The Measurement and Recognition of Intangible Assets
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Abstract
In today’s economy value is being created by intangible (intellectual)
capital. The Federal Reserve Bank of Philadelphia estimates that in the year
2000 more than $1 trillion was invested in intangibles. Some of these
intangibles were not being recognized on the Statement of Position. This paper
reviews the existing and recently promulgated accounting standards relating to
intangibles. Presently, Generally Accepted Accounting Principles allow for
inconsistencies in the measurement and reporting of intangibles. The objective
of this review is to provide evidence and alternatives to help improve the
measurement and recognition of intangible capital. This will lead to the
reporting of quality earnings that reflect the qualities of relevance and
reliability.
Introduction
When it comes to the recording of internally generated intangibles, very
little has changed during the last 70-plus years. Generally, purchased
intangibles are capitalized at cost, and the costs associated with developing
internally generated intangibles are expensed as incurred. The dollar amount of
unrecorded intangibles, however, has changed enormously. For example, knowledge
capital estimates for Microsoft were $211 billion, Intel, $170 billion, GE, $112
billion, and Merck $110 billion, to name just a few.
The Federal Reserve Bank of Philadelphia estimates that investment in
intangible assets for the year 2000 was approximately $1 trillion or greater (L.
Nakamura, 2001). The consequences related to the non-reporting of intangibles
are numerous, and are ultimately related to the fact that financial reports of
knowledge-based entities do not meet the criteria of either relevance or
reliability. The Financial Accounting Standards Board (FASB) has not taken steps
to allow for the capitalization of most internally generated intangibles even
though the technical feasibility of measuring intangibles has been well
documented and has now been sanctioned by the Board for companies that are
maintaining the value of goodwill previously purchased as part of an
acquisition.
Arguments about the inability of current US Generally Accepted Accounting
Principles (GAAP) to measure the activities of knowledge-based, hi-tech,
research dependent entities are coming at a time when the accounting profession
is under fire from the Securities & Exchange Commission (SEC), the International
Accounting Standards Board (IASB), and—in the wake of Enron—the polity at large
(Gelb and Siegel, 2000). Criticisms emanating from the SEC relate to accounting
procedures that fail to disclose, and might help to conceal massive fraud. The
IASB is pressuring the FASB to become increasingly flexible in an effort to
harmonize the global economy. In contrast to GAAP, International Accounting
Standards (IAS) emphasize conformance to principles, more than specific rules,
where the fundamental criterion is that the statements fairly reflect the
underlying economic reality of the business, rather than conformance to some
“checklist” of technical criteria (Barth, Kasnik and McNichols, 2001).
Clearly, the accounting profession is facing significant challenges. One of
the key problems that the profession faces is to effectively respond to the
criticisms of how intellectual and other capital is measured. A continued
failure to effectively address this issue undermines the credibility of reported
earnings and, therefore, the association between such earnings and stock market
valuations (Gelb and Siegel, 2000).
This paper provides further evidence that there are inconsistencies in
current GAAP between the treatment of internally generated intangibles and
purchased intangibles (Cronley 2004). Further, it describes how two newly
established Standards, Statements of Financial Accounting Standards (SFAS) 141
and SFAS 142, have confounded the non-comparability problem. Light is shed on
ways to improve the measurement and recognition of intangible assets and,
thereby, the quality of earnings. The intention is to show that (1) all
intangible (intellectual) capital meets the criteria for measurement and
reporting and should be recognized in financial statements and (2) this issue
should receive top priority in the standards-setting process.
Literature Review
The links between research and development, technological change, and
economic growth have been demonstrated theoretically. They have also been
empirically established at the firm, industry and national levels. In
particular, research and development has led to subsequent gains in
productivity, earnings, and shareholder value [Grilches, 1995; Lev & Sougiannis,
1996; Deng, Z. and B. Lev, 1999; Gelb and Siegel, 2000; Barth, Kasznik and
McNichols, 2001]. These studies suggest that R & D and technological change
expenditures promote economic growth. The extant research recommends
expenditures should be capitalized in order to present a more accurate picture
of the totality of a firm’s assets and their contribution to the future growth
of the firm (Amir and Lev, 1996).
The following paragraphs review studies on specific intangibles and the
effects of accounting treatment. These studies found that (1) omissions of
capital accumulation distort measures of productivity and earnings and diminish
predictive value, and (2) capitalization provides a more accurate description of
the firm’s position and economic performance resulting in stronger signals from
financial accounting.
