Intangibles and the OFR

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TECHNICAL MATTERS Intangibles and the OFR

This month Intangibles and the OFR RAB Equity investment Professional development

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Vivien Beattie and Sarah Jane Thomson report on their analysis of the gap between the balance sheet values and market values of firms in the FTSE 100.

In May 2004 the UK government issued draft regulations to make operating and financial reviews (OFRs) a statutory requirement for quoted companies.

Clearly, financial statements are no longer thought to tell enough of a business’s story on their own.

Many resources used in the value-creation process are generated from intellectual capital (in the form of human, structural or relational capital).

These knowledge assets don’t appear on the balance sheet because they cannot be identified and quantified reliably. You can roughly gauge just how incomplete a company’s financial statements are by considering the relationship between its market value and its balance sheet value, which is known as the market-to-book ratio.

Economic theory suggests that highly informative business disclosures improve the market’s understanding of a firm’s value-creation process and the economic risks it faces. This reduction in “information asymmetry” decreases the company’s cost of capital by lowering the information risk premium. It follows that the lower the firm’s cost of capital, the higher its market value, because the latter is the present value of expected future cash flows, discounted at the cost of capital. Looking at it the other way, deficiencies in disclosures about intellectual capital result in systematic undervaluation by investors.

Numerous studies have shown that the theoretical link between the cost of capital and the quality of disclosure applies in practice. The costs of both equity capital and debt capital are negatively associated with high levels of disclosure. Other empirical research has shown the value-relevance of voluntarily disclosed non-financial information.

MARKET-TO-BOOK RATIOS OF COMPANIES IN THE FTSE 100 Number of companies

Market-to-book ratio

Numerous studies have shown that the theoretical link between the cost of capital and quality of disclosure applies in practice Lev, a leading intangibles researcher in the US, has documented the market-to-book ratio of the Standard & Poor’s 500 over the past two decades or so. The average figure rose from just over one in the early eighties to a peak of six by 2000, falling back to 4.5 by late 2003.

We looked at the market-to-book ratios of the FTSE 100 using the latest accounts available in early 2004. After excluding companies with negative book values arising from negative reserves,

we found that the average ratio for the remaining 92 firms was 2.52. This meant that around 60 per cent of the firms’ value was not reflected in the balance sheet. But, given the wide range of individual values we observed, it was the distribution of these ratios that was most revealing (see chart, above). The market values of 17 companies were lower than their book values – ie, they had ratios of less than one – while 12 firms had ratios of more than five.

There was a clear link between the market-to-book ratio of a firm and the industry in which it traded. The average ratios for the pharmaceutical and media companies in the sample were relatively high (5.6 and 4.4 respectively), which is not surprising given the knowledge-intensive nature of their FIN A NCIA L June 2005 M A N A GEM EN T

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The OFR and intangible assets

industries. GlaxoSmithKline had the highest ratio we observed, with 10.94.

Firms operating in the financial sector generally had ratios at the lower end of the range, while the book values of all the insurance and real-estate companies were higher than their market values – ie, their ratios were less than one. Intellectual capital isn’t of great significance to the value-creation process in these industries.

The size of the market-to-book ratio can be influenced by intellectual capital in two ways. Primarily, the ratio reflects the importance of intellectual capital in a company’s value-creation process, but the quality of disclosure about its intellectual capital also has an impact. A low market-to-book ratio can be attributed to the relative unimportance of knowledge-based assets to a company and/or the fact that the company is bad at explaining the importance of such assets. To the extent that the market has information sources other than the company, the impact of the latter cause is limited.

To investigate how ratios had changed over time on the FTSE 100, we also analysed the figures for the 56 companies that had stayed on the index continuously from 1993 to 2003. Their average market-to-book ratio increased from 3.1 in 1993 to 5.3 in 1998, falling back to 2.9 in 2003. It seems that, as in the US, a large portion of intangible assets may have vanished in recent times.

The reasons that Lev has suggested for this include ever-increasing competition, the collapse of the dot-com bubble, the September 11 tragedy in 2001 and global economic stagnation.

Of course, the market-to-book ratio gives only a rough guide to the importance of intangible assets and the

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quality of disclosure surrounding them.

Although some writers have defined intellectual capital as overall corporate value minus financial capital, the difference can result from other factors.

