Executive Summary

 

The U.S. accounting and business reporting system is inadequate to cope with the growing importance of intangible assets. While a framework exists for the recognition (i.e. assigning “book value”) of intangibles under U.S. Financial Accounting Standards Board (FASB) SFAS 141 and 142, this framework is incomplete in both its scope (i.e., only those assets acquired from outside the company must be recognized) and its coverage (i.e., certain intangibles, such as R&D and workforce, are specifically excluded). In addition, simply adding intangible assets to a company balance sheet is not the answer to the reporting problem. Many intangible assets are better understood using non-financial measures and other descriptions. Disclosure of non-financial data has increased. A number of steps have been taken and various suggestions for further disclosure made. But important information on intangibles must still be teased out of financial reports from various places – Management’s Discussion and Analysis (MD&A), expense reporting and asset recognition. Nor is there any guarantee that information on some assets is disclosed at all, or even collected internally. Efforts are underway to create a more comprehensive framework for expanded business reporting, but no consensus framework exists as of now. If investors, managers, regulators, policymakers and the general public are to gain a true understanding of our economic situation, we must devise better means of reporting companies’ circumstances—with an emphasis on better understanding and measuring our intangible assets.

 

 

Introduction

 

American businesses, investors, regulators and policymakers are flying blind. The United States is now in an intangible economy, but financial reporting and accounting systems can’t deal with intangibles. Our business reporting system is, in many ways, not even adequate for the Industrial Age, let alone the Information Age. As a consequence, business, investment and economic policy decisions are being made “in the dark” (to quote the title of a recent study).[1]

 

Information, knowledge and other intangibles now drive economic prosperity and wealth creation. Intangible assets—worker skills and know-how, informal relationships that feed creativity and new ideas, high-performance work organizations, formal intellectual property, brand names—are the new keys to competitive advantage. The value of U.S. gross investments in intangibles has been estimated to be at least a trillion dollars annually, covering investments in R&D, advertising and marketing, software, financial activities and creative activities of writers, artists and entertainers.[2] This does not even count investments in productivity-enhancing changes in business processes, education and employee training.

 

Yet, report after report describes how accounting standards (known as GAAP—Generally Accepted Accounting Principles) are unable to cope with intangibles.[3] Critics point out that GAAP does not, and cannot, provide adequate information to managers, investors and regulators. Because GAAP is “less effective in providing relevant information on intangible assets, such as technology rights, human capital, and innovation,” Commissioner Cynthia A. Glassman of the Securities and Exchange Commission (SEC) worries that “the value of huge sectors of our economy may not be accurately reflected by financial reports.”[4]

 

We know that investors want better information. A study by Ernst & Young found that non-financial criteria constitute, on average, 35 percent of the equity investor’s portfolio allocation decisions.[5] But, according to Adrienne Baker, Editor-in-Chief of Investor Relations Magazine, over half of the information investors want is not reported on the balance sheet.^[6] Left out are important items such as growth opportunities, infrastructure, intellectual capital, network effects, workforce and in-process R&D.

 

We also know that business leaders want better information. According to a recent survey by the accounting firm of Deloitte, “nearly half of respondents (48%) said the company’s nonfinancial metrics were ineffective or highly ineffective in helping the board and the CEO make long-term decisions.” [7]

 

The result of our lack of good information is a distorted picture of the situation. One analyst was recently quoted in the Wall Street Journal as saying when it comes to comparing a company like Google’s core financial performance to its rivals, “GAAP is the last thing you'd use.”[8] Another critic even claims:

the historically high price-earnings ratios that we see today [2004] are a reflection not of a renewed bubble, or investors’ over-optimism, but of the failure of GAAP as a system of financial reporting in the knowledge economy.[9]

 

If we don’t understand what is happening in our economy at the basic level of the firm, then all our business and economic decisions are suspect. Capital may be misallocated, opportunities wasted, resources misused and detrimental policies adopted.

