Financial Fundamentals: Recording and Managing Non-Physical Assets Financially
In the dynamic world of business, intangible assets have become a significant part of many entities' value. These assets, which can encompass marketing-related, customer-related, artistic, contract-related, and technology-related elements, are often overlooked in traditional accounting practices.
Contrary to tangible assets, constructing an intangible is recorded as an expense, not an asset. This is the case whether an intangible is purchased or created within an entity. For instance, Amazon, in the early 2000s, expensed all costs related to its website, leading to a shareholders' deficit in its balance sheet year after year, despite a high market price of its stock.
This practice of not recording intangibles as assets can skew financial ratios such as return on assets, return on equity, or debt to equity, potentially misleading readers. The financials do not include most intangibles as assets, a situation that has changed little over the years.
However, the value of intangibles is undeniable. Investors value these assets highly, with up to 84 percent of the market value of S&P 500 entities being intangible, an increase from 32 percent only 30 years ago. This shift from brick-and-mortar business models to technology-based business models has been highlighted in a recent PwC publication.
The authors of the book "The End of Accounting and the Path Forward for Investors and Managers," Baruch Lev and Feng Gu, assert that financial accounting needs to record more intangibles as assets in order for accounting to be relevant to investors. This would provide a more accurate reflection of a company's economic performance.
Entities creating intangibles of considerable value may appear near bankruptcy based on their financials. For example, Alphabet Inc.'s 2015 balance sheet lists PPE at $29.0 billion and intangible assets at only $3.8 billion, while the value of the Google brand is over $120 billion. Similarly, The Coca-Cola Company's balance sheet for 2015 records trademarks at $6.0 billion while PPE is $12.6 billion, but estimates of trademark and brand value for Coca-Cola reach $80.0 billion.
Managers may attempt to communicate how their activities are creating value since the financials, in the view of many capital market participants, are not reflecting entities' economic performances. Articles comparing financial statements to intangible asset economic activities may garner an interested readership.
It's important to note that not all intangible costs are expensed. Some costs directly related to internally generated intangibles are measurable and can be recorded as assets, but they are often small amounts. The accounting for internally generated intangibles contrasts with the accounting for internally generated plant and equipment, where construction in process is an asset.
In conclusion, the rise of intangible assets in modern businesses necessitates a reevaluation of accounting practices to better reflect the true value of companies. As we move forward, it's crucial for investors and managers to understand the significance of intangible assets and the potential impact they have on a company's financial health.
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