Arguments for Accounting Recognition of Intangible Assets - Research Paper Example

RECOGNITION AND DISCLOSURE OF INTANGIBLE ASSETS Introduction Financial reporting within the current business context is imbued with the expectations of meeting the challenges of the new economy. Many studies have been conducted as to how various stakeholders – investors, managers, creditors, analysts, regulators and, above all, clientele – may relevantly assess the value and performance of their firm. It has long been acknowledged that the traditional financial statements, the principles of which were developed in the mid-20th century, no longer capture the value drivers that dominate the new economy (Upton, 2001). In response thereto, proposals have been considered to establish a new reporting paradigm that would capture, measure and report information that would be more responsibe to the need of the business stakeholders. Observers have been keen, in particular, on the proposal for accounting recognition and measurement of intangible assets in the balance sheet, and development of performance metrics to convey output information. It has become conventional knowledge, firstly: that in present business realities point to the fact that companies rely heavily on intangibles to drive value creation; and secondly, that there is progressive reliance on measures other than net income in determining performance output of a business. Inasmuch as present Financial Accounting Standards Board (FASB) and International Accounting Standards (IAS) Committee frameworks are perceived to be deficient in addressing these needs sufficiently, the debate as to how recognition of intangibles and performance outputs could be standardized, has spawned discussion as to whether they should be recognized at all. The views, based on literature survey and internet search, of topics both in favour and contrary to the proposal, are herein presented. The Elusive Assessment of Value Nash (2008) open-endedly enumerates accounting intangibles as “knowledge, personnel, skills and training, patents, copyrights, franchises, reputation, R&D, structure, relationships, morale, unity, brand name, experience, flexibility, creativity, product quality and value, customer base, communications, etc.” Edmonds (2008, p. 460) stresses the important point that intangible assets provide rights, privileges, and special opportunities to businesses. The IAS officially describes the intangible asset as “An identifiable nonmonetary asset without physical substance. An asset is a resource that is controlled by the enterprise as a result of past events (for example, purchase or self-creation) and from which future economic benefits (inflows of cash or other assets) are expected.” Nash relates that in former economies founded on mercantilism and manufacturing, most assets were tangible such as land, building, equipment, inventory; or financial assets (stocks or bonds). He contrasts this with today’s economy where value is largely built on the back of intangibles which cannot be accounted for by treatment devised for measuring and reporting traditional accounting tangibles, and concludes what many observers have already opined, that an accounting system that ignores intangibles delivers the wrong message to decision makers and retards economic progress. Stickney (1996, p. 251) describes how generally accepted accounting principles (GAAP) in the United States accounts for intangible assets: 1. Firms expense in the period incurred the cost of developing intangibles. The immediate expensing of such costs is due to difficulty in ascertaining whether a particular expenditure results in a future benefit (that is, an asset) or not (an expense). 2. Firms recognize as an asset expenditures made to acquire specifically identifiable intangible assets from others. The existence of an external market transaction provides evidence of the value of the intangible asset. However, internally developed intangibles are immediately expensed for the period. 3. Firms must amortize intangible assets over their expected useful lives. If the firms cannot estimate the useful life, GAAP permits a maximum amortization period of 40 years. Common practice uses straight-line amortization. Analysts have criticized the different treatments for intangibles internally developed and those acquired externally. Primarily, their objections spring form the fact that no matter how an intangible is sourced, as long as the nature and utilization are consistent, the intangible provides the same value-creating potential for the firm. However, since the firm is required to expense outright the intangible where this is internally developed, no matter if the components used in this development were sourced externally, then for the period the expense is recorded the net income of the firm appears to be much less than if the asset were capitalized. Where investors’ assessments are concerned, this puts the firm at a distinct disadvantage, particularly for the company heavily involved in research and development activities. U.S. companies are required to realize R&D costs outright, while competitor companies in Japan and Korea are allowed to capitalize their R&D costs. The more equitable distribution of costs for Asian countries enable them to report more equitable net incomes through the year, while for U.S. companies net incomes appear to dive during years R&D costs are recognized, and soar when they are not. An investor who is not aware of this treatment will erroneously conclude that the performance of the U.S. companies are erratic and, therefore, indicate more risky investments, while those of the Asian countries (and other countries with similar accounting treatment) are more consistent and therefore comprise less risky investments. Another intangible would be goodwill, defined as the value attributable to favourable factors such as reputation, location, and superior products (Edmonds, 2008 p. 460). The accounting treatment of goodwill is most commonly encountered during corporate acquisitions. Acquiring firms usually allocate the purchase price to identifiable, tangible assets, and then allocate