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.
- - -
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]
- - -
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.
<top>
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]
<top>
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;
·
time-to-market;
·
interest rates;
·
product development;
·
service offerings;
·
throughput capacity;
·
affiliations/joint undertakings;
·
market demand;
·
customer/vendor relations;
·
employee retention;
·
business strategy;
·
changes in the managerial approach or structure;
·
regulatory actions or regulatory environment;
and,
·
any other pertinent macroeconomic measures.[54]
Importantly, the guidance states
that such disclosures are not in conflict with regulations that limit use of
non-GAAP compliant financial information:
Because these measures are
generally non-financial in nature, we do not believe that their disclosure
generally will raise issues under Item 10(e) of Regulation S-K [17 CFR
229.10(e)] or Item 10(h) of Regulation S-B [17 CFR 228.10(h)].[55]
Regulation G, which restricts the use of non-GAAP financial
measures, also specifically allows performance measures by defining them as
outside the scope of the restrictions:
We do not intend the definition of
"non-GAAP financial measures" to capture measures of operating
performance or statistical measures that fall outside the scope of the
definition set forth above. As such, non-GAAP financial measures do not
include:
·
operating and other statistical measures (such
as unit sales, numbers of employees, numbers of subscribers, or numbers of
advertisers); and
·
ratios or statistical measures that are
calculated using exclusively one or both of:
·
financial measures calculated in accordance with
GAAP; and
·
operating measures or other measures that are
not non-GAAP financial measures.[56]
U.K. Operating and Financial
Review
Others are going even further in the requirement for
non-financial measures. As of this writing, the British government is in
process of re-writing their basic “Company Law,” which will include a mandatory
annual operating and financial review (OFR). As the report issued in March,
2005 notes:
The OFR is a new form of narrative
report in which companies will need to describe future strategies, resources,
risks and uncertainties, including policies in relation to employees and the
environment where these are relevant to future strategy and performance. The
requirement to produce an OFR represents a further major step forward in
improving company reporting and transparency and in promoting effective
dialogue on the key drivers of long-term company performance. It also
recognises that in a modern economy, those who run successful companies need to
develop relationships with employees, customers, suppliers and others which
support long-term value creation.[57]
In anticipation of the OFR requirement, the British
Accounting Standards Board issued draft guidance last November. It contains an
explicit requirement to disclose Key Performance Indicators (KPI):
26. The OFR shall provide information to assist investors
to assess the strategies adopted by the entity and the potential for those
strategies to succeed. The key elements of the disclosure framework necessary
to achieve this are:
a. the nature, objectives and strategies of the business;
b. the development and performance of the business, both
in the period under review and in the future;
c. the resources, risks and uncertainties and
relationships that may affect the entity’s long-term value; and
d. position of the business including a description of
the capital structure, treasury policies and objectives and liquidity of the
entity, both in the period under review and the future.
27. To the extent necessary to meet the requirements set
out in paragraph 26 above, the OFR shall include information about:
a. market and competitive environment;
b. regulatory environment;
c. technological change;
d. persons with whom the entity has relations, such as
customers and suppliers;
e. employees;
f. environmental matters;
g. social and community issues;
h. receipts from, and returns to, shareholders; and
i. all other relevant matters.
. . .
36. To the extent necessary to meet the requirements set
out in paragraph 26 above, the OFR shall include the key performance
indicators, both financial and non-financial, used by the directors to assess
progress against their stated objectives.
37. The KPIs disclosed shall be those that the directors
judge are the most effective to use in measuring the delivery of their
strategies and managing their business. Regular measurement using KPIs will
enable an entity to set and communicate its performance targets and to measure
whether it is achieving them.
38. Comparability will be enhanced if the KPIs disclosed
are accepted and widely used, either within the industry sector or more
generally.[58]
As
further guidance, the report discusses a number of possible key performance
measures, such as: return
on capital employed; market position; employee turnover; retention rates; hours
spent on training; etc. Detailed examples of how to calculate and
disclose were given for the following possible measures:
·
Return
on capital employed (ROCE);
·
“Economic
profit;” Market Share;
·
Average
revenue per user (customer) (for a telecom company);
·
Number
of subscribers (for a pay
TV company);
·
Sales
per square foot (for a retail
company);
·
Percentage
of revenue from new products;
·
Number
of products sold per customer;
·
Products
in the development pipeline;
·
Cost
per unit produced;
·
Customer
churn;
·
Employee
morale;
·
Employee
health and safety;
·
Environmental
spillage (for a company involved
in the transportation of hazardous materials);
·
CO2
emissions;
·
Monitoring
of social risks in the supply chain (a company that sources its branded products from overseas
could face additional risks relating to stakeholders, in particular customers,
concerns around local labour practices);
·
Noise
infringements (for
an airport operator);
·
Reserves
(for an
extractive industry);
·
Market
risk (for a bank);
·
“Economic
capital” (for a
financial institution); and,
·
Cash
conversion rate.