Computer Technology
The level of intangible capital investments that have accompanied
computerization of the economy is probably far larger than the direct
investments in computers. However, the omission of this capital accumulation
distorts measures of productivity and income. Unmeasured intangibles include
software and software development, training costs, organizational restructuring,
business process redesign, and reallocation of decisions rights and incentive
systems (Amir and Lev, 1996). The growth rate of investment in computers has
been 30% in real terms for the last three decades.
Complimentary intangible investments are around ten times larger than the
hardware investments. Accounting for these intangible investments will change
productivity measures substantially [Yang and Brynjolfsson, 2001]. In addition
to productivity measures, the expensing of these investments on financial
reports distorts earnings. Aboody & Lev [1998] found that software companies
that expensed all software costs [1] had positive abnormal return drifts for at
least three years after expensing whereas capitalizing firms did not, indicating
a distortion of information.
Research & Development
Healy et al [1997] studied the tradeoff between objectivity and relevance in
reporting R & D in the pharmaceutical industry. A simulation model was used to
measure the performance of pharmaceutical companies and compare the performance
measures (expensing, full cost, and successful efforts) with economic returns.
Successful efforts capitalization-based performance measures explained twice the
variation in value as did expense based measures. Additionally, forecasts based
on capitalization performance measures were 50-67% more accurate than forecasts
using GAAP values.
The book-to-market ratio reflects investors’ assessments of future abnormal
profits. Lev & Sougiannis [1999] found that low book-to-market (B/M) companies
had large R & D capital, while high B/M firms had low R & D investment. They
also reported that R & D capital was significantly associated with subsequent
returns, after accounting for other fundamentals ( beta, size, book-to-market,
leverage and P/E ratios). The fact that the book-to-market ratio was no longer
associated with subsequent returns when R & D was present in the regression was
interesting.
There has been a systematic decline over the past two decades between the
association of capital market values and earnings, cash flows, and book values
(Lev & Zarowin, 1999). The results of the Lev and Zarowin study confirmed their
hypothesis that the universal expensing of intangible investments is
inconsistent with GAAP, and therefore, this practice has led to the decline of
the usefulness of financial reports. The evidence suggests that all intangible
investments that have passed certain pre-specified technological feasibility
tests be capitalized.
Once capitalization commences all project-related, previously expensed R & D
should then be capitalized. Lev and Zarowin (1999) proposed restatement of
financial reports to reflect the materialization of benefits related to change
drivers and other uncertainties affecting the quality of financial information.
Examples include expensed items relating to employee training, reorganizations,
and acquisition of technology.
Patents
Patent application citations, references cited in patent documents, and other
references, have been found to be significantly associated with market-to-book
ratios and stock returns for technology and science-based companies (Deng and
Lev, 1999). Firms whose patent portfolios contain a large number of frequently
cited patents are generating innovative technology that is likely to yield
important inventions and successful products (Gelb and Siegel, 2000).
Human Resources
Becker and Huselid (1997) found a strong relationship between the quality of
a firm’s Human Resource Management Systems and its subsequent financial
performance. They argue that human assets should be viewed as an investment
rather than an expense. This is important because the increasing use of
technology requires greater level of human capital and will result in a better
valuation of assets. This leads to stronger signals for validation of accounting
and financial reporting, as a result, and to a more accurate description of the
firm’s position and economic performance.
In sum, many studies have demonstrated that capitalization of intangible
assets significantly improve predictive power. This results in a more accurate
picture of the firms’ future financial performance. In light of the fact that
investors use financial statements to make future investment allocation
decisions, GAAP should provide for the capitalization of intangible assets
whether purchased or internally generated.
[1] SFAS 86 permits the capitalization of computer costs after technological
feasibility has been attained.
Measurement and Recognition of Intangibles
Expenditures on intangibles, which result in new technologies and brand
names, are difficult to quantify and value. Historically, intangibles have
always been considered “risky” assets. Accounting defines assets as economic
resources with measurable future service potential. However, it is more
difficult to measure the future service potential of intangibles than the
benefits accruing from other assets such as investment in property, plant, and
equipment. Thus, with few exceptions, accounting standards require the expensing
of all internally generated intangibles (Gelb and Siegel, 2000). In the present
economy, however, intangible assets such as intellectual capital frequently
create value. The accounting profession, however, has not met the responsibility
of measuring and reporting the results of knowledge-based entities (Barth and
Kaznick, 1999).
This section discusses the conceptual issues involved in the recognition and
measurement related to the capitalization of intangibles. Of particular
importance is the measurement of the cost of the assets being capitalized (R &
D, patents, and employee training), and the use of expected present value.