any excess purchase price to identifiable, intangible assets such as patents, customer lists, or trade names, with the remainder allocated to goodwill. Goodwill is a residual and effectively represents all intangibles that are not specifically identifiable. The GAAP in the United States specifically forbid firms in general to amortize goodwill and other intangibles that have an indefinite useful life. GAAP in countries outside of the United States allows for amortization of goodwill, but set the amortization period at less than 40 years. Several countries have even shorter amortization periods because of the close conformity of tax and financial reporting (for example, France, Germany, Japan) (Stickney, 1996 pp. 265-255). Another way of accounting for goodwill is to eliminate it from assets and to subtract its amounts from retained earnings or other common shareholders’ equity accounts. The analyst then adds back to net income the amortization fo goodwill that is reflected in the accounts. The rationale for this approach is described by Stickney (1996, p. 255): 1. The amount allocated to goodwill from a corporate acquisition might simply have been because the firm paid too much, but the presence of resources with future service potential may not necessarily be indicated. Subtracting the amount allocated to goodwill from retained earnings suggests that the excess purchase price is a loss for the firm. 2. Immediate subtraction of goodwill from retained earnings treats goodwill arising from an acquisition similar to goodwill developed internally; thus so no asset appears on the balance sheet. In sum, for an expenditure to qualify as an intangible asset, it must be reasonably evident that such asset shall yield future benefits. There are many expenditures that offer some potential of producing benefits in later years, but the existence and life span of these benefits are so uncertain that most companies prefer to treat these expenditures as operating expenses. (Williams, 2008 p. 410) Arguments for accounting recognition of intangible assets In 2001, the FASB conceived of undertaking a project on the developments of standards for the mandatory disclosure of intangibles. Before embarking on the project, an inquiry was conducted among companies who expressed interest on the matter. Opinions were solicited from these companies as to the propriety and feasibility of developing such standards. As many companies reacted favourably as unfavourably, with many qualifying the degree of their agreement or disagreement with what they perceive to be conditions precedent. The Association for Investment Management and Research, which operates internationally from offices in the U.S. and Hongkong, score the discrepancy between underlying book values and companies’ stock price. They squarely attribute this to the failure of the current accounting model to recognize a company’s internally generated intangibles. Their opinion cites Bayless, Chief Accountant of the U.S. SEC’s Division of Corporate Finance, who stated that despite importance investors ascribe to the intangibles, reports filed by public companies generally lacked meaningful and./or useful disclosures about intangible assets. He therefore stressed that if intangibles are important to the business, public companies should identify these assets and, through operational, non-financial measures, explain what management does to develop, protect and exploit them. Another area of concern is the need for a clear definition of intangibles. The FASB is seen as the agency to provide this, as well as a detailed guideline on disclosures. Under the current definition, it is not clear what should be included as intangibles, opening the possibility of omission of items – for example, customer base or workforce value that would not be recognized separately from goodwill under Statement 141. Under the purchase method of accounting in business combination, these items would not be captured but would likely be buried under the residual of goodwill. Thus, it was proposed that intangibles should be classified according to the following characteristics: (1) identifiability; (2) separability or transferability; (3) legal standing or contractual basis; and (4) linkage to future sources of value, including cash flows from revenues as well as reduction in expenses. Other special-interest groups stress the need to recognize particular classes of intangible assets to assessing the value of a business. For instance, the Federation of Labor and Congress of Industrial Organizations have vigorously expounded on the need for companies to quantify their human capital investments as a distinct financial reporting item. Its stated purpose is to provide additional information that allows comparisons between companies, as well as to encourage boards to use measures of intellectual capital preservation and development in setting executive pay (http://www.fasb.org/project/intangibles.shtml, retrieved 2/19/09). Going through the list of reasons advanced by companies and professionals in favour of the recognition of tangibles in accounting report, one common element is evident: that they all see a substantial need for factoring in the value of an asset that is the major driver of creation of further value. The absence of a means of effectively accounting for intangibles is commonly cited as the cause for a failure in proper valuation of the firm, or assessment of its potential earning power. Another common factor is present among these opinions: a lack of an acceptable method of identifying, valuing, and allocating the intangible asset consistent with accounting theory and in a manner useful for the informational needs of business. This, the practical feasibility of recognizing intangible assets, is the main point raised by those companies and professionals who raised objections to FASB’s proposed mandatory disclosure. Arguments against accounting recognition of intangible assets Critics of the standardization proposal are intensely vocal about their objections to the FASB project. On the main, the protests are anchored on the failure of any method aimed at standardizing