1 Guriqbal Singh Jaiya Director. SMEs Division [email protected] Accounting of Intellectual...

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Guriqbal Singh Jaiya Director. SMEs Division

[email protected]

Accounting of Intellectual Property Assets: an Overview

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The Main Take Away

While discussions continue on how to adequately account for IP assets, businesses are best advised to develop a voluntary annual IP report, so as to: (1) enhance their market position, (2) facilitate access to funding, and(3) improves overall decision-making and effectiveness of management!

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Fixed Assets

• Fixed assets (non-current assets) represent future economic benefits which are expected to be consumed at a slow pace (generaly over more than one financial year)

• Every fixed asset can be considered an unexpired expense, and at balance sheet date a company must review to what extent the individual asset has been consumed during the accounting period

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Fixed Assets (cont.)

Two central accounting issues:

1. How do we determine tha appropriate value of an asset at the point of acquisition?

2. How do we systematically recognise the expensing of the asset over time?

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IAS 38 - Intangibles

• An intangible is an identifiable non-monetary asset without physical substance

• Main characteristics:– They meet the definition of an asset– They lack physical substance– They are identifiable

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IAS 38 – Intangibles (cont.)

• Definition refers to “identifiability”– Separability, or– Arising from contractual or other legal rights

• Recognition criteria challenge - Degree of uncertainty with respect to the future economic benefits– Magnitude and timing of future economic benefits?– Control over economic benefits

• The useful life of an intangible asset can be finite or indefinite

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Intangible Fixed Assets

• These are intangible resources such as scientific and technical knowledge, development of new processes or systems, intellectual property, privileged customer relationships, etc.

• Typical examples: R&D, patents, brands, copyrights, computer software, licences

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Definitions

•Accountants – intangible assets•Economists – knowledge assets•Managers and lawyers – intellectual capital

All are the same except for:

•Legal – intellectual property, which is intangible assets legally secured for patents, trademarks, designs, copyrights, etc.

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Classified Balance Sheet...

Generally contains the following standard classifications:

– Current Assets

– Long-Term Investments

– Property, Plant, and Equipment

– Intangible Assets

– Current Liabilities

– Long-Term Liabilities

– Stockholders' Equity

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An asset must be carried on thebalance sheet at the amount paid for it.

The cost of an asset equals the sum ofall of the costs incurred to bring the assetto its intended purpose, net of discounts

Cost Principle

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Does the expenditure increase capacity or efficiency or extend useful life?

YES NO

Capital Expenditure Revenue Expenditure

Traditional Distinction Between Capital and Revenue Expenditures

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Accounting of Intangible Assets

Intangibles

PurchasedInternally-

Created

SpecificallyIdentifiable

Goodwill-type assets

SpecificallyIdentifiable

Goodwill-type assets

Capitalize CapitalizeExpense,

except directcosts

Expense

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How Accounting meets IP

Patentsprotect

products, businessprocesses

Mark/ Geographical Indication

protects, logo,slogans, symbols

Industrial Designprotects

look of products,packaging, aesthetics

Trade Secrets protect business plans,

know how, client portfolio,

tacit knowledge, processes

Only IP that generates

direct cash flows in a commercial

transaction is considered

Copyright/Related Rightsprotects reproduction & performance in arts/software

Protection against Unfair Competition

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IP is an intangible asset, ...

SpontaneitySuccessful IP creation is risky since there is a creative & a business element to it

Non Rivalry in ConsumptionIP can be used simultaneously by different people without diminishing in its worth

TransferabilityIP is transferable to a newor similar business context

Knowledge ContentBackground of users & context determine relevance of IP to business

Partial ExcludabilityIP guarantees a firm exclusivity and freedom to operate in the market

Natureof IP

PerishabilityOver time IP may become outdated,e.g. technology cycles

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Why Measure Intangible Assets?(Purpose in order of popularity)

1. Monitor Performance (ControlControl)Six Sigma, Balanced Scorecard,

2. Acquire/Sell Business (ValuationValuation)Industry rules-of-thumb ($ per click, $ per client, brand valuation)

3. Report to Stakeholders (Justification, PRJustification, PR)IC supplements, EVA, Triple-bottom line,

4. Guide Investment (DecisionDecision)None! (Discounted Cash Flow still best)

5. Uncover Hidden Value (LearningLearning)None! (Scorecards and Direct IC methods probably best)

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… which Accounting finds difficult to grasp

Impact on Type of Language developed for IP

• Silence about a lot of a firm’s IP due to inherent definitions and assumptions in accounting

• Internally and externallygenerated IP is treated differently

• Goodwill

• Historically evolved to report tangible assets/liabilities

• Quantitative stock of performance

• Documentation of past financial position

• Factual, precise, objective, comparable information

• Determines perception of a firm’s management and other market participants

Rationale behind Accounting

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Concept Impact

Internally Generated IP is immediately expensed, Acquired IP is valued at its acquisition cost, amortized or subject to an impairment test

Fair value: “Amount at which an asset couldbe bought or sold in a current transactionbetween 2 willing parties, other than a liquidation.”

Intangible Asset: “… identifiable, controlled byan enterprise as result of past events & shouldgenerate future economic benefits for the firm.”

Goodwill: “price a market participant is ready to pay in excess of the value of a firm’s tangible assets.”