These include undervalued tangible assets on the balance sheet, intangible liabilities that aren’t captured on the balance sheet and market prices that

Many of the companies we studied had announced a major change in strategy around the time of a major change in market-to-book ratio don’t accurately reflect the intrinsic value of the business. The last of these can often result from the prevailing market psychology – ie, whether the general mood among investors is optimistic or pessimistic.

There can also be major shifts for individual companies. We looked more closely at 11 firms that had experienced extreme changes in their market-to-book ratios from 1993 to 2003, examining them for an extended period of 18 years.

The ratios of four of these – Dixons, Next, Prudential and Smiths Group – were especially volatile, which is quite common for intangibles-intensive businesses. At Next in particular, there was a strong upward trend underlying this volatility, indicating the success of its developing business model: a common brand and range for both its retail and home shopping formats.

Although the exact cause of these fluctuations cannot be established definitively, a review of what these firms were doing when they occurred gives us some idea. Many of the companies had announced a major change in strategy

around the time of a major change in ratio. In some cases this related to a key acquisition or divestment. Such announcements would have caused the market to reassess the value-creation prospects of the company concerned, including the contribution made by its knowledge-based assets.

In some cases, the cause seemed to be unrelated to intellectual capital. For example, the market-to-book value of another of the 11 firms that we analysed in depth, Daily Mail and General Trust, hit a peak at the time of its entry to the FTSE 100, suggesting that the increase in the company’s market value resulted from the jump in demand for shares in a FTSE 100 member.

What is clear from this analysis is that, for most companies, a large proportion of their value is not captured in the financial statements. One way of bridging this reporting gap is through the OFR, which can be seen as a general-purpose narrative statement.

More radical suggestions have included a dedicated narrative-based intellectual capital report, such as that proposed by the Danish Agency for Trade and Industry (www.euintangibles.net/library/ localfiles/ICS-UKsprog.pdf).

Of course, information about intellectual capital is meaningful only in the context of the user’s understanding of the company’s business model, its critical success factors and the management’s strategy for value creation. The reporting challenge is to tell this story in a cohesive and integrated way. F M

Vivien Beattie is professor of accounting at Glasgow University and Sarah Jane Thomson is a lecturer in accountancy and finance at Heriot-Watt University.

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TECHNICAL MATTERS

Resource accounting and budgeting A CIMA-sponsored study of RAB’s impact on the devolved institutions of Northern Ireland, Scotland and Wales has found politicians struggling to grasp the concept.

The creation of the Northern Ireland Assembly, Scottish Parliament and Welsh Assembly in 1999 represented a major change to the way these parts of the UK were governed. At the same time, a key change in central government accounting systems was occurring with the introduction of resource accounting and budgeting (RAB) as a replacement for traditional cash-based accounting.

A research team, jointly funded by CIMA and the Economic and Social Research Council, explored the development of these new financial practices and the implications for democratic accountability. During the first four years of the devolved system it looked at the budgeting, performance management and performance audit reporting processes, and at the link between budgeting and reporting.

RAB is an accruals-based system that seeks to integrate objectives and targets into the accounting procedures.

It was introduced in two parts: resource accounting (a set of methods for reporting on spending by departments and the relationships between spending and departmental objectives) went live in 2001–02, followed by the staged introduction of resource budgeting (the use of resource accounting data as the basis for managing public expenditure).

The research focused on the role of RAB within the new devolved bodies.

One of the main purposes of the devolution programme was to improve political responsiveness to the public.

Accounting practices have a key role to play in informing and shaping the democratic accountability of important players, particularly politicians, in these new structures. The devolved administrations are fully responsible for managing their own public spending

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and for providing detailed accountability and audit procedures, as specified in the respective devolution acts.

The process of changing central government’s accounting practices from cash accounting to RAB started more than a decade ago. The panel below outlines some of the important milestones along the way. With it came a recognition that more uniformity was needed in the system, as shown by the clearer definition of the reporting entities and the augmentation of existing performance reporting requirements.

Another important part of the devolved arrangements was the development of mechanisms for deliberating upon the business of government. The switch to RAB was

A BRIEF HISTORY OF RAB IN GOVERNMENT 1993 The chancellor of the exchequer, Kenneth Clarke, proposes the adoption of accrual accounting by central government.

1994 HM Treasury publishes a green (discussion) paper entitled Better Accounting for Taxpayer’s Money: Resource Accounting and Budgeting in Government.

1995 HM Treasury publishes a similarly titled white (policy) paper.

2001–02 Resource accounts go live.

