Valuing Intangible Assets
By Benjamin P. Foster, Robin Fletcher, and William D. Stout
Establishing Practices in an Emerging Area
Recently issued accounting standards have created the need for valuation of intangible assets for financial statement purposes. Arriving at these valuations can be a complicated and uncertain process. Although the standards address only those intangibles acquired in a business combination, they raise the question of what values remain hidden within internally developed intangibles. The variability of such assets is evidenced by the declines of dot-com companies whose reported assets could have never accounted for their market valuation highs. As business evolves, however, more reliable means of valuing intangible assets—such as a bank’s valuation of intellectual property to be used as collateral—are becoming more common, and someday may become the norm.
In recent years, three factors have changed the way financial statement users view intangible assets, especially intellectual property (IP): newly issued financial accounting standards, the rise (and fall) of many companies whose main assets were intangible, and the increase in objective external evidence of the value of IP. The business environment’s evolving view of intangible assets has significant implications for accounting for and valuing these increasingly important items.
Accounting for Intangible Assets
SFAS 141, Business Combinations, addresses accounting for intangible assets acquired in a business combination. SFAS 142, Goodwill and Other Intangible Assets, addresses accounting for the acquisition of intangible assets outside of a business combination. SFAS 142 also addresses the accounting for all intangible assets following their acquisition. Neither standard, however, addresses the reporting of internally developed intangible assets.
Business combinations. SFAS 141 requires an acquiring entity to allocate the purchase price of an acquired entity to the assets acquired and liabilities assumed at their estimated fair values on the date of acquisition. The standard provides the following guidance:
An intangible asset shall be recognized as an asset apart from goodwill if it arises from contractual or other legal rights (regardless of whether those rights are transferable or separable from the acquired entity or from other rights and obligations). If an intangible asset does not arise from contractual or other legal rights, it shall be recognized as an asset apart from goodwill only if it is separable, that is, it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented, or exchanged (regardless of whether there is an intent to do so).
Appendix A to SFAS 141 provides examples of intangible assets that might be recognized separately: trademarks, Internet domain names, noncompetition agreements, customer lists, books, advertising contracts, construction permits, use rights, employment contracts, patented and unpatented technologies, and secret formulas.
Once the acquisition cost has been allocated to acquired assets (including intangibles) and assumed liabilities, any remaining amount is then recognized as goodwill. Continuing current practice, SFAS 141 requires acquired research and development assets recognized as part of a business combination to be immediately expensed if they have no alternative future use.
Post-acquisition accounting. SFAS 142 addresses accounting for all intangible assets (including goodwill) after their acquisition, including those acquired in a business combination. The most significant change brought about by SFAS 142 is the elimination of goodwill amortization. In its place, SFAS 142 requires companies to conduct annual (in some cases interim) tests for impairment of goodwill.
The standard calls for a two-step impairment test. First, the fair value of a reporting unit is compared to the carrying amount, including goodwill previously recognized. Second, the implied fair value of the reporting unit’s goodwill is compared to the carrying amount of the goodwill. If the fair value is lower, it is considered impaired.
Accounting for other intangible assets is more straightforward. The asset is amortized over its useful life using a method that reflects how benefits of the asset are consumed. SFAS 142 permits the use of the straight-line method if no other pattern can be reliably determined. Managers should evaluate the useful life each reporting period, and report adjustments as a change in accounting estimate prospectively over the remaining useful life. Perhaps, under SFAS 142, managers could incorporate the use of appraisals if they can show that appraisals of intangible assets are reliable and reflect the pattern under which benefits are received better than the straight-line method.
Accounting and the New Economy
Recently, many companies’ GAAP stockholders’ equity per share has been significantly lower than the price per share as traded on stock exchanges. For example, Microsoft reported stockholders’ equity of about $68 billion in recent financial statements, yet its market value at the filing date was approximately four times that amount. Critics of the current financial reporting model cite the failure to report the value of certain intangible assets as a cause of these differences. Those critics say that GAAP must consider the values of these increasingly important, currently unrecognized assets in financial statements.