Capitalization Issues
Statement of Financial Accounting Concepts (SFAC) 2 states that an item and
information about it should meet the following four fundamental recognition
criteria to be recognized as an element in financial statements:
* It has a relevant attribute measurable with sufficient reliability
* The information about it is capable of making a difference in user
decisions
* The information is representational faithful and verifiable
* The information must be neutral. (FASB, 1980)
The element “asset” is defined as probable future economic benefits obtained
or controlled by a particular entity as a result of past transactions or events
(FASB). While Gu and Lev (2000) argue that traditional accounting systems fail
to capture much of what goes on in business because transactions are no longer
the basis for much of the value created and destroyed. They point out that SFAC
2 uses the terms, transactions and other events and circumstances affecting an
entity to describe the sources or changes in assets (FASB, 1980). An “event”,
however, is not limited to an arm’s length transaction between a willing buyer
and a willing seller. SFAC 6, paragraph 135, states, “An event is a happening of
consequence to an entity. It may be an internal event that occurs within the
entity” (FASB, 1985). Given this definition, the allocation of an entity’s
scarce resources to research, development, advertising, training, and other
ongoing activities are “events” of consequence to entities. SFAC 6, paragraph
36, further states that
“Circumstances are a condition or set of conditions that develop from an
event or a series of events, which may occur almost imperceptibly and may
converge in random or unexpected ways to create situations…. To see the
circumstance may be fairly easy,
to discern specifically when the event or events (…) caused it may be
difficult or impossible.” (FASB, 1985).
Research is a series of events that converge. It is almost impossible to
discern the turning point in the series of events that lead to a commercially
successful product (Gelb and Siegel, 2000). Assets are recorded at a cost or by
incurring a sacrifice of other assets in order to acquire something new.
Correspondingly, the resources directed toward internal generation of either
tangible or intangible assets meet the definition of cost. The common
characteristic shared by all assets is “service potential” or “future economic
benefit”. There exists some uncertainty relative to either the service potential
or future economic benefit of internally generated intangible assets. Therefore
the controversy focuses on risk and measurability issues. [1]
At a minimum, the “cost” in terms of employee efforts and raw materials
consumed can be measured (Amir and Lev, 1996 SFAS 25 (FASB, 1979) based the
“full cost” versus “successful efforts” in the oil and gas industry upon the
premise that the unsuccessful exploration efforts are a cost of those that are
successful. For example, the cost of drilling a dry hole is needed to find
commercially profitable wells. Similarly, the cost of primary research is needed
to find commercially successful products. For example, firms in the
pharmaceutical industry make R & D commitments at the program level, rather than
at the level of individual drug candidates (Healy et al, 1997). Expensing
research in any industry is inconsistent with the full cost method permitted in
the oil and gas industries. In addition to being inconsistent, the quality of
“neutrality” is missing when standards are promulgated favoring a particular
industry. The issue of neutrality will be discussed further in relation to SFAS
141, Business Combinations (Lev and Zarowin, 1999).
The relationship between service potential or future economic benefit of
assets and net cash inflows to an entity is often indirect for both business
enterprises and not-for-profit organizations. Therefore, the argument that “A
direct relationship between research and development costs and specific future
revenues generally has not been demonstrated, even with the benefit of
hindsight” is not only without merit, but inconsistent with the Board’s own
pronouncements. Lev and Sougiannis (1996) provide evidence that capitalization
of R & D yields statistically reliable and economically relevant information.
Recognition of elements of financial reports is subjected to decisions about
trade offs between relevance and reliability. This decision is generally decided
on proof and the verifiability of the element. Extant literature indicates the
professional acceptance for providing evidence that investment in research and
development, advertising, human resources, and other intangibles meet the
definition for classification as assets and the criteria for measurement (Gelb
and Siegel 2000). For example, the Board used evidence provided by publications
in scholarly journals in reaching their conclusions concerning the relevance of
Goodwill (SFAS 141). Market reaction is another professionally accepted medium
for providing evidence (Ofer and Siegel, 1987).
Devine argues that the value of a formal scheme for revising opinions should
be clear. He suggests that Bayesian techniques should be used for modifying
prior valuations in light of further information, as well as obtaining revised
probabilities. What is not clear is why the accounting standards setters have
ignored the possibility of a Bayesian approach to the capitalization and
amortization of internally generated intangibles.