However,
the Accounting Standards Board was very clear in stating that the list is
non-exhaustive and that these are illustrative examples of the types of
information that would need to be included if this measure was used as a KPI.
Enhanced Business Reporting Consortium
Another boost
to reporting non-financial metrics has been creation of the Enhanced Business
Reporting Consortium. A project of the AIPCA’s Special Committee on Enhanced
Business Reporting, the Consortium is bringing together various stakeholders to
unite on a set of guidelines and definitions. Launched in Fall 2004, the
Consortium is well along in its recruitment phase.[59]
As part of its activities, the
Consortium is promoting a June 2004 AICPA study by its Public Company Task
Force outlining possible best practices and sample reports. As the document
states:
These sample reports are not intended to be comprehensive.
Rather, certain components of the business reports have been highlighted and
presented here where the materials offer significant extensions to current
practice. It is the intention of the Task Force that the materials in these
sample reports be considered as a collection of ideas for potential
enhancements to existing business reports and to offer contrasts with current
methods of reporting.[60]
(emphasis in original)
In one of the sample reports,
from Lintun Solutions, Inc., specific operational goals are identified (such as
“Improved Customer Retention”) and tied to a specific value driver or
performance measure (Timely Delivery). Specific metrics are developed and
tracked:
This value driver is monitored
using the average number of days delay between anticipated and actual delivery
time. The effectiveness of this value driver is monitored by tracking revenues
per customer and customer retention rates (percentage of customers in a given
period who were also customers in the preceding period).[61]
While illustrating how a company
can use non-financial information in its business reporting, the study also
notes a need for industry standards for this type of information:
Much work has been done to
define the boundaries of an organization for financial reporting purposes. This
is not true for non-financial metrics, making comparison between reported
non-financial measures difficult. For example, when disclosing number of
personnel – does this include part-time, casual labor, personnel from equity
investments, personnel from alliance partners, spouses? When disclosing
investments in patents and copyrights and corresponding returns, do these
include investments made by joint ventures in which the business does not own a
controlling interest?[62]
Sarbanes-Oxley
An interesting twist has been
introduced into the disclosure process by implementation of the Sarbanes-Oxley
Act of 2002. Enacted in response to myriad accounting scandals, the law makes
significant changes to increase transparency and reduce conflicts of interest.
While the law does not specifically address intangibles, Section 302 requires
that CEOs and CFOs certify that companies’ financial reports do not contain any
untrue statements or omissions of material facts. Section 404 requires
companies to document and certify their internal financial reporting and
control procedures.
As a result, some are saying that
companies must make additional disclosures of intangible assets. According to
Mark Bezant and Elizabeth Gutteridge of Deloitte, “more often than not, the
internal controls needed for Sarbanes-Oxley compliance may include intangibles
which do not show up in the financial statements.”[63]
Liza Vertinsky of the law firm of Wolf, Greenfield & Sacks argues:
The new rules will have a
significant impact on how and when a company needs to measure, monitor, and
disclose information about its intangible assets. For any company with
intellectual property of material value, this will mean understanding,
measuring, monitoring and disclosing the relationship between intellectual
property rights and the company's financial performance, and translating
changes in the scope and strength of those rights into reportable indicators of
financial performance. More generally, the requirements will require a
rethinking of the role of intellectual property valuations and audits in
corporate strategy and will require new systems for ensuring that information
about intellectual property is communicated to and understood by top decision
makers and translated into appropriate financial reports.