Electronic Business recently published an article titled “The Reporting Gap: Earnings and Other Financials No Longer Suffice as Measures of Corporate Health” (Roberts, 2001). According to the author, accounting practices that prohibit the recognition of intangible assets are the main reason companies’ GAAP-based balance sheets do not reflect their true worth. In the April 7, 1997, Forbes, Baruch Lev stated, “How ironic that accounting is the last vestige of those who believe that things are assets and that ideas are expendable.” In the November 1999 Strategic Finance, King and Henry said that the intangible assets of many high-tech companies “walk out the door every night.” King and Henry further lamented that GAAP does not allow the value of such intangible assets on balance sheets, and called for change.
These criticisms of current reporting requirements for intangible assets appear to be based on the premise that the balance sheet should show the value of a company’s assets. Accountants and most sophisticated investors, however, recognize that the book value of a particular asset on a balance sheet may have little relation to the actual value of that asset. In addition, a variety of definitions of “value” exist. FASB has struggled with this issue and has promulgated some accounting standards that attempt to reduce the difference between reported values of assets and liabilities and their fair values in the marketplace. For example, investments in marketable securities are generally recognized at fair market value on the balance sheet date. Derivative instruments are also reported at fair market value, as is long-term debt in certain situations. SFAS 141 applies the fair value approach to intangible assets acquired in business combinations.
The balance sheet undoubtedly has significant limitations in terms of reporting an entity’s true value. Internally developed intangible assets, even those for which a fair value may be determinable, are not recognized in the financial statements. Other intangible assets, such as political clout and regulatory expertise, are generally not even discussed in company reports. Investors and creditors recognize these limitations, and presumably perform independent research and analysis in their investment and credit decisions.
The Intangible Asset Quandary
The two recent FASB standards do little, if anything, to help investors better evaluate this aspect of businesses. Some critics argue that currently unreported internally generated intangible assets should be reported at fair market value, just like those acquired from outside the entity. But doing so will require companies to incur potentially significant costs. Hiring appraisers and value analysts to determine the fair value of intangibles may be somewhat costly, but the extra risk incurred by executives and auditors may be extreme. Given that the value of intangibles can fluctuate wildly over time, will financial statement users perceive that the values reported previously were incorrect or perhaps even fraudulent? Will company executives and external auditors be exposed to additional liabilities?
In late 1999, Ask Jeeves, Inc.’s common stock sold as high as $180 per share. At that price, Ask Jeeves’ market value was nearly 200 times stockholders’ equity. The indicated market value was approximately $4 billion, but the company’s balance sheet showed assets of only $32 million, the bulk of which was cash, cash equivalents, and investments. Investors evidently thought that Ask Jeeves possessed significant intangible assets.
Less than 18 months later, the stock sold for about $1 per share, with an indicated market value of $50 million. Apparently some of the company’s assets “that walk out the door every night” failed to return the next morning. If the company had reported substantial intangible assets in 1999, would executives and auditors have been exposed to charges of fraud in 2001?
Recent stock market performance makes it easy to find companies whose market value has significantly declined over relatively short periods of time. One could argue that the recent fluctuations in market value indicate that measures of intangible assets are inaccurate and unreliable. Fluctuations in the value of certain assets, however, are not an adequate excuse to ignore real and potentially substantial assets.
External Evidence for the Value of Internally Developed Intangible Assets
Recognizing (or even disclosing) the fair value of currently unrecognized intangible assets has at least two major drawbacks. First, determining fair value saddles the reporting company with new, unrecoverable costs. Second, the lack of objective evidence of value (such as acquisition cost in the case of a business combination) potentially exposes executives and auditors to increased liabilities should those valuations turn out to be incorrect. Two sources of external evidence on the value of intangible assets have, however, been largely ignored.
Intangible assets as collateral. The first source of external evidence on the value of unrecognized intangible assets is the willingness of lenders to accept such assets as collateral for loans. In a report by Reuters in September 2002, Rozens reported that one bank, UCC Capital, has developed a niche by lending money for bonds secured by companies’ regular income from patents or fashion logo licensing. Also, King and Henry point out that major banks have made loans to corporations secured not by traditional assets, but rather by trade names and patents. In at least one case, a bank accepted specific intangible assets as collateral, and determined the value of these assets by appraisal.
