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The Measurement and Recognition of Intangible Assets


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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.


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.


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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