Open Response to PwC and the UK Financial Reporting Council

David Philips, whose Corporate Reporting Group at PriceWaterhouseCoopers has stuck with the challenges of reporting year in and year out, just posted about a new report from the Financial Reporting Council (FRC) called Louder than Words: Principles and actions for making corporate reports less complex and more relevant. In support of the report, PwC has written a letter suggesting concrete action plans to make that happen.

I started writing a response on his blog but it got a little too big for a comment so I moved it here. Regular readers have seen the data before (especially in my recent post on goodwill) so please excuse the repetition.

In his post, David Philips presents a call “to broaden the mindset, collaborate with others, think the unthinkable.” In that spirit, I would like to point out that, while the recommendations made in the FRC report and the PwC response are very valuable, they are made from inside the silo of the current accounting paradigm–a paradigm that ignores the effect of the shift to a knowledge economy.

For decades, there has been a slow and steady increase in the proportion of corporate value that is not visible on the balance sheet. The one time this intangible value becomes visible is when an acquisition occurs. Data from acquisitions in 2007 showed that the intangible proportion of the average acquisition was 70%. Of this, two thirds (47%) was booked to goodwill, which basically means that the accountants could not identify the source of half of the value of the acquisition. Yes half. That’s the margin of error in accounting today.

This is not just an issue around M&A. Every day in our consulting work, we see the challenges corporate managers face in understanding, leveraging and getting a fair value for their intangible capital.

It is very important to realize that this large intangible value in companies did not just appear out of the ether. It is the product of decades of investment in creating a knowledge collaboration infrastructure: the processes, capabilities and external networks that form the core “productive capacity” of every company today.

In 2007, it is estimated that US corporations invested $1.6 trillion in this kind of intangibles versus $1.2 trillion in tangible capital expenditure (a 60/40 split). We are dealing with very limited data here but 60% intangible investment is not so far away from 70% intangible portion of corporate value. Yet we have no real data from individual corporations because most of the intangible capital expenditure is passed through the income statement.

There are many good reasons why most intangibles cannot go on the balance sheet. Yet passing this spending through the income statement without breaking it out (such as the treatment given to R&D) is causing a distortion in corporate reporting that cannot be remedied through clearer narrative.

I agree with the FRC that reports “no longer reflect the reality of the underlying businesses.” But the problem will not be fixed through clearer language or increased transparency of the existing numbers.

Intangibles are the missing data point necessary to “join the dots” between corporate strategy and financial statements.