I had the pleasure of attending the Ben Graham Value Investing conference, hosted by the Ivey School of Business. The highlight of the conference was a talk from the great Michael Mauboussin about accounting for intangible assets.

TLDR: Intangible assets tend to get expensed rather than capitalized. Therefore most modern businesses report earnings that are significantly lower (~12%) than if they were investing in traditional capital assets¹.

Why this is bad: Financial statements are becoming less and less informative to investors.

→ It is more difficult to compare companies, especially across industries 

Consider two companies: Company A spends $1 million on customer acquisition, while Company B invests $1 million in a data center. Company A will expense the full amount in the current year while Company B capitalizes the expense and amortizes it over time. Both investments will generate revenue in the future but the impact on the financial statements is today widely different.

→ Operating costs no longer match revenues

Accrual accounting theory stipulates that costs should be expensed in the same period in which they are used to generate revenue, a concept called “matching”.

Selling, General, and Administrative (SG&A) expenses have grown significantly as a proportion of total operating expenses, often because intangible investments get expensed as SG&A. These expenses have very little correlation with current period revenues. Prior to the 1990s operating costs matched revenues much more closely².

→ GAAP earnings are less predictive of returns and firm survival ³

What should we do about it? 

The obvious answer is to change the way we report. The reason that intangibles like R&D get expensed instead of capitalized is because 

1. There is a lot of uncertainty around whether these relatively risky investments will in fact generate revenue (often they don’t) and 
2. Determining what is/isn’t R&D requires significant judgment.

Because standardization is challenging and uncertainty is high, the Financial Accounting Standards Board (FASB) is unlikely to embrace widespread changes anytime soon. 

My take: Financial statements that are used by investors are more valuable than highly standardized financial statements that get ignored, even if those financial statements are more likely to be manipulated.   

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Stay tuned for my related upcoming post -> “Why public markets should tolerate more fraud”. 

Find Mauboussin’s full report on this topic and supporting academic literature below: 

1. Michael Mauboussin & Dan Callahan - Intangibles and Earnings
2. Anup Srivastava - Trivialization of the Bottom Line and Losing Relevance of Losses
3. Shivaram Rajgopal et al Reassessed Earnings with Capitalized Intangibles
4. Baruch Lev - Intangibles
5. Luminita Enache & Anup Srivastava - Should Intangible Investments Be Reported Separately or Commingled with Operating Expenses? New Evidence