INTERMEDIATE ACCOUNTING I

GROUP TASK INTANGIBLE ASSETS

INTANGIBLE ASSETS
DEFINITION
Intangible assets are long- term assets with no physical properties. Because one cannot see or touch most intangible assets, it is easy to overlook their importance. Intangible are recorded as assets, however, because they provide future economic benefits to the company. In fact, an intangible asset may be the most important asset a company owns or controls. For example, a pharmaceutical company may own some property, plant, and equipment, but it most important asset may be its patent or a particular drug or process.

BALANCE SHEET PRESENTATION

Intangible assets are long- term assets and should show separately from property, plant, and equipment. Some companies develop a separate category, intangible assets, for the various types of intangibles. The presentation of intangible assets varies widely, however. The nature of many intangibles is fairly evident, but goodwill is not so easily understood. Goodwill represents the amount of the purchase price paid in excess of the market value of the individual net assets when a business is purchased. Goodwill is recorded only when a business is purchased. It is no recorded when a company engages in activities that do not involve the purchase of another business entity. For example, customer loyalty or a good management team may represent goodwill but neither meets the accountants criteria to be recorded as an asset on a firms financial statements.

Most Common Intangible Assets Intangible Asset Patent Copyright Trademark Goodwill Description Right to use, manufacture, or a sell product; granted by U.S Patent Office. Patents have a legal life of 20 years. Right to reproduce or sell a published work. Copyrights are granted for 50 years plus the life of the creator. A symbol or name that allows a product or service to be identified; provides legal protection for 20 years plus an indefinite number of renewal periods. The excess of the purchase price to acquire a business over the value of the individual net assets acquired.

The following table summarizes the companys identifiable intangible assets balances as of May 31, 2004. May 31,2004 (In millions) Amortized Intangible Assets Patents Trademarks Other Total Unamortized Intangible Assets Trademarks Total FRS 10, Goodwill and Intangible Assets (Companies) This standard was issued in December 1997, replacing SSAP 22. It applies to companies, not to the partnership or sole traders: 1. Purchased goodwill and purchased intangible assets (e.g. patents, trademarks, etc.) should be capitalized as assets. 2. If goodwill has not been purchased then there should not be any entry of it in the companys books. (This is different from the situation applicable to partnerships.) 3. Internally developed intangible assets should be capitalized (i.e. entered in the companys book as an assets) only when they have readily ascertainable market value.
4. The calculation of goodwill should be the excess of the value of the consideration given

Gross Carrying Amount $27.9 14.1 17.0 $59.0

Accumulated Amortization $(11.9) (11.5) (10.8) $(34.2)

Net Carrying Amount $16.0 2.6 6.2 $24.8

$341.5 $366.3

(the price paid) over the total of the fair values of the net assets acquired.
5. Goodwill and intangible assets should be amortised (i.e. depreciated) over their useful

economic life. However, when goodwill or intangible assets are regarded as having indefinite useful economic lives, they should not be amortized. 6. The useful economic lives of goodwill and intangible assets should be reviewed at the end of each reporting period and revised if necessary. 7. The straight line method of amortization should be adopted, unless another method can be demonstrated to better reflect the expected pattern of depletion of the goodwill or intangible asset.

MEASUREMENT AND RECOGNITION OF INTANGIBLES

Expenditures on intangibles, which result in new technologies and brand names, are difficult to quantify and value. Historically, intangibles have always been considered risky assets. Accounting defines assets as economic resources with measurable future service potential. However, it is more difficult to measure the future service potential of intangibles than the benefits accruing from other assets such as investment in property, plant, and equipment. Thus, with few exceptions, accounting standards require the expensing of all internally generated intangibles (Gelb and Siegel, 2000). In the present economy, however, intangible assets such as intellectual capital frequently create value. The accounting profession, however, has not met the responsibility of measuring and reporting the results of knowledge-based entities (Barth and Kaznick, 1999). Capitalization Issues Statement of Financial Accounting Concepts (SFAC) 2 states that an item and information about it should meet the following four fundamental recognition criteria to be recognized as an element in financial statements:

It has a relevant attribute measurable with sufficient reliability The information about it is capable of making a difference in user decisions The information is representational faithful and verifiable The information must be neutral. (FASB, 1980)

The element asset is defined as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events (FASB). Given this definition, the allocation of an entitys scarce resources to research, development, advertising, training, and other ongoing activities are events of consequence to entities. Research is a series of events that converge. It is almost impossible to discern the turning point in the series of events that lead to a commercially successful product (Gelb and Siegel, 2000). Assets are recorded at a cost or by incurring a sacrifice of other assets in order to acquire something new. Correspondingly, the resources directed toward internal generation of either tangible or intangible assets meet the definition of cost. The common characteristic shared by all assets is service potential or future economic benefit. There exists some uncertainty relative to either the service potential or future economic benefit of internally generated intangible assets. Therefore the controversy focuses on risk and measurability issues. At a minimum, the cost in terms of employee efforts and raw materials consumed can be measured (Amir and Lev, 1996 SFAS 25 (FASB, 1979) based the full cost versus successful efforts in the oil and gas industry upon the premise that the unsuccessful