 

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The current state of affairs isn’t due to a lack of study. Interest in this issue of corporate reporting of and accounting for intangible assets has waxed and waned over the past decade and a half. The 1990’s saw increased interest in new forms of business reporting and increased attention to intangibles. With the bursting of the Internet stock bubble and wave of accounting scandals based on earnings manipulations, this interest has declined. Part of the decline has been due to other issues taking priority; part is due to the difficult nature of the intangible issue itself. However, concerns over these issues have never disappeared and may be reasserting themselves in the policy arena.[10]

 

For our purposes, we will begin the story in 1991 with the formation by the American Institute of Certified Public Accountants (AICPA) of a Special Committee on Financial Reporting. The Committee’s report (Improving Business Reporting – the Jenkins Report) was issued in 1994.[11] At roughly the same time, the Association for Investment Management and Research (now the CFA [Chartered Financial Analyst] Institute) published their own report, Financial Reporting in the 1990s and Beyond.[12]

 

As a follow-on, the Financial Accounting Standards Board (FASB) issued an “Invitation to Comment” on the AICPA Jenkins report in February 1996. That led to the creation of FASB’s Business Reporting Research Project in 1998. At the beginning of 2001, FASB issued the report of its Business Reporting Research Project on enhancing voluntary disclosure.[13] FASB also issued an internal study in April 2001 on challenges of business reporting in the new economy.[14]

 

FASB started the process of issuing new standards in 1999 with the issuance of FASB Exposure Draft, Business Combinations and Intangible Assets. In June 2001, FASB issued final standards concerning accounting for goodwill and intangibles acquired as part of a merger or acquisition: Statements of Financial Accounting Standards (SFAS) 141 and 142.[15]

 

With the issuance of these standards, FASB began discussing a possible project looking at increased disclosure of intangibles outside of business combinations. The project was officially begun in January 2002 but halted a year later. Rather than continue that project, FASB felt it was more timely to focus on coordinating its existing approach to intangibles with the International Accounting Standards Board (IASB).[16]

 

Over at the SEC, then-Chairman Arthur Levitt in October of 1999 called for a task force to look at the issue of company disclosures. The Garten Task Force Report (named after Task Force Chair Jeffrey Garten of the Yale School of Management) issued its recommendation in May 2001 to “create a new framework for supplemental reporting of intangible assets and operating performance measures.”[17]

 

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Thus, the inadequacy of our accounting and business reporting system is well understood. The problem of finding a solution is not a lack of understanding the need. The problem is inherent in the nature of intangible assets and business reporting. In order to understand the issue of reporting corporate intangible assets, it will be important to keep in mind a few distinctions: between disclosure and recognition; between financial and non-financial information; and between qualitative and quantitative reporting.[18]

 

It is also important to keep in mind the relationship between the asset and the company. A Brookings Institution study on intangibles divided them into three levels:

Level 1 - assets that can be owned and sold;

Level 2 - assets that can be controlled but not separated out and sold;

Level 3 - intangibles that may not be wholly controlled by the firm.[19]

Level 1 includes not only intellectual property (IP) but also items such as contracts and business agreements, licenses and franchise rights, quotas and resource allocations (airport landing rights, water rights) and employment contracts. Level 2 describes those areas proprietary to a specific firm, but difficult to separate from the ongoing operation, such as business secrets, in-process R&D and business processes. Level 3 includes items often referred to as human capital, core competencies, organizational capital and relationship capital.

 

So the situation is as follows: many intangible assets can be reported upon and relevant information about those assets disclosed. Some can be discussed only in qualitative terms, such as a company’s leadership. Some of those assets can be measured quantitatively, such as customer satisfaction. A much smaller set can be valued and specifically recognized in a company’s financial statement.

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Major Frameworks

 

There are a number of general approaches to the issue of improved business reporting that involve intangibles:

 

1)      Improved accounting models seek to include intangible assets in book value of a company.

 

2)  Non-financial metrics approaches include performance measures and metrics of intangibles (such as customer satisfaction levels and worker skill levels) without necessarily including the value of these intangibles in companies’ balance sheets. Such approaches may also include disclosure of non-measurable attributes of intangible assets, such as company leadership.

 

3)      Value-creation models seek to tie various process metrics with future financial performance.

 

Note that these approaches are not necessarily distinct categories, but points on a continuum. Various proposals blend the models in different ways.

