What’s the point of visualizing “invisible” assets?

Assets that cannot be seen on a balance sheet

My specialty is financial accounting, a research area that considers what information is useful for decision-making related to investments, such as business performance and financial conditions, and how such information should be disclosed. Among such research topics, I am searching for limitations and possibilities in accounting by focusing on assets that do not appear on the balance sheet, so-called “invisible assets,” such as R&D capabilities and brands.

In addition to tangible assets such as land, buildings, and production equipment, companies and other entities possess what are called intangible assets. The intangibles I focus on include not only R&D capabilities and brands, but also human capital such as employee skills, traditional skills, expertise, and customer base. Since they have no physicality, they are difficult to measure or visualize, but the difference between a company’s equity capital on its balance sheet and the total market value of its stock is generally considered to be the value of the company’s intangible assets. Intangible assets appear on a balance sheet only when the company is being acquired through a corporate merger. Otherwise, the value of the company’s proprietary technologies, expertise, brands, etc., cannot be easily discerned.

However, factors such as R&D and branding are indeed sources of competitive advantage, and a company’s continued investment in such intangibles, their strategic objectives, and their probability are useful information in investment decision-making. Corporate investment in intangible assets is increasing every year, and today far exceeds investments in tangible assets. I thus believe that how companies should properly disclose this information and what investors can read from it are important topics for the future of financial accounting.

My research on intangible assets started while I was researching in France. Since graduate school, my research has focused on the history of accounting in France and the historical evolution of information disclosure systems. During my studies in France, I happened to attend a conference where I had the opportunity to listen to a finance manager from LVMH Moët Hennessy Louis Vuitton, and I was shocked to learn that luxury brands such as LVMH consider their brands as permanent assets that depreciate like land, or in some cases even less than land, and that became the starting point of my current research. At the time, intangible assets had not yet become a hot topic in Japan, so I was very interested to learn that such invisible yet important assets exist. I began researching intangible assets in earnest after returning to Japan, and here I am today.

Representing intangible assets in nonfinancial information

For some time now, there has been much debate regarding how to best describe the value of intangible assets. Common practice in the 2000s was to somehow measure intangible assets and present them on a balance sheet, but with the growing interest in nonfinancial information in recent years, the trend has been to use nonfinancial information to describe intangible assets.

Nonfinancial information is information that a company discloses to investors and creditors other than what is presented in financial statements. Primarily, this refers to information that is voluntarily reported in integrated reports or corporate social responsibility reports. Today, ESG investments—those that consider environmental, social, and governance impacts—are expanding worldwide, and nonfinancial information is becoming more important every day as companies start to disclose nonfinancial information about their ESG activities.

However, considering the nonfinancial information that is being disclosed today, it is unclear whether that information really contributes to investment decisions, and many companies, particularly those in Japan, are unsure as to what information they should disclose and how they should disclose it. Japan’s Corporate Governance Code, corporate governance guidelines for publicly listed companies, was revised in June 2021 to include a section on the disclosure of information describing intangible assets. Even so, the revision is just to say that “Information on investments in human capital and intellectual property should be disclosed and provided in an easy-to-understand and concrete manner while remaining cognizant of consistency with the company’s management strategy and management issues,” so the specifics of what information should be disclosed, and how, remain unclear.

Another issue is when information on shareholder equity and social capital, including that regarding relationships between stakeholders and natural capital such as the global environment and ecosystems addressed in ESG, gets mixed in with nonfinancial information alongside information related to intangible assets. While ESG considers corporate initiatives from perspectives such as combating climate change and preventing management corruption, the accounting world deals solely with cash flows, such as how to manage the funds entrusted by investors and how to return those funds to them. I believe that shareholder capital and social or natural capital are separate dimensions, and that unless they are separately organized, we cannot consider such information disclosure as useful for investor decision-making.

As an accounting researcher, I believe that nonfinancial information is only meaningful if it complements the limitations of financial information. In many cases, investments in intangible assets such as corporate R&D, brand development, and human capital do not produce immediate value; they must represent a continuous, long-term effort. Even so, standard accounting conventions stipulate that investments in intangible assets are recorded as expenses, so even when those investments aim at future profits, they negatively affect corporate profitability in the short term. In other words, the more a company invests in intangibles, the worse its short-term performance, despite such investment being essential for increasing long-term corporate value. I believe that nonfinancial information can complement financial information if we can organize the information about intangible assets to be disclosed in a nonfinancial manner and fully explain how investments in intangible assets can increase corporate value in the long run. I am thus currently conducting research on how the EU can formulate nonfinancial rules while communicating with the market, by analyzing the results of domestic and international empirical studies while considering examples of EU companies that actively disclose nonfinancial information and the EU’s social infrastructure.

