From 2009, advertisers and marketers in the country will have to increasingly account for the impact their advertising and marketing initiatives have on shareholder value, or, at the least, on the profit of companies. India will adopt the IFRS (International Financial Reporting Standards) accounting norms starting that year and companies have a year to transition to it.
After that companies will not be allowed to use goodwill as a nebulous entry in their balance sheets. Most firms here use goodwill to account for or put a number to intangible assets such as brands, relationships with customers, and access to technology. In 2009, the current Indian Accounting Standards (IAS) that companies follow will give way to IFRS. The standards have been evolved by the International Accounting Standards Board, an independent entity that sets accounting standards, and are in use in the European Union, Australia, Russia and several other countries. Others, including the US, which use the Generally Accepted Accounting Principles or GAAP, have laid down a policy of convergence with IFRS.
Marketing strategist Al Ries
Among the changes IFRS will bring about is one related to the capitalization of brands and intangible assets. Brand valuation will thus clearly find a place on Indian balance sheets, say brand analysts.
Here’s why: IFRS standard 3 relates to branding and customer base, and it states that all goodwill accounting will be abolished. Instead, goodwill has to be broken into components and separately recognized: marketing related (trade marks, brands, trade names, Internet domain names, etc.); those coming from customer relationships (customer lists, customer contracts and related relationships, etc.); contractual (ad contracts, licensing and royalty agreements, franchise agreements, etc.); technology related; or art related (magazines, newspaper, films, theatre, etc.).
These intangible assets will then be capitalized onto the balance sheet of the acquiring company. The sting in the tail: the company will need to annually check impairment (or erosion) to the value of brand and intangible assets and, if any reduction has happened, reflect this in the balance sheet or subtract it from profits for the year, says Unni Krishnan, managing director, India, Brand Finance Plc., a leading global brand valuation firm.
Indian companies are currently not required to mention brand valuation on their balance sheets. And accountants conveniently and routinely dump anything more than the book value or value of tangible assets of a firm into a large basket called goodwill, resulting in over valuation of many companies.
“More than 100 countries either require or permit IFRS as their accounting standard or base their own local standards on it. Canada shifts in 2011, while Brazil, Chile, India, Israel and Korea are among the countries that have also set a date for a move to IRFS. One worldwide accounting standard would be good for companies and good for consumers,” says Al Ries, legendary marketing strategist and co-founder, Ries & Ries Inc.
The significance of IFRS entry is huge and akin to the adoption of double entry accounting many centuries ago. The big difference: previously, companies could write off assets in the goodwill system, but now they will have to capitalize these intangibles.
IFRS accentuates the importance of nurturing brands and building brand value. IFRS 3 will bulldoze the Chinese walls that exist between finance and marketing. From 2009, the worlds of finance and marketing will converge in Indian boardrooms or at the corporate interface. For the first time ever—when the true spirit of the IFRS 3 comes in—marketers will be summoned to boardrooms to explain the value of brand and be accountable for shareholder value,’’ says Unni Krishnan.
Interestingly, media or ad spends, and every act of marketing from pricing to distribution will be accounted for not as spends but investments. Marketers, maybe even admen, will have to attend quarterly board meetings and learn the language of boards. Advertising will have to be more focused and explain how it creates shareholder value. This is a 360 degree turnaround which will hit Indian marketers and communicators hard, since CEOs and CFOs of a company will exert the same pressure they face from shareholders on CMOs (chief marketing officers), say brand consultants.
Al Ries says the new standard will make mergers easier.
“For the globalization of business to occur, however, what needs to happen? There needs to be a raft of mergers and acquisitions, as the strong brands and strong companies acquire the weak ones. A single accounting currency will make it much easier for these mergers to occur. Take the beer business. A South African company (SAB) has acquired the second largest beer company in America. (Miller Brewing. The company is now SABMiller. And just this year, Miller merged with the third largest beer company in America (Coors). Meanwhile, Anheuser-Busch, the largest beer company in America, has been busy acquiring other beer companies around the world. Global brands, global markets are good for both consumers (lower prices) and companies (higher profits.)’’ adds Ries.
According to Nobby Gupta, founder & CEO, Nobby Brand Architects, the new accounting standard will change the way companies are valued. “In many companies we seldom realize that the value of the brand is perhaps much higher than the consolidated assets accounted in the books. This also means that market cap of a company would get substantially influenced by the audited value of a brand. The brand equity of a company/brand would hence be a measurable entity and not a subjective statement. This automatically influences the value of a company’s stock. Brands perhaps also need to be rated. There should be an independent institute that evaluates the results of any brand valuation and certifies the same before the value is incorporated in the assets of a company.’’
The IFRS is actually critical in today’s corporate landscape. Under the existing goodwill system, company A buys company B for say Rs100 crore, but the latters assets may be worth only Rs20 crore with goodwill accounting for the rest. The acquirer then amortizes (or writes off) the goodwill over a period of time—so the brands and other intangible assets are acquired and then written off.
Using goodwill didn’t matter in the past since only 10% of a company’s Enterprise Value (EV or value of a company. It is measured as a company’s market capitalization plus debt, minority interest and preferred shares, minus total cash and cash equivalents) was intangible assets. Today, around 65% of a company’s Enterprise Value is in intangibles (value of brands, customer based value, intellectual property such as innovation, design, etc.). Suddenly, these assets are the bulwark of the enterprise.
That leads to questions such as: How does the 65% impact value of enterprise? What is driving value of enterprise? How will the enterprise secure future earnings? That’s where IFRS3 steps in, says Unni Krishnan.
This issue really came into focus in the US and Europe in the late 1980s with a wave of M&As and hostile takeovers. Huge amounts were paid for goodwill and had the accounting community scratching its head over the real value of underlying assets. Later on, companies such as Diageo and Cadbury started capitalizing band value in their balance sheet which was considered a heresy in accounting circles.
Globalizing Indian firms will obviously be the first to adopt IFRS3. Tata Steel bought Corus for about $13 billion, with $6-7 billion going to value of intangibles in balance sheet.
Building and capitalizing brand value will become critical across sectors, not just for companies in the packaged goods and durables business. In bulk chemicals, oil and gas, average value of intangibles is 40% of EV, show studies by Brand Finance. India will open up its banking sector in 2009 in keeping with its commitments to the World Trade Organization and IFRS3 is critical for the sector since it is all about branding and customer base.
“Companies here don’t appreciate the gravity of this yet, but they will have to do much more due diligence before acquiring companies and brands,’’ says Unni Krishnan who cites the experience of Vodafone Group Plc. to underscore the importance of such standards. Vodafone bought Mannesmann AG for about $100 billion in Germany, about five to six years ago and a large part of this amount went to goodwill. When the IFRS3 standards rolled out in 2004 in Europe, Vodafone had to show components of goodwill, and a year later show brand value and impairment if any. It posted the largest losses in British corporate history when it wrote off intangible value worth $60 billion last year.