 

Accounting models

 

As mentioned earlier, for companies that must register with the U.S. SEC, the controlling definitions of what must be recognized as intangible assets are FASB’s SFAS 141 and 142 issued in 2001. Further clarifications were issued in 2002 when FASB released Emerging Issues Task Force (EITF) Issue 02-17 that dealt with questions of recognition of customer relationships as intangible assets.[20]

 

It is important to note that this requirement to recognize intangible assets only applies to those acquired from outside the company, not those internally generated. Thus a company must recognize the value of a patent acquired from another company as part of a merger or acquisition, but not the value of a patent internally generated. As we will discuss later, this is viewed as a major shortcoming of the standards.

 

SFAS 141 and 142 are built upon earlier rules governing disclosure of intangibles, specifically AICPA’s Accounting Principles Board (APB) Opinion No. 16, Business Combinations and Opinion No. 17, Intangible Assets, which were first issued in 1970. When FASB replaced APB, these Opinions continued as part of GAAP, supplemented by other FASB standards and opinions, until the issuance of SFAS 141 & 142.[21]

For the most part, the description of what is an intangible asset in SFAS 141 & 142 is simply an extension of Opinions 16 & 17, incorporating in these supplemental rules.[22] This can be seen by comparing the SFAS 141 list of intangible assets in Figure 1 with the Opinion 17 list in Figure 2. The main difference is the development of a taxonomy in the FASB list.

 

There is one important difference, however, between SFAS 141 & 142 and Opinions 16 & 17: the treatment of assembled workforce. SFAS 141 specifically states that “assembled workforce shall not be recognized as an intangible asset apart from goodwill.”[23] The rationale for this exclusion was that:

the Board concluded that techniques to measure the value of an assembled workforce and the related intellectual capital with sufficient reliability are not currently available. Consequently, it decided to make an exception to the recognition criteria and require that the fair value of an assembled workforce acquired be included in the amount initially recorded as goodwill, regardless of whether it meets the recognition criteria in paragraph 39.[24]

 

It should also be remembered that the impetus for SFAS 141 and 142 was only partially intangibles. FASB was concerned with the issue of pooling versus purchase methods for business combinations and the large overhang of goodwill that had accumulated due to increased merger and acquisition (M&A) activities in the preceding decade. SFAS 141 and 142 are specifically designed to address those questions, using the mechanism of recognition and differential treatment of intangibles as separate from goodwill.[25]

 

Since the adoption of SFAS 141 and 142, there have been only a few reviews of companies’ experiences.[26] However, those reviews have raised a number of concerns about the ability of companies to value intangibles and the scope of what intangibles must be recognized for accounting purposes.

FASB Roundtable

One review of companies’ experiences was a FASB roundtable in September 2002, convened as part of the start of its (later-abandoned) intangibles project. The specific topic of the roundtable was the experiences of U.S. companies in assigning value to intangibles under SFAS 141. Two major topics dominated: the issue of determining fair value and the problem of recognition criteria. On the issue of fair value:

The group observed that although there are accepted methodologies for valuing major intangible assets (for example, the cost, income, and market approaches), minor changes in certain key assumptions may result in significant variances in the estimation of fair value. For example, although trade names are traditionally valued using a consistent approach (the relief from royalty approach), the royalty rate applied is often a subjective decision due to the lack of publicly available information.[27]

 

Concerning recognition criteria, the group highlighted the problem of:

Determining which intangible assets meet the separate recognition criterion and the meaning of that criterion in Statement 141. For example, there is significant divergence as to whether customer relationships meet the recognition criteria in Statement 141 and whether the recognition criteria were meant to affect the estimation of fair value.[28]

IASB Field Study of the U.S.

In 2003, the IASB undertook a field study on experiences with SFAS 141 and 142 as part of their own rule-making process on intangibles.[29] The review covered all aspects of business combinations, such as allocation of goodwill to units as well as recognition of intangible assets.

 

The study found concerns similar to the FASB roundtable over valuation and the ability to separate intangible assets from goodwill or other assets. Three cases illustrate the difficulty facing companies in separating intangibles for goodwill:

Airline landing slots and route authorities: Landing slots and route authorities are granted by the relevant authorities at no cost and can be taken away and given to another airline. Yet, the airline cannot operate without them. Because of this, it is claimed that these assets cannot be valued separately from the acquired business as a whole (and therefore from the goodwill) since the acquired business would cease to exist without them.

 

Mineral rights: This case concerns rights granted by the government to an undeveloped, untested and unsurveyed property. Since it is claimed that the company is prohibited from selling the rights separate from the business as a whole, the value of the mineral rights cannot be separated from goodwill.

