Wealth creation has always been one of the pressing concerns of business owners and entrepreneurs. Maximizing business assets, either for expansion or handing over to the next generation—discussions naturally evolve into how much assets are reflected in the financial statements. Does the balance sheet capture all the assets of the business or does it reflect the true wealth created by the business owners and entrepreneurs?
This is particularly pressing in the case of Robbie and Jacky, an enterprising couple who, straight out of college, established a successful fashion line. For 40 years they poured blood and sweat into their business, tirelessly working to develop a brand that would gain a sizeable following and eager customers. Slowly and scientifically, they have put up 10 outlets in prime locations across the metro. They’ve established a loyal workforce with intimate knowledge of both their creations and customers. They’ve perfected a business model that cuts design-to-display time by at least 30 percent.
Now in their 60s, Robbie and Jacky are seriously looking forward to retirement and turn over the business into the capable hands of their only child. For the first time in a long time, they took a hard look at the financial statements. They noticed that sales are steadily rising and profits at healthy levels, but they are surprised at the amounts and nature of assets reported. The parcels of land still reflect the price they were acquired decades ago. The buildings, which used to account for a huge chunk, are now almost zero. But what bothers the couple the most is that the “brand” which they painstakingly built over 40 years is nowhere to be found. To Robbie and Jacky the brand is their single biggest asset.
It is highly regarded in the fashion industry and was recently awarded as one of the top local brands. And what about the loyal and highly skilled “workforce” that they have assembled? Or the business model and very efficient “distribution channel” that they have perfected? Do they count for nothing? Is this all that they have to show for 40 years of hard work and sleepless nights?
Many business owners share the same predicament. The disconnect between what owners perceive as an “asset” versus the physical assets recognized in the books for accounting purposes. Let’s take the land and the buildings as an example. For business owners, the value of land in prime locations appreciates over time and, therefore, should reflect a corresponding increase in the assets recorded in the books. Yes and no. Yes, normally the value of land increases over time, some locations more exponentially than others, but under existing accounting rules, financial statements are generally presented using the historical cost convention. This means that the parcels of land acquired by Robbie and Jacky, for P15 per square meter some 40 years ago, are still shown in the books at that same value, regardless of the astronomical price levels of today. As for the buildings, Philippine Accounting Standard (PAS) No. 16 introduces the concept of depreciation. The objective is to allocate the cost of the building over its estimated useful life, given that over time, the value of the building reported in the books systematically decreases.
This is a situation where the financial statements show an asset that depreciates and another asset that never appreciates. Is this fair? Under our accounting rules, yes, this is acceptable. Is this the only way? No. While most companies follow the historical cost convention, under PAS No. 16, there is an option available to use the so-called revaluation model. Under this model, land, buildings and similar assets are appraised using current market prices and presented at fair values. The rule however, requires that the revaluation model should be used consistently per asset class (i.e., all land and buildings should be revalued) and that appraisal should be done with sufficient regularity.
Now let’s go to the more complex question on brand, assembled workforce and efficient distribution channel. These are all examples of intangibles and in the case of Robbie and Jacky, all internally generated. These are critical components of the business, no debate about that, but because they cannot be separately distinguished from the business as a whole, in accordance with accounting rules, these internally generated intangibles cannot be reported as part of physical assets in the financial statements. In fact, PAS No. 38 is very explicit that internally generated brands and other items similar in substance shall not be recognized as intangible assets.
If however, Robbie and Jacky decide to sell the business, then it becomes a totally different ball game, because from the point of view of the would-be buyer, these intangibles are no longer internally generated. They are now considered acquired intangibles and under existing accounting rules, these can be recognized separately as part of assets. And with this, Robbie and Jacky can, of course, ask for a premium price because they are not only selling the assets recorded in the books, but the whole business and all the related intangibles that go along with it.
But like many business owners, Robbie and Jacky are not planning to sell anytime soon.
They might be ready for retirement, but they are not yet ready to let the fruit of their labor be in the hands of someone outside the family. There is something gratifying about looking up the glitzy billboards along EDSA and recognizing the brand they have built from the ground up. Or seeing it on television draping A-list celebrities and famous personalities.
To them, it is not just about business. It is about their family legacy. And that is priceless.
* * *
Aldie P. Garcia is a Partner from Assurance, Markets Lead for Priority Targets and the PwC Experience Leader of Isla Lipana & Co./PwC Philippines. Email your comments and questions to email@example.com. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.