Integrated Reporting and Goodwill

American corporations can now record an asset named Goodwill on their formal audited financial statements. Is it so far-fetched to believe that they might eventually be permitted to record an asset named Trust as well?

With those words, I concluded my prior blog posting. But perhaps I should have continued the posting a bit further. After all, you might be wondering:

Huh? Can American corporations really record Goodwill on their financial statements? What, exactly, does that mean? And how, precisely, is it measured?

Well, when a company acquires another firm, it sometimes pays a price that exceeds the value of that firm’s recorded net assets. Although it might simply be overpaying for the firm, it’s also possible that it is paying a premium for certain net assets of the acquired firm that are not recorded at all.

What kinds of assets are not recorded at all? Trust, perhaps. A well trained work force. A reputation for using innovative practices to avoid polluting the natural environment. Although such assets do exist, they are often very difficult to value and are thus unrecorded on the traditional financial statements.

However, when American corporations pay acquisition prices that exceed the value of the acquired firm’s net assets, the amount of the overpayment can often be recorded as Goodwill. This serves as a generic catch-all name for any such unrecorded assets.

And yet, if one doesn’t know how much of Goodwill is attributable to each specific unrecorded asset, then how can one determine whether those assets will continue to exist after the time of the acquisition? For instance, if a company records Goodwill (as a catch-all asset) during an acquisition that is made in the year 2015, how can it possibly know what the components of Goodwill are worth in the year 2016?

The answer to that question might be found in an alternative form of accounting known as Integrated Reporting. According to the <IR> framework, there are six “capitals” that companies use to produce goods and services.

Financial capital (such as cash) and manufactured capital (such as factories) are owned by companies and are recorded in the traditional financial statements. Intellectual, human, and social relationship capital are also owned by companies, but are not recorded in the financial statements.

And then there is natural capital, which refers to the environment surrounding companies. Although companies don’t own their surrounding natural environments per se, they might indeed own pollution credits or other rights to use natural resources.

Though the <IR> framework refers to these six resources as “capitals,” they also represent assets that can be utilized by companies to produce products and services. Thus, consistent with the <IR> framework, Goodwill can be sub-divided into the types of assets (or “capitals”) that do not normally appear on the financial statements, namely: intellectual, human, and social relationship assets.

Trust itself would thus represent a social relationship asset. A well trained work force would represent a human asset. And the innovative practices that prevent the pollution of the natural environment would represent intellectual assets.

Why is this classification system helpful? Well, in the very first paragraph of this posting, we asked whether an asset named Trust might eventually join Goodwill on the financial statements. Under the <IR> system, however, if Goodwill appears in the financial statements, Trust (if it exists) would reside within an implicit component of it.

Indeed, Trust would reside in the social relationship asset. And human and intellectual assets would represent components of Goodwill as well.

Still not convinced that this classification system is helpful? Then let’s look at the situation a bit differently. If you purchase a firm (or any other item, for that matter), you should always understand precisely what you are actually buying.

If a major asset within your newly purchased firm is simply called Goodwill, then you can’t possibly know with any precision what is included therein. But if Goodwill is divided into social relationship, human, and intellectual assets, then you more likely can know so.