12 November 2019 by John Stittle
Are the current reporting rules still fit for purpose?
Intangible assets are a vital asset for many companies. But the practice of reporting one type of intangible assets, namely brands, is muddled, illogical and needs reform. Some companies ignore brands in their financial statements, others capitalise them and some companies then confusingly report brands in different ways. But just how should brands be reported fairly, meaningfully and transparently?
The importance of brands and their subsequent loss in value has been highlighted by Kraft Heinz. This US food giant has been rocked by a colossal write-off of its brands. Indeed, for a company to lose in total over $15 billion in just one financial year takes real effort. But Kraft Heinz easily met the challenge. The troubled food company, which has many leading branded food products, recognised this enormous impairment charge for intangible assets against earnings in its 2018 full year results. These impairments, belatedly published this summer, were later compounded by yet further write-offs of intangibles of over $1.2 billion. These write- offs were largely the result of a massive hit to the value of its intangible assets – that mainly comprised of its brands.
Many of the Kraft Heinz brands are increasingly regarded as being stale and reaching the end of their effective lives. Kraft Heinz has been accused of clinging to some of its branded product fortunes for far too long. Product innovation and development has been slow. The outcome is that many of its brands were previously over-stated in their financial statements, so their recent impairments have hit the company hard. Kraft Heinz’s substantial impairments of these intangible assets arose especially from under-performance in its US refrigerated and Canadian retail companies and particularly from its Kraft and Oscar Mayer global brands. Even though it generates annual turnover in excess of $26bn and has total assets of over $103bn, its intangible asset write-offs represent sizeable damage to earnings. Although Kraft Heinz correctly point out in their latest annual report that these write-offs are non-cash items in the financial statements, they do nevertheless represent a substantial destruction of shareholder value.
The importance of intangibles is also relevant to many other multinational companies. On this side of the Atlantic, Unilever recognises a net goodwill balance of £17.3bn and, in particular, other intangible assets of £12.2bn in its latest annual report. Taken together, these intangible assets including brands represent almost 50% of the group’s total assets. Although both Kraft Heinz and Unilever have substantial investments in branded consumer products, Unilever has not currently suffered from any significant impairment losses on brands.
The international reporting in IAS38 has clear requirements for reporting intangible assets – but not for goodwill which is covered in detail by another standard (IFRS3). IAS38 defines an intangible asset as an ‘identifiable non-monetary asset without physical substance’. The reporting rules insist that these intangibles should be both ‘identifiable’ and ‘separable’ – meaning they can be sold or transferred in their own right. In addition, they must be controlled by the company, and are expected to generate future economic benefits. The category includes brands, software, trademarks licences, quota rights and customer lists. However, to recognise a separate and self-developed intangible asset in the balance sheet (specifically brands) then not only must the asset be separately identifiable, but also the cost of the asset should be capable of being ‘measured reliably’. If an intangible asset fails to meet these conditions – then it is treated as an expense and written off the income statement.
But where the reporting aspects become questionable is in the difference in treating brands that are acquired and those brands that are ‘home-grown’ (or sometimes termed ‘self-developed’ or ‘self-generated’).
Admittedly, in a business combination, brand names might sometimes, in effect, be subsumed within the overall goodwill that arises on the take-over of another company. But, significantly, IFRS3, Business Combinations, permits brands to be separately recognised in the balance sheet at their fair value – if the recognition criteria are met. Unilever points out that its intangible assets which are mainly trademarks and brands are not automatically amortised but instead subject to annual impairment tests.
But what is so important for many companies and confusing for investors is that IAS38 prohibits companies from capitalising its own ‘home-grown’ brands. Essentially, the accounting regulators claim that these self-created brands must not be capitalised because they fail both the ‘identifiable’ and ‘separable’ tests – because they cannot be normally sold or transferred in their own right. For example, in practice, it would not be practical to separate and sell the branded soft drink product, Coca-Cola, from that of the company itself. The accounting regulators claim that frequently the ‘home-grown’ brand and the company itself are inextricably intertwined.
Indeed, history also indicates that ‘home- grown’ brands can be valued. Until the late 1990s there was little regulation about the treatment of internally generated (or home grown) brands. Previously companies had considerable freedom for their brand accounting treatment. Some companies used this lack of regulation to experiment with new ideas and sought advice from external brand and marketing specialists. In 1988, Rank Hovis McDougal (RHM), a highly branded UK food company was threatened with a hostile takeover by a US predator. RHM’s brands included Hovis bread, Mr Kipling’s Cakes and Golden Shred marmalade. These brands were major and fashionable assets of their time and RHM wanted to show the value of these brands in its balance sheet to deter their shareholders from accepting the predator’s low-priced offer.
In what became seen as a novel approach, RHM called in Interbrand, the brand consultancy, to value their home-grown food brands. The brands specialists then identified the previously ‘hidden value’ of RHM home grown brands by using factors such as brand profitability, support and investment and global reach, etc. The consultants concluded that the brands had a value of £678m – which allowed RHM to successfully shore-up its balance sheet defences.
But in 1997, the UK’s Accounting Standards Board intervened and prohibited the recognition of ‘home-grown’ brands in the balance sheet. Shortly afterwards the IASB followed the same practice.
A report in 2019 by WPP/Kantar compiled a ranking of the value of the leading 100 global brands. The values were determined by a complex methodology that combined ‘consumer insights with rigorous financial analysis’. Although this corporate branding is even more contentious, these valuations are sizeable. This year, Amazon occupied the leading position in global corporate brandings, with its own brand being valued at $315bn; followed by Apple ($309.5bn); and Google close behind ($309bn).
However, neither Amazon, nor Apple, nor any other company that has internally generated its own brands will recognise them in their own balance sheet. For balance sheet reporting purposes, these brands simply do not exist in financial terms – as far as the US and international reporting rules are concerned. This makes little sense - given that, for example, Coca-Cola’s branding is the very essence of a large proportion of the company’s market value. In contrast, hypothetically, if another company acquired Coca-Cola then a value could be attributed to the brand product although it may sometimes be subsumed in the acquisition goodwill. But normally, when consumer brands are acquired in an acquisition then a value is attributed to them. In other words, the key point is that a ‘home-grown’ value of a brand is ignored in the balance sheet. But, as if by magic, it suddenly appears if another company makes a successful take-over acquisition.
In an IASB conference in London this summer, it was clear that intangible assets are coming back to the regulatory agenda. Hans Hoogervorst, chair of the IASB, stated in future there “will be more focus on intangibles that underpin companies’ long-term success”. But he does admit that trying “to capture the value of intangibles is a hugely subjective exercise and would pose enormous recognition and measurement challenges”. As a start to the reporting reforms, there is no reason why companies cannot recognise both ‘home-grown’ and acquired brands in their balance sheets, provided regular impairment tests are conducted. The value of all brands will then be more transparent, even if impairment charges against profits are later required. Let’s hope the IASB and US regulators sort out this issue soon.