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.

Quantifying The Value Of Trust

Once again, I am deeply grateful to my friends and colleagues who have offered such passionate responses to my prior blog post In Corporations We Trust. In that post, as in the previous one entitled Is Trust Necessary?, I suggested that politicians and business professionals need not worry about a lack of trust between nations or organizations if verification controls are in place to monitor the activities of the parties.

Nevertheless, I also suggested that the existence of trust can be extremely beneficial, and that trust itself represents a valuable asset that is increasingly recognized by accounting and metrics organizations like the International Integrated Reporting Council (IIRC) and the Global Reporting Initiative (GRI). In fact, I noted that these organizations have directly inserted the concept of trust into their core frameworks and paradigms.

So why the passionate response from my readers? Apparently, many are skeptical that any one can place a value on trust. Although they agree that trust represents a conceptual corporate asset, they cannot see how any one could ever assign a monetary value to it. And yet, despite their skepticism, the equity markets are already doing so.

Imagine, if you will, two nearly identical companies that compete directly with each other for a single customer segment with a single product. But let’s imagine that Company A is deeply trusted to treat customers in a respectful manner, while Company B is sorely mistrusted because of a history of rude service.

Even if Company B revamps its service function, if customers remain distrustful of the firm, its equity market value would likely languish behind the comparative value of Company A. Thus, Company A’s premium value would be attributable to the value of an intangible asset called Trust.

Of course, one might argue that Company A might become so blindly committed to this asset called Trust that it might fail to pursue beneficial opportunities to roll back or outsource its customer service function. In that case, the equity market value of Company A might fall below the comparative value of Company B.

Even under such circumstances, though, trust would possess a value. Instead of representing an intangible asset of Company A, it would represent an intangible liability of Company A. And its value would be equal to the premium value of Company B’s stock in comparison to Company A’s.

In other words, to the extent that the existence of trust (or mistrust) affects the future financial performance of any corporation, it will likewise affect the current valuation of that corporation. And thus, such trust can be modeled as an asset or liability with a specific financial value.

Does that mean that the Financial Accounting Standards Board (FASB) in the United States, or the International Accounting Standards Board (IASB) in other nations, will ever permit Trust to be recorded in the formal audited financial statements as an asset or liability? Quite possibly not; after all, those accounting regulators tend to respond conservatively to any proposal that involves significant changes to the traditional accounting model.

But just as investment analysts routinely transform the traditional definition of Operating Cash Flow to the contemporary definition of Free Cash Flow, they might indeed be willing to adopt transformational definitions of assets and liabilities as well. And when they do so, trust will represent a meaningful off-balance sheet asset or liability, similar to other off-balance sheet items that can immensely impact the value of a corporation.

Furthermore, who’s to say that the conservatism of FASB and the IASB will last forever? After all, 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?

From Detroit To Miami: Shifty Finances

If you’re a financial specialist who specializes in the municipal bond market, you were probably fixated on the news about Detroit, Michigan last Thursday. After all, the announcement of the largest municipal bankruptcy filing in American history reminded investors of Meredith Whitney’s 2010 prediction of the imminent fiscal collapse of dozens of cities.

Nevertheless, just one day later, an even more worrisome announcement was released for public consumption. The United States Securities and Exchange Commission (SEC) revealed that it is charging the city of Miami, Florida and its former budget director with securities fraud for making false and misleading statements about certain fund transfers. In other words, the city and its chief fiscal officer are accused of lying to the capital markets.

Because an advanced understanding of municipal accounting principles is often required to distinguish between true and untrue statements about fund transfers, the Miami story received far less news coverage than the Detroit story. Nevertheless, the Miami story may ultimately generate far more significant concerns for investors.

That’s because, even if Ms. Whitney proves to be correct, her predicted fiscal collapse would only involve a limited number of municipalities. The types of accounting practices that were charged by the SEC, though, represent much more pervasive problems.

In essence, the SEC has accused the City of Miami of inappropriately shifting monies in and out of certain high visibility funds in order to improve their cash positions. For instance, the regulator has charged that the city “orchestrated … transfers from (its) Capital Improvement Fund to its General Fund in order to mask increasing deficits in the General Fund, which is viewed by investors and bond rating agencies as a key indicator of financial health.”

Of course, shifting monies from one account to another is merely one approach that government officials take to hide financial shortfalls. Former Minnesota Governor Tim Pawlenty, for example, had been accused of shifting spending obligations from his state government to localities in order to improve his own fiscal budgets.

Connecticut Governor Dannell Malloy avoided such cost shifting activities, relying instead on tax increases and other tactics to balance his state’s budget. Interestingly, though, Malloy did opt to delay Connecticut’s adoption of Generally Accepting Accounting Principles (GAAP) by at least two years, a shift that allowed him to defer the recording of certain GAAP costs.

Such accounting shifts have long been employed in the private sector as well as the government sector. The accounting profession has adopted the phrase earnings management to describe such practices.

If the SEC is successful, though, some of these practices may come to be known by another phrase as well; namely: “criminally fraudulent activities.”

How Many Accounting Standards Do We Really Need?

Are you aware that two different sets of accounting standards exist around the world? American organizations follow Generally Accepted Accounting Principles (GAAP), whereas other organizations adhere to International Financial Reporting Standards (IFRS).

