Put a number on it: the universal law of accounting (post #3).

(This post requires prior accounting knowledge. If you are not an accountant, please read the 2 previous posts of this newsletter. Please keep reading below. It will be worth your while.)

Part A. Accounting theory of intangible assets: cost-based systems

Intellectual Property (IP) is the largest asset in the world, according to Lars Seier Christensen, the co-founder of the Saxo Bank trading platform. He says that the totality of IP is greater than the value of all stocks and bonds in the world. Despite such importance, the accounting treatment of intangible assets is lacking. (Bold for emphasis.)

The problem is lack of adoption of the intangibles’ approach by businesses, and even a perfect methodology will not change this (source1: European Commission).

My article (previous posts #1 and #2) is based on accounting theory and practice, as per the quotes in section A below. It supports the cost-based system for asset values, as opposed to valuations based on market values. Cost-based valuations make sense for non-traded intangible assets. (This is the first line in the chart below).?

Warren Buffet famously quipped of the requirement to mark to market nontraded assets/liabilities: “This is not marked-to-market, rather marked-to-myth.” (Source2: Baruch Lev and Feng Gu).

When sales of assets are only an incidental part of an entity's business model, the amortised cost classification is appropriate. Profit and loss statement is associated with market value. This is different from the balance sheet, which is associated with intangible assets. (By the way, choosing a fair value valuation technique implies that the asset in question has higher risk than normal, which is not always the case.)

As stated in previous posts, reputation as an important intangible asset. This is supported by the IFRS Conceptual Framework for Financial Reporting (hereafter CF), if the asset “has the potential to generate economic benefits”. (Source3: Jeremy Nicholls and Rosie Dunscombe et al.) (This is about the third line in the chart below).

Let us quote the book by Baruch Lev and Feng Gu The End of Accounting and the Path Forward for Investors and Managers (2016) (source2). (This is about the first line in the chart above).

?“Accountants should avoid the periodic valuation of assets/liabilities that are not traded in active markets. Such assets should be recorded at original costs, and their essential attributes (ages, nominal values, description of properties) should be adequately disclosed in financial report footnotes, allowing investors who are interested in current values to estimate them. Accountants have no special expertise in valuation. Financial reports should stick to the facts and ‘near facts’, namely, highly reliable and verifiable estimates. After all, that’s what accounting, derived from counting (of facts), is all about. A positive by-product of eliminating unreliable asset/liability valuations: mitigating the detrimental effect on the informativeness of earnings (sheer noise) from the gains/losses of such periodic valuations.”

“Extensive evidence links investors’ information uncertainty to share price decline and volatility increase, particularly for medium and small companies, for which investors’ information is generally constrained.” This could be due to e.g., “low institutional holdings, low analysts following etc.”

“Overall, given the large number of intangibles owned by companies, while the life of some intangibles may be overestimated, it will be largely offset by underestimation of other intangibles.”

“We don’t suggest to value intangibles by their current purchase or sale prices (fair values). Rather, in line with the treatment of these assets in the national income accounts (in the US issued by the Bureau of Economic Analysis), we propose to capitalize the investment in these intangibles, using their objective original cost. We leave intangibles’ valuation to appraisers and just propose properly accounting for the facts – that is, the costs of intangibles. After all, that’s exactly what’s done in accounting for tangible, physical assets (despite their decline in importance). But what good will it do to report the historical values of intangibles on the balance sheet? What can investors learn from these numbers? Answer: The same things they learn now from balance sheet values of tangible assets (property, plant & equipment): the original spend on these resources. Not much information, but better than the complete absence of intangibles from the balance sheet. Importantly, the main reason to capitalize intangibles isn’t to enhance the realism of the balance sheet – very few, if any investment decisions are based on asset values anyway – rather its aim is to restore the income statement to the statues of a meaningful indicator of operating results, by properly separating investments from current expenses, thereby substantially improving the measurement of business performance.”

“Wouldn’t you like to know how much the company spent on IT, brand enhancement, employee training, customer acquisition or the development of unique business processes, and wouldn’t you like to track the trends in these investments?”

“Consider eliminating quarterly reporting, leaving only semi-annual and annual reporting. Every 3 months you only need a simple sales and cost of sales report, not a full-fledged financial report.”

“The capitalization of certain intangible investments will undoubtedly improve the quality of reported earnings, but much more is needed to provide relevant information on intangibles to investors. Most companies provide extensive footnote disclosure to reveal information on physical and financial assets, so, why aren’t any details provided on the far more consequential intangible assets? After all, that is what the generally lauded, yet never really followed, ‘principles-based accounting’ is all about.”

“Analysts' forecasts move markets, not their analysis of past financial reports. When the financial reports are publicly released, their thunder is largely stolen.”

There is an interesting thing to keep in mind, if your company is applying for various state programmes, which support innovation. Angela Browning, chartered accountant and tax adviser, says at 6 minutes into the webcast, "If you capitalize some your cost as either a tangible or intangible asset, that has an effect on your (R&D tax credit) claim." (Source4).

The reason we need to capitalize all capital expenditures, not just the tangible capital expenditures, is to hold the company accountable that it gets an adequate return on invested capital. If we don't capitalize intangible capital expenditure, the calculated return on capital will be too high. (Source5: Professor of valuation Mr. Aswath Damodaran.)

