What does new SEC disclosures on climate mean for intangibles?

Earlier today, the Securities and Exchange Commission (SEC) released draft new regulations on how companies should report information on climate change (see SEC Fact Sheet and article in The Hill). The new rule would enhance and standardize disclosure on both the impact of climate change on the company and the extend that the company is contributing to climate change.

The new rules are part of the general trend to enhanced disclosure on Environmental, Social, and Governance (ESG) issues. The SEC took an earlier step in 2020 toward enhanced disclosure when they finalized a rule amending Regulation S-K to require disclosure of information on a company’s human capital (see earlier posting.)

As important as these new disclosures are, I am not sure that the ESG movement will necessarily get us to where we need to be. As I noted in an earlier posting, the driving interest in the new requirements for disclosure of human capital was focused on ESG issues of diversity and inclusion – not on economic performance such as improving innovation and productivity. And the focus of these efforts seems to be on outputs (i.e., the impact, costs, and risk) rather than inputs (i.e., intangible assets). Likewise, the climate change disclosures focus on the interaction between companies and the natural environment.

The attention to EGS issues is useful to the broader debate on intangible to the extent it hones in on the guiding principle of standardization: that the disclosures be consistent, comparable, and reliable. The only way to achieve these goals is for the disclosures to be mandatory. Voluntary disclosures leave information gaps that undercut reliability and do not allow the enforcement of standards of uniformity required for consistency and comparability. The question of mandatory disclosure is one that has bedeviled regulators since the beginning. Remember that there was a time when the disclosure of even basic financial data such as revenues, expenses and profits was opposed on the grounds it was proprietary. But as I noted back in 2005 in our paper on Reporting Intangibles, without such information investors and managers are flying blind.

The new rules will be out for public comment. I suspect there will be a great deal of discussion. To the extent that we can untangle the issues of mandatory disclosure from that of climate change policy, it should provide some insight as to how to proceed with additional disclosure on information on intangibles.

Is spending on intangibles always an investment?

Question: Are expenditures on intangibles an operating expense or an investment? Answer: Yes, but it requires confronting the Red Queen problem.

When we seek to measure intangibles, we invertible look at company (and national economy) spending as a metric. But not all expenditures are the same. A key concept in accounting and management is the separation of expenditures into operating expenses and investments. For the most part, intangibles are treated by account standards as expenses. Such a framework is, however, controversial. There is a long history of arguing that intangibles should be treated as an investment rather than an expense.

The logic behind this argument is straightforward: expenses are negative and should be minimized; investments are positive and should be encouraged. Treating intangibles as an expense leads to bad results. For example, almost every business leader mouths the line that “our employees are our most valuable asset.” Yet reduction in labor costs is a standard means of reducing operating costs, which can sometimes lead to disastrous outcomes. Thus, it is important for managers to view intangibles as an asset.

But are all expenditures on intangibles really investments? The latest article by Michael J. Mauboussin and Dan Callahan at Morgan Stanley (“Underestimating the Red Queen: Measuring Growth and Maintenance Investments”) explores the difference between company spending for growth and spending for maintenance (i.e., operational activities). They conclude that “SG&A [selling, general, and administrative expenditures] and capital expenditures have an investment component that drives future earnings growth and a maintenance component that is necessary to sustain the current operations.”

Similarly, Matthias Regier and Ethan Rouen (“The Stock Market Valuation of Human Capital Creation”) point out that while personnel expenses are treated in accounting as an operating expense, they include both day-to-day expenses and investments in human capital. And Vijay Govindarajan et. al (“It’s Time to Stop Treating R&D as a Discretionary Expenditure”) argue that “a significant component of digital companies’ R&D costs are necessary operating expenses whose curtailment might stop the companies’ operations.”

