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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.
The new FASB rules for reporting on Intangible
Asset - The U.S. versus the European way
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.
Summary
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).
Additional resources:
The new FASB rules SFAS
141 and 142 (Accounting for Business Combinations, Goodwill and Intangible
Assets):
FASB Summary of Statement
No. 141, Business Combinations
FASB Summary of Statement
No. 142, Goodwill and Other Intangible Assets
Arthur Andersen's executive summary of the new
FASB rules SFAS 141 and 142 (PDF 26k, 4 pages)
Arthur Andersen's controller guideline for the
new FASB rules SFAS 141 and 142 (PDF 102k, 20 pages)
The concept of a Intellectual Capital Supplement:
The
“Guideline For Intellectual Capital Statements” from the Danish Ministry of
Trade and Industry
Human Capital in
Transformation: Intellectual Capital Prototype Report, Skandia 1998
Previous related new
New Economy Analyst reports about this topic:
July 26, 2001 - How
accounting gets more radical in measuring what really matters to investors
July 18, 2001 - Interview
with David P. Norton: "Intangible Assets and the Balanced Scorecard"
Oct 03; 2000: The book of
the month: “Future Wealth” by Stan Davis and Christopher Meyer
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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