2001–03 The transitional years for resource budgeting – big non-cash items are not included in the departmental expenditure limits (DEL).

2003–04 Full resource budgets go live, with cash and non-cash items included in the DEL.

seen as a fundamental change for improving decision-making processes (by supplementing existing planning and control mechanisms) and strengthening accountability for the use of public resources. RAB entails the use of performance indicators and the incorporation of department objectives in budgets. It also requires that management accounts are better aligned with financial statements.

Although the research team analysed documents and observed meetings, most of its evidence came from 58 semi-structured interviews with key individuals in each of the three devolved bodies. Nearly all of these were with politicians – including ministers and the chairmen of key committees – representing a range of parties. The researchers’ main questions related to the role that accounting played in democratic accountability and how the devolved bodies were using financial information.

The team identified a number of major themes, but the general conclusion is that devolution has helped to improve democratic accountability in Northern Ireland, Scotland and Wales, resulting in more openness, consultation and scrutiny. Some of this improvement may have resulted from general public-sector reforms over the past 20 years that have increased the supply of management accounting information but devolution has increased the demand for, and salience of, this information.

The interviewees were generally positive about RAB. A few “insiders” – particularly ministers or those involved with committees on financial, auditing and accountability issues – showed a clear understanding of its potential benefits and drawbacks, even though

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some of them found it harder to grasp the technicalities. But a much larger group of “outsiders” knew little about RAB or the intentions behind it. They found it hard to identify what RAB was, what its purposes were and whether it had affected (or would affect) the availability and significance of financial information as an aid to planning, control and the process of discharging accountability.

Many politicians who weren’t well versed in the intricacies of RAB and issues of accountability relied on the expertise of more knowledgeable colleagues in their devolved body, or on their advisers and researchers, to give them the relevant information. This put a small group of experts in a crucial position by virtue of their ability to understand financial issues and advise other members. Because the information they provide may be mystifying, rather than clearer, to a large number of

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Thrice removed from Westminster: Holyrood, Stormont and Cardiff Bay.

politicians, this situation could pose a threat to democratic processes.

The interviewees said that budget information was widely scrutinised (if not fully understood) and perceived as the most important accounting information used in the devolved bodies.

They also considered organisational performance data valuable for decision-making because it provided checks and balances. Conversely, financial accounts – particularly complex resource accounting schedules – were rarely understood and hardly used by the politicians.

Introducing RAB may improve the quality of information relevant to political decisions, but the information is seen as too complex for most politicians to understand. If RAB is to be used in politics, the system should be simple and it must be accompanied by training.

This would allow the members of the devolved bodies to scrutinise budget

information effectively. But there’s little evidence of any interest on the part of the politicians, which is a big challenge if RAB is to improve decision-making in these institutions and make them more accountable. F M Further reading The detailed findings of this research are to be published in Management Accounting in Politics: Devolution in the UK and Democratic Accountability, which will shortly be available on the CIMA website (www.cimaglobal.com).

The members of the team that conducted the research and wrote this report were Mahmoud Ezzamel (University of Cardiff); Noel Hyndman (Queen’s University, Belfast); Åge Johnsen (Oslo University College); Irvine Lapsley (University of Edinburgh); June Pallot (University of Canterbury); and Simona Scarparo (University of Warwick).

FIN A NCIA L

Photographs: Scottish Parliamentary Corporate Body, David Nixon/Alamy, wales.gov.uk

June 2005 M A N A GEM EN T

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TECHNICAL MATTERS

Equity investment Last year Malcolm Howard began an experiment to see whether an accountant could outperform the economists at predicting share values. Here are the results.

In the field of finance and economics, the current system of university funding in the UK is not conducive to the achievement of beneficial research work. The assessment exercise that’s used to determine universities’ research funding is biased towards the quantity of studies undertaken and tends to overlook long-term research that leads to new knowledge. This puts researchers under pressure to publish and also places a lot of strain on their integrity. If their findings are at odds with the established theories, the academic journals are reluctant to publish them for fear of losing face if they are later proved wrong. Returns from the major finance houses suggest that pension fund managers suffer from the same malaise: most would rather follow the herd than risk being wrong.

The starting point for a hypothesis in many academic papers is, therefore, a modification of an established theory, which is then tested using a large sample of historical data. The dilemma comes when the findings do not fit the model. Academics with integrity will go back to the drawing board and, given time, might make a valuable breakthrough. But the pressure to publish will lead others to massage the sample to fit their model.

