Understanding Intangibles as an Investment

One of the difficulties in managing intangibles has been making them understandable and measurable. The Corrado, Hulten, and Sichel (C-H-S) framework has done an excellent job of this at the macroeconomic level. But at the firm level, little has changed on that subject since my working paper Reporting Intangibles back in 2005.

That may be changing. Michael J. Mauboussin and Dan Callahan at Morgan Stanley have produced an excellent primer for investors: One Job: Expectations and the Role of Intangible Investments.

The paper looks at the nature of intangibles and how to measure them. When it comes information provided to investors, however, Mauboussin and Callahan’s bottom line is that the bottom line has lost its usefulness. “It used to be that earnings were on the income statement and investments were recorded mostly on the balance sheet,” they note. “The rise of intangible investments means that the bottom line is now a mix of earnings and investment.” Since accounting standards “do a poor job of reflecting the rise of intangible investment,” their advice is that a “thoughtful investor’s best response is to make the adjustments necessary to see the world as it is.”

Thankfully, the article provides some guidance on how to make that adjustment and allocate information provided by companies between expenses and investments. They cite a 2017 paper by Luminita Enache and Anup Srivastava (E-S), “Should Intangible Investments Be Reported Separately or Commingled with Operating Expenses? New Evidence.” As Mauboussin and Callahan describe it:

Their [Enache and Srivastava] approach starts with total SG&A [sales, general, and administrative costs] subtracts R&D and advertising, generally considered intangible investments, to come up with what they call “Main SG&A.” They then assess what part of Main SG&A is necessary to maintain the business (“Maintenance Main SG&A”) and designate the remaining Main SG&A to intangible investments (“Investment Main SG&A”). Maintenance Main SG&A, which is matched with sales, captures costs such as office and warehouse rents, customer delivery costs, and sales commissions. Investment Main SG&A reflects spending that seeks to build organizational assets and includes employee training, customer acquisition costs, and software development.

Updated to 2019 data, this approach is generally consistent with the macroeconomic findings, based on C-H-S.

Of course, this does not answer all of the questions about accounting for intangibles. For example, there is still the question of valuation of an asset that cannot easily be separated from the value of the ongoing enterprise. And, as Mauboussin and Callahan note, applying the E-S framework can be difficult.

But still, the Mauboussin and Callahan article is a useful step forward and should be widely read.

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