The same IP may beperceived to beworth nothing or 100 Mn $

Implies a benchmark, yet worth of IP depends also on context & background

Much IP won’t qualify since it has an indirect impact on cash flows

Difficult to makeworth of IP explicit & compare Goodwill of different firms

How Accounting Concepts Impact Business

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Accountants Recognize the Challenge

• FASB & SEC recommend Voluntary IP Reports“Companies are encouraged to continue improving their business reporting & to experiment with types of information

disclosed & the manner by which it is disclosed.”

• US GAAP allows to account IP explicitly in M&AFAS 141 & 142 require to identify each single asset & determine its fair valueThe amortization of Goodwill is replaced by an annual impairment tests

• Basel Committee on Banking Supervision recognizes the inadequacy of “fair value” for financial assets“In the absence of active markets it will be difficult to obtain or calculate a reliable fair value for certain non-marketable financial instruments held at cost.”

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Explicit IP accounting gains momentum

— Comparison of different Accounting Standards —

Recognition of IP

US-GAAP German HGB

• Forbidden: § 248/2 HGB

• Exception: acquired IP

IAS/IFRS

• Recognition of IP if IAS criteria are met: IAS 38

• Recognition of IP: Novel approach under FAS 141 &142

Trend towards the explicit recognition of IP increases

InternallyGenerated

IP

• Immediately expensed • Immediately expensed • Immediately expensed

• Recognition of acquired IP:

§ 255/4 HGBAcquired IP

• Recognition of acquired IP if IAS criteria are met: IAS 38

• Purchase Price distributed across all items: FAS 141

• Impairment Test of Goodwill: FAS 142

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Advantages of Reporting IP

• Communicates the value of IP to investors • Shows what IP the company owns• Puts a value to the IP• Explains how the IP relates to business segments

INVESTORS

FOR

FOR

MANAGERS

• Get information on how IP drives growth • Receive adequate inputs for earnings/sales forecasts• Can better estimate risks/revenues of an investment• Can better understand the nature of a business• Increases predictability while decreasing volatility

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The IP Reporting Process

•Align IP portfolio to overall business strategy

•Explain to all in the firm why IP matters

• Audit IP

•Set ownership in correlation to expected results

• Understand legal scope of IP

• Use a reporting system demonstrating

the value of IP to your business

Create IP ownership Understand

IP Ownership

ReportIP

GenerateSuperiorResults

Create IPOwnership

Build IPBusinessCulture

•Ensure market position through IP ownership

•Establish an enabling IP policy and environment

$$$or

¥¥¥or

£££

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Elements of an IP Report

• Executive SummaryHow does IP relate to the bottom line of your business?How do you make money and what role does the IP play in it?

• Relate your income streams to IPWhat were the returns from IP protected business segments?Does the IP help you to gain market share or profits?

• Relate IP to your position in the MarketHow did IP give you an advantage over competitors?Do you have freedom to operate & exclusivity in the market?

• Demonstrate your managerial skillsHow determined are you to extract revenue from IP?What experience do you have in managing IP?

• Understand the legal scope of the IP rightsWhat level of protection does your IP guarantee you?Is there a risk that you infringe the IP of competitors or that competitors (legally) steal your IP?

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The Agenda

A) The today’s rise of intangibles

D) Policy indications

B) Consequences of the Non-treatment of intangiblesC) Initiatives and actions undertaken (by companies/academics, and institutions)

E) Some open problems and conclusions

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“The substantial foundation of the industrial corporation is its immaterial assets”

“There may be peculiar difficulties in the way of reducing this goodwill to the form of a fund, expressing it in terms of a standard unit”

Thorstein Veblen, 1904

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Reprinted from Baruch Lev’s Intangibles Management Measurement and Reporting, The Brookings Institution 2001

Why did market values diverge from book values?

What information does the market use that is not included in the financial statements?

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A) The Rise of an Interest in IntangiblesA) The Rise of an Interest in Intangibles

• Change in the bases of creation of firm value

- from industrial to post-(post-)industrial

economy (e.g. advanced service firms)

- post-fordist, interactive mode of production

- decentralization/diffusion of knowledge • From unidimensional to multidimensional performance

of an organisation • Obsolescence of traditional accounting systems (2004:

Market-to-Book ratio 3)• Scarcity of data on intangibles in National Accounts

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Goodwill and Intangibles

• The Stock Market Perspective – If the market is efficient

• The nature and treatment of intangible assets should be sufficiently disclosed to help users assess the treatment used

– If the market is inefficient• Skepticism exists concerning analysts adjustments

• Markets are affected by international and national political and economic factors

– More disclosure means fairer stock prices

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Goodwill• Only an issue when purchase method is

used• Controversies

– Should goodwill be included as an asset?– Should goodwill be amortized?

• Accounting Methods– Asset without Amortization– Asset with Annual Impairment Testing– Asset with Systematic Amortization– Immediate Write-Off

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Purchased Goodwill• Goodwill - the excess of the cost of an

acquired company over the sum of the fair market value of its identifiable individual assets less the liabilities– Goodwill often results from such factors as:

• brand recognition

• reputation

• market share

• earnings potential

• location

• customer list or base

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Goodwill and Abnormal Earnings

• The final price that a company will pay for another is the culmination of a bargaining process.

– The amount of goodwill is subject to the negotiating process.

– Goodwill is essentially the price paid for “excess” or “abnormal” earning power.

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Amortization of Goodwill

• Goodwill does not have a perpetual life, but it may be maintained by continuous efforts.

• GAAP requires that goodwill be amortized and charged as an expense against net income for a period not to exceed 40 years.– Many companies use a much shorter

amortization period.– Most companies use straight-line amortization.

