The Limits of Financial Statements

Financial statements are like a company’s medical chart.
One of the key statements, the balance sheet, shows where the company’s money comes from and what kinds of assets have been acquired or built using that money. The balance sheet is divided into two sides: the right-hand side shows how funds were raised, and the left-hand side lists the assets obtained.

No one knows exactly when financial statements were first created or who invented them, but they were already widely used in Venice during the Middle Ages. In Japan, they were formally introduced in the Meiji era.

The fact that financial statements have been used for centuries is proof of how effective this system is.


However, in today’s information-driven economy, the shortcomings of financial statements are becoming more and more apparent.

Intangible Assets Are Information Assets

Financial statements primarily record tangible things—physical assets. A company with plenty of land, factories, inventory, and securities is seen as “wealthy.”
It’s not impossible to record intangible things as assets, but intangibles are vague and hard to measure in value, so they are rarely included. As a result, financial statements end up focusing on tangible assets.
Intangible assets include know-how (experience), sales information, manuals, human networks, brands (corporate image), and so on. Patents are also a typical intangible asset.

In other words, intangible assets can be described as information assets that are valuable for business activities.

Many people recognize that intangible assets are the real source of a company’s earnings power and competitiveness. But clearly identifying what intangible assets a company has, and putting into words how much they are worth, is extremely difficult.

Costs Are Visible, Value Is Not

Today, it is often said that most corporate assets are intangible.

Many mergers and acquisitions (M&A) are carried out to obtain the intangible assets of the target company. When an acquiring company pays more than the book value of the target’s assets, the explanation is that there are intangible assets not shown on the financial statements.
The difference between the value of a company as recognized through tangible-asset-based financial statements and its true value including intangible assets is usually very large.

Patents, which are a kind of intangible asset, are also not normally recorded on financial statements.

Obtaining patents costs money. These costs are treated as part of research and development (R&D) expenses. Even if you invest one million yen and obtain a patent potentially worth one billion yen, the financial statements will not show “a patent worth one billion yen.”

An exception is when a company purchases a patent from someone else. For example, if Company A buys Patent P from Company B for 300 million yen, Company A can record “Patent P worth 300 million yen” as an asset. But even then, outsiders cannot know whether Patent P is really worth that much. From this perspective, the credibility of financial statements becomes questionable.

As mentioned, because patents are generally not capitalized as assets, it is hard to get everyone to recognize their value. Only those who use patents, or those who might be subject to them, really feel their importance.

On the other hand, the cost of acquiring and maintaining patents is obvious and easy to understand. As a result, if the value is not well explained, patents are often seen as “just costs.”

This is like money itself: if you’ve never actually used money, you wouldn’t truly feel its value. Patents are similar in that way.

Are Japanese Companies Undervalued?

One common stock market indicator is PBR (Price-to-Book Ratio).
It shows how many times higher the market price of a company’s stock is compared to its net asset value per share. In simple terms, it compares the net assets listed in financial statements (roughly: total tangible assets minus total liabilities) to the market valuation of the company.

If you include the intangible assets that don’t appear in financial statements, companies should have far more value than their tangible assets alone. In that case, PBR should be well above 1.0.
Yet in reality, many Japanese companies have a PBR below 1.0. That means the market values them at less than the net assets recorded on their books. In theory, these companies are extremely undervalued.

Investor Relations (IR) refers to activities where companies communicate with investors about their business, financial condition, and performance outlook. The goal of IR is to provide information beyond what financial statements can show, in order to reassure investors and lower the cost of raising capital.

If companies could skillfully explain, as part of IR, the quality and quantity of their intangible assets—patents included—investors would have an easier time recognizing their true potential. Stock prices might rise as a result.

Recognizing what intangible assets you have, and explaining how they generate earnings power, is what makes intellectual property activities useful for management.