Using intangible assets as collateral can temper the two major drawbacks of reporting the value of currently unrecognized intangible assets. If the cost of the appraisals is evidently not significant enough to prevent obtaining bank loans, why should appraisal costs be an issue for reporting to all investors and creditors? Interestingly, annual appraisals are required in the case King and Henry describe.
The second drawback is the reliability of the information and the potential for increased liability for executives and auditors. For a bank to accept intangible assets as collateral based on appraisals indicates that it is satisfied with the reliability of the appraisal. (Of course, the bank may lend only a fraction of the value of the intangible. The absolute reliability of the appraisal may not be as important for a particular bank loan as it would be in overall financial reporting.)
Insured values of intangible assets. The presence of insurance for intangible assets also offers objective external evidence of their value. Insuring individual intangible assets, or portfolios of intangible assets, began in the mid-1970s, and such insurance was offered to cover infringement litigation expenses in the 1980s. Protecting IP from or through litigation is costly. A goal of litigation insurance is to address the needs of small companies owning IP. Many small companies experience difficulty penetrating markets because they cannot afford the expense of IP litigation encountered when facing competition from large companies that have extensive access to IP legal services. Companies without adequate resources or insurance may not be able to enforce their IP claims against larger competitors. Small companies may also not be able to adequately defend against allegations of IP infringement, whether or not those allegations have merit.
Insuring IP against other forms of loss was a natural extension of IP litigation insurance. The potential losses that threaten the value of IP include infringement, loss of royalty stream, invalidation, unenforceability, or loss of ownership. The amount at risk is the IP value itself, which is based on factors such as income, competitive advantage, and other intangible benefits generated by the IP. Thus, a formal valuation taking into account all relevant factors regarding an item or portfolio of IP is required to insure its value for a specific amount. The dollar amount determined for IP in the formal valuation may be the amount to be insured. (The value of IP used for collateral on loans could also be insured, providing protection to lenders.)
The fact that insurance companies are willing to accept and insure the risks that companies face with IP, and that lenders face from collateralized loans, provides external evidence that an intangible asset has value. If a company chooses to insure its intangible assets, disclosure of the practice and the insured values could provide useful information to creditors and investors. The value they are willing to insure could be used for purposes of lending, borrowing, or financial reporting. Such a disclosure could help bridge the gap between reported values and market values.
Intangibles and GAAP
Appraisals are used to determine the value of intangible assets used as collateral for loans. Appraisals are also used to determine the value of intangible assets, especially IP, to be insured. The fact that IP is used for collateral on a loan or as an insured value is important in valuing such assets acquired through a merger under SFAS 141. The records of an acquired company for appraisals related to the use of intangible assets as collateral for loans or insurance of intangible assets could provide valuable evidence for the existence and valuation of intangibles. In most instances, such items should be separately recorded as assets resulting from the business combination.
SFAS 142 permits the use of the straight-line amortization method if no other amortization pattern can be reliably determined. Annual intangible asset appraisals used to determine values of collateral for loans and values for IP insurance may be another way to reliably determine amortization.
Application to future GAAP. In the long run, external evidence could help allow internally developed intangible assets to be included in financial reports. Initially, companies might voluntarily report these appraised values in the notes to their financial statements. If research determined that such disclosures were useful to investors, and if the valuation costs had already substantially been incurred, then FASB could consider recognizing those values directly in the financial statements.
Assets disappearing overnight, however, raises the issue of the need for a new scope for the definition of loss. Intangibles are not lost to tangible threats such as fire and storm. Intangibles are at risk of loss due to intangible forces, such as changing overall economic conditions, increased competition, new technology, and employment changes.
Accountants have long addressed asset value risks. Some of the same forces that can cause intangible assets to lose value can also affect fixed assets. SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, addresses issues related to such declines in the value of tangible assets. Future standards regarding the reporting of internally generated intangible asset values could also specify how inevitable fluctuations in value should be handled.
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