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Goodwill

• Comparative National Practices– Conflict existed between U.S. and U.K. over benefits

derived from immediate write-off• Problem magnified by increased merger activity

• Conclusions– Goodwill is not an asset under “separability”– Goodwill meets the “reliability” criterion– Goodwill meets the “relevance” criterion– Accounting for goodwill should be flexible, but fully

disclosed within competitive limits

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Brands, Trademarks, Patents, and Related Intangibles

• Should brands be capitalized?– Brand capitalization would

• Restore equity

• Enhance borrowing capacity

• Facilitate takeovers without consultation with shareholders (U.K.)

• Avoid undervaluation of firms

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• Methods of Accounting– Asset without Amortization– Asset with Systematic Amortization– Immediate write-off

• “Current Cost” approach – U.K.• Capitalization without amortization if no limit

to useful life – France• Brands are identified as intangible assets in

Australia, France, and the U.K.

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• U.S. – combination of asset-without-amortization method and asset-with-systematic-amortization method depending on estimate of useful life

• IFRS requires recognition of intangible assets for consolidated statements

• U.S. and Canada must write off internally developed intangibles immediately

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• International Accounting Standards– IAS 38

• Intangible assets only recognized if future benefits will flow to the enterprise and cost of asset can be measured reliably

• Systematic amortization required for finite lives

• Impairment testing for assets with infinite lives

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• Conclusions– Problems are linked with the goodwill issue– Brand names qualify as assets under

“separability”– Measurement of intangibles may not be

“reliable”– Value-oriented approach to brands and

intangibles should be used

A) The New Value Creation Process and Its Implications

• Change in production processes: strategic phases are research, marketing and know-how, and not so much manufacturing phases where intangible assets are key

• Today main determinants of growth at firm (micro) and country (macro) levels are, therefore, intangible assets

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A) Benefits of Intangible Investments

Scalability, non-rivalry, non-scarcity

•Large sunk costs, negligible marginal costs•Not subject to diminishing returns

•Use by one user does not preclude the use by another user•Scalability only limited by the size of the market

i.e. A computer operating system, a drug

•Increasing returns to scale

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A) Benefits (continued)Network Effect

•Metcalf’s law – the value of the network increases geometrically with each new user

•i.e., software:

• Window Office suite – the more users that can share documents the more valuable the software is

•Instant messenger – the more people on your buddy list the more valuable it is to you.

•The more travel agents and airlines that use Sabre the more valuable it became

•Positive feedback loop – Napster, AOL, Win 95/98/2000 XP

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A) Costs Unique to Intangible Investments

Partial Excludability and Spillover

•Difficult to exclude non-owners

•Employee training benefits the employee and if the employee quits, the new employer gets the benefits

•Non-patented employee know how

•Electronic devices can be reverse engineered

•New software functionality can be incorporated in rival products

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A) Costs (continued)

Partial Excludability and Spillover (continued)

•Intellectual property laws for patents, trademarks, copyrights etc. vary from country to country

•Not recognizing the value of an innovation and giving it away

•AT&T – cellular telephony

•IBM – PC architecture, cpu, DOS

•Xerox PARC – Laser printing, Ethernet, GUI and the mouse

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A) Costs (Continued)Inherent Risk

•Intangibles are inputs into innovation and innovation is risky

•10% of patents account for 81-93% of total patent value•Most new products fail

•Earnings volatility (risk) is three times greater for R&D than physical investments

Risk mitigation

•Portfolio of patents•Many R&D projects•Research alliances

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A) Costs (Continued)

Non-tradability (except for intellectual property)

•No organized and competitive markets•Measurement and valuation difficult without market prices•None or little value if projects abandoned•Result – most innovation in corporations and research centers

•But, companies cannot use all of their innovations and there is no market for selling them(except patent licensing and royalties)

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A) Problems encountered by firms capturing benefits from intangible

investment…Economic attributes of intangible assets make it:

– Difficult to exclude other users (public good problem) so firms cannot appropriate the full benefits from the investment (Geroski 1995)

– Difficult to estimate ex ante the precise use of intangible inputs, potential products, and timing and magnitude of benefits

– Difficult to write contracts for transfer or exchange of intangibles that are not embodied in a physical asset

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A) Effect of uncertainty

• Investment in intangibles is also associated with high levels of uncertainty/risk

• While there is evidence that investment in intangibles leads to tangible investment, there is a lag between intangible investments and economic benefits (intangible investment occurs early in the life cycle)

• To overcome problem associated with this risk, most accounting standards require expenditure on (particularly internally generated) intangible assets to be expensed considered more reliable

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A) Measuring Intangibles

Accounting and economic models relate inputs to output

•For tangible assets you know costs (input), risk, and return (output)

•For intangibles:• you don’t know the cost, risk, and returns

•There may be no relationship between cost of input and value of output, but, you do know the risk is enormous.

Without knowing how to measure intangibles you cannot understand them, and, therefore cannot manage them !