Companies now need to
conduct regular audits of their intangible assets and report on material
changes that are likely to impact their financial strength and operations.[64]
There are those who have hoped
that Sarbanes-Oxley will push companies to make major improvements in their
management information systems.[65]
However, the implementation process seems to be moving in the direction of
incremental, rather than radical, changes.[66]
<top>
Value-creation Models
The AICPA sample reports, SEC's MD&A guidance
and the others are simply illustrations of the types of information that might
be disclosed. The AICPA Task Force study mentioned above subsequently points
out the problem with that approach:
Current reporting models do
not explicitly provide information about the underlying relationships between
the variety of internal and external value drivers and the company’s
performance, sufficient to allow stakeholders to obtain a reliable
understanding of past performance, current situation and a reasonable basis on
which to predict future results.[67]
However, there are a number of
specific frameworks that go beyond these lists to create models connecting
external factors and inputs with intermediate variables and performance
measures and then with ultimate financial outcomes. Some consider the Balanced
Scorecard as a first attempt to link performance measures together in a
management, rather than a measurement, system.[68]
Others see this as a similar model to the Skandia Intellectual Capital
Navigator and the Intellectual Assets Monitor models mentioned earlier.[69]
In the Balanced Scorecard, the
model seeks to link factors from four areas:
·
The Learning and Growth Perspective
·
The Business Process Perspective
·
The Customer Perspective
·
The Financial Perspective
Each of these perspectives has
its own set of objectives, measures, targets and initiatives specifically
tailored to the organization’s unique situation.
A more direct model that links
intangibles to company performance is Jonathan Low and Pam Cohen Kalafut’s
Value Creation Index.[70]
They base their model on the following intangibles that play a role in
business: [71]
·
Management: Leadership:
·
Strategy Execution;
·
Communication; and,
·
Transparency.
·
Organization:
·
Technology & Processes;
·
Human Capital;
·
Workplace Organization & Culture;
·
Innovation;
·
Intellectual Capital; and,
·
Adaptability.
·
Relationships:
·
Brand Equity;
·
Reputation; and,
·
Alliances & Networks.
The model
specifically links specific value drivers to intangible assets and then to
company financial performance.
The PriceWaterhouseCoopers (PwC)
ValueReporting model is another specific value-creation model that attempts to
provide linkages between and among various performance measures and measures of
intangibles.[72] This
model links the external environment (the market overview) to the company’s
competitive position and strategy for creating value (the value strategy). It
then links that strategy to the financial targets and mechanisms to deliver on
them (managing for value) and to the underlying intangibles and value drivers
(the value platform).
The KPMG Value Explorer model is
another strategic planning model that explicitly builds upon intangibles. This
model identifies five types of intangibles:[73]
·
Skills and tacit knowledge, including know-how
and competencies.
·
Collective values and norms, such as client
focus, reliability and quality.
·
Technology and explicit knowledge, such as
patents, manuals and procedures.
·
Primary and management processes, including
leadership & control, communications and management information.
·
Assets and endowments, including the installed
base of customers, brand & image, network of suppliers, network of talent
and ownership of standards.
The now defunct accounting firm
of Arthur Andersen had its own version, called Value Dynamics. Under this model
assets were categorized as physical, financial, customer, employee &
supplier and organizational.[74]
<top>
Observations and Conclusions
In both accounting (recognition)
and disclosure of intangibles, there continues to be ongoing confusion. On the
accounting side, SFAS 141 and 142 are clearly not the final words in
recognition of intangible assets. A review of the various studies and
discussions with those involved in the process reveals three points.
First, there is some continued
lack of clarity about what should be included. Both FASB and AICPA have
attempted to provide guidelines as to what intangible assets may be recognized.