the treatment of intangibles. Three institutions in particular, the American Council of Life Insurers (ACLI), the American Accounting Association’s Financial Accounting Standards Committee (AAA-FASC), and Financial Executives International (FEI) are particularly detailed and technical in their critiques. Between them, the following points have been raised: 1. Difficulty of identifying assets; no concrete enforceable definition. The ACLI is certain that a consistent and effective classification of what comprise intangible assets will elude standards advocates. They cite that in the wake of the September 11, 2001 terrorist attacks, it is possible for companies outside of the New York and Washington DC areas to “dream up” an intangible assets relative to security and being a “less likely target”. The point is that in the absence of a concretely enforceable method of describing an “intangible” (which, from the definition of the word, will continue to be elusive), companies could dream up any means of classifying intangible assets. 2. Different usefulness of asset to different companies; comparability cannot be achieved effectively. Further, the value of an intangible is highly dependent upon the future utilization of the intangible. For example, an enterprise may have developed product distribution channels that are of significant value to one potential acquirer, but not to another potential acquirer that has similar distribution capabilities (ACLI). Trying to uniquely identify and value each of these intangibles has no meaning except in the context of how they are uniquely combined in a business to provide value (FEI). 3. Greater degree of disaggregation without consistent basis, and may raise issues of consistency that finer disclosures should be conducting on other areas of financial reporting as well. Determining expenditures to develop and maintain intangibles requires more detailed disaggregation than currently available in the financial statements. However, deciding how to disaggregate expenditures is problematic if there are difficulties in deciding on, say, how the major classes of intangibles would be determined. Requiring such disaggregation raises issues of consistency in the sense that perhaps finer disclosures in other areas of financial reporting should be required as well. (AAA-FASC) 4. Element of prospectivity renders valuation uncertain and misleading due to assumptions. Any valuation model would be much too reliant on projected data (and the inherent assumptions, including possible future utilization of the intangible), and would, at best, merely produce a range of values that have little relevance to readers of the financial statements. At worst, it could create extremely misleading financial information (ACLI). This concept of fair value of intangibles would require the continuous application of forward-looking information in determining changing values, which is not subject to the reliability and measurability standards. (FEI) 5. Speculative nature of valuation rather than factual. The reason internally generated intangibles are not recognized as assets in financial statements is that there is no basis for recognizing them. Any attempt to ascribe a value to something so subjective could potentially lead to serious abuses. (FEI) 6. FS users do not need overly detailed report. General F/S sufficient; disclosure has no net benefit to F/S users. General-purpose FS are intended to provide all-inclusive information to the potential investor or acquirers of a business. Adding the value of intangibles to the disclosures or to the primary financial statements would not diminish the necessity for due diligence work by qualified financial analysts, and would, in many cases, only add to the obfuscation of financial results. (ACLI) 7. Expensive and time consuming. Any disclosures of “non-financial indicators about intangible factors such as market size and share, customer satisfaction, and new product success rates” would likely significantly increase the amount of time to deliver these statements. Items such as market share are not available except by estimates from industry association and not until data from all sources is submitted and published (FEI). Furthermore, the need to resort to experts and consultants to interpret these market data will entail additional expense on the part of the company, which is not expected to enhance productivity or profitability since it only has to do with reportorial requirements. 8. Disclosing proprietary information can potentially ruin business. Releasing public statements, which are accessible to competitors, concerning the existence of competitive advantages, proprietary information, or other intangibles actually has the potential of damaging the business enterprise. Placing a value on, and describing, such items in the notes to financial statements only increases that possibility. (ACLI) 9. Comparability could not be achieved in all cases. Nor is it desirable for complete comparability to be sought. For example, comparable distribution systems will have non-comparable values, depending upon the expected future utilization of those systems. When dealing with similar issues in Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information, the FASB recognized that companies often are not comparable and further noted that “Both relevance and comparability will not be achieved in all cases, and relevance should be the overriding concern.” (ACLI) 10. In general, valuation of intangibles is innately subjective and contextual, and thus resistant to standardization. Since the nature of many intangibles is such that they are difficult to value on a stand-alone basis, it is not surprising that there is little evidence on how precisely the values of intangible assets can be measured. According to Lev (2001, Ch. 2), intangibles are characterized by a lack of well-defined property rights, “spillover” effects, etc., which leads in turn to a lack of well-established secondary markets for intangibles. These suggest that the measurement issues related to the valuation of intangibles will be substantial. Valuation issues in the area of