Although the two sets of standards share many similarities, they maintain several important differences as well. Nevertheless, one might guess that a single set of unified standards would represent a desirable goal, and that the existing two sets of standards would provide more than sufficient flexibility to satisfy every entity.

Is this your guess as well? Then perhaps you should guess again! Last week, the experts at the Financial Accounting Foundation who maintain GAAP announced that a third set of standards is now available. Small and medium sized entities can choose to follow a “non GAAP” set of standards that is much simpler than traditional GAAP.

On the one hand, it is difficult to take umbrage with the Foundation’s announcement. After all, traditional GAAP is regarded as a terribly complex accounting framework by even the largest and most sophisticated global organizations. It undoubtedly imposes an onerous regulatory burden on entrepreneurial groups.

And yet, wouldn’t it be preferable to simplify GAAP for all organizations, as opposed to developing alternative standards for various “non GAAP” organizations? Multiple sets of standards may cause inconsistency and thus confusion among financial statement users, thereby further complicating an already troublesome status quo.

Indeed, if the Financial Accounting Foundation continues to create customized “non GAAP” standards for various groups, its activities may result in chaos. So how many sets of accounting standards do we really need? The answer, perhaps, should be “as few as possible.”

Power, Money, and (Legal) Loopholes

Score one for the “old media” scions of journalism! Thanks to the investigative reporters at CBS News’ Sunday program 60 Minutes, the STOCK Act has now been passed by both houses of Congress and appears to be on its way into the law books.

The Act prohibits members of Congress from engaging in insider trading activities. Once passed, our elected officials will no longer be able to trade on confidential information that they obtain while performing their governmental duties.

It’s always a pleasure to watch the venerable news program, one that came of age over 40 years ago, serve the public interest by practicing the profession of journalism. But isn’t it odd that, at this moment in time, federal officials are still permitted to engage in insider trading?

Loopholes, Loopholes, Loopholes

Apparently, the criminal laws that prohibit insider trading have never covered members of Congress. Although they’ve been employed for decades to imprison business executives from the fictional Gordon Gekko to the real Martha Stewart, they’ve never been applied to our Congressional officials, thanks to loopholes that were written into the law by those same officials.

Such loopholes are, regrettably, relatively common. Elected officials at both the national and local levels, for instance, are often permitted to spend their political campaign contributions for personal benefit. And when Indiana Senator Evan Bayh recently announced that he would retire from government, government officials confirmed that he could dedicate his $13 million campaign fund to any legitimate charitable or political purpose.

To be sure, Bayh has undoubtedly earned far more money after leaving office by joining the “K Street” Washington law firm McGuire Woods and the private equity firm Apollo Global Management. Nevertheless, even though Senator Bayh has never been accused of committing an illegal act, the existence of the campaign contribution loophole — like the existence of the insider trading loophole — feeds the sense of ethical skepticism that Americans harbor about government ethics.

Words vs. Deeds: A National Republican

A similar sense of skepticism is generated when our elected officials fail to take the time to explain technical business concepts to the general public. Consider, for instance, the issue of Republican presidential candidate Mitt Romney’s recent tax returns. According to the Romney campaign, he simply pays the stipulated 15% tax rate that is applicable to long term capital gain transactions.

What they fail to explain, though, is that the vast majority of Romney’s earnings are not classified as capital gains at all. They’re actually deferred earnings, which — due to another loophole in the federal law — are classified as carried interest and are taxed at the 15% rate.

Like Democratic Senator Bayh, Republican candidate Romney follows the law and simply takes advantage of existing loopholes. And yet, by failing to fully explain the technicalities of the situation to the American people, Romney’s campaign arguably feeds a sense of public skepticism in government.

Words vs. Deeds: A Local Democrat

Some loopholes, incidentally, are verbal (and not legal) statements that utilize technical business jargon, albeit in ways that are incomprehensible to the general public. Last week, for instance, in the annual Governor’s State of the State Address in Hartford, Connecticut, Governor Malloy proudly proclaimed that his administration “brought honesty and transparency to the state’s books by moving to GAAP.”

He was referring, of course, to his heavily publicized (and deservedly praised) Executive Order #1, which ordered the Nutmeg State to adopt Generally Accepted Accounting Principles (i.e. GAAP) in lieu of non-traditional budgetary accounting methods. What he didn’t mention, though, was that he followed his Executive Order #1 with a subsequent order to delay GAAP’s adoption by two years. In other words, at the present time, Connecticut is not yet utilizing GAAP.

If a Governor initially announces the adoption of GAAP, and then subsequently delays its adoption, is it fair to assert that his State has moved to GAAP? It depends on how you interpret the phrase “moved to GAAP,” doesn’t it? The vagueness of the phrase itself represents a verbal loophole of sorts, given that very few citizens have any idea what it really means.

Power to the Press

And that’s why press stalwarts like 60 Minutes generate civic value. Once American citizens understand how these loopholes actually function, and what these technical terms truly mean, they can apply pressure to their elected officials to act more transparently and speak more clearly.

The STOCK Act, after all, languished for six years until 60 Minutes presented a story about it last November. Then, in response to public pressure, our Congressional leaders finally began to move it towards passage.

Although “new media” companies have earned a significant amount of respect for contributing to the public discourse, the 60 Minutes story demonstrates that “old media” journalists remain a potent force as well. Whether or not you read newspapers and watch traditional television newscasts, you are undoubtedly benefitting from their investigative activities.