“The essence of capital expenditure is that it is an expense whose expected benefits are not just in the current period, but in future periods. Research & development (R&D) expenses clearly fit the bill. There is nothing in the definition that requires that those investments be in physical tangible assets. It can be anything. Furthermore, uncertainty of future value is never used with other types of capital expenditure (building a factory to make a new and untested product) as the driving rod for capital vs. operating expenses.” (Source: Professor of valuation Mr. Aswath Damodaran at 13 minutes in source6 and at 11 minutes in source7.)

”For a company reliant on human capital for its value, it makes sense to treat human capital as something that they invest in for the long term.” Source: Professor of valuation Mr. Aswath Damodaran at 11 minutes in source7.) I n most consulting companies recruiting and training expenses are capital expenditures.

Elliot Schreiber at 56 minutes in video8: “I do believe that good governance can become an intangible asset that can be used to competitive advantage. They are creating all the value and all the profits right now!”

Think about the royal families of the world. Some developed democracies interestingly don’t remove their royal family from the taxpayer bill – for the sake of intangible assets like brand value. That is income from tourism as well as representation at international trade trips. Intangible assets is not a modern invention, but it is a mystery why accounting of intangibles has not followed suit.

It is well known that many countries recognise crypto assets as commodities (assets). The asymmetry starts when those same countries don’t recognise other essential intangible assets as assets, like reputation, data quality, brand value, natural capital, R&D and many others. These just get written off as expenses. After all, these are the very things that crypto assets are trying to emulate, however nascent and unregulated. I believe that there is nothing preventing capitalization of intangible assets in business accounts, if you want to do so. And for regulators: if we evaluated the mentioned intangible assets properly, the need for and appeal of crypto assets would probably be lower. This is a better strategy than fighting crypto assets, which will only lead to backlash. This is because we are fighting the symptoms instead of treating the underlying reasons.

And in any case, “it is very hard for a regulator within a single jurisdiction to manage something that is global” (source9: Kate Baucherel at 35 minutes in video).

Reciprocally, an entity keeping crypto assets in custody is expected to disclose any contingent liabilities. But the same expectations are not put on non-crypto assets. ‘Entity A may need to provide disclosure describing the types of loss or additional obligations that could occur, including customer or user discontinuation or reduction of use of services, litigation, reputational harm, and regulatory enforcement actions and additional restrictions.’ (Source10: SEC 1).

My take from this is that it is just a matter of time before contingent liabilities will become mainstream for traditional companies. Many emergent regulations are already trying to emulate contingent liabilities, for instance EU Data Act and other acts on data security, climate risk, cybersecurity, special purpose acquisition companies, labour law etc. (Source11: SEC 2.)

The S.E.C. recently adopted a rule to allow companies to recover incentive-based pay from current or former executives if it was based on wrongly reported financials and the business is forced to do an accounting restatement. (Source12: SEC 3).

This leads us to the next section, which talks about the other side of the balance sheet, i.e. contingent liabilities.

Part B. Accounting theory of contingent liabilities

This article (posts #1 and #2) was written before the crisis in Ukraine. The crisis has demonstrated the power of stakeholders, where many businesses had to pull out of Russia. It’s all about the economic consequences of reputation.

Furthermore, the crisis demonstrated the power of contingent liabilities. (Even IAS38 mentions liabilities in the introductory paragraph 9. We can hope that sometime, the internally developed/created intangible assets as a means of mitigating contingent liabilities, will be recognised on equal footing to any acquired intangible assets.) Also remember our discussion of the real cost of assets, called opportunity cost in post #2.

(This is about the 6th line in the chart above).?

?“As directors we have a legal responsibility to ensure that valuations present a ’true and fair value’, a foundational principle in accounting which overrides even accounting standards. You can have limited liability as a company and as its owners and in return you must provide information that it is a true and fair position of the value you have created.” (Source13: Jeremy Nicholls.)

According to Jesse Powell, the Kraken CEO, ‘The statement of assets is pointless without liabilities.’ (Source14).

Business is the only place in society where it is advantageous to integrate contradictory values at the same time (after all, assets and liabilities are opposites). As if one had a mild form of personality disorder. (Source15: Abraham Zaleznik).

CF describes contingent liabilities: “An obligation is an unavoidable duty or responsibility. The obligation must have the potential to transfer an economic resource, but it does not need to be certain or likely that the entity will need to make the transfer. It may be required only if an uncertain future event takes place. Finally, it must relate to past events where the entity has already obtained economic benefits or taken action and therefore, will or may have to transfer an economic resource that it would not otherwise have had to transfer.”

“This includes a situation where avoiding the duty or responsibility would have higher economic consequences than the transfer [of payment to a stakeholder], for example from loss of reputation.” (Source3: Jeremy Nicholls and Rosie Dunscombe et al.)

There is an example of loss of reputation, which has economic consequences for PayPal through loss in its share price. (Source16).

For a company contingent liability could be reparations in a (potential) lawsuit or loss of reputation. (This is the 6th line in the chart above). For a country a contingent liability could be outright war. But contingent liabilities can also take the shape of development of alternative products and services, as a response to needs not addressed. Arguably, crypto assets is a contingent liability of the traditional financial system, because they were originally implemented as a response to the 2008 financial crisis. If the traditional financial system had recognised the liabilities it creates, maybe crypto assets had not been introduced, or at least had not taken hold. (Source17: Alan Kohler).

If crypto businesses become an increasing part of the economy, they should not repeat the same mistakes as the legacy financial system (source18: Yanis Varoufakis, source19: Jeff Booth, source20: Jason Meyers at 6 minutes in the video 1, source21: Christian Kameir at 36 minutes in another video, source22: Jason Meyers at 30 minutes in the video 2, source23: Jason Meyers at 21 minutes in the video 3, source24: Timothy Gieseke).

