Figure 1 demonstrates quite clearly that, from the investor point of view, intangibles create value for a business In fact at 80 per cent, intangibles create most of an enterprise’s value with much of that value hidden, only a small portion is exposed. That is the amount that is shown in post-Merger & Acquisition (M&A) balance sheets where the value of the brand has been identified, measured and added to the balance sheet under the heading of intangible assets and clarified in a note to the accounts. (see: Mizik, 2009; Hsu et al, 2011; Wiesel et al, 2012 for recent evidence of the link between brand and company value).
Since 2001 in the United States under FAS 141 and 2005 in the rest of the world (where IFRS applies), there have been untold mergers and acquisitions, where brands with an indefinite life were recognized and have been carried in the balance sheet at their value at acquisition. They are tested annually for impairment and some might therefore have been written off; however, most brands do not lose value and many will still be carried at their post-transaction value.
The Swiss bank, UBS (2008), analyzed M&A transactions in Europe and in its report it showed the goodwill and intangible assets being carried in the balance sheets of the firms they examined with the average for all being 4 per cent of aggregate European asset value. Not all companies involved in business combination transactions will possess significant intangible value because many on the list would be companies which do not attract large premiums over net asset value such as miners and heavy industrial firms. This distinction emphasizes the competitive advantages companies acquire over time when they develop intangible assets such as brands (see for example Brealey et al, 2008).
Figure 3 illustrates a random selection of companies and in 50 per cent of the cases the intangible portion is under 10 per cent of market capitalization. The rest of the cases show acquired brand or brands having significant value, such as P&G at 16 per cent which is primarily Gillette and Kraft’s 35 per cent is primarily Cadbury (bought in 2010).
In order to illustrate graphically the impact of these conflicting accounting standards we employ a single company example, Proctor & Gamble (P&G) and the brand is Gillette. The 2005 P&G purchase of Gillette is interesting because, aside from the status of the acquiring company and that the acquired brand is a famous market-leader, according to the post-acquisition accounts, the deal was nearly 100 per cent made up of intangible assets and goodwill. Table 1 shows how the purchase price of US$53.4 billion was allocated.
In the P&G balance sheet, the Gillette brand falls under the heading of indefinite lived intangible assets. In 2007 the amount being carried was US$29.7 billion (see line item in Table 1) of which 90 per cent was Gillette (US$24.0 billion) and in 2013 the amount being carried is US$26.8 billion (for all acquired intangibles including Gillette). Since there is no allowance for an increase in asset value (accretion) in the current accounting standards, the amount for Gillette will be unchanged. In January 2014 the market capitalization for P&G was US$218 billion and at US$24 billion the Gillette brand accounts for 11 per cent (the difference between 11 per cent and 16 per cent is due to a lower market capitalization when the figure was constructed).
It is axiomatic that an investor would want to know the value of the brands a company owns for two reasons:
For a company like P&G or any firm that relies on brands for its survival, the value of the enterprise is dependent on its stewardship of these cash-generating assets. An investor would want to know what proportion of the firm’s value the main brands in the portfolio represent and how they go about protecting and building these resources.
The source of a firm’s revenue as stated in the top line of its income statement is the customer. In many cases (basic resources such as iron and coal are probably exceptions) the reliability of these income flows depends on the strength of the relationship the customers have with the brand. Most current annual reports fail to show data that supports this, but with the integrated report and expanded exposure in the statutory accounts, greater disclosure of how the customer/brand relationship is managed will initially be demanded and eventually become mandatory.
How this data is displayed for the users of the report will be determined by the accounting technicians at FASB and IASB, but the extant standards provide some guidance of what will happen. In post-transaction accounts, the acquired intangibles are aggregated under a single line item: intangible assets. The residue not accounted for remains under a second line item called goodwill and if internally generated brands are reported as well, they are likely to be aggregated under a third line item called intangible assets.
Detail as to what this item comprises will be reported under notes to the accounts. Several authors have suggested that brand values be dealt with in the narrative part of the annual report or in the Management Discussion and Analysis (MD&A) section (Mizik and Nissim, 2011; Gregory and Moore, 2013). This might serve as an interim measure until such time as the corrections covered in this article are dealt with. But the ultimate aim is to have a number in the balance sheet in the asset section that provides information to investors about the intangible assets the firm has developed and acquired and how they contribute to enterprise wealth.
In developing and issuing the accounting standards that deal with business combination accounts (FAS 141; IFRS 3), the standard setters have made a substantial start (see the previous section timeline and explanation above). But, as Figure 3 shows, this tells only part of the story: nothing is said about the balance; the brands, such as Coca Cola, Kraft, Honda, Colgate and OMO or other intangible assets the firm developed itself. These are what the standard setters describe as ‘internally generated’ and fall under the standard that deals with intangible assets (FAS 142; IAS 38), they are not recognized in the balance sheet.
During the past decade, the FASB and then the Australian Government Accounting Standards Board invested time and resources to aid in the progression and recognition of internally generated assets. In each case the projects were aborted before they were completed and the IASB stated in December 2007 that this project would be ‘paused’:
The agenda proposal was discussed at the IASB meeting in December 2007. At that time, the Board decided not to add a project on identifiable intangible assets to its active agenda because properly addressing the accounting for identifiable intangible assets in the near-term would impose a large demand on the Board’s limited resources. (http://www.ifrs.org/Current-Projects/IASB-Projects/Intangible-Assets/Pages/Intangible-Assets.aspx)
Although the project was ‘paused’ in December 2007, the Australian Accounting Board continued its work for another one to two years. This project was stopped at the time of the financial crisis to allow the IASB and FASB to concentrate on the four projects scheduled for convergence at the time: revenue, leases, financial instruments and insurance.
When the Business Combination standards were introduced they were accompanied by guidelines identifying intangible assets that would be considered, post-transaction, as comprising the purchase consideration and these are shown in Table 2. Notice, the first column details ‘marketing related IAs’, under this is ‘trademarks’ and these are noted in the text as referring to brands. This extensive list makes it clear that the accounting standard setters are fully aware of the nature of intangible assets and trademarks (brands) in particular. It also gives strength to the notion that a key reason why the standard setters have not updated the intangible asset standard is because it has not been prioritized.
If, under conditions of a merger or acquisition these intangibles are considered sufficiently important to be identified and recognized, it is illogical that the same assets are not recognized as the driving force behind the 80 per cent intangible margin illustrated in Figures 1 and 3 above.
Table 3 shows graphically how important these intangibles are. The values estimated by both Interbrand and Millward Brown (see Table 5) for the leading brands in their listings, even though the numbers are far apart, indicate the extent to which brand value explains a major portion of this margin. If a reliable approach to brand valuation could be adopted universally (see below in the section ‘Is there a better way?’ for the authors’ proposal), investors would be provided with solid evidence of a major underlying driver of enterprise value.
The best conclusion to be drawn from this analysis is that eliminating this contradiction is not a priority for the standard setters at this time. It will always be the next item on the list after the ones deserving attention as was the case with the IASB’s Agenda Consultation process of 2011/12. There are however compelling reasons for attending to the conflict sooner rather than later as the next section will attempt to prove.