1] Although software is risky and volatile (it has diverse technologies and
short-life cycles relative to overall R & D in pharmaceuticals) capitalization
of technologically feasible software is permissible (SFAS 86).
In SFAC 6 we find the following:
Absence of a market price or exchangeability of an asset may create
measurement and recognition problems, but it in no way negates future economic
benefits that can be obtained by use as well as by exchange. Incurrence of cost
may be significant evidence of acquisition or enhancement of future economic
benefits. (FASB, 1985).
The distinction between research and development, advertising, training, etc.
and other recognized assets is not based on the definition of assets but rather
on the practical consideration of coping with the effects of uncertainty
complicated by the fact that the benefits may be realized far in the future. As
a result of SFAC 6 (FASB, 1985), relevance and reliability are the two primary
qualities that make accounting information useful for decision-making.
Information is considered relevant if it has the capacity to make a difference
in making a decision. Furthermore, the essence of reliability is faithful
representation, neutrality and verifiability.
The preceding is significant since the FASB has acknowledged the relevance of
disclosing information relative to intangible assets. Information is verifiable
(reliable), according to the FASB, if there is a high degree of consensus among
measurers. As mentioned earlier, there is a consensus of academic scholars,
accountants, financial analysts, and the financial press that intangible capital
can and should be measured. The measurements and tools thereof seem no more
susceptible to error than other risky assets and financial instruments that are
currently recognized by GAAP. For example, SFAS 123 computes compensation
expense based on an option-pricing model (FASB, 2004). SFAS 86 permits the
capitalization of technically feasible software (FASB, 1985). SOP 93-7 permits
the capitalization of direct-response advertising. SFAS 133, 1998) promulgates
the rules for recording assets/liabilities that meet the definition of a
derivative or an imbedded derivative. In light of current and previous market
volatility, it seems inconsistent to recognize compensation expense based on an
option-pricing model, and yet be unwilling to capitalize intangible assets. SFAC
1 stated that:
the purpose of the series is to set forth fundamental objectives and concepts
that the Board will use in developing future standards of financial accounting
and reporting. They are intended to form a cohesive set of interrelated
concepts, a conceptual framework that will serve as tools for solving existing
and emerging problems in a consistent manner (FASB 1978).
Consistency, however, has been and continues to be compromised (Karim and
Siegel 1998). Other well-grounded financial accounting assumptions are being
overlooked (Schipper and Vincent, 2003) (Barth, Beaver, and Landsman, 2001). The
accounting model, which was designed to produce relevant and reliable
information, has failed to do so. The accounting standard setters have
historically been faced with the trade-off between relevance and reliability.
Similarly, accounting for derivative instruments and hedging activities is also
an example of recognizing assets [1] and liabilities when the application of the
quality of verifiability requires a great deal of estimation. The recognition of
derivative instruments and embedded derivatives has taken us far beyond
traditional historical cost accounting. Nonetheless, the benefits of recognition
were considered greater than the costs of measurement error.
Some internally generated intangibles are capitalized. Costs incurred in
creating a computer software product that is to be sold, leased, or otherwise
marketed, is charged to research and development expense when incurred until
technological feasibility has been established for the product. [2]
Technological feasibility, however, is a criterion that is difficult to apply.
There is no such thing as a real, specific baseline design. Erlop (1996) argues
that a company can apply the technological feasibility threshold as early or
late as they choose. Kirk (1985) says the criterion of technological feasibility
is difficult to define. Therefore it can lead to abuse. Financial analysts have
consistently argued against capitalization of computer software because the
useful life is relatively short lived compared to other R & D projects.
Technologically feasible software is recognized as an asset, whereas other
intangibles that are both more relevant and reliable, that have greater
consequences in terms of both dollar amounts and useful lives, continue to be
ignored (Gelb and Siegel, 2000).
IAS 38, Intangible Assets, employs the term “technological feasibility” for
capitalizing expenditures in the “development phase”. The criteria listed for
capitalization of research in the development phase are as follows:
* Technical feasibility of completion for use or sale,
* Intention, technical and financial ability to complete and use or sell it,
* Existence of market or internal usefulness, and
* Measurability during the development phase (IASB 2004).
The existence of internal usefulness is a worthwhile criterion for us to
consider in our deliberations on the capitalization of research and development
expenditures. Even non-commercially successful products provide knowledge
(intellectual capital) that will be used internally in producing successful
products (Amir and Lev, 1996).
[1] The time value of options is recognized based on expectation that the
price will increase above the strike price. Quarterly reviews are required with
subsequent recognition of unrealized holding gains/losses.
