If your business exists within a labour-intensive industry such as software, then it is likely your accountant is penalizing your valuation. This is not their fault!  Your highly capable accountant is hamstrung by accounting standards that are not able to accurately measure the value of human capital.

Over the past 50 years, there has been a gradual – though seismic –  change in the composition of leading corporations across the globe.  This is due to major economies transforming from post-industrial to knowledge-based. Within such an economy, the production of goods and services is based principally on knowledge-intensive activities. The key element of value is dependent upon human capital and intellectual property. In other words, a knowledge-based economy relies on the crucial role of intangible assets in facilitating modern economic growth.

In 1975, intangible assets made up approximately 14% of the S&P 500’s total enterprise.  The leading companies in those days were IBM, Exxon Mobil, P&G, GE, and 3M.  This is to say, assets that did drive value in the 70s were tangible.  For example, machinery, inventory, factories, and plants.  These assets sat on the balance sheet and as such, that financial statement was a fair reflection on the value-creating assets at any given point in time. 

Currently, intangible assets make up more than 90% of the S&P’s total enterprise value.  Now the leading companies are Apple, Alphabet, Microsoft, Amazon, and Facebook. Intangibles have taken centre stage and are the predominant creators of value.  Items such as software, data, brands, trademarks, and goodwill.  This trend is likely to continue with companies, particularly large technology corporations, investing more in intangibles vis-a-vis tangible assets.

The problem is the majority of investments in intangibles such as software are not reflected in the financial statements.

A large chunk of investments (i.e., R&D) in these “assets” are expensed rather than being capitalised.  This is explicitly saying that such an investment has zero value beyond the current financial year.  How can this be so?  Creating software requires a substantial investment which would generate sales for future financial periods. There needs to be an element of R&D in order to determine the most commercially viable version.  Furthermore, additional expenditure is required to market the product in order to acquire customers.  These customers will generate revenue for future years. And yet, the marketing expenditure is also expensed.

This is a result of accounting standards being stuck in the 70s.  Whilst it is a much-debated topic within the accounting sector, change has been slow.  Australia and Canada have been more progressive but global standards are moving at a glacial pace. 

It is no wonder that many listed companies are fond of presenting “non-GAAP” performance measures to their investors.  An attempt to reflect the value of human capital.

The crux of the matter is the eligibility criteria for what can be regarded as an intangible asset. A quick definition: an intangible asset is a non-monetary asset that does not physically exist.  An example would be a patent or trademark. The international accounting standard IAS 38 (incorporated into the Australian Standard  AAASB138) provides the factors when determining an invested cost as an intangible asset. 

Within these factors is the “future economic benefit” test.  The invested cost must be able to generate future measurable income otherwise it is to be expensed in the P&L.  At the onset of R&D initiatives, it is impossible to determine with certainty whether such a test can be satisfied.  Consequently, such costs are simply expensed.  The conundrum is that R&D is a necessary foundation for creating valuable assets.

In summary, with current accounting standards, earnings can be rendered as meaningless for companies that are R&D intensive or are scaling their top line through innovation.  Earnings from such companies are depressed as a result of their activities.  Moreover, their balance sheet is not reflecting all the assets that the company is utilising to generate revenue. 

Once again, human capital is not being accurately reflected in the financial statements. 

Oddly enough, while a company appears to be penalised for internally generating IP; the same company can be rewarded by acquiring a third party’s IP.  It’s called goodwill and is an asset on the balance sheet.

If a company is part of the knowledge economy, then one will need to look beyond the financial statements.  A deeper dive into the company’s ability to generate healthy operating cash flows and where its capital is invested would be a better gauge of value.  As no one company is alike, adjustments to earnings and cash flows would need to be made in order to ensure a level playing field.    

Finally, the momentum does appear to be shifting.  The World Economic Forum has reported the shifting of major groups: regulatory bodies, international organisations, investor communities, and policymakers towards creating a framework for valuing human capital. Just don’t hold onto your breath.