ACCOUNTING & AUDITING

Business Valuation

Intangible Assets: Framing the Debate

By Bruce H. Nearon

The growing public distrust of audited financial statements should give all CPAs pause. Some critics claim that the only reason CPAs are engaged to provide audit opinions is that regulators, financial institutions, contracts, law, or regulation require it. This should be a troubling thought if it is indeed true; is our fundamental service—auditing financial statements—irrelevant and useless? Are financial statements no longer relevant? If so, why?

Relevance of Financial Statements

One school of thought posits that the way generally accepted accounting principles (GAAP) treat intangible assets has led to financial statements’ loss of value and relevance. Two recent books explore this issue: Baruch Lev’s Intangibles: Management, Measurement, and Reporting, and Margaret Blair and Steven Wallman’s Unseen Wealth: Report of the Brookings Task Force on Intangibles. This article is based on ideas expressed in these books.

GAAP reporting’s decline in relevance can be measured by observing equities’ market-to-book-value ratios. In the late 1970s, average share prices approximated book values for the S&P 500. The ratio then began to climb at a constant rate until 1995, when average share prices reached approximately three times book value. In 1995, perhaps not so coincidentally, share prices began to climb at a sharply higher rate than book values, as Netscape and Windows 95 gained widespread adoption and the Internet made information freely available to millions. Silicon Valley venture capitalists and Wall Street analysts began to pitch the idea that the previously conceived foundations of wealth creation—such as financial and physical asset strength, and earnings growth—were irrelevant to business valuation. They held business models and executive teams to be more important. Market participants—including both sophisticated institutional investors and naïve consumer investors—bought the idea, pushing share prices to seven times book value at the height of the bubble in 2000.

After the bubble burst, the average price-to-book ratio for Merrill Lynch’s 20 most widely held stocks on September 2, 2002, was 4.28 (New York Times, September 2, 2002). A similar exercise was conducted for a random sample of S&P 500 companies, and the average price-to-book was 2.93. To complete the exercise, an unscientific sample of 20 NASDAQ stocks was selected; for these, the market-to-book averaged 1.78 (see the Exhibit).

For small companies, book value appears a better measure of value than for large companies. This may be misleading, because academic research and anecdotal evidence have shown that investors discount the value of intangible assets for smaller companies, which in turn raises their cost of capital—one damaging consequence of current intangible asset accounting policy. The major lesson to be learned is that, even after much hot air has been taken out of the market, GAAP book values fail to explain a large part of enterprise value.

Principles of Intangible Assets Accounting

“Intangible” is defined by the dictionary as “something that cannot be touched, easily defined, formulated, or grasped; vague.” “Asset” is defined by FASB Concept Statement 6 as “a probable future economic benefit obtained or controlled by a particular entity as a result of past transactions or events.”

Clearly, enterprises that invest in intangible assets expect to obtain probable future economic benefits from the investments; otherwise, they would not expend resources on them. An inherent economic characteristic of intangible assets is that it is difficult, if not impossible, to control them wholly. Furthermore, while the value of intangible assets is partially due to a past transaction or event, part of their value stems from transactions or events that have not yet occurred. Therefore, intangible assets do not strictly conform to FASB’s definition of an asset.

Understanding financial reporting objectives is also important in evaluating whether intangible asset reporting needs to be overhauled. According to FASB Concept Statement 1, financial reporting should provide information -

Who could argue that an entity’s investment and return on innovation in business processes, supplier and customer relations, workforce quality, system implementation success and failure, and all intangible assets hidden from investors under current accounting standards, wouldn’t be useful in making investment and credit decisions? Who could argue that information about intangible assets, consistent over time and between companies, couldn’t reduce uncertainty about an entity’s cash flow? Who could argue that consistent information about intangible assets, claims to intangible assets, and what causes them to change, wouldn’t help investors and creditors decide which investments to make?

Current GAAP

With regard to intangible assets, the AICPA’s Accounting Principles Board (APB) Opinion 17 (August 1970) stated the following:

SFAS 142, Goodwill and Other Intangible Assets (June 2001), represents the current position on intangible assets:

Business has not been exempt from the drastic changes to technology that the world has experienced over the last 30 years. But yet, with few exceptions, we account for intangible assets in the same manner as we did 30 years ago.

The Issue

According to Baruch Lev, “Wealth and growth in today’s economy are driven primarily by intangible assets.” Margaret Blair and Steven Wallman concur: “The factors that have become most important to business success and economic growth in developed economies in the twenty-first century are ‘intangible’ or nonphysical.” Yet accounting ignores and obscures the key factors to business success and value creation. Lev states, “Intangible investments are by and large written off in the income statement.” And again Blair and Wallman agree: “For the most part, intangibles do not appear on the balance sheets of corporations. When they are acquired or developed they are treated more like consumption than additions to net worth.” So rather than being a faithful representation of the substance of an investment in intangible assets, accounting is blind in its treatment of them, as if they have no value and are not worthy of reporting.

Improving the information used by decision makers for optimal investment in intangibles would serve the different parties in this debate. Investors and creditors want to know which companies to invest in and which holdings to liquidate. Business managers want to know which projects to invest in or which to drop. And government policy makers, regulators, and standards setters want to know which research needs to be funded, and whether increased information reporting and disclosure on intangibles should be mandated. A discussion on how to improve intangible asset measurement and reporting can provide guidance on all of these questions.