Intangibles Seek Due Recognition - Coursework Example

Intangibles Seek Due Recognition Introduction In common parlance assets of a corporation are understood only as physical assets like plant and equipments, properties, cash and cash equivalents, receivables and like that. These assets appear on the balance sheet of the firm and have book values. In modern world market value of a successful company is much higher than the value of these tangible or physical assets. In certain cases physical assets constitute even less than half of the market capitalization of the company. So where is the other half or remaining assets that contribute to the market value of the company? This remaining value is the value of non physical assets called by accountants as intangible assets. Intangibles are mostly represented by patents, goodwill, copyrights, human capital, intellectual property, and like others. Even successful companies some times are not fully aware of the market worth of such assets. One view is that the fault lies with late recognition of intangibles by the accountants and that too with a partial, incomplete and unsatisfactorily approach. Accounting standards developed so far have not given that due recognition or prominence to intangibles. It is really amazing that more than ninety percent of accounting regulatory nitty- gritty surrounds less than half of company’s capitalization factors and other half goes a begging for proper recognition at their true value. It is time that due recognition be given to intangible assets that contribute effectively to the value of the companies. An effort is made out in this write up to bring out the reasons of such accounting negligence to the fore with recommendations to start presenting the financial statements as ‘true and fair’ in the real sense of this terminology. Contents Introduction Contents Importance of intangibles Lackluster accounting system Suggestions Conclusion Importance of Intangibles There is a basic difference in businesses being carried on production and trading of physical goods than the businesses that are executed on basis of trading in services, technology, experiences, and ideas. The difference is that performance of former is measureable, where as in later case it is very difficult to measure the volume of trade. At the same time concrete and effective efforts have not so far been made to measure the capacity of an economy in terms of its potential of promoting businesses in exchange of services, experiences and technologies. The basic reason is that such services, experiences, and technologies are result of assets called ‘intangibles’ that do not have physical appearance like properties, plant and equipments. It is difficult to define the term ‘intangible’. But some efforts have been made to provide some credentials to the term ‘intangibles.’ As per Margaret M. Blair and others (page 10)1, ‘intangibles are non- physical factors that contribute to, or used in, the production of goods or the provision of services or that are expected to generate future productive benefits to the individuals or the firm that control their use.’ Thanks to the wave of globalization, the firms have now started realizing the value and importance of ‘intangibles assets’ that have been disregarded or ignored so far; and all this has happened in last two decades. The realization of the importance of intangibles is due to the impact intangibles have made on the earnings and market value of the multinationals. ‘Specifically the relentless competitive pressure induced by the globalization of trade, far reaching deregulations, and technological changes (mostly recently the internet) forced companies in the last two decades to increasingly rely on continuous innovation (of products, processes, and organizational designs) for survival and growth. Innovation, in turn, is primarily achieved by investments in intangibles (research and developments, information technology, employee training, customer acquisition) - hence the steep rise in the role of these assets in the production functions of businesses.’(Baruch Lev, page 2)2 After the revolution of globalization of businesses, the intangibles are gaining importance both in business and accounting fields mainly because of following reasons: Service industry is making rapid strides and intangibles are directly related to execution of various professional and technical services as human intelligence or human capital. Business in trading of consumables is growing because manufacturing of consumables is getting concentrated mostly in those parts of the world where costs of production are economical. For example production activities of consumable goods are getting clustered in and around China and India. With the result, trading in rest of word has become major business activity. As intangible assets like brand name, goodwill, copy rights, and others are directly related to trading activities, the contributions of such intangibles to the value of organizations have become immensely important. Manufacturing activities are getting dematerialized. Now – a – days products are developed and manufacturing rights are sold. The stress is on distribution and marketing of products. Human intelligence is being recognized as the real source of innovations. Book values of companies are completely different from their market values. This is because many intangibles remain out of the accounting systems. Intangibles have started playing valuable role in value creation of any product, service and organizations as well. Despite the fact that intangibles are gaining importance in modern business world, there exist certain limitations and challenges that are limiting the real recognition and valuation of intangibles. These limiting factors are described here under: “ Often there is a fundamental lack of awareness of the nature of (or even the existence) of intangible assets, and thus a failure to recognize the value and opportunity of managing them. Knowledge and ideas throughout organizations remain un-captured and un- developed. Tangible asset management paradigms and managerial competencies vary from firm to firm. The functional management of strategic assets is done whereas strategic management of intellectual capital is neglected. There is lack of intangible asset leadership.”