 

Water acquisition rights: In this case a paper and paperboard products manufacturer claims that the rights cannot be sold other than as part of the sale of a business as a whole and the plant could not be operated without the rights. [30]

 

As the IASB field notes put it, “there was a general consensus amongst the roundtable participants that the assumptions used by independent valuers to measure the above intangible assets were often so highly subjective/debatable that it is unlikely those values represent reliable fair value measures.”[31]

 

The discussion also raised a consistent problem concerning recognition of customer contracts and relationships. As the field notes state, “of the nine field visit participants that acquired in business combinations customer contracts, related customer relationships, and core deposit intangibles, only one believes it was able to reliably measure the contract-related customer relationships, and only then because it could do so by reference to observable market transactions.”[32]

SEC Review of Annual Reports

A different way of getting at the U.S. experience with accounting for intangibles can be seen in the SEC’s 2002 review of all FORTUNE 500 annual filings. Accounting for intangible assets falls within the problems facing the SEC in enforcing compliance with GAAP. In the wake of various accounting scandals, SEC took a sharp look at company practices with respect to disclosure of financial and non-financial information. The review was specifically targeted at “disclosure that appeared to be critical to an understanding of each company's financial position and results, but which, at least on its face, seemed to conflict significantly with generally accepted accounting principles or SEC rules, or to be materially deficient in explanation or clarity.”[33]

 

The review accomplished its purpose; comment letters went out to 350 companies asking them to amend their filings.

 

The SEC review highlighted problems with application of the impairment test under SFAS 142. The summary report by the SEC’s Division of Corporation Finance reveals general problems concerning impairment of goodwill and indefinite-lived intangibles, allocation of goodwill among reporting units, and explanations of accounting decisions regarding goodwill and indefinite-lived intangibles.

 

Interestingly, the summary report did not highlight problems with the ability to separately recognize intangibles. However, conversations with SEC staff indicated that this was not because of a lack of comments back to companies on issues of recognition. Rather, the comments were so company and industry specific that the issue did not rise to the level of a common set of problems.

 

SEC staff did subsequently comment on the recognition of intangibles: whether a customer-related intangible asset exists separate from the specifics of the contract (such as a real estate lease).[34] That comment was specifically meant to provide additional SEC guidance on the issues raised in EITF Issue 02-17 on customer relationships as intangible assets.

Survey of U.S. 10-Ks

As part of a study for the European Commission, Mantos Associates also looked at annual SEC 10-K filings. In this case, they specifically examined filings for 102 companies where an acquisition occurred between December 2001 and April 2003.[35] While they found a high level of compliance with the requirement to break intangibles out from goodwill, they:

also found worrying inconsistencies as a result of the freedom companies are allowed in the classification and grouping of intangible assets. For example, take Rights and Licenses. Some companies use a single rights category and combine an array of entirely different rights covering all contracts and marketing assets. Others distribute them over a wide spectrum of asset classes. In the case of patents, some companies single them out individually, whilst others aggregate them with licenses and contracts. If the US experience is any guide, this could be a serious obstacle to aggregating sensible values for individual intangible assets.

 

Even within industries the picture exhibits wide variations. We looked at two industries within our sample to see whether the picture might be more coherent for companies from the same industry sector. Across our sample of 10 software companies, 11 different classes of intangibles were used in varying degrees. Within the pharmaceutical industry sample (of 5) the number was 6.[36]

(emphasis in original)

A Valuation Model Alternative

The GAAP approach is not the only model for calculating value of intangible assets. An alternative valuation approach to understanding the financial situation of intangible assets has been developed by Baruch Lev.[37] In GAAP accounting, valuation is calculated from the ground up by aggregating the value of all the separate assets—physical, financial and intangible. Lev’s expanded valuation model backs out the value of the unreported intangible assets from the whole. In part, this is done by estimating the contribution of intangible capital to normalized earnings (by estimating a certain rate of return on physical and financial capital). Specific intangibles do not need to be identified and independently valued – but the value of intangibles as a whole can be estimated. Using this figure, it is claimed, along with traditional capitalization gives the analyst an undistorted version of traditional financial measures (such as ROE).