Crypto businesses should ensure that they account for the contingent liabilities of their operations (source: Jeremy Nicholls). We know that a crypto business is on-chain, i.e., it is transparent. So far so good. But here we are only talking about the asset side of the balance sheet. As we know the balance sheet has 2 sides, of which the liability side cannot be fully on-chain, and needs to be disclosed in the financial statements (source22: Jason Meyers video 2).

Traditional company structures do not encourage taking into account the potential dark side of doing business (source: Jeremy Nicholls). This is the case in all industries, both established and the crypto ones (source25: Crypto Eri at 33 minutes and Oz Crypto at 58 minutes in the video.)

For a crypto business this could be risk of fraud or internal power struggles, risk of cybercrime and money laundering, risk of technological and regulatory changes etc. - which are contingent liabilities and should be recorded on the liability side of the balance sheet of the crypto business. (This is the 6th line in the chart above.) Not to mention the greatest risk of them all facing crypto businesses: the risk of loss of privacy of individuals, i.e., enabling a surveillance economy. (See several sources26 on the surveillance economy in the sources section after the article).

Justin Trollip puts it like this: "If we don't get our house in order, someone else is going to come in and put our house in order." (at 28.20 minutes in video, source27).

?“Not putting your house in order” is when your business does not account for contingent liabilities, nor develops intangible assets to mitigate those liabilities. It’s like betting that the government or another company will bail your business out, if you fail (source28: Mark Nelson, at 10 minutes in the video). It is equivalent to when an individual person, e.g. a smoker, is betting that the government, their employer or their children will bail them out, when they get sick (source29: Jennifer Radin). In the stock market they call this a put option/shorting (source30: Thomas Murphy).

It is very interesting that Satoshi Nakamoto, the creator of the first adopted blockchain, decided to remain anonymous. When you remain anonymous, there is nobody to sue, so you don’t incur contingent liabilities. Also remember our previous discussion on the vital importance of trade secrets (post #1). Who knows, maybe this anonymity was even helpful for the adoption of the product. Bitcoin is deemed commodity and not a security (though anonymity is not the main reason for this classification). On another note, there is new legislation in the EU, whereby data can be protected only in case its value stems from it being secret (source31: European Innovation Council and SMEs Executive Agency (EISMEA)).

According to Frank Giustra, CEO of the Fiore Group, "I know as a former trader, if you are trying to accumulate something, the last thing you want to do is show your hand. Because you are going to drive the price up." (source32 at 14 minutes in video).

According to Jeff Booth (source19), “A well-worn strategy used in business is to sue a competitor to put them on the defence and subsequently slow them down while the competing business in parallel develops a plan to win a key market. (Irrespective of the actual facts of the case or the implications.)”

An example from the financial industry was brought to my attention by Robert Kauffman, professor of digitalization at Copenhagen Business School. Some crowdfunding platforms have revenue sharing structures, which favour the least productive party in the transaction. My take is that this is a classic example of a long-term liability, if the structure really is unfair.?

Ramtin Matin, Head of Innovation at Sparebank 1-SR Bank (source33), the second largest regional bank in Norway, says, "The root cause is the inequality of the access to wealth building instruments. Some events related to companies like Game Stop, where hedge funds investment strategies were perceived as unfair towards the broader public, have resulted in people joining forces to even out that playing field. The sense of inequality is in my opinion the true core issue."

He went on to point out, "We are seeing cultural trends like the financially independent retire early movement (FIRE). It boils down to becoming financially independent which requires savings and a complete want to be independent from the financial system. There is an us versus them culture which to a certain extent I can understand. It is this current type of mindset that is fuelling the democratization of wealth management."

According to professor Kauffman, regulation is usually lagging behind innovation. My take is that, if a business really values its long-term survival, it should act as if regulation is in place, thus accounting for contingent liabilities long before they materialise. Remember our important discussion on the power of stakeholders in post #2.

On another note, even regulation could be some sort of a contingent liability, only externally implemented, in response to a lack of internal regulation. According to Alexandra Andhov, Associate Professor of Law & Technology at University of Copenhagen, regulation is equal to a hypothesis about how things are interconnected – what do we believe about humans? Authorities create a hypothesis with the goal of ensuring foreseeability and consideration for a variety of stakeholders, among other things. As we will see in section C below, real options methodology is also based to a large extent on hypotheses creation for different states of the future.

My take is that, by implementing internal regulation, you force yourself into the discipline of not viewing your immediate product or service as the only asset of the business. It forces you to discover and invest in your intangible assets. (You also reduce exposure to contingent liabilities.) So, this method has actually nothing to do with regulation as such. It forces you to ponder what your business really is about when push comes to shove. The value of having a focus cannot be underestimated. (Source: Ms. Inma Martínez, Digital Pioneer and Government Advisor on AI). Focus could be facilitated by accounting, as described in section A above. Case in point, Steve Jobs said (source34), “Technology is nothing. What’s important is that you have faith in people.”

Back to our description of contingent liabilities. A classic example of contingent liabilities is trade credit insurance (source: Robert Kauffman), swaps (source35) and derivatives (source36), because these instruments are sometimes not reflected in the balance sheet of the companies who sell them.

Jason Meyers from Auditchain said, “If you pay me an advance for a product, and I don’t deliver the product to you, that’s an accounting issue. That’s a liability on your balance sheet.” (source 37: Jason Meyers video 4, at 13 minutes in video).

