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;