However, as reviews of SFAS 141 & 142 and the earlier discussion on the EITF
statement on customer relationships point out, there continues to be a need for
specific technical guidance. In April 2004 FASB amended SFAS 141 and 142 to
remove mineral rights from the list of intangibles and require them to be
treated as tangible assets. (However, the Board made clear that certain
speculative mineral rights are financial assets and outside the scope of the
amendment.)[75]
At its January 19, 2005 meeting FASB decided to reconsider how intangible assets are amortized, including
determination of the useful life, under SFAS 142. The project came about:
in order to address
diversity in practice that has developed in determining the useful life of an
intangible asset for which a marketplace participant anticipates renewal
(hereinafter referred to as “renewable intangible assets”). [76]
This project clearly recognizes
the nature of intangibles and the factors that contribute to their value. The
project specifically raises the concern that under SFAF 141, the useful life of
an intangible asset may depend on a number of factors, including:
The effects
of obsolescence, demand, competition, and other economic factors (such as the
stability of the industry, known technological advances, legislative action
that results in an uncertain or changing regulatory environment, and expected
changes in distribution channels).[77]
As the
question of useful life points out, broader valuation methodologies are also a
bone of contention. The IASB field study discussed earlier found a consensus on
the “highly subjective” assumptions used by valuation experts. However, this
may reflect more of a clash between auditors and valuation experts than an
inherent problem with classification of intangibles.[78]
Had valuation experts been included in the discussion, they might have disputed
that statement and argued that auditors are seeking an unrealistic level of
precision. They would also have pointed out that many contested items, such as
mineral rights and airport landing rights, have been subject to acceptable
valuations for a number of years.[79]
Part of that
valuation problem is the ability to value certain intangible assets on a
stand-alone basis. The IASB field study and Brookings Institution study pointed
out that certain intangible assets are difficult to separate either from other
assets or from the operation of a firm as a whole.[80]
As Baruch Lev points out, there are intangibles that “cannot be valued on a
stand-alone basis because they are enablers and they have strong interactions
with various other intangibles.”[81]
If they cannot be separated out, are they destined to remain lumped together in
that catch-all category of “goodwill”?
The
accounting profession understands that there may be differences of opinion. The
AICPA Auditors Guide, in paragraph 89, specifically recognizes the issue of
whether certain intangibles are properly identified (using the example of
customer relationships) – and recommends what the auditor should do if those
differences cannot be resolved.[82]
As discussed earlier, the
Sarbanes-Oxley Act now requires disclosure of assumptions and methods of
accounting as part of disclosing information on internal controls. It also
requires a discussion as to why a company used those methods if alternative
methodologies exist. Numerous companies have reported material weaknesses in
their internal controls. As they fix these problems, there may be an increase
in disclosure as to what is a recognized intangible and what is still lumped
into the category of goodwill.
Second, there
are areas that have been clearly excluded from SFAS 141 and 142 which some feel
need to be addressed.
In-process
R&D is still covered under SFAS 2, Accounting
for Research and Development Costs. SFAS 2 generally treats in-process
R&D as an intangible asset if acquired during a merger or acquisition but
requires the value to be immediately expensed except under certain
circumstances. Some continue to point out that expensing R&D creates a
distorted picture of return on equity, corporate profits and corporate
productivity:
The reason the corporate
profit share fell in the 1997-1999 boom is simple accounting: accounting
profits understated economic profits because corporations were making large
intangible investments in the late 1990s that they expensed. Adding intangible
investments to accounting profits and to accounting investment implies a very
different picture of the U.S.
economy.[83]
Interestingly,
economic statisticians are looking at this issue in the context of the System
of National Accounts. The Bureau of Economic Analysis (BEA) and the National
Science Foundation (NSF) are continuing their work on refining the R&D
portion of Gross Domestic Product (GDP) numbers. That work includes looking at
the issue of treating R&D as an investment (i.e. capitalizing cost over a
number of years, similar to what is already done with plant and equipment)
rather than expensing it.[84]
This movement by economists in charge of macroeconomic statistics toward
capitalization of R&D in the national accounts may give a new push for
similar capitalization of R&D in business accounting.
It should be noted that U.S. GAAP and the IASB standards
differ significantly in their treatment of in-process R&D and the
capitalization of development costs. In this case, the Committee of European
Securities Regulators recommends that companies listed on EU stock exchanges but
who report according to U.S. GAAP procedures be required to disclose a
“quantitative indication of the impact of an event or transaction, had this
event or transaction been accounted for following IAS/IFRS provisions. Such
quantification should provide the gross and net of tax effect of the difference
on the profit and loss or on the shareholders’ equity of the issuer, as
applicable.”[85] These
required disclosures will provide a quantitative record of the effect of
alternative treatments of R&D on the bottom line. This should provide
sufficient evidence to resolve the issue one way or another.
Assembled
workforce is also specifically excluded from the list of intangibles. However,
valuation experts have been valuing assembled workforce and using it to
determine value of other reportable intangible assets.[86]
If a calculation of the value of assembled workforce is used as an input in
reporting other intangibles, shouldn’t it be reported as well (under the
Sarbanes-Oxley Act requirements)?
