangible assets. While compliance with DTR is mandatory for listed companies, it is a matter for a company’s board of directors to exercise its collective judgement to determine when to disclose significant inside information, typically applying the ‘reasonable investor test’. Disclosure to the market could even be daily if necessary to comply. The DTR are aimed at preventing market abuse and, as Efrat says, 
“The fact that managers have better information than the market on the value of their IP assets gives them an advantage as they can control the extent and timing of that information disclosure.” 
It seems that while the traditional accounting system may not be coping with volatile intangible asset valuations, the DTR mandate that listed companies must cope with disclosing ‘price sensitive information’ in narrative form or risk their shares being suspended from trading. They must ‘comply or explain’.

To revert to Efrat's problem, one important reason that companies don't rush into voluntarily disclosing additional qualitative information about their intangible assets is that they will then be held accountable for that information. There are severe legal consequences for any failure to report ‘fairly’ so as not to mislead under the CA 2006 and under the DTR for failure to disclose timely price sensitive information. The ‘silence is golden’ argument is problematic. In the UK, a director is liable to compensate the company for any loss it suffers as a result of the omission of anything legislatively required to be disclosed. Directors certainly have tough decisions to make regarding intangible asset disclosures. They will also be concerned about the cost to gather and verify the information, as well as advisor fees.

In fairness to company directors, in my opinion they need more guidance to identify the type of disclosure and how, what, when, where and how much to disclose with respect to the valuable intangible assets they manage on behalf of the company. There is minimal if any bespoke guidance on corporate intangibles reporting published by the regulators. So, although mandatory legal disclosure requirements relevant to corporate intangible assets already exist, the lack of guidance and enforcement by the regulators perpetuate the gap in publicly available information. A broad understanding of an appropriate level of intangible asset reporting has not yet emerged. The ability to evaluate the quality of intangible asset disclosures and then assess whether a company has fallen below the standard, in breach of its disclosure obligations, is highly specialised and a murky area even for the regulators.

One thing is certain however, demand for relevant, accurate and timely information regarding modern companies’ intangible assets will grow. Imperfections in both financial and corporate reporting will cause imperfections in the effectiveness of corporate governance and the protection of a company’s shareholders and other stakeholders. Corporate governance practices, especially in relation to accountability for intangible assets, need additional scrutiny in the public interest. As Efrat suggests, currently companies (that are risk tolerant) may actually benefit from information asymmetry and the lack of regulatory scrutiny. Nevertheless, I am firmly of the opinion that it is always good to shine a light in a dark corner.

1 comment:

Anonymous said...

IP is an asset, and one can see that its value should be estimated and reported. However if you are going to 'shine a light' and in particular try to protect investors then I wonder whether there should be responsibility to report whether a company knows it is likely to be infringing third party rights. This would be very onerous and I would be against making this mandatory. However the 'effect of IP' on value clearly works both ways, and shouldn't investors be protected from this risk too?