‘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.