No wonder all the buzz these days is about the “irrationality” of markets. Fed a constant stream of misinformation, how rationally could they behave?
The Evolution of Goodwill
Although intangibles are not exiled from the balance sheet altogether, where and how they do show up is testimony to the nature of the problem. In conventional accounting, intellectual capital and other intangibles appear on a company’s balance sheet only in the course of an acquisition, as “goodwill” — the lump-sum difference between the amount a buyer paid to acquire another company and the book value of the acquired firm or its acquired shares. This amount generally represents the value that a company has accrued by way of its brand, reputation, customer service, and other nonphysical assets.
Until 2001, in the U.S. the acquiring firm was required under generally accepted accounting principles (GAAP) to amortize goodwill in subsequent years as an expense. Then, in a halfhearted and barely perceptible nod to the importance of intangible assets, the Financial Accounting Standards Board (FASB) stopped requiring companies to amortize goodwill as a lump sum. Some intangibles with a definite useful lifespan, such as a patent, may still be amortized. Those with an indefinite useful life, such as a trade secret, can’t be amortized, but are subject to an impairment test. That means that companies must record losses, such as a decline in brand value after a product recall. Other intangibles — for example, the value of an acquired workforce — are explicitly not included. This 2001 improvement in M&A accounting rules ignores the much larger issue: how to account for intangible assets that are created organically by and within an organization, not those that are acquired.
Two years later, in 2003, the Securities and Exchange Commission (SEC) established new guidance for Management’s Discussion and Analysis (MD&A) statements. MD&A statements address the disclosure of nonfinancial performance measures that are material to a company’s financial health. The SEC didn’t use the word specifically, but some of these measures include intangibles, such as patents, technical licensing arrangements, and customer–vendor relations. Companies are now allowed to detail the number of patents in their portfolios — along with generally accepted industry performance measures, such as the number of citations by other patent applications or the cash flow from royalties. But they are barred from discussion of valuation or depreciation of those assets. The practical result, as in the case of the Google Network, is that investors are left to infer value from how the assets are disclosed.
What’s more, although such measures at least give companies the option to disclose some of their intangible assets, the lack of clarity regarding intangibles opens the concept of materiality itself to debate — defeating the original intention of disclosure and reporting. For example, both the FASB and the American Institute of Certified Public Accountants (AICPA) developed lengthy lists of intangibles, but the two lists barely resembled each other. The FASB list, which replaced AICPA’s, breaks intangibles into categories, such as “marketing-related” and “contract-based,” whereas AICPA’s list was more specific, including items such as “airport gates and slots” and “non-compete covenants.”
Lists notwithstanding, neither accounting bodies nor regulators offer official definitions for intangible assets, individually or as a class. For example, under what circumstance does the money spent on an activity like research and development count as an intangible asset rather than an expense? When is technology classified as an asset rather than as a capability? Which intangibles should go on the balance sheet, and which can simply be disclosed? What constitutes effective disclosure? These innate ambiguities, coupled with the contentious nature of the problem, have kept official accounting bodies and financial regulators from fully engaging in solving the intangibles problem.