well-defined financial instruments have proved quite complicated; therefore the reliability of information pertaining to the value of intangibles can only be highly dubious (ACLI). There are many other reasons why accounting recognition of intangibles will continue to remain a contentious issue, involving the need for flexibility to address the divergent needs of firms, and what Microsoft calls the “standards overload”. This latter factor refers to the volume, complexity and detail of accounting standards due to the issuance of detailed accounting guidance on almost every accounting question that is raised (Microsoft). The Software Finance and Tax Executives Council (SoFTEC) likewise asserts that an intangibles disclosure project would not lead to the development of an accounting standard which would be generally accepted, would not provide financial statement users with additional information, would be expensive to implement, and would further erode (rather than enhance) financial system comparability. Surprisingly, software companies such as Microsoft and SoFTEC which deal with the processing of financial information for institutions, advocated against the mandatory disclosure and standardization of intangibles. Software companies have a high percentage of tangible assets. Microsoft was described by Nash as comprised of 96% intangible assets, with the remaining 4% attributed to book value. It is probably their expertise with the capture, assessment, and reporting of data that causes them to critically score the proposal’s viability. Conclusion The context of the new economy is characterized by cutthroat global competition, advanced electronic technology, and the ascendance of intellectual property. Interestingly, intangibles have to a great extent come to determine the performance and survival of business players. The market has clamoured for more, and more detailed, information. It is thought that by revising the accounting paradigm to accommodate the standard reporting of intangible asset values, stakeholders will have a better assessment of company value. This simplified view finds little basis in practical application. The accounting process is based on transaction values because it is grounded on factual information. When valuation of intangibles and their future worth enters into the equation, the result will tend to tread into the speculative rather than the factual. The simple truth is, nobody can put a price tag on an intangible based on its intrinsic value. The intangible will always draw its worth from the context in which it is regarded. The elusiveness of the nature of the intangible will continue to defy efforts at uniformity and standardization imposed by a regulating authority. It should be considered that the accounting report is not the proper vehicle to convey this sort of information. The market participants themselves, with the aid of non-financial disclosures and advice from knowledgeable analysts, must assess for themselves what the value of intangibles would be to the company as they see it. On the proposal to require mandatory reporting of intangibles, the Financial Executives International (FEI) expressed preference for a voluntary “supplemental reporting for intangible assets, operating performance measures, and other information that would help investors assess a company’s future performance,” as recommended by a task force chaired by Dean Garten of the Yale School of Management. Garten’s report recommends that specific reporting standards, including the development of formal required formats, metrics, or ratios should not be mandated. The report goes on to recommend instead the creation of an environment that encourages innovation in disclosures, and that this will be best accomplished by voluntary supplemental reporting about intangible assets, operating performance measures and forward-looking information – not replacing or modifying GAAP. With the view towards simplicity, feasibility, and propriety, Garten’s insight appears to address squarely the needs of stakeholders. The FASB and IAC will do well to heed this recommendation. REFERENCES Edmonds, T.P, Edmonds, C.D., McNair, F.M., and Olds, P.R. (2008) Fundamental Financial Accounting Concepts, Sixth Edition, McGraw-Hill, New York, NY Financial Accounting Standards Board, (2001) Proposal for a New Agenda Project: Disclosure of Information About Intangible Assets not Recognized in Financial Statements Haskins, M.E., Ferris, K.R. and Selling, T.I. (2000), International Financial Reporting and Analysis, A Contextual Emphasis, Irwin McGraw, Boston IAS 38 Intangible Assets History of IAS, as seen in http://www.iasplus.com/standard/ias38.htm. Retrieved February 19, 2009. Lev, B. (2001) Intangibles: Management, Measurement and Reporting. Brookings Institution Press, Washington, D.C. Nash, H. Intangibles, as seen in http://home.sprintmail.com/~humphreynash/Intangibles.htm. Retrieved on February 19, 2009. Project Updates: Disclosures About Intangible Assets as seen on http://www.fasb.org/project/intangibles.shtml (Last Updated: May 21, 2004). Retrieved on February 19, 2009 Rechtman, Y. (2001), Accounting Treatment of Intangible Assets, as seen in http://www.rechtman.com/acc692.htm. Retrieved on February 19, 2009 Skinner, D.J. (2007) Accounting for Intangibles - A Critical Review of Policy Recommendations, The University of Chicago - Booth School of Business,as seen in http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1080572. Retrieved February 19, 2009. Stickney, C.P. (1996) Financial Reporting and Statement Analysis: A Strategic Perspective. Third Edition. The Dryden Press, Fort Worth, TX Upton, W.S. Jr. (2001) Business and Financial Reporting, Challenges from the New Economy, Financial Accounting Standards Board of the Financial Accounting Foundation, Norwalk, Connecticut White, G.J., Sondhi, A.C. and Fried, D. (1999), The Analysis and Use of Financial Statements, John Wiley and Sons, New York, NY Williams, J.R., Haka S.F., Bettner, M.S., and Carcello, J.V. (2008), Financial & Managerial Accounting, The Basis for Business Decisions, Fourteenth Edition, McGraw-Hill, New York, NY Read More