Intangibles

Equity analysis when accounting and economics diverge

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Analysis becomes more difficult for investors if financial statements fail to faithfully represent the underlying economics of a business. Sometimes this reflects the limitations of accounting; however, sometimes the accounting is simply misleading – for example, US GAAP accounting for loan losses.

The FASB has recently issued an amendment to US GAAP to correct an anomaly where an accounting loss is recognised when loans are acquired, even though no economic loss has occurred. We explain why accounting and economic reality can diverge, and how the US GAAP amendment will help investors.

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Football player transfers highlight wider reporting issues

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In many transactions the amount payable may not be not known until sometime after the related asset, liability, income or expense is recognised in financial statements. In some cases, the accounting for this ‘variable consideration’ is clearly specified by IFRS. However, in others, including the purchase of fixed assets, companies may adopt different approaches.

Intangible assets arising from football player transfers are a good example of where companies can apply different accounting policies for variable consideration. We use the financial statements of Manchester United to explain the challenges for investors.

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Analytical insights from DCF value analysis

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DCF based values can be analysed between a current operating value and the value created by short-term growth, medium-term investment, and long-term franchise factors. We provide an interactive value analysis model and explain how this can help in understanding and refining DCF valuations, particularly if combined with adjustments in respect of intangible investment.

DCF value analysis gives more insight than the common split between the present value of cash flows in an explicit forecast period and the present value of the ‘terminal value’ at the end of that period. We demonstrate the approach by analysing the enterprise value of UK retailers Tesco and Ocado.

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Goodwill accounting – Investors need something different

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Once every decade or so accountants fret over goodwill and reconsider how best to report it in financial statements – should it be amortised, impaired, amortised and impaired, or something else? There is no obvious right answer, positions are entrenched, and debate usually gets nowhere.

The problem is that neither amortisation nor impairment provides much help for investors. The debate needs to move on to what really matters – reporting about business value. There are already encouraging moves in this direction. It is time to apply similar innovative thinking to goodwill.

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DCF terminal values: Returns, growth and intangibles

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If DCF terminal values are based on continuing forecast cash flow, it is important that the reinvestment assumption is consistent with long-term return expectations. We provide an interactive DCF model that demonstrates four alternative cash flow growth-based terminal value calculations, along with related returns analysis.

One of the challenges when using returns in equity valuation is the limited recognition of intangible assets. Adjustments to capitalise intangible investment do not change cash flow but can help in ensuring that the assumptions that drive forecast cash flows are realistic.

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Missing intangible assets distorts return on capital

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The inconsistent and incomplete recognition of intangible assets in financial statements distorts performance metrics. Invested capital and profit are understated – to what extent depends on the business dynamics and nature and source of investment in intangibles. The combined effect is generally to overstate return on capital.

With the ever-increasing importance of intangible assets, few companies are unaffected by this accounting problem. We suggest adjustments to help your analysis, provide an interactive model to illustrate, and calculate an intangible asset adjusted return for Amazon.

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Bitcoin: The financial reporting challenge for investors

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Whether you view Bitcoin as a modern-day tulip bulb mania bubble, that will inevitably burst, or an unstoppable development in finance, one thing is certain, companies are increasingly purchasing this asset. But how do Bitcoin and other cryptocurrencies affect reported financial position and performance metrics?

There are no accounting rules dedicated to cryptocurrencies. Under current US GAAP and, usually under IFRS, intangible asset accounting is applied.  We use the reporting by MicroStrategy to illustrate why this does not provide the right information for investors and explain how you should include cryptocurrency assets in your analysis.

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Intangible asset accounting and the ‘value’ false negative

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Few people seem to be satisfied with intangible asset accounting; depending on your perspective, there is either not enough or far too much of it. What is clear is that many valuable intangible assets go unrecognised in financial statements. The result is distorted financial ratios, including price to book.

The lack of intangible asset recognition means that most investors know to use book value with caution. This may not be the case for index providers, ‘smart beta’ funds and quant-based investing where price to book ratios are used to identify ‘value’ stocks and related indices.

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Goodwill impairments may not identify impaired goodwill

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Failed acquisitions do not always result in goodwill impairments. Management optimism is part of the problem, but so is application of the impairment test in a way that maximises the shielding effect of other assets. This reduces the value of goodwill impairments for investors.

Analysing the success or failure of M&A is important to assess management stewardship. We applaud the IASB’s proposal for more disclosure, but also believe the goodwill impairment test needs a critical review. Some use the ‘too little, too late’ character of impairment to advocate re-introducing goodwill amortisation. We do not agree.

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