Time for a revolution in financial reporting?

Time for a revolution in financial reporting?
The tortuous attempts by accounting bodies to account for intangible assets has been an abject failure
David Haigh
By David Haigh | Fri Apr 30, 2010
TAGS: Cadbury, financial reporting, Kraft, RHM

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In 1988, Ranks Hovis McDougall (RHM) shocked the accounting world by conducting a brand portfolio valuation during its defence against an unsolicited takeover bid by Goodman Fielder Wattie Limited (GFW). RHM put the brand values in its balance sheet even though the brands were ‘home grown’. The International Accounting Standards Board (IASB) subsequently banned this accounting treatment. Brands and other intangible assets may now only appear in balance sheets if they are acquired, and then only at the price paid.

The IASB is concerned that if companies are permitted to value and revalue internally generated intangible assets in their balance sheets, it will lead to creative accounting. However, it is often hard for companies to communicate their real asset value to shareholders.

The result is that strongly branded companies can find their shares marked down to unacceptably low levels, and then fall victim to opportunistic bids. Management naturally wants all investors, not just asset strippers and vulture funds, to understand their true worth.
In 1989, Rowntree was taken over after a bidding war between Suchard and Nestlé. Nestlé eventually bought Rowntree for £11 per share. Rowntree’s brands and intellectual property were transferred to Switzerland and KIT KAT became a global powerbrand. But Rowntree’s pre-bid share price was only £4.50 and many argued that the markets had failed to understand the real value of its brands.

In 2009, the acquisition of Cadbury’s was therefore like déjà vu. A world famous Quaker chocolate company, based in the north of England, taken over by a foreign food conglomerate after a protracted bid battle. Ferrero, Hersheys, Nestlé and Kraft pushed the Cadbury’s pre-bid share price from £4.50 up to £9, although some analysts said it was worth £10 a share.

The implied Enterprise Value of Cadbury’s was £12 billion. But the company had managed to reduce its fixed capital, minimise its stock and debtors and extend its creditor balances to such an extent that its net tangible assets were effectively zero. This meant that the whole £12 billion was attributable to brands and other intangibles, most of which appear nowhere in the Cadbury’s balance sheet!

The Kraft takeover of Cadbury’s demonstrated that the tortuous attempts by accounting bodies to account for intangible assets has been an abject failure. The Financial Reporting Council (FRC) recently reviewed the first five years of compliance with International Financial Reporting Standard (IFRS) 3, the standard introduced in 2004 to better explain acquired tangible and intangible assets. The FRC concluded that CFOs generally do not take disclosure seriously and that IFRS 3 has not improved the role of published financial statements in explaining either enterprise or individual intangible asset values.

Meanwhile, in January 2010 the International Valuation Standards Council (IVSC) published its guidance notes 4 and 16 which provide a recommended approach to the valuation of intangibles. The International Standards Organisation (ISO) will shortly publish it ISO 10668 standard on brand valuation. These standards both took valuation experts three years to write and provide reassurance that these elusive assets can be transparently, robustly and reliably valued. This is a major breakthrough after 20 years in which brand and intangible asset valuations were considered my many CFOs to be voodoo economics.

ISO 10668 requires a thorough analysis of legal, behavioural and financial parameters before an opinion can be reached and all assumptions and sensitivities must be clearly disclosed.
The problem now is how will ISO compliant valuations be communicated to shareholders? In my opinion, the format of published financial accounts needs a radical rethink so that asset values can be properly communicated to shareholders. This is not just a matter for accountants. It is a public policy issue. Following the acquisition of Cadbury’s by Kraft promises are being reneged on, factories are being closed, employees are being made redundant and one of the great pillars of British business has been toppled. It is quite likely that if the market had not under-valued the shares Cadbury’s would still be independent.

The Labour government has irritated the financiers by proposing tougher laws on such takeovers. However, the answer is not legislation to prevent takeovers. It is a more useful and insightful approach to financial reporting.