 

It should be noted that Lev also argues for increased disclosure of other financially relevant data, specifically: products in the R&D pipeline; royalty stream (showing that there is a market for the R&D); percentage of revenues coming from new (or recently introduced) products; and the contribution of brand to premium pricing. The purpose is to disclose information that is useful to financial analysts for estimating future earnings, not to find current value of the intangible asset.[38]

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Non-financial metrics

 

In the area of disclosure, companies have a wide range of experiences. A 2004 study commissioned for the consulting firm Accenture clearly shows that managers believe in the importance of managing and disclosing intangibles, but very few (5%) have any real system for doing so.[39] As mentioned earlier, numerous official and quasi-official studies have called for increased disclosure. The FASB Business Reporting Research Project’s findings on disclosure of information on intangibles was not very positive. Based on its analysis of the current disclosure practices in eight industries it found that:

companies in the pharmaceutical industry made considerable disclosures about their research and development activities and product development pipeline. Disclosures by companies in other industries were generally sparse. The few disclosures found tended to be somewhat vague and not particularly helpful.[40]

 

The issue of other metrics was also discussed at the FASB September 2002 roundtable:[41]

Some participants believe that the disclosure of certain metrics about intangible assets may provide more valuable insights than would disclosure of their fair value. The group generally agreed that users would welcome improvement in disclosures about intangible assets (as has been discussed in various reports, such as the Garten Task Force Report). Some participants noted, however, that any requirement by the FASB to disclose such information might be quite burdensome to smaller companies.

 

These calls for greater disclosure of non-financial metrics focus on three sets of information: external factors, “value-drivers” and internal performance measures. Intangible assets are included in such disclosures to the extent that they are seen as value drivers.

AICPA Report

As mentioned earlier, in the early 1990’s AICPA created a Special Committee on Financial Reporting charged with looking at what information should be made publicly available. Chaired by Edmund L. Jenkins (later the Chairman of FASB), the Committee published its report Improving Business Reporting – A Customer Focus, which came to be known as the Jenkins Report, in 1994.[42] The report makes a number of recommendations concerning ways to improve financial reporting.

 

The heart is a call for development of a new comprehensive reporting model which would include non-financial metrics. Major components of the new reporting model were:

I. Financial and Non-Financial Data

· (A) Financial statements and related disclosures

· (B) High-level operating data and performance measurements that management uses to manage the business

II. Management's Analysis of Financial and NonFinancial Data

· (A) Reasons for changes in the financial, operating, and performance related data, and the identity and past effect of key trends

III. Forward-Looking Information

· (A) Opportunities and risks, including those resulting from key trends

· (B) Management's plans, including critical success factors

· (C) Comparison of actual business performance to previously disclosed opportunities, risks, and management's plans

IV. Information About Management and Shareholders

· (A) Directors, management, compensation, major shareholders, and transactions and relationships among related parties

V. Background About the Company

· (A) Broad objectives and strategies

· (B) Scope and description of business and properties

· (C) Impact of industry structure on the company[43]

 

The section of this new framework on “High-level operating data and performance measurements that management uses to manage the business” would include:

 

·        Statistics related to activities that produce revenues, market acceptance, and quality, such as units and prices of product or services sold; growth in units sold or average prices of units sold; growth or shrinkage in market share; measures of customer satisfaction; percentage of defects or rejections; and backlog.

·        Statistics related to activities that result in costs, such as the number of employees and average compensation per employee, and the volume and prices of materials consumed.

·        Statistics related to productivity, such as the ratio of outputs to inputs.

·        Statistics related to the time required to perform key activities, such as production or delivery of products or services and developing new products or services.

·        Statistics related to the amount and quality of key resources, including human resources, such as the average age of key assets, or the quantity of proved reserves of natural resources.

·        Measures related to innovation, such as the percentage of units produced in the current year that were designed within the last three years, or the number of suggestions to improve businesses processes received from employees in the last year.

·        Measures of employee involvement and fulfillment, such as employee satisfaction and the rate of change in that measure.

