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The new New Economy Analyst Report – Nov 10, 2001
Juergen Daum’s new New Economy Best Practice service
©2001 Juergen Daum. All rights reserved.
News categories: the role of finance and financial management, investor and stakeholder relationship management, value based management
With the arrival of the new information technologies, the structure of enterprises have changed dramatically, shifting the focus of value creation from tangible based activities to intangible based value creation. The value of intangible assets has therefore constantly increased in the last two decades from an average of 40% of total market value of business corporations at the begin of the 1980s to over 80% at the end of the 20th century (see figure 1). In knowledge intensive industries, like in the software business, a corporation’s book value is often lower than 10% of it’s market value, of which the largest part are constituted by intangible assets such as relations to customers and business partners, a company’s workforce, patents, trademarks or other intellectual property, organizational capital in form of superior business processes, organization structures and a unique corporate culture. The recent correction on the stock markets has not changed this and had nearly no effect on this situation.
Figure 1: The value of corporate Intangible Assets has continuously increased in the last decades and is dominating today the market value of many corporations (here the average values for S&P 500 corporations in the U.S.)
Physical and financial assets are rapidly becoming commodities, yielding at best an average return on investment. Abnormal profits, dominant competitive positions, and sometimes even temporary monopolies are achieved by investments in intangible assets such as R&D, advertisement or new business models and processes. Empirical research demonstrates, that companies with high levels of investments in R&D and advertisement for example, show far better earnings and stock performance than companies with lower levels of spending in those areas. But unfortunately traditional accounting is not able to capture, measure and report on intangible assets – forcing investors, but often also managers, to act in the dark.
The accounting rules did not allow to account for intangibles
While intangible assets have become so important today for both managers, who are seeking to increase value for both shareholders and other stakeholders of their companies, and for investors, who are trying to optimise their investment portfolios and want to make more wiser investment decisions, the standards for external corporate reporting (which should enable investors to assess a company’s value creation potential for the future) and for internal management reporting and controlling (which should enable managers to make more appropriate resource allocation and internal investment decisions in an effort to improve performance and increase corporate value) have not yet kept pace with the raise of intangibles.
Accounting rules did not allow companies to capitalize investments in intangibles and to report on them like on other assets. And this is the major reason for the growing disconnect between market values and financial information. Financial statements are insufficient to assess properly the performance and the value generation potential of today’s companies, where intangible assets are the major drivers of corporate value. Evaluating profitability and performance of a business enterprise, by say, return on investment, assets or equity (ROA, ROE) is seriously flawed since the value of the firm’s major assets – intangible capital – is missing from the denominator of these indicators. Measures of price relatives - for example price-to-book ratio – are similarly misleading, due to the absence of the value of intangible assets form accounting book values. Valuations for the purpose of mergers and acquisitions are incomplete without an estimate of intellectual capital. Resource allocation decisions within corporations require values of intangible capital. But Managers don’t have the tools for intangibles’ resource allocation. These and other uses create the need for valuing intangible assets, in practically all economic sectors, old and new.
The U.S. FASB’s (Financial Accounting Standards Board) new rules for business combinations, goodwill, and intangibles (SFAS 141 and SFAS 142) represent the U.S. way to deal with these challenges
Under the new FASB regulations (Statement of Financial Accounting Standards No. 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets), companies obliged to report under US GAAP are required now to stop amortizing goodwill at the start of their fiscal year and perform instead a complex impairment test to check the value of their goodwill and intangibles against market value.
What has changed exactly and why ?
In a simplified way, goodwill is the difference between the amount a corporation is paying for an investment in another company and the book value of the acquired firm or of the shares which had been acquired. Goodwill includes therefore the value of the so far invisible intangible assets of the acquired firm (or of the part of it that has been acquired) which have been now uncovered by the transaction. Until recently the acquiring firm was required under US GAAP according to the so called “purchase method” to report this difference as goodwill on its balance sheet and amortize it in subsequent years. Only under certain conditions (“pooling of interest method”) it had more flexibility. The problem with goodwill was, that the goodwill amount on the balance sheet of many companies and the amount of goodwill amortization, which was posted to the income statement and reducing earnings, was constantly growing in recent years. And because “goodwill” was just a lump sum on corporate level for all acquired intangibles, it did not tell anything anymore to investors – the contrary: it diluted the usefulness of financial statements. In addition intangible assets are often subject to faster changes of value (based for example on changes of competitive positions) than tangible assets, which has increased doubts, if the practice of linear amortization of goodwill is really the appropriate way to deal with intangible assets. But with the new rules, things have changed:
- pooling of interest is not allowed anymore - which means: all acquired intangibles have to be reported
- goodwill will not be amortized anymore – which means: corporate earnings are not, without economic reason, diluted anymore by amortization of assets with a infinite life
- the purchase price of acquisitions (also of past acquisitions) including goodwill has to be reported on and brought down to the operative unit (“reporting unit”), where it has originated, that is, for which the referring assets have been acquired – which means: goodwill will not be “lumped” anymore into one sum on corporate level, but it will become transparent, which operating unit is using how much of corporate assets including the intangibles
- if acquired goodwill includes individual identifiable intangible assets that have been obtained through contractual or other legal rights, or if the can be sold, transferred, licensed, rented, or exchanged (such as patents or other economic assets), these intangibles have to be reported separately from goodwill and will require amortization over their useful life – which means: again more transparency concerning the intangibles used, because companies have to value them.