This is a break from the standard (and implicit) view that conceptually treats all intangibles as an investment leading to growth (through productivity and/or innovation) and that accounting treatment of intangibles as an expense is always wrong. By recognizing that some intangible expenditures are needed just to sustain on-going operations, Mauboussin and Callahan have introduced the “Red Queen” problem to our view of intangibles: “it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” [says the Red Queen in Through the Looking-Glass and What Alice Found There].

It is important to note that the Red Queen problem is especially acute in industries with high technological obsolescence. As Mauboussin and Callahan note, “the costs for companies in certain industries addressing climate change, or for automobile manufacturers migrating from internal combustion engines to electric vehicles, are potentially massive. These costs are necessary to maintain market position, sales, and competitiveness.”

Teasing out the growth versus operating expenditures may be harder than it seems. Even for tangible assets, understanding the difference between operating expenses (maintenance, repair & replacement) and investment can be tricky. For example, accounting considers equipment maintenance as an operating expense whereas replacement is an investment (to be depreciated subject to accelerated depreciation for tax purposes) even if it is simply to continue the current level of operations. Buying an additional new piece of equipment would clearly be a growth-related investment. But replacing a piece of equipment with an ungraded version may or may not be an investment.

Thus, something can be treated by accounting as an asset and depreciated as investment but be absolutely necessary for production. In fact, most of the intangibles that accountants would consider assets are of this operational type, including licenses, current customer lists, databases, patents on existing products, etc. While these items create a competitive advantage, they do so by creating a moat or ring-wall around existing operations. They do not necessarily, in and of themselves, promote growth.

Mauboussin and Callahan do not solve the Red Queen problem but they offer a direction. They reference work by Enache and Srivastava (“Should Intangible Investments Be Reported Separately or Commingled with Operating Expenses? New Evidence”) on using company SG&A disclosures to measure intangibles (as also cited in their earlier article “One Job: Expectations and the Role of Intangible Investments”). (See also my two earlier postings.) This approach separates SG&A in to operating or investment by category. For example, office rent and delivery costs are part of operating expenses whereas worker training is part of investment.

They do not, however, go the next step to look at the allocation into the two types of expenditures within SG&A categories. For example, all of R&D is allocated to investment whereas, as noted earlier, some R&D expenditures may be more of an operational expense. Likewise, worker training is classified as investment even though some might be better classified as keeping up or as part of worker “on-boarding” activities. 

This is not a minor problem. Obviously, right now any division within a SG&A category between operating expense and investment seems — and probably is — a little arbitrary and subjective.

And using the SG&A data has a technical problem. The R&D and advertising portions of SG&A are measured directly. The other parts (“Main SG&A”) are calculated. “Maintenance Main SG&A” (operating expenses) is estimated using revenues and “Investment Main SG&A” is calculated by subtracting out R&D, advertising and estimated operating expenses from total SG&A. Total investment expenditures is then calculated by adding Investment Main SG&A, R&D and advertising. In other words, investment expenditures are R&D, advertising, and everything else that is not an operating expense. As a result, this methodology cannot tell us how much of Investment Main SG&A is, for example, worker training or how much is for organizational development. In fact, it cannot even tell us what activities are part of the investment SG&A (other than R&D and advertisement). As Enache and Srivastava note, “its [SG&A] constituent items cannot be identified.”

Even if we were able to clearly articulate the level of expenditure in each component of intangibles, we would not necessarily know what is the optimal level of spending on moving forward (growth) or keeping pace (supporting operations). As Mauboussin and Callahan note, “A company with a competitor that has spent the money to provide a better good or service has little choice but to match the competitor’s outlays.” This is a chicken and egg problem. Which came first, my spending to foster growth matched by my competitor’s spending to keep up (the egg) or my competitor’s spending to break new ground forcing me to spend simply to keep up (the chicken)?

Clearly more works need to be done, both conceptually and in data collection.

However, it starts with recognizing the Red Queen Problem. By interjecting that into the debate, Mauboussin and Callahan have substantially increased our understanding of investment in intangibles.