The same thing explained differently, is when Elliot Schreiber says, “Non fulfilment of promise is the very definition of risk.” (Source38).

Let us now apply this general accounting principle to crypto assets.

Meyers says (source37 at 13 minutes): “It has very substantial accounting implications. If you raise X amount of dollars and you sell a token, which has to be used to access a network, but you haven’t built the network yet: you have a revenue that you’ve received, but you also have a liability, because you owe those people a network. And to the extent that you have not yet delivered it, is the extent that you must keep recorded a contingent liability. When you deliver the network, you then revert, you then make the adjustments in your accounting to reflect the fact that you delivered. You made the delivery.”

Meyers continues (source37 at 22 minutes): “You have a moral responsibility to tell the people who you’re asking to make a capital contribution, what the dangers are.”

Meyers continues (source37 at 29 minutes): "Let's say for a moment that if Celcius were a public company and they filed financial statements, and they booked custody of digital assets as 30 June, 2022 of 4 bn. What happens when those digital assets go to 2 bn? That's a challenge because, if you mark them to 2 bn, what you're actually doing is you're impairing intangible assets, because that's how they are treated. Anything that is immediately convertible into cash should probably not be classified as an intangible asset. Except for an NFT, maybe. An NFT is I think is fair to classify as an intangible asset, because it's unique, it's only one of them, and there is no established market for the one and only one unique thing. But when you are dealing with Bitcoin, which is a fungible asset, I don't think its fair that it should be treated as an intangible asset. But my point in this whole thing is, if Celcius was a public company, they'd have a challenge telling the truth. And that's not to defend them. MicroStrategy has the same issue. Will they revalue and impair their intangible assets? I don't know. Nobody knows. And if they do, you cannot revalue it until you sell it. When you sell it, you're then recording the difference between its value after impairment and the price by which you sold it. If you have profits, you're taking the aggregate of the impairment and you're hitting your earnings with it, e.g. if you earned a billion dollars and you got half a billion in impairments - means your net earnings will be half a billion dollars for tax purposes. And that's another problem because in the USA tax reporting and financial reporting are divorced. In Europe and elsewhere they're married. It's not only the accounting industry that has challenges ahead of it with digital assets and even the legacy system, but it's the way that that industry is regulated and needs to move into the future."

There is another source, which states the same thing, i.e. that crypto assets should be marked at fair value (source 39: Alex Tapscott).

I will suggest an answer to this important question of valuation of cryptocurrencies in post #5. Because fair value is akin to option valuation, see section C below.

Jason Meyers has also said, "The sale of a token is not paid in capital, like equity in a company is, when you sell shares in a company. That's paid in capital, it is not a taxable event. When you sell tokens, that's prepaid revenue, it's tax implications." (source20 at 33 minutes).

Part C. Real Options and Contingent Liabilities/Capabilities

In parts A and B above we talked about the cost-based system of valuing intangible assets, which is a great method and does not require advanced accounting knowledge. However, having worked with intangibles for a while, you might explore the next level of valuation methodology, i.e. real options. The next posts #4 and #5 will be dedicated to real options. (This is the last line on the chart above).?

According to Lars Ohnemus, Director of Center for Corporate Governance at Copenhagen Business School, the greatest issue we are facing in business is how to price risk.

Quoting the book by Vladimir Antikarov and Tom Copland on real options (source40):

“The central paradigm for making decisions about large investments is net present value. Unfortunately, it is badly flawed and systematically undervalues every investment opportunity. Why? Because it is based on expected future cash flows, thereby failing to account for value flexibility. To illustrate a typical net present value (NPV) problem, suppose that we are evaluating an 8-year project that will cost $50 million to design and $300 million to build. The NPV approach says to figure out the expected free cash flows over the 8-year life of the project, to discount them at the weighted average cost of capital, and to subtract out the present value of th e required investments. If the resulting NPV investment is negative, do not accept the project.

The NPV rule fails to consider flexibility. In the example that we are discussing, management has many options. The project can be abandoned after the design phase, it can be expanded or extended if it does better than expected, and it can be deferred. When optimally exercised, all of these options provide flexibility that adds to the value of the project. Senior managers intuitively know that NPV fails to capture these flexibilities and often disregard (for good reasons) the results of the analysis.

In ten years, real options will replace NPV as the central paradigm for investment decisions.”

In short, real options increase the value of your investments through considering ALL possible sources of value, which DCF ignores.

Hedging is a financial option. While a real option goes to changing course of real strategy.

Valuation Techniques by Larrabee, David T., Voss, Jason Apollo (source41) states:

“Many, if not all companies, have opportunities that are not so apparent. These opportunities are in the form of options that give a company flexibility in making decisions. Companies can terminate projects, switch to alternatives, enter new markets, exit old markets, delay expansions, and expand or contract existing investments. Standard accounting principles do not allow the value of such opportunities to appear on balance sheets, and the gains and losses from changes in the value of these opportunities are never recorded in earnings.

Unquestionably, these opportunities are a source of value, but are difficult to detect. In fact, we can probably safely say that many companies themselves are unaware of many of these valuable opportunities that they possess.

These opportunities are called real options, named as such because they deal with opportunities related to real investments, as opposed to financial investments. Options on the latter, such as puts and calls that trade on option exchanges and over-the-counter markets and options that are issued by companies to employees and executives, are well known in the financial markets. A large body of literature exists on valuation of these instruments, much of which can be traced to the celebrated Black-Scholes model, for which the Nobel Prize was awarded in 1997.