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- ECONOMIC TRANSACTION AS THE “ENGINE” OF TRADITIONAL ACCOUNTING

A) The Logic of Traditional Accounting

- ECONOMIC TRANSACTION SETS ACCOUNTING VALUE PRICE HISTORIC COST/FAIR VALUE- MEASUREMENT CATEGORIES LINKED MAINLY TO “FORDIST” INDUSTRIAL ACTIVITY

- MEASUREMENT OF PERFORMANCE & SURPLUS IN A SHAREHOLDER PERSPECTIVE

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B) Traditional Accounting for Intangibles (e.g. International Accounting Standard 38)

• General suspicion• Recognition issues (R&D, Brands, Training)• Conservative measurement criteria:

- General principle: Immediately expensed as a period cost

- If recognised as an asset, then valued at Cost or Revalued Cost (not value)

- Amortisation over a short period of time• No attention to the intangible drivers of value

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B) Accounting for Goodwill

• Most countries treat goodwill as an asset subject to systematic amortization– Maximum amortization periods of 5 to 40 years apply in

some countries

• U.S. and IASB treatment is an annual impairment test of goodwill

• Some countries use immediate write-off method against reserves– Not permitted in U.S., Australia, Japan

• Some countries retain goodwill as a permanent asset

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General Guide for Financial Accounting (GAAP)

• Generally

• Accepted

• Accounting

• Principles

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What is financial accounting supposed to accomplish?

Provide the the most useful financial

information for…

Decision Making

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Primary Accounting Setting Body in the USA

• Financial

• Accounting

• Standards

• Board

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U.S. Government Agency That Oversees Financial Markets

• Securities

• Exchange

• Commission

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Remember…

GAAP Are the Rules

The FASB makes the rules.

The SEC enforces the rules.

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Statement 141: Business Combinations

• All business combinations initiated after June 30, 2001 must use the PURCHASE METHOD

• Pooling-of-Interests method is no longer permitted

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• Requires disclosure of the primary reasons for a business combination and the allocation of the purchase price paid to the assets acquired and liabilities assumed by major balance sheet caption.

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• Application of the purchase method requires identification of all assets of the acquiring enterprise, both tangible and intangible.

• Any excess of the cost of an acquired entity over the net amounts assigned to the tangible and intangible assets acquired and liabilities assumed will be classified as goodwill.

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• Fair Value is defined in SFAS No. 141 & 142 as

“The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.”

• It is more of an “Investment Value” concept as the benefits of synergies and attributes of the specific buyer and specific seller are included.– The ability of a controlling shareholder to benefit from synergies and other

intangible assets that arise from control might cause the fair value of a reporting unit as a whole to exceed its market capitalization.

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Intangible Asset Recognition

• An intangible asset shall be recognized as an asset apart from goodwill:

– If it arises from contractual or other legal rights

– 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.

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• An acquired intangible asset (other than goodwill) with an indefinite useful economic life should not be amortized (regardless of whether it has an observable market) until its life is determined to be no longer indefinite

• If no legal, regulatory, contractual, competitive, economic, or other factors limit the useful life of an asset, the useful life of that asset should be considered indefinite.

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• “The accounting for a recognized intangible asset is based on its useful life to the reporting entity. An intangible asset with a finite useful life is amortized; an intangible asset with an indefinite useful life is not amortized. The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity.”

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• A number of pertinent factors that should be considered in deciding the useful life of an asset:– Expected use of the asset by the entity• Legal, regulatory, contractual limits to useful life• Ability to renew/extend contractual or legal life• Effects of obsolescence, demand, competition and other

economic factors• Level of maintenance expenditures required to realize

expected future cash flows• Useful life of another asset (or asset group) to which useful

life of intangible relates

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• Separable intangible assets that have finite lives will continue to be amortized over their useful lives.

• A recognized intangible asset that is not amortized must be tested for impairment annually, and on an interim basis if an event or circumstance occurring between annual tests indicates that the asset might be impaired.

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• The FASB has classified intangible assets into five categories:

• 1. Marketing-related intangible assets

• 2. Customer-related intangible assets

• 3. Artistic-related intangible assets

• 4. Contract-based intangible assets

• 5. Technology-based intangible assets

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Marketing-Related Intangible Assets

•Trademarks, trade names

•Service marks, collective marks, certification marks

•Trade dress (unique color, shape or

package design)

•Newspaper mastheads

•Internet domain names

•Non-compete agreements

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Customer-Related Intangible Assets

• Customer Lists

• Order or Production Backlog

• Customer Contracts and Related Customer

Relationships

• Non-Contractual Customer Relationships

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Artistic-Related Intangible Assets

• Plays, operas, ballets• Books, magazines, newspapers, other literary works• Musical works such as compositions, song lyrics, advertising jingles• Pictures, photographs• Video and audiovisual material, including motion pictures, music videos, television programs

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Contract-Based Intangible Assets• Licensing, royalty, standstill agreements• Advertising, construction, management, service or supply contracts• Lease agreements• Construction agreements• Franchise agreements• Operating and broadcast rights• Use rights such as drilling, water, mineral, timber cutting and route authorities• Servicing contracts such as mortgage servicing contracts• Employment contracts

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Technology-Based Intangible Assets

• Patented technology

• Computer software and mask works

• Unpatented technology

• Databases, including title plants

• Trade secrets, such as secret formulas,

processes, recipes

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GAAP

FASB Statement No. 142 Goodwill and Other Intangible Assets (June 2001)

This statement carries forward without reconsideration the provisions of Opinion 17 related to the accounting for internally developed intangible assets. This statement also does not change the requirement to expense certain acquired research and development assets at the date of acquisition as required by FASB Statement No. 2.

AICPA APB Opinion 17 (August 1970)

A company should record as expenses the costs to develop intangible assets which are not specifically identifiable.

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Statement 142: Goodwill and Other Intangible Assets

• This Statement addresses how intangible assets that are acquired individually or with a group of other assets (but not those acquired in a business combination) should be accounted for in financial statements upon their acquisition.

• This Statement also addresses how goodwill and other intangible assets should be accounted for after they have been initially recognized in the financial statements.