Finally, as
mentioned at the very beginning of this paper, the different treatment of
acquired intangible assets and those generated internally is a major area of
concern. As the earlier FASB report on accounting for the New Economy stated:
There is no conceptual
basis in the definition of an asset for applying different recognition rules to
intangible assets purchased from outsiders and the same assets created
internally. Different recognition rules, if appropriate, require some other
justification.[87]
The lack of
such a requirement is both father to and son of the lack of internal accounting
system for capturing investments in other intangibles. In many cases, ongoing
investments in human capital, such as expenditures on in-house training,
mentoring, etc., are not reported separately as either investments or expenses
and apparently not even tracked internally.
Inability to
capture such information makes recognition of such ongoing investments
difficult – and the lack of a requirement to include such data provides no
incentives for creation of such systems. FASB requirements clearly drive, and
limit, company responses. The 2004 Accenture survey found that half of the
respondents limit the definition of intangibles to those defined by the
relevant accounting standards board.[88]
The Sarbanes-Oxley Act is pushing companies to upgrade their internal
accounting systems.[89]
However, as discussed earlier, it remains to be seen whether this will provide
any significant incentive for revamping these systems to provide better
measures of intangibles.
Thus, under
current requirements, the value of certain intangible assets must be reported
only if those assets are acquired from outside the company and if they can be
valued separately – which may be a matter of interpretation. Certain
intangibles, specifically assembled workforce, may not be recognized as assets.
Others, such as R&D, must be reported as part of expenses. Still others,
such as worker training, may not even be captured by internal data.
The abandoned
FASB follow-up project on intangibles would have been an attempt to address
some of these issues. It was very carefully limited to disclosure
of assets that are not currently recognized in statements of financial position
but would have been recognized under SFAS 141 and 142 if acquired in a business
combination. Clearly, FASB needs to revisit this project – and step up to
the plate to address these issues.
- - -
For all these problems, in
accounting there are recognized guidelines for what must be recognized and
placed on the balance sheet. They may be imperfect and not always followed. But
they are agreed-upon guidelines nonetheless. In disclosure of non-financial
measures and non-recognized intangible assets, the situation is different.
Disclosure is guided by the framework requirements of Regulation S-K, which
governs content of SEC-required reports.[90]
Those requirements, and SEC interpretations, call for disclosure of information
that would be “material” to an investor’s decision making. Over the years,
there has been guidance from the SEC as to what is considered “material.”
However, when it comes to performance measures and non-recognized intangible
assets, disclosure has been left up to the companies’ discretion.
There are numerous
variations of a framework for disclosing operating performance and value
drivers. Each tries to link non-financial (or alternative financial)
information to financial outcomes and the types of information investors and
analysts use to make their decisions. As is often pointed out, the very nature
of the important drivers – and the performance measures – are industry
specific. Thus, no one set of measures is relevant for all companies.
However, the state of play is
rapidly changing. First and foremost, investors are demanding more and better
information. The Deloitte survey found that “nearly three-quarters (73%) of the
executives and board directors said their companies are under increasing
pressure to measure nonfinancial performance indicators.”[91]
The competitive pressures of the financial markets are such that if a company
does not disclose information that is being disclosed by its competitors,
analysts will wonder why and inevitably draw the conclusion that the
information is negative.
The SEC’s guidelines on MD&A
are only slightly over a year old. Since this guidance is new, it remains to be
seen how tightly it is followed by SEC staff in reviewing corporate filings.
The opportunity exists to make the MD&A section more relevant. According to
SEC Commissioner Glassman:
The current reporting
framework—and in particular the MD&A—gives companies flexibility to provide
useful information to investors outside the GAAP framework. In that spirit, we
would love to see metrics and indicators that the market deems useful.
Unfortunately, MD&A disclosure has not reached its full potential because
companies view it as an obligation, rather than an opportunity to discuss their
business with investors and potential investors. Last year, the Commission's
Division of Corporation Finance reviewed the reports of all of the FORTUNE 500
companies. The Division's most frequent comments related to the MD&A, and
typically cited instances where companies simply recited financial statement
information with boilerplate analysis that did not provide any insight into the
companies' past performance or business prospects. That, in my opinion, is a
tremendous lost opportunity to fill the gaps in GAAP, and is one of the main
reasons programs like this one are questioning the relevance of GAAP.[92]
Another potential force for
change is the continued push by AICPA, under the rubric of the Enhanced
Business Reporting Consortium, to develop a common framework for disclosure of
value drivers and performance measures. As discussed earlier, the consortium’s
goal is to “drive the development and acceptance of enhanced business
reporting.”[93]
Needless to say, should the consortium succeed, it could dramatically change
the way in which intangibles are reported.