Real options involve choices: to invest or not, to terminate or continue an investment, to defer or carry on with an investment, to name a few.”

Real option analysis takes the methodology and the intuition of option pricing from financial markets and applies them to real assets. In the financial markets you can make a contract with another party, which promises to sell you an asset for a specified price sometime in the future. You have the right but not the obligation to buy that asset when the time comes, but your counterparty is obliged by the contract if you decide to exercise it. Therefore, if you believe that the price will go up, you can buy an option. The fee charged by the vendor depends on the consensus probabilities, i.e. how likely it is that the market will move in this direction. You must pay the fee, whether you exercise the option or not.

A put option is the mirror image of a call option. A call option is an option to buy, while a put option is an option to sell.

As explained by Vladimir Antikarov, “Risk management is done by getting an OPTION, rather than buying an ASSET. This way we do not penalize the business for spending money on the right things. Options are about finding the qualitative value of resilience.” (source42).

“Options are used to quantify the SWOT analysis of your company” (source30). Usually SWOT (strengths-weaknesses-opportunities-threats) analysis is only described in words, but with real options we make the SWOT actionable.

Money is a special type of language (source: Kristian Cameir). And with real options we finally have a tool for translating the language of words into this language of numbers. More in future posts.

Kevin Thomas Murphy further states, “Real options enable managers to both limit risk and downside exposures and still capitalize on growth opportunities.” (source43).

How is that you might ask? Thomas Murphy explains: “Manufacturing companies often rely on the futures market to lock-in raw material costs, and real options exist in the flexible operation of physical equipment. An oil refinery having flexibility to switch inputs and outputs has an embedded real option to switch when heating oil is in greater demand than gasoline. Flexibility increases the value of every asset under conditions of uncertainty. Long-term contracts contain option-like features, including volumetric swing components when demand is uncertain. Contract prices can be tied to an index, or a basket of commodities.” (Source30).

As we discussed in post #1, real options are useful to map both upwards and downwards movements of events. They are basically decision trees with different outcomes subject to probabilities, tracing the value to the present day. Contingent value means a value which is subject to future development. Flexibility to change decisions is of utmost importance in running a business, leading to resilience. Traditional valuation techniques leave out this added value, thus underestimating the value of an investment. Also, traditional insurance cannot replace investment in resilience. Real options provide the value of flexibility by reducing uncertainty, e.g. deferring, expanding, contracting or abandoning an investment. (Source40: Vladimir Antikarov and Tom Copland).

Double entry bookkeeping is made for computers (source44: Jason Meyers). My take is that options are made for accountants.

Traditional accounting is about control of assets, while options is about controlling a possibility, not about buying the asset itself - a major change in mindset. Who said that ownership of an asset is a guarantee for reaping the benefits from that asset? This only applies in a simplified world, where competition is the greatest threat, and all it boils down to, is which competitor controls the assets. This does not apply in the real world, where we recognise that the greatest threat is internal – the risk of having a culture, which encourages spending time on insignificant things, or worse – spending time on things that hurt the business (source45: Benjamin Graham). Moreover, the real world includes contingent liabilities, like lawsuits and loss of reputation, which are just as important as the threat from competitors. Traditional accounting is about believing that traditional company structures will protect your property rights, while real options is about recognising that a lot of value creation comes from timing.

Traditional accounting looks at inputs to a business, while real options look at the outputs. Traditional accounting is about satisfying regulation, while real options is about satisfying needs as they arise. Traditional accounting (double entry bookkeeping) is created to support the limited liability legal structures (source46: Andy Martin), while real options give the possibility to include reactions from all stakeholders, even if they are not formal owners.

Back to the discussion of control, or perceived control. Accounting sources propose changes to the CF: "the replacement of the concept of control with the concept of responsibility to recognize positive and negative changes to capitals which are not controlled, building on the attribution hierarchy in the Principles of Integrated Capitals Assessments." (source47: Jeremy Nicholls and Prof. Mario Abela et al.).

We have seen how unexpected events like COVID and the war in Ukraine have disrupted business and society. Vladimir Antikarov says that we respond to a risk scenario only when it occurs. This is the opposite of proactive resilience. For instance, traditional NPV decision making is based on average cost and best-case scenario. It wouldn’t justify buying an umbrella while it’s still sunny. It is the correct cost benefit analysis and methodology of assessing the value of building those contingent capabilities. An umbrella is a contingent capability. You buy an option to stay dry. It is not about buying the umbrella itself. Thus, we should rather talk about Agility Adjusted Net Present Value, which is the same as quantifying a SWOT analysis! In other words, preparing for the worst, whilst taking advantage of the best. (Sources48).

Kevin Thomas Murphy points out, “Traditional capital budgeting methods using DCF techniques often conflict with business strategy because they ignore the strategic value of the investment. Option theory is the appropriate linkage between qualitative business strategy and quantitative financial analysis.”

“These embedded real options are the result of some flexibility and growth opportunity, which may be exercised by management over time as new information arrives to resolve some uncertainty.” (source49).

Real options perspective is already implemented in the Danish public system for worker development, with the introduction of the so-called ressourceforl?b in 2013. It is a lengthy process through which all possible development opportunities of the worker are required to be utilized. (Source50: Louise Schelde Frederiksen.) As the law permits the use of real options on individuals, this method could be used on companies as well. Private individuals will be held to a higher standard of accountability than companies if companies don't account for intangible assets and liabilities. This is very important to remember for the adoption of real options method in companies, which has been very limited so far.

