The main problem with quantifying intangible assets like brand, R&D or corporate reputation is that there is no clear consensus on how companies should disclose them. That’s in the process of changing. FASB is now in the midst of a project on the disclosure of intangible assets and a draft proposal is expected soon. For the first time in history, companies will have clear guidelines on disclosing the value of intangibles like trade secrets, patents and brands. But the exercise of quantifying intangibles does not begin and end with FASB’s efforts. In fact, experts say this is just the tip of the iceberg.
The following is an excerpt from a panel discussion hosted by Niri’s New York chapter in October 2002. Moderated by Adrienne Baker, North American editor of Investor Relations magazine, the panel comprised Baruch Lev, professor of finance and accounting at the Stern School of Business, and John Wood, president and CEO of the Playfair Group and advisor on FASB’s intangibles project.
IR: Do you think that companies should quantify intangibles on the balance sheet?
Baruch Lev: Most people think of putting intangibles on the balance sheet but this is not of great importance. What is important is to disclose the value of intangible assets. It’s only under very special circumstances that you can put a value on intangibles and it’s an extremely difficult thing to do because most intangibles are enablers of things.
The greatest intangible of Wal-Mart, for example, is its structural capital. When you go to Wal-Mart and pay for something, the bar code is read and the information goes directly to the supplier. It’s an ingenious way of shifting their inventory management, which is the most costly thing for retailers.
IR: But aren’t investors interested in seeing intangibles quantified on the balance sheet?
Lev: There is a lot of evidence that investors don’t like intangibles. Companies that are intense in intangibles like R&D, for example, are systematically undervalued. So my message is that it’s not as important to value something [like R&D, for instance] as it is to provide information.
You can classify R&D as good and bad. Good R&D can be measured by how many times a company’s patents are cited. Companies can communicate about good R&D but it has nothing to do with valuation. You are speaking about attributes – telling investors what you have that is better than others.
CEOs and CFOs would kill to not put these things on the balance sheet so IROs are fighting a losing battle. Now some companies will have to start [valuing intangibles] because of FASB’s Statements 141 and 142 but it’s really about providing information.
IR: Where is FASB with its project to disclose intangibles?
John Wood: Well, I have to say I am a bit shocked. A bit like the followers of Jim Jones, the FASB drunk the Kool-Aid you gave them, Baruch. Essentially, based on the premise that there is a correlation between the disparity of the market value of companies and their book value, FASB started a project to disclose intangibles. The fact that 114 companies in the last nine months have written off $283 bn somehow suggests there was value [in their intangibles] and that value is now less than before. Two days ago, AMR announced that it was going to write down $990mn. The analysts dropped their rating and their shares fell in short order.
FASB in its nominal wisdom has come up with a definition of intangibles by defining them as legal or contractual rights or any right that is separable from goodwill in terms of an asset. [See paragraph 39 of FASB’s Statement 141.] Working on that foundation, they have gone forward with their project to disclose intangibles and we are expecting a draft proposal sometime in November or December this year. The market has not responded but I think that is because it has got enough on its mind. Also, measuring intangibles is a nascent area.
IR: FASB’s definition of what qualifies as intangible assets leaves out brand and human capital. Should companies be looking to disclose information about intangibles beyond what FASB comes up with?
Wood: Because of the very strict framework in which accountants work and because employees may leave a firm, FASB feels it is difficult to value human capital. That doesn’t mean it’s not important. There isn’t an investor relations officer in this room who has not written in an annual report: our people are our most important asset. So I agree with Baruch that there is a need for non-financial measures. The area for financial disclosure will grow incrementally. FASB is also proposing separately that companies value brands and business processes. So whether it’s a pleasure or a pain, this area is becoming more significant.
IR: Therefore companies may eventually have to disclose the value of brands on the balance sheet?
Wood: Yes, purchase price allocation and the disclosure of brands and brand processes will most likely be in the draft proposal in some form but human capital is quite firmly outside the camp. You can send a letter to FASB expressing your views on measuring brands. There are also other projects on the way to include internal intangibles but that is a good 18 months down the pipeline.
IR: How is it possible to quantify the brand of a company?
Wood: According to FASB, brand is seen as a synergy between R&D, intellectual property, business lines, sales and marketing. The cost of a brand should be seen as all the different things it passes through to commercialization. It’s easy with R&D because once it reaches patent, you have a fixed number for the R&D. You have to monitor the entire process with branding. Some companies are starting to do this but it requires a discipline that doesn’t exist inside the organization. We can now use the FASB as an excuse to identify [the value] of brands.
Lev: I still think companies need to do more than what FASB is proposing. For example, six years ago 3M came out with a measure they called innovation revenues which is the percentage of total revenues generated by recently produced products. The percentage of revenues from products produced in the last three years was enormous – something like 27 percent. This is a hugely important measure. It is not a valuation measure, it doesn’t require any great effort in the accounting book, and lots of companies are doing it.
IR: Under FASB’s Statements 141 and 142, companies have to now test for impairment. How often?
Wood: A lot of companies are laboring under the illusion that they only need to do the impairment test once a year; that is not true. All companies covered by Statements 141 and 142 need to do at least two impairment tests in the first year. Every organization should also be doing useful life tests [on intangibles] going forward and documenting them every quarter. For example, something with a definite useful life is a patent because you know exactly how long it will last but something with an indefinite useful life is a brand. The useful life test looks to see if that indefinite life has changed. For example, if Pepsi won the war against Coke and Coke decided to can the brand, the indefinite useful life would change to a definite.
IR: What is going to be the real challenge for companies in measuring intangibles?
Lev: One of the asymmetries of accounting for intangibles is that many are accounted for when they are acquired but the main intangibles that are self-generated like R&D and brand are not accounted for. These are the value-generating processes of a company, and that is what you cannot see on the balance sheet. Serious financial analysts are interested in these internal intangibles.
These intangibles cannot be valued on a stand-alone basis because they are enablers and they have strong interactions with various other intangibles. Take the brand name Sony, for example. Is the brand’s value related to the enhancement provided by promotion and advertising or is it because of the R&D? In some cases there is no way in the world to separate these intangibles. That’s why what is important is information about the value-generating processes and the linkages between [intangibles]. In my opinion that is what really interests investors.
IR: How do companies begin to value intangibles?
Wood: I see a three-tiered approach. First get the appraisers to appraise the value [of intangibles] using their arcane information focused on historical costs. Then look at current best practices on measuring intangibles. In the UK, companies like Interbrand and Brand Valuation have done a lot of work in the brand area. Then look at what the economists say about this to get the macro view.
Then you come up with a compromise that is sort of weighted between those approaches. Companies don’t really have a choice – we need to do this. Impairments will occur left, right and center because up until now we have not measured intangibles properly.
