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Traditional accounting or financial management? David Allen looks at how the growing interest in valuing intangible assets can help managers to define the true worth of a business

The idea of putting a value on intangible assets has become increasingly popular over the past couple of years. Various advertising agencies, for example, are urging accountants to put values on their companies' brands. Others, including auditors, cast the net wider to cover intellectual capital. Sadly, a key component of the argument is that, unless such values are incorporated, the company's balance sheet will not indicate the worth of the business.

A considerable proportion of my work comes from chief executives who have lost patience with their accountants' preoccupation with the way assets are defined for balance sheet purposes. The problem is that, in conditions of rapid change, the things that the accounting model calls assets are likely to prove strategic liabilities. Property is in the wrong place, plant is less flexible than that of competitors and, in a just-in-time environment, stock is a sign of failure.

In these businesses, the most important assets are things such as pace of innovation, reputation in the marketplace, ability to attract and retain good people, and the speed with which they are able to respond to changing customer needs. Significantly, such assets result from investments which the accounting model must treat as costs to be deducted from current revenue (research and development, marketing, training and information management respectively). The easiest way to increase short-term profits is to skimp on the very investments needed to ensure survival.

The problem, of course, is that the values of those assets are not objectively verifiable, and so are not auditable. If you can't kick it, your auditor can't tick it. Value, like beauty, is in the eye of the beholder. It can be quantified, but only subjectively. In this context, it means the net present value of projected benefits (in the case of a distributable profit-seeking enterprise, projected cash flows).

There is a major difference between accounting and financial management models. The former is based on simple adding up and taking away: the net worth on the balance sheet is the algebraic sum of the costs not yet charged against revenue plus the anticipated profit inherent in the debtors figure. The value of the business, on the other hand, depends on the interaction of its prevailing strategies.

Let's look at two archetypal revenue investments -product development and advertising:

* The value of an investment in product development is obviously a function of the increase in demand which it creates (the exact function depending on such factors as unit contribution). In turn, the increase in demand will depend on the extent to which potential customers are made aware of the improvement through advertising.

* The value of an investment in advertising depends on the extent to which customers who try the product are convinced that it is competitively superior. That depends on the quality of the product, which is influenced by the level of investment in product development.

In isolation, each investment may have a negative impact on the net present value of the business but, together, they could have a positive impact. Of course, many other investments also interact -- investment in training might lower the variable costs of the product and therefore increase its contribution and the value of advertising. It would be foolish to try to put a value on each of the asset categories, hoping that this equalled the total value of the business. The value of a business is holistic, not additive.

But before you say farewell to the numbers produced by the accounting model, consider a question I received from a group chief executive when I was reviewing the strategic progress of a constituent division acquired a year earlier. The division used a strategic financial management (SFM) approach to monitoring, and this put the closing entity value at around 20 million [pounds sterling], whereas the closing assets shown in the accounts amounted to just 5 million [pounds sterling].

The group chief executive asked for a reconciliation of the key numbers. He asked: "What is to stop a competitor buying 5 million [pounds sterling] of kit, to match your capability? If he does, and is happy with a reasonable return on that sum, whereas you are seeking to get a return on 20 million [pounds sterling], is he not going to undercut you and drive you out of business?"

The divisional chief executive pointed out the fallacy in that logic. She was convinced that her business had the best product on the market, thanks to the quality of its workforce. Anyone who wished to match her capability would need to make a substantial investment in training. The business had an excellent reputation with customers, so the competitor would need to invest substantial sums in marketing. The 20 million [pounds sterling] also included benefits expected from new products that would result from the investment in research and development, and so on.

You might say she was listing intangible assets. In strategic terms, she was listing the sources of competitive advantage and barriers to entry. Her conclusion was that anyone who wished to match her capability would need to invest at least 20 million [pounds sterling], and therefore she felt safe seeking a return on that figure.

The important issue was that two executives were using the language of financial management to highlight the real assets of the business. They appreciated the importance of those assets and looked at how they could be enhanced and did not try to skimp on the investments which created them. Strategy and finance were in harmony and the finance function was assured of a place at the top table.

David Allen is a past president of CIMA. He has been a financial director at Cadbury Schweppes Group and is a director of consultancy firm SFM. He is a non-executive director of a number of companies.
COPYRIGHT 2001 Chartered Institute of Management Accountants (CIMA)
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Copyright 2001 Gale, Cengage Learning. All rights reserved.

Article Details
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Author:Allen, David
Publication:Financial Management (UK)
Article Type:Brief Article
Geographic Code:4EUUK
Date:Jan 1, 2001
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