In other words, there already exists a system in the world for how to develop companies. Most of the business community just don’t know about it. It is possible that this system is similar to the one applied by Private Equity funds when they streamline a business before exiting.

Let’s investigate an analogous example. As patents can be valued using real options (so urce51: Grid Thoma), it is obvious that real options can be useful for valuation of other intellectual property too. Quite interestingly, the real option approach can be reconciled with the Tobin's q market value model of the firm.

Furthermore, patents represent a textbook example of a contingent liability. The main feature of a patent is that “to make use of the right to exclude others from using the patented innovation, the patent holder must actively find and take actions against infringers” (Source52: Robert Heurelin). Litigation is thus set by default in connection with patents. Litigation is a put option.

An alarming question is whether litigation (contingent liability) is an almost expected result stemming from certain legal terms. Murphy (source30) explains, “In the Black-Scholes case [the theoretical option formula], the option is the result of limited liability of stockholders, which gives them the choice of either defaulting on the bonds if a bad state of nature occurs, or paying off the bondholders and receiving the value of the firm (exercising the call option) if the project is successful. “

My take is, that a lawsuit is actually a process of mendaciously unwinding the history of events in order to discern what (and who) impacted the final result. A lawsuit is like a real options exercise, but performed after the process, not before it. History of events is the same as the forward-looking data collection discipline, which we discussed in previous posts. But why do we have to wait until after the fact to make decisions, when we can prevent the pain of contingent liabilities simply by valuing them properly?

Legal structures in business is like being married: if you want it to last, do not sign a prenup.

Think about education. We treat it as an option to expand (otherwise known as a strategic investment), due to the possibility that it will open doors in the future, and because we don't know if it will pay off. The price of the option is the value of time spent on education plus any tuition fees. But why don't we approach investments in other intangibles the same way? Might it be because we assume that the government is taking the risk of education not paying off? After all, you can deduct any losses from taxes, if you were an incorporated business. Now there is nothing wrong with taking an education. This is just to illustrate that as business leaders we need to take our own risks. If the government takes your risk, it simultaneously takes your opportunities, as you cannot have only half of the bargain.

According to lawyer Casper Rose, “Equity in a company is a call option. This is because equity might increase a lot in value, if the company does well. What is valuable is what is in the head of employees, not what is written on the balance sheet. Valuation of your company depends on different scenario outcomes, which you map out using real options analysis. The real option method is very good, but you need to know the underlying assumptions of this model, as no model is perfect. Real options have value because this method is based on cash flow. Without cash flow there is no value. For example, in an event of a hostile takeover you need to know what you are really worth” (i.e. a put option).

Rose continues to say that “Carefully chosen legal terms of the shareholder agreement creates value in itself, thus impacting firm valuation. You should get options, not give options, f.ex. an ability to opt out of a contract, or pre-emption rights.”

?Chart 10: Summary of the first 3 articles:

Increase positives:

• Don’t sell your equity for peanuts. There is no lack of money from private investors. Compare the value of your assets using different methodologies and make your own decision on how much your assets are worth.
• Track your intangible assets on a continuous basis, by introducing dedicated processes for data collection. It is not a one-off exercise. That is because data itself is not the goal. The goal is learning about your business, which you will see will provide more flexibility and control in daily operations.
• Traditional accounting is designed to calculate taxes. So, if you don’t want to work for the tax office, don’t worry about traditional profits. The cost accounting method (the most basic of the valuation methods) will defer registration of costs to reveal true profitability, at a time when revenues from your intangibles finally arrive.
• It is your decision which unit of account is important, so design your own, based on what you believe in. No accountant or lawyer knows more about your business than you do. Even regulation provides a lot of room for discretion.
• Introduce alternative revenue streams, that capitalize on your intangible assets in new ways. The good news is that your intangibles don’t disappear, the more they are shared, as opposed to a physical good, which you lose when you sell it.
• Create scenario planning, for both favourable and unfavourable turn of events. Can you defer a decision until more information is obtained (perform real option analysis)?

Decrease negatives:

• You can decrease future costs by investing in intangible assets before things get out of hand. Insurance is not enough for risk management, as it is not addressing systemic risks.
• Rest assured that contingent liabilities do exist, and need to be addressed on the liability side of the balance sheet (quantify risk of e.g. lawsuits). It’s all too common for businesses to focus solely on the sunny side of building assets. Money is never free, so the rule of thumb is that the more money you make, the more contingent liabilities you simultaneously incur.
• More importantly, awareness of risks can bring a sense of urgency, focus and motivation, so essential in the daily running of a business.
• Remember that when you work on making one stakeholder happy, this increases the risk from other stakeholders. It is a trade-off, which you have to balance.
• The greatest risk is internal: the risk of creating a culture that doesn’t do what is in the best interest of the business. Traditional accounting doesn’t help either, as it creates incentives for short-term solutions.
• The existence of competitors is an excuse not to be selective when investing time and money in what matters for business survival, i.e. essential intangible assets like reputation, trade secrets, data quality and customer experience. Even if the government wanted to protect your assets, like reputation, it couldn’t.
• The thing not often told, is that you incur a great responsibility, when incorporating a business. There are so many rules and regulations, so it is impossible to know it all before deciding to start. The only thing in your control is the internal processes and culture. They facilitate learning and flexible decision making, with the dual goal of increasing revenue and avoiding risk.