[2] Statement of Position 98-1 establishes the accounting rules for software
developed or obtained for internal use. Capitalization begins at the application
development stage.
Expected Present Value
The objective of using present value in accounting measurement is to capture
the economic differences between sets of future cash flows. This measurement of
expected present value is one method of capturing an asset valuation and can be
used in the case of internally generated intangibles. SFAC 7 (FASB, 2000)
introduces the measurement of “expected present value”. This differs from
traditional accounting present value calculations in that it refers to a sum of
probability-weighted present values in a range of estimated cash flows. When no
market exists for the item or comparable items, the appropriate rate must be
observed from some other cash flows (Lev and Sougiannis, 1996). SFAC 7 also
lists the features that present value measurements should incorporate to fully
capture economic differences between assets.
… the estimate should include a single or series of future cash flows,
possible variations in the amount, timing, and uncertainty, and unidentifiable
factors including illiquidity and market imperfections. …Value-in-use and
entity-specific measurements [1] can be applied to capture all five elements.
The measurement substitutes the entity’s assumptions for those of the market
place. (FASB, 2000).
Clearly, this would lend support to the capitalization process. The riskiness
attached to internally generated intangibles can be measured using internally
generated metrics incorporating “expected present values” amenable to the
measurement of intangible (intellectual) capital). In the absence of a cash
transaction, measurement can be made based on comparison of similar transactions
in the market place. In other words, payments made for in-process R & D and
other internally generated intangibles can be used in some situations.
[1] SFAS No. 33 and 89 permit the use of internally generated indices to
restate historical costs statements to current cost.
The Cost of Certain Intangibles
Although the cost of most internally generated intangibles is presently
expensed as incurred, methods do exit to measure which of these costs should be
capitalized. An example is the measurement via expected present value. The
following gives specific examples of measuring capitalizable costs associated
with advertising, R & D, patents, and employee training.
Advertising and R & D
The costs of all advertising are expensed in the periods in which those costs
are incurred (SFAS 2; FASB, 1974), with the exception of direct-response
advertising. SOP 93-7 requires that the primary purpose of such advertising be
to elicit sales, and that there must be a system for documenting the sales
activity. Treating customer-acquisition costs differently leads to inconsistent
financial reporting. It’s difficult to document over multiple time periods using
estimated present values the increase in sales and income of advertising
campaigns (Gelb, 2002).
The expensing of R & D and advertising are required based upon the risk and
uncertainty related to their benefits. For example, there should be sufficient
documentation between R & D expenditures and the ratio of
successful/non-successful drugs. For each company the success/failure ratio over
an extended period of time should be documented (Sannella, 1995). SOP 93-7
requires a historic pattern of results for the entity; however, industry
specifics are not objective evidence. If the entity does not have operating
histories for new products or services, statistics for other products or
services may be used if it can be demonstrated that these are products/services
that are likely to be highly correlated. The Statement also permits the payroll
and payroll related costs for the activities of employees who are directly
associated with, or devote time to, the advertising to be reported as assets
(Gelb and Siegel, 2000).
Intellectual Property: Patents
Revenues (royalties) from patents were $110 billion in 1999 (Reivette and
Kline, 2000). Investors at four to five times earnings value royalty income with
deficient information leading to under-valuation (Gu and Lev, 2000). Licensing
intensity provides investors with an important signal about the quality of a
firm’s R & D. Many companies (IBM, Lucent, and Dow) have independent divisions
dedicated to licensing of patents and know how. They also provide consulting
services in the valuations of patents and potential licenses [Linden and Somaya,
1999].
SFAS 133 (FASB, 1998) prescribes the accounting rules for recognizing
options. The Patent & License Exchange currently offer products to assist owners
of intellectual property to value their intellectual property (IP) as financial
assets, thus converting goodwill-based valuation to market-based valuation. They
provide IP valuation and monetization products and also distribute IP valuation
data. Patents are options on technology. They are call options on the future
cash flows that may or may not arise from technology. The Exchange provides
evidence that IP behaves like a financial call, and are therefore subject to
monetization. Option pricing models have already been sanctioned by the FASB (SFAS
123; 2004) as acceptable pricing models. The accounting rules for call options
are already in existence, and the market-test for treating patents as call
options has been met. The Exchange provides bona fide transaction and valuation
data. (Kawaller 2004)
Presently there exist markets in patents both on-line and off-line. Sony and
Dow are an example of companies that have placed parts of their patent and
know-how portfolios for trade on websites (Gu & Lev, 2000]. The recognition of
patents is in accordance with GAAP.