- companies have to perform at least at the end of each fiscal year a so called “impairment test”, that is, they have to check on a reporting unit level, if book value (including intangible assets and goodwill) is below the fair value (market value) of this reporting unit and have to write off the difference if there is any, reducing earnings on the P&L statement. If an event or circumstances occur between the annual test that might reduce the fair value of a reporting unit below its carrying value or book value (such as a legal factor, regulatory action, competitive action, or loss of key personal), the write off has to be made even during a fiscal year. – which means: management has to value the company’s intangibles in detail and has to report on changes and has to explain the reasons for these changes.
Since March 15, 2001, all companies reporting under U.S. GAAP with fiscal year after this date – except calendar year firms, may choose early adoption of the new rules und the purchase method. Since June 30, 2001, the pooling of interest method in business combinations (and therefore the “hiding” of intangibles) is eliminated. From December 15, 2001, on, companies with fiscal year beginning after this date no longer must amortize existing goodwill and have to start with impairment test for the annual report of the first fiscal year beginning after this date. A lot of questions are still open, how to handle the new rules in practice. Also some experts see the required complex impairment tests as a breeding ground for Securities and Exchange Commissions inquiries and required restatements. But one thing is clear: we will see changes – not only in corporate reporting practice but also in behaviour of management and investors.
The possible consequences
Until today, most companies have avoided to report in such a detailed way about their (intangible) assets and total performance (which includes also for example significant decrease of the value of intangibles). These new rules and the obligation to valuate goodwill and intangible assets regularly represent therefore a major change in disclosure practice and will affect behaviour of management and of investors in the future. It will force managers, who have to report on intangibles and may fear dilution from intangible assets amortization, to evaluate the possible return of the investment in an acquisition more carefully before making the investment decision. This will probably result in more moderate acquisition prices compared to what we have seen in recent years. And investors will pay more attention when companies begin to test for goodwill impairment. When goodwill is not amortized anymore, it can have much more of an impact on results in a single stroke when it is written off. So investors will have a closer eye on companies with large goodwill amounts on their balance sheets. Positive impairment tests may be an indication for bad management, because the company is not able to secure and to keep its assets. Restatements may send out a signal that perhaps there is not as much financial control as there should be. All this will require management, to make better acquisition decisions and to manage intangible assets better.
In Denmark companies are now obliged to report on their Intellectual Capital
Europeans have a different more active approach to deal with the problem of hidden corporate intangible assets. The innovations in this field in the last couple of years came specifically from the Nordic countries in Europe. Skandia in Sweden, a financial service company, was the pioneer in providing their investors and the public with the world’s first Intellectual Capital Report as a supplement report to its annual report 1998 (see the new New Economy Analyst report from July 26, 2001). Skandia reported in its IC supplement report about such things like the increase of the skills in its workforce, the development of its customer base etc. (see figure 2).
Figure 2: Extract from Skandia’s Intellectual Capital supplement report to its annual report 1998
This may have served as a guideline for the Danish government, which has passed this year before summer a accounting law that obliges Danish companies through a clause, that they have to report on their Intellectual Capital through a supplementary IC statement, if they dispose of intellectual resources which are important to the firm. While it is not known yet how these new rules will be interpreted by accountants and the authorities, it is an interesting development. In difference to the U.S., the focus is not on valuing intangible assets on the balance sheet and integrating them into traditional financial reporting after their value was revealed through a equity sales transaction. Instead, the focus is on the provision of information, in addition to financial reports, on the status of all of a company’s knowledge and intellectual resources. This should force management to manage these resources and related assets more actively and to enable investors and the public to evaluate how well management is doing its job in this field.