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?Sources numbered in order of appearance:

1) European Commission: “Final Report from the Expert Group on Intellectual Property Valuation”. 29th November 2013).

2) Baruch Lev and Feng Gu. The End of Accounting and the Path Forward for Investors and Managers (2016).

3) Jeremy Nicholls and Rosie Dunscombe et al. at Capital Coalition.

https://capitalscoalition.org/publication/disclosing-impacts-on-natural-social-human-capital-in-financial-statements/

4) Angela Browning, chartered accountant and tax adviser at 6 minutes into the webcast. https://matter-ip.com/rd-tax-credits-and-patent-box/

5) Professor of valuation Mr. Aswath Damodaran. https://www.youtube.com/watch?v=landwqMR3AA

6) Professor of valuation Mr. Aswath Damodaran at 13 minutes in the video. https://www.youtube.com/watch?v=un6-H_wOizM

7) Professor of valuation Mr. Aswath Damodaran at 11 minutes in the video. https://www.youtube.com/watch?v=o4_GwR_6jR4

8) Elliot Schreiber at 56 minutes in the video. https://www.youtube.com/watch?v=ne_5z8i820Y&t=5s

9) Kate Baucherel at 35 minutes in the video. https://www.youtube.com/watch?v=f5weMis5wbc

10) SEC 1. https://www.sec.gov/oca/staff-accounting-bulletin-121

11) SEC 2. https://www.dhirubhai.net/feed/update/urn:li:activity:7024437075735191552/

12) SEC 3. https://www-nytimes-com.cdn.ampproject.org/c/s/www.nytimes.com/2023/01/14/business/dealbook/how-common-is-corporate-fraud.amp.html

13) Jeremy Nicholls. https://www.pioneerspost.com/news-views/20221111/true-and-fair-how-directors-should-be-presenting-accounts-the-21st-century

14) Jesse Powell, the Kraken CEO. https://coingape-com.cdn.ampproject.org/c/s/coingape.com/breaking-kraken-ceo-calls-binance-proof-of-reserves-pointless/amp/

15) Abraham Zaleznik. Managers and Leaders: Are They Different? Business leaders have much more in common with artists than they do with managers. From the Harvard Business Review Magazine (January 2004).

https://hbr.org/2004/01/managers-and-leaders-are-they-different

16) There is an example of loss of reputation, which has economic consequences for PayPal through loss in its share price. https://www.dhirubhai.net/posts/activity-6985273380497203201-Qt2k?utm_source=share&utm_medium=member_desktop

https://www.dhirubhai.net/feed/update/urn:li:activity:6984974108979560448/

17) Alan Kohler. https://thenewdaily.com.au/opinion/2022/06/27/bitcoin-capitalisms-failure-kohler/

18) Yanis Varoufakis, former Greek finance minister, https://diem25.org/yanis-varoufakis-crypto-the-left-and-techno-feudalism/

19) Jeff Booth. The Price of Tomorrow - Why Deflation is the Key to an Abundant Future. 2020.

20) Jason Meyers video 1, at 6 minutes and 33 minutes. https://www.youtube.com/watch?v=pQ29uIyL2lk

21) Christian Kameir at 36 minutes in the video:

https://www.dhirubhai.net/video/event/urn:li:ugcPost:6983203190544461824/

22) Jason Meyers video 2, at 30 minutes on disclosure of affiliated relationships between entities (and disclosure of general risk factors at 35 minutes, about bail out at 43 minutes)

https://www.youtube.com/watch?v=L_VjQsWcoT8

23) Jason Meyers video 3, at 21 minutes. https://youtu.be/tGBYu0AAn28

24) Timothy Gieseke on Natural Capital Units (NCU).

https://www.dhirubhai.net/feed/update/urn:li:activity:6987868980564631552/?commentUrn=urn%3Ali%3Acomment%3A(activity%3A6987868980564631552%2C6987895652743610369)&dashCommentUrn=urn%3Ali%3Afsd_comment%3A(6987895652743610369%2Curn%3Ali%3Aactivity%3A6987868980564631552)&origin=COMMENTS_BY_YOUR_NETWORK

25) Crypto Eri at 33 minutes and Oz Crypto at 58 minutes in the video.

https://www.youtube.com/watch?v=5m3GomqCxfM

26) Different sources on surveillance economy:

https://www.youtube.com/watch?v=SbvOC_Y0-6k

https://www.dhirubhai.net/posts/joe-mckeating_paypals-updated-acceptable-use-policy-aup-activity-6984672229930266624-til_?utm_source=share&utm_medium=member_desktop

There is a disturbing development within the surveillance economy. In Denmark public authorities have written to recipients of the lowest public benefits, that their bank statements could be reviewed without the person’s consent. (Legal source: Retssikkerhedsloven (det sociale omr?de) § 11c stk. 4). Source: https://www.elov.dk/retssikkerhedsloven-det-sociale-omrade/paragraf/11c/

Also note Jayson Meyers’ comments on “gatekeepers” within private financial institutions, who are essentially deputised by regulators to do regulators’ job.