exploration efforts are a cost of those that are successful. Expensing research in any industry is inconsistent with the full cost method permitted in the oil and gas industries. In addition to being inconsistent, the quality of neutrality is missing when standards are promulgated favouring a particular industry. The relationship between service potential or future economic benefit of assets and net cash inflows to an entity is often indirect for both business enterprises and not-for-profit organizations. Therefore, the argument that A direct relationship between research and development costs and specific future revenues generally has not been demonstrated, even with the benefit of hindsight is not only without merit, but inconsistent with the Boards own pronouncements. Lev and Sougiannis (1996) provide evidence that capitalization of R & D yields statistically reliable and economically relevant information. Recognition of elements of financial reports is subjected to decisions about trades off between relevance and reliability. This decision is generally decided on proof and the verifiability of the element. Extant literature indicates the professional acceptance for providing evidence that investment in research and development, advertising, human resources, and other intangibles meet the definition for classification as assets and the criteria for measurement (Gelb and Siegel 2000). For example, the Board used evidence provided by publications in scholarly journals in reaching their conclusions concerning the relevance of Goodwill (SFAS 141). Devine argues that the value of a formal scheme for revising opinions should be clear. He suggests that Bayesian techniques should be used for modifying prior valuations in light of further information, as well as obtaining revised probabilities. What is not clear is why the accounting standards setters have ignored the possibility of a Bayesian approach to the capitalization and amortization of internally generated intangibles. Absence of a market price or exchangeability of an asset may create measurement and recognition problems, but it in no way negates future economic benefits that can be obtained by use as well as by exchange. Incurrence of cost may be significant evidence of acquisition or enhancement of future economic benefits. (FASB, 1985). The distinction between research and development, advertising, training, etc. and other recognized assets is not based on the definition of assets but rather on the practical consideration of coping with the effects of uncertainty complicated by the fact that the benefits may be realized far in the future. As a result of SFAC 6 (FASB, 1985), relevance and reliability are the two primary qualities that make accounting information useful for decisionmaking. Information is considered relevant if it has the capacity to make a difference in making a decision. Furthermore, the essence of reliability is faithful representation, neutrality and verifiability.

The preceding is significant since the FASB has acknowledged the relevance of disclosing information relative to intangible assets. Information is verifiable (reliable), according to the FASB, if there is a high degree of consensus among measurers. As mentioned earlier, there is a consensus of academic scholars, accountants, financial analysts, and the financial press that intangible capital can and should be measured. The measurements and tools thereof seem no more susceptible to error than other risky assets and financial instruments that are currently recognized by GAAP. For example, SFAS 123 computes compensation expense based on an option-pricing model (FASB, 2004). SOP 93-7 permits the capitalization of direct-response advertising. SFAS 133, 1998) promulgates the rules for recording assets/liabilities that meet the definition of a derivative or an imbedded derivative. In light of current and previous market volatility, it seems inconsistent to recognize compensation expense based on an option-pricing model, and yet be unwilling to capitalize intangible assets. The accounting model, which was designed to produce relevant and reliable information, has failed to do so. The accounting standard setters have historically been faced with the trade-off between relevance and reliability. Similarly, accounting for derivative instruments and hedging activities is also an example of recognizing assets and liabilities when the application of the quality of verifiability requires a great deal of estimation. The recognition of derivative instruments and embedded derivatives has taken us far beyond traditional historical cost accounting. Nonetheless, the benefits of recognition were considered greater than the costs of measurement error. Some internally generated intangibles are capitalized. Costs incurred in creating a computer software product that is to be sold, leased, or otherwise marketed, is charged to research and development expense when incurred until technological feasibility has been established for the product. Technological feasibility, however, is a criterion that is difficult to apply. There is no such thing as a real, specific baseline design. Financial analysts have consistently argued against capitalization of computer software because the useful life is relatively short lived compared to other R & D projects. Technologically feasible software is recognized as an asset, whereas other intangibles that are both more relevant and reliable, that have greater consequences in terms of both dollar amounts and useful lives, continue to be ignored (Gelb and Siegel, 2000). IAS 38, Intangible Assets, employs the term technological feasibility for capitalizing expenditures in the development phase. The criteria listed for capitalization of research in the development phase are as follows: Technical feasibility of completion for use or sale, Intention, technical and financial ability to complete and use or sell it, Existence of market or internal usefulness, and Measurability during the development phase (IASB 2004).