(Dr. G. Bharathi Kamath, 11 July 2006)3 Lackluster Accounting Systems Present accounting systems are at fault for not providing the due recognition to intangibles that is warranted by the effective presence of intangibles in modern businesses. Present accounting standards and regulations are based on preconceived objectives and notions. It is observed that such notions often ignore the realities surrounding the business world. That is the reason that the present accounting system is being made responsible for present economic crisis world over. “The basic challenge is that the entire accounting system, and everything built around the accounting system was optimized for much simpler economy. The IRS cues off of the International Accounting Standard Board and the FASB, Financial Accounting Standard Board of the United States, which is trying to move towards international standards. Neither of them has developed particularly good rules for handling the intangibles.” (John Eastman, page 3)4 Accounting standards in most of the countries do not deal with most of intangible assets. Only goodwill out of all intangibles is dealt with by such standards even after such huge impact on businesses of intangibles like human capital, intellectual properties and others. Intangible assets have often been sidestepped by the developers of accounting standards. Such intangibles are not recognized and thus do not count in book values of the firm. Earlier the recognized value of (mostly only the goodwill) was subject to amortization over a period of 20 or 40 years. Now the standards seek impairment testing of recognized intangibles. That is book value of intangibles is compared with fair market value and the excess, if any, found is written off to income statement. But the irony is that ‘the accounting standards do not specifically prescribe a method for calculating fair value, although they conditionally emphasize that the best available evidence is an active market.’(Jeffery Cohen, page 49)5 This treatment of intangibles suggests that present day accounting systems do not treat intangibles at par with other assets like properties, plant and equipments, even though intangibles, wherever they are effective, are greater source of revenue to the organizations. Practically speaking impairment losses written off to income statements are treated like extraordinary items, even after drastic changes in accounting standards. Such transactions are often ignored while making merger or acquisition deals. Expenditure on research and development for creating intangibles are immediately expensed with if such expenditure does not result into an intangible that is identifiable. But the tragedy is that accounting systems have so far not developed any bases of such identification of internally generated intangibles. Frankly non- recognition of such internally generated intangibles is like putting forth unfair view of the affairs of the businesses. Moreover, the effect of expensing R & D is directly on the earnings of the company and the book value of equity. Both will be understated and that again is not a fair view presentation of financial statements. “This makes it practically impossible for investors and company managers to assess the rate of return of investments on intangibles, and change over time in the efficiency of the firm’s investment activity; evaluates shifts in the characteristics of intangible investments, such as from long term research to short term development, or from product development to ‘process (cost reducing) R & D; and determine the value of firm’s intangible capital and the expected lives of such assets’(Patrizio Bianchi and Sandrine Labory, page 157)6 ‘A central element in the critique of current accounting practice relates to the observation that significant difference often exist between company book values and their market capitalization. The book to market gap tends to be particularly large in services and high technology firms (for example, bio technology and software houses) which typically invest their little in tangible assets, though they often invest heavily in people, processes, and technologies.”(Gordon V Smith and Russell L Parr, page 90)7 Measurement of returns of assets is the barometer of performances of entity using those assets. But accounting systems do not prescribe specific rules and regulations to measure the returns on intangibles. It is true that intangibles can not be described, but the accounting system can formulates some rules to judge and evaluate the performances of intangibles. The result is that the success attained by the organizations by using intangibles is given to physically recognized assets and not to those unknown intangible assets. Suggestions Though hidden, unnamed sometimes, and certainly not in physical shape, intangibles have to a big role to play in modern style of business operations, particularly after globalization of the businesses. International accounting bodies like IASB and other national accounting standards setting bodies have a role to play in developing an equal recognition and reporting rules, regulations and standards for intangible assets like that of physical assets. As stated by Derek L Bosworth and Elizabeth Webster (page 252)8 ‘improved accountancy practices for intellectual assets can have a variety of effects that can contribute to making enterprises more aware of value potential which might otherwise be overlooked, and sensitizing other actors in the innovation system to a more realistic understanding of risks and rewards through these values.’ Accounting bodies must come forth to introduce rules and regulations that bring intangibles on equal footings with physical assets. Conclusion We must now think beyond goodwill and develop the identification procedures of other intangibles. Every intangible asset should not be dumped under the category of goodwill under the pretext that present accounting rules cannot identify them. It is surprising that benefits are being taken from those intangibles that remain un- identifiable as per our accounting system. A radical change is required in rules, regulations, and standards for recognition, measurement, and valuation of intangible assets. Accounting bodies must hear the warning alarms. References Read More