Source23: Jason Meyers video3 at 21 minutes.

https://youtu.be/tGBYu0AAn28

https://www.youtube.com/watch?app=desktop&v=R674gbjVKTU

https://www.youtube.com/watch?app=desktop&v=9fPE4Qtr7s4

Facebook/Meta was fined for trying to circumvent GDPR. https://dataprotection.ie/en/news-media/data-protection-commission-announces-conclusion-two-inquiries-meta-ireland

27) Justin Trollip at 28.20 minutes in the video.

https://www.dhirubhai.net/posts/thinking-crypto_flare-flr-token-distribution-pangolin-activity-6963153842251132928-HgEX?utm_source=linkedin_share&utm_medium=member_desktop_web

28) Mark Nelson, at 10 minutes in the video. https://www.youtube.com/watch?app=desktop&v=GfzpsOs2JNk

29) Jennifer Radin from Deliotte at 36 minutes in the video below. She says that our employers are in fact healthcare organizations, because if an employee is not well, productivity goes down.

https://www.dhirubhai.net/video/event/urn:li:ugcPost:6958598111661322240/

30) Thomas Murphy. Derivatives and Model Risk, 2010.

31) European Innovation Council and SMEs Executive Agency (EISMEA). Study on the Legal Protection of Trade Secrets in the Context of the Data Economy (GRO/SME/20/F/206). 2022. Alfred Radauer, Martin Bader, Tanya Aplin, Ute Konopka, Nicola Searle, Reinhard Altenburger,

Christine Bachner.

32) Frank Giustra, CEO of the Fiore Group (source31 at 14 minutes in video).

https://m.youtube.com/watch?v=W6EAmeO8BF8

33) Ramtin Matin, Head of Innovation at Sparebank 1-SR Bank (source32), the second largest regional bank in Norway. Nordic Fintech Magazine, September 2022.

34) Steve Jobs said, “Technology is nothing. What’s important is that you have faith in people.” Source: https://www.cnbc.com/2019/10/05/apple-ceo-steve-jobs-technology-is-nothing-heres-what-it-takes-to-achieve-great-success.html

35) SWAPs off the balance sheet. https://www.dhirubhai.net/feed/update/urn:li:activity:6925050807125995520/

36) Derivatives off the balance sheet. https://www.zerohedge.com/markets/were-end-major-era-von-greyerz-warns-25-quadrillion-disaster-waiting-happen

37) Jason Meyers video 4 at 13 minutes, 22 minutes and 29 minutes in video. https://www.youtube.com/watch?v=hJBfq26v8n4

38) Elliot Schreiber on risk.

https://www.dhirubhai.net/feed/update/urn:li:activity:6993779556721565696?updateEntityUrn=urn%3Ali%3Afs_feedUpdate%3A%28V2%2Curn%3Ali%3Aactivity%3A6993779556721565696%29

39) Alex Tapscott. Crypto is about to change bookkeeping rules—and soon the accounting profession.

https://fortune.com/crypto/2022/11/04/crypto-is-about-to-change-bookkeeping-rules-and-soon-the-accounting-profession/

40) Vladimir Antikarov and Tom Copland. “Real Options – a Practitioner’s Guide”. 2003

41) Larrabee, David T., Voss, Jason Apollo. Valuation Techniques.

42) Vladimir Antikarov on buying an option rather than an asset. https://www.dhirubhai.net/feed/update/urn:li:activity:6932055676974194689?commentUrn=urn%3Ali%3Acomment%3A%28activity%3A6932055676974194689%2C6932397485436878848%29

43) Kevin Thomas Murphy. https://www.dhirubhai.net/feed/update/urn:li:activity:6932055676974194689?commentUrn=urn%3Ali%3Acomment%3A%28activity%3A6932055676974194689%2C6932397485436878848%29&replyUrn=urn%3Ali%3Acomment%3A%28activity%3A6932055676974194689%2C6932410237467463680%29

44) Jason Meyers. Blockchain and the impact on Accountancy & Audit lecture.

45) Benjamin Graham. ”Intelligent Investor”. https://www.youtube.com/watch?v=E6PPeIi37_Q

46) Andy Martin on double entry bookkeeping.

https://www.dhirubhai.net/posts/andy-martin-387188a_blockchainthoughtfortheday-activity-7017723800859365376-aye0?utm_source=share&utm_medium=member_desktop

47) Jeremy Nicholls (ambassador to the Capitals Coalition) and Prof. Mario Abela (IESEG School of Management, Paris, France) on behalf of the Capitals Coalition with input and guidance from Mark Gough (Capitals Coalition). Supported by: Stephany Breytenbach and the Capitals Coalition Team."Capitals Coalition, 2022. Towards a Conceptual Framework for Sustainability Reporting”

https://capitalscoalition.org/wp-content/uploads/2022/08/CFSR-report-2022.pdf

48) Vladimir Antikarov. https://www.aferm.org/aferm-risk-chats

Episode 56: ERM for Capital Budgeting

Episode 26: The Costs and Benefits of ERM

49) Murphy, Kevin Thomas, "Financing research and development projects: Real options, spillover, and SWORD securities" (1995). Business Administration - Dissertations. 59.

https://surface.syr.edu/busad_etd/59

50) Louise Schelde Frederiksen on ressourceforl?b. https://event.webinarjam.com/replay/114/o8nvqa90irrt6mcl2z

51) Grid Thoma.

https://journals.aom.org/doi/pdf/10.5465/AMBPP.2019.96?download=true

52) Robert Heurelin

https://odr.chalmers.se/bitstream/20.500.12380/304440/1/E2022_001.pdf

“Patents exist to incentivize innovation by creating temporary monopolies, but they only give the right to exclude other actors from using the technology (Granstrand & Holgersson, 2014). In order to have use of the patent for this purpose, the patent holder must actively sue any alleged infringer and win over them in the following process (Yang, 2019).”