What is the point of financial reporting? This is a question that could seem like an existential crisis caused by too many months working from home, sat staring into the garden. But rather than simply being a case of me questioning my entire career, this question is one I pondered during a recent panel discussion at PwC’s Meet the Experts conference in November.
I suppose it would be useful to look at the International Accounting Standards Board’s stated objective of financial reporting for help with an answer. The IASB’s goal is ‘to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions’. That is the quest on which many of us brave, party-avoiding souls are attempting to embark.
Valuation gap
Ian Bishop, head of accounting for the Roche group, stated during the November conference that the group had a market capitalisation of €300bn but net assets of only €40bn. He pointed out that this must mean that either the company was vastly overvalued or that financial reporting is simply failing to capture the true value in many entities (he was, of course, keen to stress it was the latter).
In many ways it feels like the financial reporting industry is at a crossroads. It’s fair to say we’ve been inching towards this juncture for a while, but the underlying problem is this: in far too many cases, the current system of recognition of assets bears little or no relation to the market capitalisation of entities. This column has raised this issue before (see AB, November 2018), and if anything the situation has worsened.
In far too many cases, the current system of recognition of assets bears little or no relation to the market capitalisation of entities
Apple, Amazon and Microsoft all have market capitalisations of more than US$1.5 trillion. Of these tech behemoths, only Apple records total assets of above US$300bn. Of course, the job of financial reporting isn’t simply to try to match to the volatile world of share prices, but very few people would argue that there isn’t a significant disconnect here.
The disparity has been brought even further into focus with Pfizer’s announcement of successful results from trials of its Covid vaccine. Of course, Pfizer’s share price rose dramatically, but it’s likely that the value of any asset vaccine recorded on its balance sheet will be insignificant compared with its market value.
Any vaccine asset recognised by Pfizer is likely to be recognised at either the cost of any licences or patents registered, plus any research and development that is capitalised. As development costs can be recognised only once stringent criteria for capitalisation have been met, the reality is that any asset recognised will bear no significance to the actual value the vaccine creates for Pfizer.
Internally generated
The recognition and measurement of intangible assets is becoming an urgent issue in the modern economic environment. You can have intangible assets that are internally generated that can be sold, such as a licence or patent. They are separable, owned and will have a price, but they are often unrecognised in the balance sheet. Even if they can be recognised, as is the case in R&D costs, the amount recorded is often a mere fraction of the benefit that can be expected from the asset.
In order to solve this problem, there has to be an element of fair value. To recognise internally generated assets, or to reflect a more accurate position on items such as development costs, it has to be possible to revalue such items. In theory such a concept exists under IAS 38, Intangible Assets, but the standard acknowledges that revaluation is rare.
Any asset recognised will bear no significance to the actual value the vaccine creates for Pfizer
The examples it gives of items that would qualify for revaluation (including fishing licences and taxi licences) simply highlight the standard’s failure to capture the value of digital assets. That, certainly, is to be expected from a standard written in 1998 (while I was still at school dreaming of ‘making it’ as a professional footballer). The world has changed beyond recognition since then, yet the standard has remained the same.
A seismic shift
Most analysts accept that the balance sheet simply fails to capture the value in many entities. To move towards an approach that is based more on fair value will naturally cause some level of concern among accountants. For things to change, it will take a big step into the unknown and need agreement from preparers, auditors and regulators. It would be seismic, but it feels needed.
As accountants, we will naturally find this difficult. We tend towards the more verifiable end of the scale. A level of prudence is a good trait to have, but if it serves to make the balance sheet less and less relevant, then we come back to the original question: what is the point of financial reporting?