·        Measures of strength in vendor relationships, such as vendor satisfaction, and the rate of change in that measure.[44]

 

Importantly, non-financial metrics are not limited to just the performance measures section of the report. They are woven throughout the model. For example, the section on the new framework calls “Management's Analysis of Financial and NonFinancial Data” should include:

Innovation, such as the percentage of revenues resulting from products that did not exist within the last three years, or the percentage reduction in costs resulting from new processes, and the reasons for changes in those percentages.[45]

FASB Report

As discussed earlier, FASB launched its own follow-up project—the Business Reporting Research Project—and issued its own report (with the same name), Improving Business Reporting, in 2001.[46] As part of the project, the team looked in detail at types of non-financial (non-GAAP) information that was voluntarily disclosed in eight industries: Automotive, Chemical, Computer Systems, Food Processing, Domestic Integrated Oil, Pharmaceuticals, Regional Banks and Textile—Apparel.

 

Because of its detailed look at current industry practices, the report contains a wealth of specific examples of possible non-financial metrics:

·        Table of monthly orders broken down by strategic business unit and by product category (Computer Systems).

·         Information about the company’s sales and marketing teams, including number of experienced professionals, backgrounds, sales force productivity, and image (Pharmaceuticals).

·        Quarterly changes in physical volume of product by business group and by geographic location of customer, expressed as percentages (Chemicals).

·        Description of products in development and product agreements with strategic alliance partners (Pharmaceuticals).

·         The number of physicians prescribing specific products, the total number of prescriptions written for specific products, and the number of patients currently being prescribed for specific products (Pharmaceuticals).

·        Plant capacities by product, including the past year’s additions to those capacities and the additions scheduled for the upcoming year (Chemicals).

·        Productivity gains over several years in terms of sales per employee and earnings before interest and taxes (EBIT) per employee (Chemicals).

·        Initial production rates from new fields and test flow rates for new exploration wells (Oil—Integrated Domestic).

·         The percentage of garments sewn offshore (Textile—Apparel).

·         Disclosure of the company’s goals for the percentage of revenue from products introduced within the last three years together with a five-year chart on revenues from products introduced in the last three years (Computer Systems).

·         Detailed listing of products, brands, and registered trademarks (Food).[47]

 

Taking its cue from the AICPA Jenkins Report, the FASB report organizes the information into the following categories:

Business data (for example, high-level operating data and performance measurements that management uses to manage the business)

Management’s analysis of business data (for example, reasons for changes in the operating and performance-related data, and the identity and past effect of key trends)

Forward-looking information (for example, opportunities and risks including those resulting from key trends; management’s plans, including critical success factors; and comparison of actual business performance to previously disclosed opportunities, risks, and management’s plans)

Information about management and shareholders (for example, directors, management, compensation, major shareholders, and transactions and relationships among related parties)

Background about the company (for example, broad objectives and strategies, scope and description of business and properties, and impact of industry structure on the company)

Information about intangible assets that have not been recognized in the financial statements.[48]

 

Note that these are the same general categories as in the Jenkins Report with the important addition of the last category of non-recognized intangible assets.

Other Models

Of course, the U.S. is not the only nation where there are intense discussions about increased disclosure. Over the years, there have been a number of national and international projects and models. The Scandinavian countries have a long history of developing such models, including the Danish Intellectual Capital Statement[49] and the Skandia Intellectual Capital Navigator.[50] Another model that came out of the Scandinavian experience is Karl-Erik Sveiby’s Intellectual Assets Monitor.[51] While not focused specifically on intangible assets, the Global Reporting Initiative, an international organization made up of companies, environmental groups, labor organization and others, has developed disclosure guideline for economic, environmental and social factors.[52]

SEC Guidance on MD&A

The movement toward greater disclosure of non-financial metrics in the U.S. was given a boost when, at the end of 2003, the SEC issued new guidance for the Management’s Discussion and Analysis (MD&A) statement required as part of annual corporate filings. MD&A statements were first required by the SEC in 1980 as a way for companies to discuss forward-looking information. This new guidance gave the green light to disclosure of generally accepted industry performance measures. As the guidance states:

when preparing the MD&A, companies should consider whether disclosure of all key variables and other factors that management uses to manage the business would be material to investors, and therefore required. These key variables and other factors may be non-financial, and companies should consider whether that non-financial information should be disclosed.[53]

 

The guidance specifically references both the FASB and Jenkins reports for examples of types of metrics that would be permissible. In a footnote, the statement gives further clarification, specifically mentioning the following factors:

·        manufacturing plant capacity and utilization;

·        backlog, trends in bookings and employee turnover rates;

·        customer satisfaction;