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• Goodwill and intangible assets that have indefinite useful lives will not be amortized but rather will be tested at least annually for impairment.

• Intangible assets that have finite lives will continue to be amortized over their useful lives, but without the constraint of an arbitrary ceiling.

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• Goodwill will be tested for impairment at least annually using a two-step process that begins with an estimation of the fair value of a reporting unit.– The first step is a screen for potential

impairment, and – The second step measures the amount of

impairment, if any.

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• This statement requires disclosure of information about goodwill and other intangible assets in the years subsequent to their acquisition. Information to be disclosed:– The changes in the carrying amount of goodwill from

period to period, – The carrying amount of intangible assets by major

intangible asset class for those assets subject of amortization and for those not subject to amortization, and

– The estimated intangible asset amortization expense for the next five years.

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• The provisions of this Statement are required to be applied starting with fiscal year beginning after December 15,2001.

• This Statement is required to be applied at the beginning of an entity’s fiscal year and to be applied to all goodwill and other intangible assets recognized in its financial statements at that date.

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Impairment of Goodwill and Other Intangible Assets

• SFAS No. 142 mandates that goodwill and intangible assets without a defined live shall not be amortized over the defined period; rather they must be tested for impairment at least annually at the “reporting unit” level.

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• All acquired goodwill should be assigned to reporting units. This will critically depend on the assignment of other acquired assets and assumed liabilities.

• The amount of goodwill allocated to a reporting unit is contingent upon the expected benefits from the synergies of the combination. This goodwill allocation is required even though other assets or liabilities of the acquired entity may not be assigned to that reporting unit.

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• The measurement of the fair value of intangibles and goodwill can be performed at any time during the fiscal year as long as the timing is consistent from year to year.

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• The annual impairment test is to be accelerated and goodwill of a reporting unit should be tested for impairment on an interim basis if an event occurs that would more likely reduce the fair value of a reporting unit below its carrying value.

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• Impairment Test Triggering Events:– A significant adverse change in legal factors or in the

business climate– An adverse action or assessment by a regulator– Unanticipated competition– A loss of key personnel– A more-likely-than-not expectation that a reporting unit will

be sold or otherwise disposed of– The testing for recoverability under SFSA No. 144 of a

significant asset group within a reporting unit– Recognition of a goodwill impairment loss in the financial

statements of a subsidiary that is a component of re reporting unit

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Goodwill Impairment Test

• The Two-Step Impairment Test:

• Compare estimated fair value of each reporting unit to the carrying amount of the unit. – If FV > Carrying Amount, no need to perform

Step 2– If FV < Carrying amount, then Step 2.

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• If the carrying amount of a reporting unit goodwill exceed the implied fair value of that goodwill, then an impairment loss must be recognized for an amount equal to that excess.– In order to determine the implies fair value of the goodwill, all

assets must be valued.– The impairment loss cannot exceed the carrying amount of the

goodwill. Only the value of goodwill is adjusted through this process.

– The adjusted carrying amount of goodwill will be its new accounting basis.

– Goodwill cannot be increased to its original carrying amount in the future. Once written down, it stays down.

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• Ex: Assume a company has a reporting unit with a fair value of $10,000,000 including goodwill of $3,000,000. further assume that the relative fair values of the assets have been valued and recorded on the books of the acquirer as:

• ______________________________________________• Recognized tangible assets $5,000,000• Recognized identifiable intangible 2,000,000 assets (with definite life)• Goodwill 3,000,000• ==========• $10,000,000• ______________________________________________

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• After one year assume the carrying amount of certain assets after amortization are:

• ______________________________________________

• Recognized tangible assets $3,500,000

• Recognized identifiable intangible 1,500,000

assets (with definite life)

• ______________________________________________

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• Assume that an impairment test is performed at this time one year later and the fair value of the reporting unit is $9,000,000. A new asset allocation must be performed to determine the new goodwill amount:

• ______________________________________________• Recognized tangible assets $3,800,000• Unrecognized tangible assets 1,000,000• Recognized identifiable intangible assets 1,400,000• Unrecognized identifiable intangible assets 800,000• Goodwill 2,000,000• ___________• Fair Value of the reporting unit $9,000,000• ______________________________________________

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Net Carrying amount

Fair Value Impairment Amount

SFSA Citation

(Taiwan)

Recognized tangible assets $4,000,000 $3,800,000 200,000 142

Unrecognized tangible assets

0 1,000,000 0

Recognized identifiable intangible assets (with a defined life)

1,800,000 1,400,000 400,000 144

Unrecognized identifiable intangible assets

0 800,000 0

Goodwill 3,000,000 2,000,000 1,000,000 142

Total $10,000,000 $9,000,000 $1,600,000

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B) Consequences of Accounting Standards

Current GAAP•Except for R&D almost no reporting and disclosures on intangibles•Required capitalization of software development costs is often ignored

•Result•Investors and some levels of management are kept in the dark about investment and return on intangibles•Asymmetry of information

•Abnormal gains to those that know the potential return on intangibles – insiders•As investment in intangibles increases, volatility and risk increases, asymmetry of information increases, and insider gains increase

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B) In company reporting, once upon a time there was Goodwill...