Employee Training Costs
The argument against capitalizing the costs of training employees has
centered on the definition of an “asset.” An asset is either owned or controlled
by an entity, and employees are neither owned nor controlled by the entity.
Nonetheless, the future service potential of employees is given recognition in
pension accounting. When unfunded, an accumulated benefit obligation is recorded
with a credit to minimum liability and a debit to an intangible asset, deferred
pension cost (FASB, 1985). Also, the future service of employees is considered
when recognizing compensation expense for employee stock options (FASB, 2004)
and when amortizing prior service cost (FASB, 1985). Human Resources have a
significant role in the development and performance of a firm. Of all the assets
an entity has, the one that is overlooked and produces significant value is
Human Resources (Patra & Khatik, 2003).
A recent report on voluntary disclosures by the FASB indicates that
additional data about unrecognized intangible assets would be beneficial because
of the importance of intangibles to a company’s value. Intangibles include not
only R & D, but also human resources, customer relationships, innovations,
etc.[1] The FASB argues that intangible assets are subject to fluctuations due
to external factors not wholly within management’s control. The FASB therefore
recommends disclosure rather than recognition of internally generated
intangibles. The FASB argues that the measurements used by companies to manage
their operations and drive their business strategies are very useful voluntary
disclosures. [2] The question raised here is whether or not all intangibles
should be recognized if they are reliably measurable and are relevant. The next
section of this study will discuss how the FASB has supported the capitalization
of internally generated metrics in the case of maintaining the value of
intangibles purchased in an acquisition. These same metrics could be used to
restate the traditional financial reports to include all intangible
(intellectual) capital, with full disclosure on how these metrics were derived.
Furthermore, there are very few assets, tangible or intangible, that are wholly
within any company’s control.
[1] The Board suggests preparing a list of items that may require disclosure.
Examples include agreements, contracts, patents, copyrights, trademarks,
databases, customer lists, and software.
[2] Improving Business Reporting: Insights into Enhancing Voluntary
Disclosures, FASB 2001
Confounding Statement: SFAS 141 and SFAS 142
SFAS 141, “Business Combinations” (FASB, 2001) requires that certain
intangibles be listed separately that previously were recognized as goodwill.
However, this Statement did not change the expensing of R & D costs inherent in
a purchase. SFAS 142, “Goodwill and Other Intangible Assets” (FASB, 2001)
requires that purchased goodwill be capitalized and not amortized based on the
premise that a company can maintain the value of this asset. Annually, the fair
value of goodwill is tested and written down when this value has been impaired.
This section explains how these changes compounded the inconsistencies
associated with accounting for intangibles.
Business Combinations and Intangibles
SFAS 141 requires all business combinations within the scope of the Statement
to be accounted for by the purchase method of accounting. There are several
reasons for issuing this Statement, so as:
·
* To improve comparability of methods of accounting for business
combinations.
* To provide better information about intangibles that are an increasing
proportion of acquired assets.
* To increase fairness in the markets for mergers and acquisitions. (FASB,
2001).
SFAS 141 provides examples in five different categories: Marketing, Customer,
Artistic, Contract, and Technology related intangibles, such as trademarks,
television programs, leases, and patents. FSAS 141 does not change the
requirement that amounts assigned to research and development that have no
alternative future use shall be charged to expense at the acquisition date (Lev
and Sougiannis, 1999). Another disadvantage listed by the Board of using two
different methods for acquisitions was the difficulty in drawing unambiguous and
non-arbitrary boundaries between transactions to which the different accounting
methods would apply (Lev and Sougiannis, 1999). The FASB in this Statement made
two exceptions for recognizing an intangible asset separately from goodwill:
An assembled workforce
Even though an assembled work force meets the criteria for recognition, it
becomes a component of goodwill. The FASB argues that replacement cost is not a
representationally faithful measure of the intellectual capital of an entity,
and therefore reliable measures are not available for separate recognition (Lev
and Zarowin, 1999).
