The FRC’s relatively unheralded discussion paper on business reporting on Intangibles, in respect of which the consultation period has recently ended, raises far-reaching but little discussed issues not only on the future of corporate reporting but also for Sir Donald Brydon’s review on the future of audit.
For most modern businesses the vast majority of their value arises from their intangible assets- their brands, intellectual property in other forms such as patents and copyright and their human capital-and yet few of these appear in their financial statements. At least as importantly, they are only generally vaguely covered in the narrative report. As a result, the relevance of financial statements is coming under severe challenge and, no matter how good the audit is, if the underlying accounts on which the audit opinion is issued do not meet the expectations of stakeholders, in terms of representing the economic reality of the business, it is unlikely to be well regarded. And its fundamental role in the case of listed companies of providing confidence to the capital markets on the reporting by companies of their performance, position and prospects is likely to be severely undermined.
For the above reason, the FRC‘s discussion paper is welcome. As the title suggests, it is a pragmatic step forward in considering the issues, more than a sticking plaster over a very open wound but not an integrated long-term solution. One of the challenges the paper faces is that issues such as when intangibles should be included on the balance sheet and at what amount are really beyond the FRC’s scope as they are primarily the province of the International Accounting Standards Board and are currently dealt with in IAS38 Intangible Assets.
There is an important clue in the title of the standard- it is an IAS rather than an IFRS, the former being the name of the standards issued by the predecessor body to the current IASB and IAS38 in fact goes back to 2004. Just think of how the business world and the nature of intangibles has changed over the past 15 years with interlinked advances in technology and communications and the emergence of new business models across a range of sectors. It is puzzling when an enormous amount of time has been spent on issues such as accounting for leases and for insurance contracts why intangibles has not been high on IASB’s agenda. Some suggest it is because it raises issues that are difficult to address within our current accounting framework.
The most useful section of the FRC’s discussion paper probably relates to narrative reporting where the FRC, or its successor, can itself implement change. It raises a number of helpful ideas including reporting on intangibles that are closely linked to the current business model and providing much better metrics on them. Useful improvements suggested include setting out the relevant metrics used by management and with those disclosed being clearly defined and prepared on a comparable basis as that adopted by industry competitors. It is also proposed that metrics provided should cover a number of reporting periods and that there should be suitable discussion of the figures.
If, however, key elements of the business are to be primarily found in narrative reports this points to the need for the proposed new regulator, the Audit, Reporting and Governance Authority (ARGA), to increase its scrutiny of narrative reporting, as recommended by the Kingman Review. It also suggests the narrative report should be subject to full assurance to help ensure it is fair, balanced and understandable.
Moving forward on narrative reporting nationally does not, however, reduce the need for progress internationally, on the contrary it highlights the fact that it is long overdue. A thorough review is now needed of how intangibles are recognised in financial statements and, in particular, whether we can continue to justify the huge disparity in the number of purchased intangibles that appear in the accounts compared to their internally generated counterparts which rarely do. On the other hand, some care is needed to only to allow those intangibles with sustainable value which can be reliably measured to be capitalised. We also need to look more closely at the future relationship between IFRS and wider aspects of reporting as covered by, in particular, by the International Integrated Reporting Council with its six types of capital including human, social and relationship, intellectual and natural as well as the traditional financial and manufactured capitals.
We must delay no longer in moving reporting on from its 19th century roots in the industrial revolution and bringing it up to date and fit for purpose for the third decade of the 21st century.