Interviewing established companies to learn the power of intangible assets

In the seminar I teach, this year our research took the form of interviews with well-established companies in Tokyo’s Nihonbashi district, conducted with the support of the Tokyo Chamber of Commerce and Industry. We interviewed those companies about how they preserve their traditions amidst transformation in response to the changing times, and we plan to publish videos of those interviews.

Through this activity, my students got a sense of the kinds of traditional skills and brand values that cannot be expressed in financial statements, as well as the thoughts of managers who hold such values in esteem. They got firsthand experience of forces that support a company, but cannot be sensed from numbers. Representatives at one food-industry company told us that although their market is shrinking due to changes in eating habits, instead of lowering prices they are instead focusing on customers seeking quality products made using artisanal techniques. Even more impressive was their dealings with manufacturers of the ingredients they use. Another reason they haven’t lowered their prices, they told us, was so that they can support the fishers and farmers who provide them with high-quality ingredients by buying those ingredients at the highest price possible. I was very impressed by that attitude, and I hope my students realized the value of a business that takes care of its suppliers.

Interesting accounting shows the truth behind the numbers

In the classroom, I am conscious of how to convey to my students the interesting aspects of financial accounting. There are many interesting aspects of accounting, but the most interesting to me is being able to read between the lines of all the numbers. When you look at a company’s financial statements, all the numbers are neatly presented, down to the last digit, which gives an impression of “truth.” However, even when following the rules of accounting, there’s a lot of room for tweaking those numbers. One example is the accounting strategy called the “big bath” method, where restructuring and other measures are performed during a period of poor financial performance to cover up previously accumulated losses and make it appear as if a V-shaped recovery is taking place in the following period. Utilizing the big bath method just as new management comes in can make it look as if the new leadership has “washed away” the failings of their predecessors, dramatically improving performance thanks to their management prowess. I believe that the world of accounting is more interesting when you take the perspective of how to create such performances without breaking any rules, or of seeing the truth behind invented numbers.

My courses also emphasize the development of students’ abilities for constructing their own ideas and logically applying them to problems for which there are no correct answers. In response to the COVID-19 pandemic, universities throughout Japan, including our own, are now offering online classes. On-demand classes allow students to watch recorded lessons whenever they want, so they can focus only on specific parts of lessons or watch them at double speed, but that attitude aims only at acquiring knowledge as quickly as possible; it does not help students acquire the ability to think on their own and express their opinions. There are no correct answers in the social sciences. Through lectures and reports, I want to teach my students to consider issues from various perspectives, to ask why things are the way they are, to come up with their own answers, and to give logical explanations.

Effective information disclosure will enhance the competitiveness of Japanese companies

The EU is proactively working toward systems for disclosing information on intangible assets, and a third-party review system for nonfinancial information is already in place. In Asia, South Korea too has issued reports on the disclosure of intangible assets, but Japan has yet to do so, and the nonfinancial information that is now being disclosed contains nearly no information that might be unfavorable to companies. I believe that organizing nonfinancial information that mixes the good with the bad and effectively discloses information that is truly useful for investment decision-making will enhance the competitiveness of Japanese companies in the future, and I hope to continue conducting research that contributes to that goal.

Focusing on developments in Europe, I am also interested in how strongly the EU will advance rules regarding nonfinancial information. Governments establish strict rules for how companies publish financial data to ensure that they cannot use misleading information to deceive investors. One of those rules is called “accounting standards,” and countries and regions are currently competing for leadership in the standardization of international accounting standards. The EU is at the center of that competition. The EU now requires publicly traded companies to adopt its International Financial Reporting Standards (IFRS), and those standards are now spreading to companies worldwide that do business with EU companies. The EU hopes to make its preferential IFRS the global standard, and last year it began treating nonfinancial information within the IFRS framework. The balance of power between the EU and other countries trying to gain an upper hand in terms of both financial and nonfinancial information, as well as how Japan should respond to such international developments, are other issues I hope to explore in the future.