The Danish Ministry of Trade and Industry has issued “A Guideline For Intellectual Capital Statements” that explains, how to set up a ICS. It is the result of a major R&D achievement of a project co-ordinated by the Danish Agency of Trade and Industry started in 1998. 17 Danish companies have contributed to the project by preparing two sets of intellectual capital statements each.
The intention behind the Danish concept of a “Intellectual Capital Statement” (ICS) is the opinion, that companies today need to manage more actively and systematically their resources that deal with knowledge. The ICS should work as a tool for managing knowledge resources and thus creating added value in organisations. In preparing such a ICS, an organisation will undergo a process that prompts it to work out a strategy for knowledge management. But the main intention of the ICS is to report externally of a company’s efforts to obtain, develop, share and anchor the knowledge resources required to ensure future results. The ICS therefore provides a status of the company’s efforts to develop its knowledge resources through knowledge management in text, figures, and illustrations.
The ICS according to the Danish concept consists of three elements: a knowledge narrative, management challenges and reporting:
- The knowledge narrative describes how the company ensures that its products or services accommodate the customer’s requirements, and specifies how the company has organised its resources to achieve this. It comprises a description of the company’s mission, a description of the use value of the company’s products or services, and a description of the company’s basic conditions of production disclosing the knowledge resources required to meet user needs.
- The part named management challenges describes the management challenges that, on the basis of the knowledge narrative, represent logical challenges within knowledge management. It also includes a list of actions illustrating necessary or rational approaches in response to management challenges. These actions are related to knowledge resources in connection with customers, employees, processes, and technologies. Each action is then tied to one or more indicators of the reporting part.
- The reporting part is the document reporting on the company’s strategy for knowledge management in text, figures and illustrations. The text relates to the knowledge narrative, the management challenges and the specific actions defined. The figures document the initiatives launched to address management challenges and their success. The illustrations are photos, charts or other graphics used to communicate the knowledge narrative and the management challenges, and to give the reader an impression of the company’s style, character and identity.
Intangibles assets have increased in recent years both in significance and value. They require now much more attention from managers, investors and financial analysts. The American approach, reflected in the new regulations issued this year by the FASB concerning business combinations, goodwill and intangible assets, is a more defensive move than the Danish and is focusing on the right reporting of the results achieved so far (values on the balance sheet of goodwill and intangible assets, uncovered after a equity transaction) and is penalizing companies and managers of companies, which have experienced a loss of the value of their uncovered intangible assets, through write offs that reduce immediately earnings. While this approach seems to be more rigid (through detailed FASB rules, through the threat of restatements of financial statements required by the SEC if an impairment test is not done properly), it goes not that far like the Danish approach. The concept of the Danish ICS requires companies to report in depth and more comprehensively about all their intangible assets and also about their capabilities to create and exploit these such assets. It requires them to report about strategies, management challenges and about the actions taken to create, manage and exploit intangible assets based on knowledge resources. It forces therefore companies to reveal much more in advance about their intentions, how they want to create value with activities related to intangibles. The FASB rules require companies to report about these activities only, if a impairment test has ended with a positive result (then they have to report about the reasons for the loss of the value of intangibles, which are probably tied to some company activities or strategies). So the Danish concept results in a much higher degree of transparency, but less rigidity, which means also in more opportunities to “play with the numbers and reports”. The future will show us, which of these concepts will be the better one to “invite” companies to manage their intangible assets more accurately.
The best solution could be a combination of both approaches: recognition of intangible assets in financial statements including the ones that have not been acquired but created in-house (to enable investors to better assess the past performance of companies) and in addition to the financial statements a supplement report which is reporting on the potential available and in creation to enable for future performance (which is then measured against financial results in the future).
The new FASB rules SFAS 141 and 142 (Accounting for Business Combinations, Goodwill and Intangible Assets):
The concept of a Intellectual Capital Supplement:
Previous related new New Economy Analyst reports about this topic:
I will continue in future reports to report on issues related to managing companies in our information and Intangible Assets based economy of today. To subscribe for my free-of-charge e-mail newsletter click here.
The concept for a new accounting, controlling, and management system for knowledge and intangible assets based businesses, that integrates strategy management (strategic innovation) and product and market development (product and market innovation) with operations management (supply chain management, customer relationship management) and resource management (finance, hr, alliances, IT) is described in detail in my forthcoming book "Intangible Assets oder die Kunst, Mehrwert zu schaffen: Erfolgreiche Unternehmensführung im Zeitalter des Intellectual Capital" ("Intangible Assets or the Art to Create Value: Successfull Enterprise Management in the Era of Intellectual Capitalism").
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