Purchase price – Fair value of net assets = Goodwill

- Poor (synthetic) representation in cognitive terms of the intangibles possessed by an organisation

- Residual value used to represent all the “unidentifiable”/“unseparable” intangibles of the acquiree

- Managerial and users’ need for a more analytical knowledge, control, and representation of intangible elements of a firm’s wealth (brands, organisational capabilities, IPR, etc.) and of its drivers

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B) Unmeasured intangible inputs and outputs in the economy

• Problem: Changing composition of investment is not reflected in financial reporting

• Problem: Accountability of management for actions/decisions in managing the firm’s resources

• Problem: Lack of data for analysis and rational resource allocation info. asymmetry

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• Serious economic consequences for the firm from the poor accounting treatment of intangibles

B) Micro-Economic consequences

• The non-measurement of intangibles at the company level has adverse economic effects in terms of:

- Investment decisions

- Level of information asymmetry concerning a firm (volatility of share prices & insider trading)

- Internal/management information systems

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• Intangibles as connecting tissue, the “glue” that allows the homeostasis of the economic system

B) Intangibles at a macro level

• We need to better understand how tangibles and

intangibles combine to create collective value• Intangibles are not measured or quantified –

more often under-measured – at a macro level

• Potentially serious consequences at a policy level wrong indicators wrong diagnosis of a country performance and policy recipe

93

Current US GAAPCriteria to be considered an asset

•Defined and distinct•Effective control•Possible to predict future economic benefits•Possible to determine impairment

Asset Examples:•Property, plant, equipment•Financial assets•Purchased identifiable intangibles such as patents, trademarks, copyright and mailing lists•Purchased goodwill

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GAAP (continued)

Internally developed intangibles•Expense when incurred (Except for software when certain conditions are met)

Examples:•R&D•Training•Advertising

Inequity in accounting treatment – intangible assets have future economic benefits—the matching principle is violated.

95

Characteristics of Useful Information

Relevance

1. Provides a basis for forecasts

2.Confirms/corrects prior expectations

3. Is timely

95

Reliability

1. Is verifiable

2. Is a faithful representation

3. Is neutral

Comparability

Different companies use similar accounting PRINCIPLES

Consistency

Company uses same accounting METHODS from year to year

96

Basic Terms Relevance - information makes a difference in

decisions Reliability - information must be free of error

and bias Comparability - ability to compare

information of different companies because they use the same accounting principles

Consistency - use of same accounting principles and methods from year to year within the same company

97

GAAP (continued)

Inequity between:

acquired intangibles—capitalized

and

internally developed intangibles – expensed

Cannot compare a company that acquired intangibles with another company that internally developed intangibles even though cost and benefits between the two companies are identical

98

Constraints in Accounting Permits companies to apply GAAP without

hurting the usefulness of information• Materiality - The constraint of determining whether

an item is large enough to likely influence a decision. • Conservatism - The approach of choosing an

accounting method, when in doubt, that will be least likely to overstate assets and net income.

99

B) The Issue

Improving information used by decision makers for the optimal investment in intangibles:

• Investors and creditors – which companies to invest in or liquidate?

• Business managers – which projects to invest in or drop?

• Government policy makers, Regulators, and Standard Setters– what research needs to be funded and should increased information reporting and disclosure on intangibles be mandated?

B) Costs of Non-measurement

- Firm level: risk of poor or wrong strategies - Industry level: misallocation of resources

within and between industries; skill bias - Capital market level: under- or over-

valuation of companies; misallocation of resources; volatility

- Country level: policy making based on imperfect set of indicators may result in inappropriate policies

C) A series of initiatives: company and academic reactions

• In 1994 Skandia starts the production of an Intellectual Capital Statement

• Many measurement and reporting models are put forward by practioners, academics, companies

• In 1992 Kaplan and Norton propose the Balanced Scorecard non-financial measures break in

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C) A framework of analysisLegend

MarketCapitalisation

Method

Return onAssets

Method

DirectIntellectual

Capital

Score CardMethod

HumanCapital

Intelligence

Intangible Assets Measuring Models

Non-monetary Methods Monetary Methods

BalancedScorecard

Value ChainScore BoardTM

IntangibleAssets

Monitor

SkandiaNavigatorTM

IC-IndexTM

TechnologyBroker

Intellectual Asset

Valuation

The ValueExplorerTM

InclusiveValuation

Methodology

Citation-WeightedPatents

TVCTM

HRCA

AFTFTMIAMVTM

EVATM

CalculatedIntangible

Value

KnowledgeCapital

Earnings

Tobin’s qMarket-to-book Value

VAICTM

HolisticMethods

AtomisticMethods

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Balanced Scorecard, Norton & Kaplan 1992

Financial Perspective(goals and measures)

Innovation andlearning perspective(goals and measures)

Internal businessperspective

(goals and measures)

Customer perspective

(goals and measures)

104

Skandia Navigator, Edvinsson & Malone 1998

OPERATIVE ENVIRONMENT

CUSTOMER FOCUS

HUMANRESOURCE

FOCUS

INNOVATION AND DEVELOPMENT FOCUS

FINANCIAL FOCUS

PROCESSES FOCUS

105

External Structure Internal structure Personnel Competence

Growth/Renewal

- Growth of personnel - Growth of market share - Customer satisfaction or

quality

Growth/Renewal

- Investment in IT - Time for R&D - Personnel behaviour

towards managers, culture, customers

Growth/Renewal

- Competence-enhancing customers

- Growth of average professional competence (years)

- Turnover of competence Efficiency

- Revenues per customer - Sales per agent

Efficiency

- % of administrative staff - Sales per staff

Efficiency

- Value added per employee

- - Changes in the proportion of highest competence employees

Stability

- Repeat orders - Age of structure

Stability

- Age of organisation - Rookie ratio

Stability

- Employees turnover

Intangible Assets Monitor, Sveiby 1997

INTANGIBLE ASSETS

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Value Chain Scoreboard, Lev 2001

