Denice R. Preston
The shift towards a digital economy has been accompanied by a more significant percentage of value for enterprises 84% of the S&P 500 – derived from intangible assets, including the patent system and computer software. However, accounting regulations aren’t up to speed with this trend, and the current disclosure practices may give a false impression to investors.
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Current accounting guidance guidelines don’t precisely capture the value drivers for digital businesses. They are not as accurate as they would be for conventional physical goods-based firms. Valuing assets in physical goods businesses is relatively straightforward: Take the fixed asset and then depreciate it along the x amount of time.
What do you think of when an asset’s investment is primarily intangible, such as patents, software, and brands? In my experience with finance and strategy, I’ve seen these topics become more relevant in the context of the shift towards a digital economy and the growing importance that tech companies enjoy in our lives and, in particular, the market. For instance, consider Alphabet, the parent company of Google, and reported a $1.3 billion operating loss in 2019 for moonshot projects classified as “other bets” on its earnings line. What is the best way for a discernible investor in Alphabet to determine the value of such expenses when compared with a company that bought a brand modern warehouse?
In a nutshell, based on my experiences with my time in the PwC Transaction Services team, I will outline why this is a problem and my suggestions on how to fix it. I will discuss how recent ways digital companies are evaluated and benchmarked have created issues in accounting and financial statements. After that, I’ll provide suggestions for financial guidance and reporting so that the worth of digital businesses is correctly and accurately recorded.
The Digital Industry: Financial Reporting and Evaluation Framework
In the past 10-20 years, we have witnessed a rise of digital and technology-based businesses in the US economy. We have observed the shift from companies that provide physical products to companies that offer information, digital products, and services.
I’m thinking about companies like Disney, Netflix, Facebook, Google, LinkedIn and numerous others. Beyond the digital realm, corporations generally invest in the intangibles of software, technology customers, brands, and customers, in addition to physical assets, property, machinery, and plants. A substantial part of corporate balance sheets comprises intangible assets instead of physical assets. While 30 years ago, it was different. Today, there is a gap of about 5 percent between the two corporate America.
Investment Rate by Type of Asset as Percentage of Private-Sector GDP
This digital shift has led to new strategies for monetization and business models. This has resulted in different revenue sources, sharing of information possibilities efficiency, productivity, and efficiency increases, which has increased business profitability and market expansion. Customers have also benefited from a greater emphasis on customer service improvement and accountability to ensure product and service satisfaction.
Digital transformation has, however, increased the complexity and complexity of financial decision-making, financial reporting, and accounting guidance that market participants and investors make their capital market decisions on. This leads to the question: Does our current system accurately represent the worth of these companies and the tangible assets they rely heavily on?
How is the Valuation of Intangible Assets Conducted?
Conventional estimation methods employed by companies use methods like DCF analysis and comparatives analysis to accurately estimate a company’s worth or a specific asset value. Though highly efficient, these methods only apply to firms creating steady revenues and cash flows, enduring steady increases in their earnings, and frequently having a significant amount of their assets into fixed assets. In addition, these companies depend heavily on sales of physical products. What about digital businesses that sell intangible products to the touch? What is their value, and how can you make it possible to capture the value of something you cannot be able to touch?
One method I can inform you based on my experience with Transaction Services is utilizing the cash flow and earnings methods specially designed for assessing the intangible assets’ worth. These could include various assets, like trade names, technology, customer relations, film libraries, and research and development.
Current Financial Statements Don’t Capture Value of Digital Companies
While essential and mandated by monetary authorities, the current framework for financial statement reporting does not necessarily reflect the return generated through intangible assets. Digital businesses create significant portions of their brand equity and are worth using intangible assets. The issue is: How are financial statements measuring the value of these intangible assets? It’s not like they’re performing the task correctly.
According to merchant bank Ocean Tomo, In 2015, intangible assets comprised about 84 percent of the worth of S&P 500 companies. As I’ve previously mentioned, they are essential factors in the growth of businesses. They are one of the major catalysts behind the bull market we’ve observed in recent years in public exchanges.
Market Value of Intangible Assets, S&P 500
However, under the current accounting regulations, US companies aren’t allowed to include these items in their accounts as assets, which is a significant flaw (unless the assets were purchased through or through an M&A agreement). Instead, these items are internally accounted for on the income statement according to US GAAP. In contrast, specific industries like industrial retail, which are more physical, are permitted to capitalize on their tangible capital assets (e.g., PP&E and tooling) and are key value drivers.
This means how much a technological or digital business invests in growth and advancement through intangible investments in the long run; it’s also losing money through more operating expenses. Additionally, we should consider the fact physical assets decline and lose value when used, whereas tangible assets rise with usage. Take, for instance, an eCommerce website or social media site. The more people who visit the site, the more beneficial it is for the company, as this can bring advertisers and customers to the website. Therefore, there is more network effect for everyone affected.