- - -
Everyone
agrees that accounting rules do not capture all the relevant information on
intangible assets. Debate continues over the merits of recognition versus
disclosure among accountants, auditors, valuation experts, financial analysts
and scholars. Questions linger about what should be recognized on a company’s
balance sheet (and therefore valued) or simply disclosed. And questions linger
about the accuracy and validity of valuations and assumptions used in valuation
methodologies. Yet the investor community and corporate management continue to
demand more qualitative and quantitative information on intangible assets,
performance measures and value drivers.
Increasing
availability of information on intangibles will take time and effort. There are
many issues to unravel. However, at a minimum, there are some steps that can be
taken in the near term. First, FASB and IASB must confront the disparity in
treatment of acquired versus internally generated intangibles. Second, the
accounting profession should address the issue of expensing R&D.
More importantly, we must focus
on the goal of better disclosure. Even if all the accounting problems can be
fixed, there is too much important data and information that can never be
reduced to an accounting valuation. In that regard, we need to go beyond simply
adding more to MD&A. It is too easy to lose important information there or
simply fill the space. As Alan Beller, Director of SEC’s Division of
Corporation Finance said, “I believe that some of the boilerplate and ‘elevator
music’ seen in too much MD&A can be safely eliminated.”[94]
Instead of adding more “elevator music,” there needs to be a comparable
framework for mandatory disclosure of material non-financial metrics.
Mandatory disclosure is generally
justified in terms of:
the informational asymmetries
that exist between companies and investors. The logic is that by arming
investors with information, mandatory disclosure promotes informed investor
decision making, capital market integrity, and capital market efficiency.[95]
However, increased disclosure also
forces better information collection by companies. It is not just the asymmetry
in information between the parties, but the lack of information altogether.
Such a framework would be as useful to management as to investors.
That is not to say that there
should be a one-size-fits-all framework. Any framework must be tailored to
important factors for the specific industry sector–but still allow for
cross-company and cross-industry comparisons. The Mantos study for the EU
suggests that at a minimum the following measures be included: investment in
training; investment in R&D; investment in information and communications
technology (ICT) infrastructure; new products ratio/ turnover; patent approval
rate/profile; employee turnover; and employee productivity.[96]
Going beyond cross-industry
comparison, the framework also needs to be a management tool. It needs to tie
the metrics directly to corporate financial performance, management’s financial
rewards and management accountability.
Likewise, it needs to deal with
problems of information overload. An “everything-including-the-kitchen-sink”
approach is more likely to confuse and obfuscate, rather than illuminate. As
Troy Paredes of the Washington University School of Law puts it:
Meaningful, effective
disclosure does not simply mean more disclosure. Because of information
overload, in some cases, more disclosure can mean less effective disclosure.[97]
The SEC MD&A guidance
discussed earlier was an attempt to focus on “material” information and remove
the extraneous.
Getting to such a framework will
be a difficult task. As the Deloitte survey points out, “the two biggest
obstacles to enabling the board and senior management to track nonfinancial
vital signs of the business are the lack of sophisticated measures and doubts
that they truly matter.”[98]
That is a good description of our
ongoing research and creative task, beginning with a new look at measures. In
order to create new, more sophisticated measures, we must first take a hard
look at what companies actually disclose and what investors are asking for. We
must go beyond discussion of potential frameworks that were reviewed in this
report to look at specific measures. This will be our next research task.
We must also look for new
measures at the macro-level. For example, as we have noted elsewhere, the U.S.
does not have a set of innovation measures.[99]
We collect data on science and technology (such as patents) but not directly on
innovation. Other countries are well ahead of us in this regard; we must update
our statistical system to make better economic policy.
Finally, we need to better
understand the role of intangibles in financial markets. How the market values,
and potentially trades, intangibles is another area of ongoing research.
With these and other studies by
numerous organizations, we can create a corporate reporting system that is an
accurate reflection of the intangible economy.
<top>
