Disclosing relevant information about intangibles
ICAS and EFRAG have jointly funded and published a study to examine the role of intellectual capital (IC) in the value creation process and provide a baseline in intangibles reporting for a sample of IC intensive high-tech companies.
Background
The corporate reporting landscape is continuing to evolve. The decision by the European Commission to revise and extend the non-financial reporting directive into the Corporate Sustainability Reporting Directive (CSRD), the development of draft sustainability reporting standards by the European Financial Reporting Advisory Group (EFRAG), and the establishment of the International Sustainability Standards Board within the IFRS Foundation, have emphasised the power of narrative reporting to convey decision-useful information.
Among the non-financial items that companies communicate in the narrative section of their annual reports, intangible elements have attracted the attention of many economic actors. The difficulties in capturing the value of intangibles have spurred debate, which culminated in an EFRAG discussion paper about better information on intangibles. Among the proposed solutions to convey meaningful information, EFRAG emphasises the role of narrative reporting and the linkage to value creation. That is particularly true for the knowledge-based resources that are difficult to identify and recognise in a company’s balance sheet, such as know-how, relationships, expertise and skills. Those resources fall under the name of intellectual capital (IC).
The renewed attention of different actors to IC led ICAS and EFRAG to sponsor a project developed by Chiara Crovini (Aalborg University Business School), Francesco Giunta (University of Florence), Christian Nielsen (principal investigator, Aalborg University Business School) and Lorenzo Simoni (University of Genoa).
The project investigates IC disclosure in the narrative reports of intangible-intensive companies, focusing on two provisions related to narrative reporting: the duty to report information about the business model and to present the main risks associated with a company’s operations.
The business model offers a schematic representation of how a company delivers and captures value through its resources, activities, and relationships. Hence, business model reporting is the lens that allows users of the annual report to interpret financial and non-financial information, as it represents the link between corporate communication and the value creation process. Risk reporting addresses the main elements affecting a company’s capacity to exploit and protect the business model value drivers. Therefore, companies could take advantage of those requirements to offer investors valuable information about IC. On the one hand, business model reporting helps to illustrate the role of the main IC items in value creation. On the other hand, risk reporting could be a valuable tool to describe the main threats and opportunities relating to the company’s ability to exploit and protect those (intangible) value drivers.
Consequently, the project investigated whether and how companies use business model reporting and risk reporting to convey information about IC, and the integration between the two by analysing the correspondence between the IC elements presented in the business model section and those reported in the risk section.
The examined sample and the results
The research team examined 2018 annual reports issued by listed companies operating in the pharmaceuticals, computer and electronics, and air and spacecraft industries based in the UK, France, Germany, the Netherlands, Norway, and Denmark. Those countries have all implemented regulations that require large entities to disclose information about business models and risks. Moreover, the UK, France, the Netherlands, and Denmark have the highest contribution of intangibles to GDP.
The findings show that 29% of companies do not report either the business model or principal risks in the annual report, resulting in non-compliance with existing regulations. On the other hand, disclosing entities tend to include IC elements in both the business model and risk sections, although business model reporting is more frequently used than risk reporting to convey information about IC. Additionally, most of the descriptions related to IC risks are backward-looking and have a negative connotation, and less than half of the IC items identified in business model reporting are addressed in risk reporting, demonstrating a limited level of integration between the two sections.
Policy implications
This evidence has the power to inform the debate raised by ICAS and EFRAG on how to better report on intangibles, showing how narrative reporting is used to convey information about IC, which is contextualised in the value creation process. Furthermore, by providing evidence of a scarce integration between business model reporting and risk reporting regarding the communication of IC, the study suggests that policymakers should devote more attention to promoting linkages between business model reporting and risk reporting in the annual report.
These linkages might help companies offer a better vision of how IC contributes to generating and maintaining value, and how companies are protecting their intangible value drivers from potential adverse contingencies. According to the model proposed by the authors, companies should:
- offer a description of the main IC elements they rely on to create and deliver value in the business model section of the annual report;
- in the devoted section, illustrate the risks associated with the main IC elements that drive a company’s value.
To some extent, better integrating the two sections could also help to overcome limitations imposed by disclosure disincentives. Companies could be reluctant to disclose risks associated with their IC as they do not want to show investors that their value drivers might be at harm. This circumstance could be attenuated by an effective linkage between risks and the business model. Indeed, the exploitation of IC elements is often associated with uncertainty that may lead to positive or negative outcomes. Although the isolated illustration of IC risks may represent a concern for some entities, a clear representation of how those items generate value if successfully exploited through business model reporting may attenuate those concerns and provide users with a more reliable view of IC. Thus, improving the integration between information on IC value drivers and the related risks may provide meaningful information on the outcomes of the value creation process.