At the very heart of almost every major company in the world is a vast stock of intangible capital. In 2022 the consultancy firm Ocean Tomo estimated that 90% of the S&P500 market value consisted of intangible assets, up from 32% in 1985.
The dominance of intangible assets, or the ‘knowledge economy’, is a widely accepted part of modern business, but the finance profession hasn’t fully caught up with the shift. This is to be expected.
What financial statements miss
Financial statements don’t tell the whole intangible story. Valuing future benefits of expenditure on intangibles, like brands or software, is more uncertain than on tangible assets, like plant and machinery. For this reason, expenditure on creating intangible assets is expensed rather than capitalised.
When a company develops its own intangible asset, for example a strong brand, it appears to have low capital expenditure relative to its size and growth potential, but its earnings are reduced because the costs of development have to be expensed in the profit and loss statement. However, if it acquires a company with a strong brand then the value of the brand is capitalised on the balance sheet in the form of goodwill, and this does not reduce the earnings that year.
This might create a perverse incentive for managers to cut investment in developing intangible assets and to acquire them instead. The potential negative effect is that valuable businesses end up getting absorbed by organisations which underinvest in intangible asset development, which is the main driver of future value. This shows how relying on financial statement analysis for your understanding of the organisation puts you in danger of missing how the business really works.
Telling your intangible story
Leaders cannot hope to take good strategic decisions if they do not fully comprehend how the organisation creates value. For management accountants, the challenge is communicating the value of intangible assets and explaining how they relate to the business model
It is a mistake to try and solve this challenge simply by assigning financial metrics to your intangibles. You need to establish a combination of financial and non-financial measures to represent how they are created. The goal is to start conversations across the business about the contributions and costs associated with the creating of intangible value.
You only have to look at the increasing gap between the market value and the book value of any tech company to know that investors are well aware of the value of intangible assets. This gap is actually a good starting point for thinking about how you tell your intangible story, because it identifies two value chains, tangible and intangible.
Your tangible value chain consists of the cost of resources and the processes required to convert them to output. This leads to the book value. In contrast, the intangible value chain is made up of the value of your employees and relationships combined with transformative investment in hard to copy activities which creates intangible assets like patents and brands. This is what greatly contributes to market value.
People drive value
By considering two chains separately you can start to look for the activities and assets in your organisation that contribute to creating intangible value. More often than not these come down to people, or to put it more technically, human capital. The skills, experience, networks and relationships of the people within and around your organisation are the primary drivers behind the creation of intangible assets. By looking at the value they create as a whole, we as finance leaders can make a significant contribution to the way decision makers understand, protect, and develop the people who are instrumental the long-term success of the business.
Once you accept that a modern business is increasingly dependent on nurturing intangible value, you realise it is imperative for finance leaders to account for their value when making and guiding strategic decisions. Although doing so can be a little out of our traditional comfort zone, understanding business models and value creation has always been a core competency for us. That means we must become as adept at describing the intangible as we always have been with the tangible.