Disc. and learning Implementation Commercialisation

1. Internal renewal

- Research and development - Work force training and

development - Organizational capital,

Processes

4. Intellectual property

- Patents, trademarks and copyrights

- Licensing agreements - Coded know-how

7. Customers

- Marketing alliances - Brand values - Customer churn and value

2. Acquired capabilities

- Technology purchase - Spillover utilization - Capital expenditure

5. Technological feasibility

- Clinical tests, Food and Drug Administration approvals

- Beta tests, working pilots - First mover

8. Performance

- Revenues, earnings, and market share

- Innovation revenues - Patent and know-how

royalties - Knowledge earnings and

capital

3. Networking

- R&D alliances and joint Ventures

- Supplier and customer Integration

- Communities of practice

6. Internet

- Threshold traffic - Online purchases and sales - Major internet alliances

9. Growth prospects

- Product pipeline and launch dates

- Expected efficiencies and savings

- Planned initiatives - Expected breakeven and

cash burn rate

C) A series of initiatives at an institutional level

• Half ’90s: OECD Studies

• 1999: International Conference in Amsterdam (OECD + Dutch and Danish Governments)

• 2000: European Commission’s High Level Expert Group on the Intangible Economy

• 2001-2003: Research projects Prism and Meritum/E*Know-net funded by the Commission Meritum Guidelines on ICR

• 2002-2003: Official Study for the European Commission on the measurement of intangible assets (Ferrara+New York+Melbourne)

• 2002: International Conference in Madrid (Autonomous University Madrid + Spanish Government + OECD + European Commission)

• 2004: International Conference in Helsinki (Sept.) + OECD Forum in Paris (Oct.)

C) A series of initiatives at an institutional level (cont’d)

• 2004: German Guidelines on IC Reporting by the Ministry of Labor

• 1997-2003: Danish Guidelines on IC Reporting as a result of a Government-driven project


• 2002-04: Various documents on intangibles by the UK Department of Trade and Industry

• 2003: Letter on Intangible Economy signed by the UK, German and French Governments

• April 2005: A new policy by the city's Pudong New Area recognition of human resources as capital contribution up to a maximum of 35% of the enterprise's registered capital, and a report and filing system for enterprise annual reviews (for both domestic and foreign companies)

• June 2004: The Japanese Government issues a White Paper about making economic policy in the knowledge era strong emphasis on intangibles and intellectual capital reporting


• 2005: Action Plan of the European Commission on business-related services strong recommendation to these co’s to prepare an intangibles-based report

• 2004-05: High Level Expert Group set up by the DG Research of the European Commission with the task of producing an official report on Intellectual Capital Reporting especially for research-based SMEs


• June 2005: World Bank has organized a Conference on “Intellectual Capital for Communities in the Knowledge Economy: Nations, Regions and Cities” held in Paris


• 20-22 Oct. 2005: OECD will hold an International Policy Conference on Intellectual Assets in conjunction with the University of Ferrara (www.ferraraonintangibles.net)

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A 2003 STUDY ON “THE MEASUREMENT OF

INTANGIBLES” MADE BY THE

UNIVERSITIES OF FERRARA, NEW YORK

AND MELBOURNE FOR THE DG

ENTERPRISE. Available at:

http://europa.eu.int/comm/enterprise/services/

business_services/index.htm

C) Official Study for the European Commission

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• Far too many definitions & different classifications and taxonomies of intangibles (micro & macro)

C) Definitions of Intangibles

• Need for reducing them through consensus

• In the Study intangible assets defined as a source of future benefits that is without a physical embodiment:

• Intellectual property is an intangible asset with legal rights

• Includes innovation-related intangibles (patents), but also

market-related (brands), human resource (compensation systems, training policies), and organizational intangibles (internal structures, systems and processes)

• “Hard” intangibles (tradable) vs. “Soft” intangibles

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Objectives of Financial Reporting

FASB Concepts No. 1Financial reporting should provide information:

• That is useful to potential investors and creditors and other users in making rational investment, credit and similar decisions.

• To help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts and net cash inflows to the enterprise.

•About the economic resources of an enterprise, the claims to those resources, and the effect of transactions, events, and circumstances that change its resources and claims to those resources.

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• Various innovative methods for the recognition, measurement, and disclosure of intangibles and intellectual capital (IC) have been analysed

C) New measurement & reporting models for Intangibles

• A taxonomy of the different new methodologies (holistic vs. atomistic; monetary vs. non-monetary)

• Analysis and comparison of the four main Guidelines on IC statements proposed so far (Meritum, Nordika, IFAC, and DATI)

• Exploration of the relations between IC statements & Corporate Social Responsibility (CSR)(e.g. GRI)

• The rise in company practice of IC statements

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C) A working definition of IC Intellectual Capital – IC – is the internal (competencies,

skills, capabilities, etc.) and external (image, brands, customer

satisfaction, etc.) stock of intangibles of an organisation, which allows the latter to transform a bundle of material, financial and human resources in a system capable of creating stakeholder value through the pursuit of sustainable competitive advantages (Zambon, 2000)

Organisational knowledge becomes IC only when it is durably and effectively internalised or appropriated by an organisation

118

IC as New Concept for Representing & Managing Intangibles

A concept that encompasses the various types of intangibles, including social and environmental intangibles

- a “new” notion of the wealth of an organisation- thrust towards information relevance instead of

reliability in reporting- a concept in evolution different accents- a concept on whose basis company reporting

might be reformed?