Research & Development
The FASB concluded that the issue of R & D in business combinations could not
be addressed without addressing the issue in general. Therefore they have
decided to defer the issue to a future date. With respect to intangibles,
improvement in financial reporting is achieved due to the requirement that
intangible assets meeting the recognition criteria be listed separately, rather
than being a component of goodwill. Nonetheless, the major issue of recognizing
intangible (intellectual) capital has still overlooked (Lev and Sougiannis,
1996). In SFAS 142, the Board explains its interest in Goodwill and in the
intangibles separately recognized as part of goodwill. It states:
Analysts and other users of financial statements, as well as company
managements, noted that intangible assets are increasingly important economic
resources for many entities and are an increasing proportion of the assets
acquired in many transactions. As a result, better information about intangible
assets was needed… The changes in this Statement will improve financial
reporting because the financial statements of entities that acquire goodwill and
other intangible assets will better reflect the underlying economics of those
assets. As a result, financial statement users will be better able to understand
the investments made in those assets and the subsequent performance of those
investments… provide...better understanding of the expectations about, and
changes in, those assets over time thereby improving their ability to assess
future profitability and cash flows. (FASB, 2001)
Thus, the Board believes this approach gives the user better information on
management’s accountability of assets.
Goodwill and Other Intangible Assets
SFAS 142 deals with the initial recognition and measurement of acquired
intangibles, except those acquired in a business combination. SFAS 142 has taken
a significant step away from accounting standards in that it changes the
approach to goodwill thereby changing the approach to goodwill and other
intangible assets subsequent to their initial recognition. Goodwill and certain
intangible assets will no longer be amortized, resulting in greater volatility
in reported income than under prior standards. This is because an impairment
loss may occur in varying amounts and at irregular time intervals.
If no legal, regulatory, contractual, competitive, economic, or other factors
limit the useful life of an intangible asset to the reporting entity the useful
life of the asset shall be considered to be indefinite. The term indefinite does
not mean infinite. An intangible asset that is not subject to amortization shall
be evaluated each reporting period for the indefinite life criterion, and tested
for impairment annually if circumstances warrant (SFAS 142).
The amortization of recognized assets, including acquired goodwill, is no
longer mandatory under SFAS 142. Under the prior standards, all assets had to be
depreciated or amortized, other than land. Goodwill will be tested for
impairment at a level of reporting referred to as a reporting unit. The FASB
acknowledges that goodwill is a residual, and therefore cannot be directly
measured. The Board therefore included a method for measuring “implied fair
value of goodwill”. This method allocates the fair market value of all assets
and liabilities as if the reporting unit had been acquired in a business
combination. The fair value of the reporting entity is the acquisition price and
the value allocation should include the cost of research and development. The
measurement of the fair value of a reporting unit is inconsistent with GAAP.
There is, in general, no market price for a reporting unit (segment).
More than three decades of scholarly research and publication have documented
the relevance and reliability of the market in assessing performance based upon
measures that include intangible capital. Statistically significant proof of the
predictive value, as well as the representational faithfulness, of earnings
based on an asset base that incorporates intangible capital has been carefully
studied (Gelb and Siegel, 2000). The FASB has consistently responded that the
qualities of both relevance and reliability were lacking, and currently make an
exception for acquisitions. The inconsistency is compounded by “backdoor
capitalization” of intangibles that must be expensed. The original purpose of
the Standard on Business Combinations was to provide fairness in financial
reporting. Instead, the financial accounting standards have allowed acquiring
firms to capitalize the intangibles that non-acquiring firms cannot.
The FASB argues that the cash flows identified with acquired goodwill usually
are intermingled with those associated with internally generated goodwill and
other assets. The FASB concluded that acquired goodwill could be replaced by
internally generated goodwill provided that an entity is able to maintain the
overall value of goodwill. This is exemplified by expenditures on advertising
and customer service. The FASB, in effect, is saying that expenditures on such
items as advertising and customer service can only be capitalized for companies
engaged in acquiring other companies. The FASB contends that advertising
provides evidence that goodwill is being maintained. However, current GAAP
requires that those expenditures that prolong the useful life of an asset should
be capitalized. Expenditures that simply maintain a given level are expensed.
Therefore the inconsistency in the above argument is twofold. Expenditures on
maintenance are capitalized but expenditures relate to intangibles are expensed.
The Board admits that in effect non-amortization of goodwill is capitalization
of internally generated goodwill. The FASB states that the irregularities that
result from differences in how acquired goodwill and internally generated
goodwill are accounted for, also justify a departure from the current accounting
model.
