What does your real balance sheet look like?

March 14, 2017

 

The goal of this post is to provide a framework for anyone wanting to characterize the economic resource base of their business.

As is often the case, I need to begin by noting the difference between how things are defined from by accountants and by economists. Specifically, I need to shatter the illusion you may have that the Balance Sheet of a company provides a comprehensive inventory of its assets.  As I explain below, the Balance Sheet actually represents a very partial view of the true economic assets of a business.

My view is that modern business has moved beyond the “company as a machine” metaphor that was appropriate during the Industrial era.  In the new knowledge- and network-based economy, a biological metaphor seems more appropriate.  Specifically, what are the economic resources on which a company draws in order to create value, and what role does the company play in the overall economic “food chain”?

The financial statements of a company (Income Statement, Balance Sheet and Cash Flow statement) are governed by strict accounting rules. Three accounting principles in particular – the requirement for a transaction; the definition of an asset as something “owned and controlled”; and its valuation at the lower of its acquisition price or net realizable value – limit the usefulness of the Balance Sheet as a basis for economic analysis because they restrict the definition of the assets that can be shown on the balance sheet.

The accounting rules mean that the Balance Sheet actually represents the cumulative impact of all of the transactions that the company has entered into since inception, and the stock of tangible and intangible assets that have been acquired through these transactions.  Any asset now worth less than its acquisition price will have been written down, but any asset that has gained in value will still be shown at its historical cost of acquisition. Any intellectual property created internally by the business will not appear on the Balance Sheet (there is some limited exception for certain forms of software) and nor will any asset that is not backed by legal property rights – so none of your investment in human capital or in customer preference will appear.

This explains why there is such a huge discrepancy between the Balance Sheet of a business and its enterprise value.  The Balance Sheet gives you the net book historical value of the limited set of resources that qualify as assets for accounting purposes.  Enterprise value reflects the risk-adjusted present value of the cash flow that the company is expected to generate using all the economic resources on which it draws.

So what are the true, economic assets of a business?

There is general consensus around how to define the physical and financial assets of a business. They are categorized as either Property, Plant & Equipment (PP&E) and or various forms of “current asset” – those required to run the day-to-day operations of a business such as cash, raw materials, work in progress, inventory and accounts receivable.  As I have noted elsewhere, together these represent the less than half of the value of the average business.

In contrast, there is no generally accepted taxonomy of intangible assets.

My personal view is that it is helpful to think of assets as falling into four main categories – current assets; fixed assets; intellectual property; and non-controlled assets.

The first two categories of assets appear on the Balance Sheet, albeit at historical cost.

The third (intellectual property) can appear on the Balance Sheet if acquired from a third party as part of a transaction. IFRS3 (International Financial Reporting Standard) helpfully spells out the five forms of intangible asset (and the specific form of intellectual property on which they are based) that can be considered for inclusion on the Balance Sheet post-acquisition:

 

The final category of asset are all based on human relationships and will never be accepted as accounting assets (at least, not until the requirement that an asset be legally “owned and controlled” is changed). They are, however, real economic assets because they represent the preferences for your core audiences to do business with you.

If you agree, then we can think of the “real” balance sheet of your business looking something like this:

 

Please let me know if you find this a helpful framework, and how you think it might be improved.

{ 2 comments… read them below or add one }

1 Jonathan Trost March 22, 2017 at 5:33 am

I like this idea. But how would you go about putting a value on customer equity, employee engagement, corporate reputation, etc?

2 Jonathan March 22, 2017 at 7:38 am

Mergers give a really good indication of the likely scale of this value because they show what the acquirer is prepared to pay for target company’s entire resource base. My analysis of 150 large mergers over the past 10 years shows that, on average, tangible assets represented around 30% of the purchase price, and intellectual property assets another 30%. That means that 40% of the purchase price was not explained by specific physical, financial or intellectual assets. I would argue that this represents the value of the customer equity, employee engagement and corporate reputation. Hope this is a helpful answer!

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