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C) Towards a New Reporting Tool Intellectual Capital (IC) Statements or Report on Intangibles

Based on indicators many without a financial nature

The partitioning of IC into three interrelated sections is quite widely accepted: Human Capital, Organizational Capital (including Innovation Capital), Relational Capital visualized/measured through indicators and parameters

120

C) Guidelines on IC statements: some emerging convergences and differences

- International Federation of Accountants (IFAC) – Study no. 7 (1998)

- Danish Agency for Trade and Industry (DATI) Guidelines (2000, but new edition 2003) - Nordika Project Guidelines (2001)

- Meritum Project Guidelines (2002)- “Intellectus Model” (Spain) (2003)- German Guidelines (2004)- Japanese Guidelines (2005)

Other documents deal with some aspects of IC reports, but without focussing on them (e.g., GRI, EFQM, ISO)

121

C) INTANGIBLES AND INFO. USERS: THE CASE OF FINANCIAL ANALYSTS

In 2001, the Italian Association of Financial Analysts (AIAF) set up a study group on Intangibles

In January 2002, a model has been developed – in collaboration with the University of Ferrara – to measure the level of disclosure on intangibles by companies in their external reports

This model has now been refined/extended in order to represent/rank European companies on the basis of their level of disclosure on intangibles

C) The Basic Framework for Ranking the Level of Disclosure on Intangibles (AIAF 2002)

Actual Forecast

Level 3Extended information

Level 2“Reasoned” information

Level 1“Minimum” information

Strategy

Customers & Market

Human resources

Innovation & IPR

Organisation

LEVELS OF COMMUNICATIONON INTANGIBLES

FIVE DIMENSIONS OF COMMUNICATION

NATURE OF INFORMATION

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IC Statements and Environmental and Social Reports: The case of GRI

• The Global Reporting Initiative (2002) is:

- a reporting framework for non-financial aspects

- based on the three-dimensional concept of “sustainability” (economic, environmental and social) so called triple bottom line

- evidence of an overlapping between IC statements and social & environmental reports (e.g., indicators on employees’ training and education, supply chain management, quality of management, investment in R&D, stakeholder engagement)

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THE BASIC IDEA SOCIAL CAPITAL & ENVIRONMENTAL CAPITAL AS PARTICULAR INTANGIBLES TO BE MANAGED BY COMPANIES (AND PUBLIC SECTOR ENTITIES)

An Intangible Perspective on CSR and Stakeholder Value

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The Integrated Reporting System

TRADITIONAL FINANCIAL

REPORTING

Investors/Auditors/Financial Analysts

Collectivity Society

Intangibles / Intellectual

Capital Reporting

SOCIAL

REPORTING

ENVIRON-

MENTAL

REPORTING

D) Main Policy Implication

• Urgent to better measure intangibles both at micro and macro level

• Priority: better measurement at firm level because good indicators at micro level allow also to build better indicators at macro level

D) Intangibles Reporting: policy recommendations

• Policy aim: Develop and promote a new, integrated, reliable and verifiable company disclosure system which is based on intangibles

• What is needed is CONVERGENCE between existing methods and reports

D) Intangibles Reporting: policy recommendations (cont’d)

• Identify a standardised set of intangibles indicators serving as minimum common information denominator

• Consistent data at micro level as foundation for more aggregated analyses in this respect we need rather detailed categories in the prospective intangibles taxonomy

D) Intangibles Reporting: policy recommendations

• Provide incentives to firms to adopt a new reporting system based on intangibles, as well as to use and reveal that information

• Favor the emergence of a generally agreed taxonomy and definition of intangibles

• Encourage voluntary experimentations & exchange of best practices good IC reporting guidelines are already in place

D) Intangibles Reporting: policy recommendations (cont’d)

• Induce information system/software providers to develop the collection of data on intangibles e.g. XBRL

• Promote the gathering of the reported information on intangibles in a systematic and coherent way (cf. US Edgar)

• Support ad hoc research

D) Intangibles reporting:policy recommendations (cont’d)

• Convergence to be searched for with statistical offices, but starting point of intangibles information should be corporate reporting a delta, not a substitute

• Looking for synergies in the efforts e.g. OECD + European Commission + US Institutions + Japanese Institutions

• Drawing on other forms of voluntary/ supplementary reporting (such as social, environmental, sustainability reports etc.) for inducing companies to produce information on intangibles

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E) Some questions on IC Reports

Despite their value and innovativeness, IC reports face some criticisms concerning their:

- consistency

- reliability/subjectivity

- thoroughness

- meaningfulness:

a) high subjectivity in the choice of the useful indicators

b) indicators do not possess additive properties

c) high specificity of indicators

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E) Some questions… (cont’d)

However, some open problems:

- Value in absence of a market price (value in use vs in exchange) (i.e., credibility and meaningfulness)

- Specificity vs Generalisability (i.e., consistency & comprehensiveness problems)

- Regulation vs Voluntary Compliance

- Atomistic vs Holistic measurement approach

- Common vs Different Measurement Units

- Relevance vs Reliability

- Users stakeholders?

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We face a major PARADOX:

- The more the system is based on intangible assets, the stronger it is (because intangibles are major determinants of growth and value creation).

Final consideration

- However, at the same time:the more the system is based on intangibles, the more vulnerable it becomes.

The challenge we all face is to learn how to measure and report in this intangibles environment

1 Guriqbal Singh Jaiya Director. SMEs Division [email protected] Accounting of Intellectual...

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