Expected Present Value

The objective of using present value in accounting measurement is to capture the economic differences between sets of future cash flows. This measurement of expected present value is one method of capturing an asset valuation and can be used in the case of internally generated intangibles. SFAC 7 (FASB, 2000) introduces the measurement of expected present value. This differs from traditional accounting present value calculations in that it refers to a sum of probability-weighted present values in a range of estimated cash flows. When no market exists for the item or comparable items, the appropriate rate must be observed from some other cash flows (Lev and Sougiannis, 1996). SFAC 7 also lists the features that present value measurements should incorporate to fully capture economic differences between assets. Clearly, this would lend support to the capitalization process. The riskiness attached to internally generated intangibles can be measured using internally generated metrics incorporating expected present values amenable to the measurement of intangible (intellectual) capital). In the absence of a cash transaction, measurement can be made based on comparison of similar transactions in the market place. In other words, payments made for inprocess R & D and other internally generated intangibles can be used in some situations.

The Cost of Certain Intangibles Although the cost of most internally generated intangibles is presently expensed as incurred, methods do exit to measure which of these costs should be capitalized. An example is the measurement via expected present value. The following gives specific examples of measuring capitalizable costs associated with advertising, R & D, patents, and employee training.

Advertising and R & D

The costs of all advertising are expensed in the periods in which those costs are incurred (SFAS 2; FASB, 1974), with the exception of direct-response advertising. SOP 93-7 requires that the primary purpose of such advertising be to elicit sales, and that there must be a system for documenting the sales activity. Treating customer-acquisition costs differently leads to inconsistent financial reporting. Its difficult to document over multiple time periods using estimated present values the increase in sales and income of advertising campaigns (Gelb, 2002). The expensing of R & D and advertising are required based upon the risk and uncertainty related to their benefits. For example, there should be sufficient documentation between R & D expenditures and the ratio of successful/non-successful drugs. For each company the success/failure ratio over an extended period of time should be documented (Sannella, 1995). SOP 93-7 requires a historic pattern of results for the entity; however, industry specifics are not objective evidence. If the entity does not have operating histories for

new products or services, statistics for other products or services may be used if it can be demonstrated that these are products/services that are likely to be highly correlated. The Statement also permits the payroll and payroll related costs for the activities of employees who are directly associated with, or devote time to, the advertising to be reported as assets (Gelb and Siegel, 2000).

Intellectual Property : Patents

Revenues (royalties) from patents were $110 billion in 1999 (Reivette and Kline, 2000). Investors at four to five times earnings value royalty income with deficient information leading to under-valuation (Gu and Lev, 2000). Licensing intensity provides investors with an important signal about the quality of a firms R & D. Many companies (IBM, Lucent, and Dow) have independent divisions dedicated to licensing of patents and know how. They also provide consulting services in the valuations of patents and potential licenses [Linden and Somaya, 1999]. SFAS 133 (FASB, 1998) prescribes the accounting rules for recognizing options. The Patent & License Exchange currently offer products to assist owners of intellectual property to value their intellectual property (IP) as financial assets, thus converting goodwill-based valuation to market-based valuation. They provide IP valuation and monetization products and also distribute IP valuation data. Patents are options on technology. They are call options on the future cash flows that may or may not arise from technology. The Exchange provides evidence that IP behaves like a financial call, and are therefore subject to monetization. Option pricing models have already been sanctioned by the FASB (SFAS 123; 2004) as acceptable pricing models. The accounting rules for call options are already in existence, and the markettest for treating patents as call options has been met. The Exchange provides bona fide transaction and valuation data. (Kawaller 2004) Presently there exist markets in patents both on-line and off-line. Sony and Dow are an example of companies that have placed parts of their patent and know-how portfolios for trade on websites (Gu & Lev, 2000]. The recognition of patents is in accordance with GAAP.

Employee Training Costs

The argument against capitalizing the costs of training employees has centered on the definition of an asset. An asset is either owned or controlled by an entity, and employees are neither owned nor controlled by the entity. Nonetheless, the future service potential of employees is given recognition in pension accounting. When unfunded, an accumulated benefit obligation is recorded with a credit to minimum liability and a debit to an intangible asset, deferred pension cost (FASB, 1985). Also, the future service of employees is considered when recognizing compensation expense for employee stock options (FASB, 2004) and when amortizing prior service cost (FASB, 1985). Human Resources have a significant role in the

development and performance of a firm. Of all the assets an entity has, the one that is overlooked and produces significant value is Human Resources (Patra & Khatik, 2003). A recent report on voluntary disclosures by the FASB indicates that additional data about unrecognized intangible assets would be beneficial because of the importance of intangibles to a companys value. Intangibles include not only R & D, but also human resources, customer relationships, innovations, etc. The FASB argues that intangible assets are subject to fluctuations due to external factors not wholly within managements control. The FASB therefore recommends disclosure rather than recognition of internally generated intangibles. The FASB argues that the measurements used by companies to manage their operations and drive their business strategies are very useful voluntary disclosures. The question raised here is whether or not all intangibles should be recognized if they are reliably measurable and are relevant. The next section of this study will discuss how the FASB has supported the capitalization of internally generated metrics in the case of maintaining the value of intangibles purchased in an acquisition. These same metrics could be used to restate the traditional financial reports to include all intangible (intellectual) capital, with full disclosure on how these metrics were derived. Furthermore, there are very few assets, tangible or intangible, that are wholly within any companys control.