The economic theory that the price of a share at any time reflects the information available to the market, and that share prices go on a “random walk”, is completely flawed in my view.

I believe that the market is totally irrational in the short term, but that it will fall in line with the true financial position of a company in the long term.

The problem, however, is that not all published accounts are accurate. In my October 2004 article “For what it’s

HOW THE 16 CHOSEN COMPANIES FARED FROM JULY 1, 2004 TO APRIL 30, 2005

Jarvis Danka Ultraframe Beazley Molins Beattie (James) Hardy Underwriting (56.3%) Goshawk Insurance Chaucer Insurance (91.7%) Cox Insurance Hitachi Capital (80.0%) Tops Estates (97.0%) Unite Group Lavendon Regent Inns Ashtead Group

Opening share price (p) 78.00 63.00 127.50 96.50 175.00 126.50 237.50 40.25 48.00 71.50 197.50 332.00 197.50 125.00 43.50 27.50

worth…” I demonstrated the tests I used to assess this.

I could have tested my hypothesis using reams of historical data, but I could easily have massaged the sample to fit it. To avoid this, I selected shares based on my theory and set a marker for ten months into the future. I chose four firms’ shares from 16 companies selected by Tom Stevenson, then head of research at financial analyst Hemscott (www.hemscott.com). I based my choice on an interpretation of their latest accounts.

The results of this test are shown in the table above in reverse order – ie, the least successful firms are at the top.

My four selections are highlighted in bold. The figures in brackets next to the name of the company show my

Closing share price (p) 10.25 16.50 51.50 88.00 162.50 116.50 212.50 42.50 56.00 92.00 256.50 442.50 285.00 184.50 80.50 86.75

Percentage of capital returned 13.1 26.2 46.6 91.5 92.9 94.9 100.0 105.6 118.2 129.4 131.4 134.5 145.6 149.4 185.1 315.5

“percentage confidence” in my choice, as shown in the October 2004 article. The column headed “Percentage of capital returned” takes into account capital gains or losses and dividends received.

In my view, the first objective in assessing published accounts for investment purposes is to sift out the companies that are likely to fail.

Management accountants can see signs of impending disaster, one of which is when published accounts are delayed.

Accordingly, it was clear to me that the market-makers didn’t understand the financial basics when they rated Jarvis at 78p on June 30, 2004, when that company’s accounts had been delayed pending the completion of a strategic review. Sure enough, the bombshell soon came and the accounts showed FIN A NCIA L June 2005 M A N A GEM EN T

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Equity investment

that the company was technically insolvent. Its share price closed at 10.25p on April 29, 2005, the last trading day of the experiment.

Out of the 16 shares, nine showed a profit, one broke even and six lost money. My financial analysis managed to avoid all of the losers, but it also missed out on the top four performers.

So how did I not spot the winners?

The answer is that I simply do not know.

The share price of the best performer in the experiment, Ashtead Group, rose from 27.50p to 86.75p, yet its latest accounts show continuing losses and a slight increase in net debt.

The next best performer, Regent Inns, which I rejected because of low earnings, saw its share price increase from 43.50p to 80.5p, despite turning in a worse performance: annual earnings per share fell to 0.5p from 4.6p. Lavendon, which I rejected for the same reason, turned in a loss of 3.3p per share excluding exceptionals, or a loss of 31.2p per share with all costs taken into account.

Unite Group, which I rejected on the grounds of its negative earnings, still can’t make enough profit to cover its interest payments and is racking up debt – £731m on December 31, 2004, compared with £594m the year before – like there’s no tomorrow. Despite this, its share price increased from 197.50p to 285p.

I believe that the circumstances of these four winners underline just how irrational the stock market really is.

Despite its failure to pick out the top performers, the management accountant’s approach still outperformed that of the economists.

It has to be said that the result is a matter of luck, because the overall result changed practically every month.

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My financial analysis managed to avoid all of the losers, but it also missed out on the top four performers. So how did I not spot the winners? The answer is that I simply do not know But, at the finishing line – the only place that matters – the accountant, with a profit of £3,363.67 on an investment of £16,000, compared with the economists’ profit of £2,796.44, won by a margin of £567.23.

Hemscott’s stock-picking methods came up trumps as well, with an annualised profit of £3,355.73 – or, after brokerage and stamp duty costs of three per cent, £2,837.95. This represents a return on investment of 17.7 per cent.