During the 1970s the FASB had an active project to consider accounting for
business combinations and purchased intangible assets, but deferred the issue
until it had completed the development of its conceptual framework. The purpose
of the financial accounting conceptual framework is to set forth fundamental
objectives and concepts that the FASB will use in developing future standards of
financial accounting and reporting. The statement of financial accounting
concepts are intended to form a cohesive set of interrelated concepts, a
conceptual framework, that will serve as tools for solving existing and emerging
problems in a consistent manner. The financial accounting standards provide for
impairment tests of goodwill based on aggregate goodwill rather than only
acquired goodwill. The same concept could be applied to R & D by aggregating all
R & D costs on commercially and non-commercially successful projects alike. The
non-successful projects could be considered maintenance of continued research;
the workforce; the successful image of the firm; and its viability as a going
concern. The ongoing research creates confidence and goodwill in the ability of
an entity to produce products for the good of humanity (Lev and Zarowin, 1999).
There are other controversial and inconsistent arguments that appear in the
financial accounting standards. Analysts usually disregard goodwill amortization
since it is not considered relevant for decision-making. Fluctuations in
reported income do not fairly reflect the economic changes in those periods.
Non-amortization is more closely aligned with how entities manage their business
and how investors view goodwill. Barth, Kasznik, and McNichols (2001) reported
that financial analysts commonly restate financial reports for their internal
use. Gu and Lev (2000) studied the benefit/cost argument that involved the cost
to analysts of changing their analytical models. They found that analysts rarely
formulate their models based on GAAP. Similarly corporate managers use internal
financial reports for their decision-making. These reports indicate that the
expensing of all intangibles will not appropriately reflect economic
performance. Financial analysts typically capitalize research and development,
operating leases, and other intangible (intellectual) expenditures. They also
frequently expense dubious deferred charges and related items buried in the
other assets section. If the FASB promulgates standards based on the information
analysts and managers find useful, then recognition of intangible capital should
have been a priority on their emerging standards list. (Born and Giaccotto,
2004).
The Statements of Financial Accounting Concepts were designed by FASB to
promote comparability and consistency in financial reporting. The Statement on
Business Combinations (SFAS 141) was promulgated to enhance the comparability of
entities involved in mergers and acquisitions. The rule that all business
combinations will be accounted for by the Purchase Method of accounting will
promote comparability between acquiring firms. However, this same Statement, in
combination with the Statement on Goodwill and Other Intangible Assets (SFAS
142) has created an environment wherein entities that have substantial
internally generated intangibles cannot be compared to firms engaged in merger
activity. In additional to the lack of comparability, the Statement favors
acquiring firms by changing measurement and recognition criteria, and providing
exceptions to the accounting model for these firms.
Conclusion and Recommendations
There are many issues facing the accounting profession and not all of them
can be traced to the failure of our information system. Nonetheless, the impact
of inconsistent standards on the design and delivery of accounting information
to investors and the rest of the user community cannot be ignored (Stittle,
2004). Compromises, albeit necessary in the real world, have led to the
development and application of inconsistent standards. One of the key problems
that the profession faces is to effectively respond to the criticisms of how
intellectual and other capital is measured. Failure to effectively address this
issue undermines the credibility of reported earnings and, therefore, the
association between earnings and stock market valuations (Gelb and Siegel,
2000).
The FASB considers several factors in developing its review agenda. These
factors include: pervasiveness of the issue, alternative solutions, technical
feasibility, and practical consequences. This study points out that (1) the
amount of unrecognized intangibles is enormous, (2) various methods are
available to measure costs relevant to the capitalization of these intangibles,
(3) analysts and accountants already measure intangibles using these methods,
and (4) the predictive value of financial statements is diminished when
statements do not include these intangibles. The FASB has issued a “Proposal for
a New Agenda Project”, Disclosure of Information about Intangible Assets not
Recognized in Financial Statements. This is a first step in the right direction
that may lead to the measurement and reporting of internally generated
intangible capital in financial statements.
International Accounting Standards offer a slightly different approach than
US GAAP. They conform to principles more than specific rules. Their fundamental
criterion is that the statements fairly reflect the underlying economic reality
of the transaction, event or circumstance. US GAAP in contrast conforms to
technical criteria (Barth, Kasznik and McNichols, 2001). IAS 38 criteria for
recognizing intangibles in the development phase would be a good starting point
and would also encourage the harmonization of international accounting
standards. Technological feasibility is described as the ability to complete the
process for use or sale. Although this may be as subjective as the technological
criteria outlined in SFAS 86 (FASB, 1985) the scope of IAS 38 encompasses all
intangibles, rather than one subset thereof, and capitalization based on the
existence of a market or internal usefulness may be more meaningful.
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About the Author
Philip Siegel and Carl Borgia, Florida Atlantic University
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Article Published/Sorted/Amended on Scopulus 2007-04-07 14:20:30 in Business Articles