Further pruning based on financial analysis produces an annualised profit of £3,514.82 (after the same 3 per cent agency costs). This represents a return on investment of 22 per cent.

I hope that this and my previous article show that, with a little financial analysis, it is possible to beat the market.

Taking the ten-month figure and deducting the full agency cost (three per cent of the average of the opening and closing investment), the accountant’s approach achieved a profit of £2,842 on an investment of £16,000 – ie, a return on investment of 17.8 per cent. In the same period the FTSE 100 moved from 4464.1 to 4801.7 – ie, an increase of only 7.6 per cent.

Fund managers are proud of themselves when they beat the FTSE 100 by even a small amount. If only they could read accounts, our pensions would be worth an awful lot more. F M

Malcolm Howard FCMA is a lecturer in financial management at the University of Surrey.

A CLOSE CALL In the October 2004 article “For what it’s worth…”, Malcolm Howard and Financial Management offered a prize to the reader who most accurately predicted whether the accountant or the economists would come out on top in his investment challenge – and by how much.

Congratulations to Edmund Wu, who estimated that the accountant would beat the economists by £600, only £32.77 out from the actual result. He wins £200.

Photograph: Richard Gleed

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TECHNICAL MATTERS

Professional development

AT A GLANCE

CIMA’s new CPD scheme is a solid, formal – yet flexible – framework to support what members already do to keep themselves at the cutting edge of accounting.

CIMA’s new CPD scheme will: ■ Take effect from 2006.

All members will have to comply with its rules from January 1*.

■ Concentrate on outputs.

The scheme is concerned with the outcomes of activities, not the time spent on activities.

■ Be built on trust between CIMA and its members.

You are responsible for your own CPD. ■ Centre on the CIMA professional development cycle.

The scheme will require you to proceed regularly through this six-stage process.

■ Include monitoring.

You may be asked to submit your development record to CIMA. The institute will audit a number of members every year.

■ Require evidence.

Members must provide evidence of their CPD activities if requested.

Those chosen for reviews will be asked to show that they have been through the development cycle and have kept a record to support this. Records will need to be kept for a rolling three-year period.

■ Provide you with a resource pack.

CIMA will send you this in November. It will contain information on CPD policies, guidelines and supporting products and services.

■ Not require an annual declaration of CPD completion. CPD will be a condition of membership.

Bearing in mind the increased need for professionals to show that they are maintaining their competence and ethical awareness – and the introduction of mandatory CPD for CIMA members from January 1, 2006* – the institute’s professional development framework has been designed to offer you a supportive scheme based on the outputs of the development activities you undertake, whatever field you’re working in.

Its flexibility should allow you to tailor your development to your own professional needs. You decide what CPD you need to do; you decide how much CPD you do; and you decide what sorts of activities you will include.

In most cases it will be business as usual. You will already be undertaking CPD activities in your day-to-day work – eg, learning new skills; mentoring other professionals; or keeping abreast of technical developments by reading professional journals and attending seminars, conferences and courses.

Through the scheme you will be able to do the following: ■ Achieve your own development objectives and aspirations, whether

You decide what CPD you need to do; you decide how much CPD you do; and you decide what sorts of activities you will include you work in a financial management capacity or not.

■ Enhance your employability.

■ Drive your own progression.

■ Increase your competitive edge.

■ Maintain your professional competence and ethical awareness.

■ Protect the public interest.

■ Uphold the integrity and market value of the chartered management accountant designation.

Further information about the scheme can be found on the newly launched professional development section of the CIMA website at www.cimaglobal.com/cpd. If you have any queries about the scheme, contact Nigel Race, CPD manager, via e-mail at cima.pd@cimaglobal.com. F M * Pending approval at the institute’s AGM on June 11 (you vote – you benefit).

HOW CIMA WILL SUPPORT YOU A range of products to help CIMA members with their professional development will be made freely available. They will include: ■ A professional development planner to help you to plan and analyse your CPD. ■ An online news and information service to ensure that you are up to date on the latest issues.

■ An e-journal service to help you improve your technical knowledge.

■ Harvard ManageMentor Plus to guide you on interpersonal and business skills.

■ The Insight e-newsletter service to bring news on key professional issues straight to your PC’s desktop.

■ A technical information service to give you support and detailed information on specific topics.

CIMA will also make many other products available. Visit www.cimaglobal.com/cpd to see a full list of support materials.

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