Tangible Agitation Over a Proposal on Intangible Assets

When investors, analysts and other interested parties review a company’s audited financial statements, there is an implicit assumption that virtually all pieces of relevant and material information are disclosed in a timely manner, either in the body of the financial statements or in accompanying notes to the financial statements.

But according to Wharton accounting professor David Larcker and other industry professionals, there may be a disconnect between the information provided in today’s financial statements and the information needs of investors, creditors and others. And partly as a result of that, the accounting profession’s rule-setting body, the Financial Accounting Standards Board (FASB), may consider revamping the system of accounting and reporting that businesses have been following for more than 500 years.

In its recent “Proposal for a New Agenda Project,” the organization asked for comments on a proposed project to establish standards for requiring greater disclosure of information about intangible assets that are not recognized in financial statements.

Currently, such intangible assets—which some financial professionals estimate have a market value measured in trillions of dollars, and include such things as agreements with suppliers and customers, rights to scarce resources, patents and copyrights, computer programs and secret formulas and processes—are generally recognized only if acquired, either separately or as part of a business combination. Intangible assets that are generated internally, and some acquired assets that are written off immediately after being acquired, are not reflected in financial statements, and little quantitative or qualitative information about them is reported in the notes to the financial statements.

Beefing up the disclosure of intangible assets would potentially yield greater transparency, enabling the investment and lending communities to make better decisions about how to allocate their capital. But while FASB considers the proposal – the comment period originally ran until September 19, but was extended to October 5 – it can expect to hear from skeptics as well as supporters.

The fact that FASB, along with the SEC, is even examining the issue is due, in no small part, to the rise (and fall) of the so-called New Economy, under which businesses like Microsoft rely on intellectual capital and other intangibles the way that Old Economy companies relied on machinery and equipment.

Larcker, who sat on a FASB steering committee responsible for a report on “Insights into Enhancing Voluntary Disclosures,” says that the current accounting system “is incredibly good at measuring items that aren’t so relevant.” He points to depreciation as an example: Reported depreciation expense is fairly precise, he says, but how relevant is it to predicting a company’s future performance?

“Managers run companies using non-financial metrics like employee turnover, innovation, customer loyalty and alliances,” he explains. “They utilize these measurements, and tools like the balanced scorecard, internally because they provide a good idea of the direction and the value of the business. Perhaps they should disclose measurements about intangibles to outsiders.”

Baruch Lev is asking similar questions. A professor of accounting and finance at New York University’s Stern School of Business, Lev’s work on intangibles was cited by FASB in its proposal to value intangible assets, and by the SEC in a March report on “Current Accounting and Disclosure Issues.”

In a March interview with CIO magazine, Lev commented that “underneath all of the ‘hard’ facts about plants and inventory and capital investment, some financial experts say, lies a mountain of soft data about such things as R&D, brands, patents and general know-how that traditional accounting methods don’t capture.”

But even if you agree that an important measure of value is not being captured, there is still the issue of how to quantify the information. Larcker, for example, admits that it may be difficult but not impossible to measure such elusive concepts as intellectual and human capital.

“Even if we don’t put a dollar value on the intangible assets themselves, we can come up with indicators – like the change in customer satisfaction or employee turnover – that point to the direction of the underlying customer and employee assets,” he says. For example, lower employee turnover might be an indicator of employees who work smarter and more efficiently, which should result in a higher quality of goods and services, more innovation and higher subsequent shareholder value. Right now we may not have the tools to directly quantify the effects of those results, but we can use such indicators as employee turnover to provide indirect measures of intangible assets.

Judging by the chorus of voices calling for greater disclosure, it might seem that the financial community is solidly in favor of the proposal. In fact, however, serious questions are being raised about just how necessary it is, and whether it could, in fact, cripple some companies.

For example, Wharton accounting professor Chris Ittner admits there is “a lot of evidence that intangible assets are associated with market value,” but goes on to note that inconsistent measuring could corrupt any conclusions.

“The idea is ultimately for investors to find out about current or future cash flows, and intangible assets are leading indicators,” he says. “But common standards may not be predictive across or within industries. Look at retailers: Some go for a low-cost market and some for the high end. Different questions need to be generated for different situations. Simply asking customers ‘are you satisfied?’ won’t do when considering an issue like customer satisfaction.”

In an accounting environment that pays more attention to intangibles, the very definition of an asset may have to be reconfigured, Ittner adds. “What is an asset? The standard definition is that it’s an item in which a company has a legal right or interest. But that concept gets fuzzy when you talk about something that can walk out the door, like knowledge or customers. You can say that a company owns a patent, but what happens when a business invests in customer satisfaction? Management may expect a return on its investment, but it’s not something that the enterprise owns.”

Ittner adds that companies may resist releasing details about what they consider to be proprietary information. “Does a business always want to release details about a change in future business strategy?” he asks. “Clearly, this type of proprietary information can be used by competitors to the detriment of the company. Analysts may also oppose further disclosure because their job involves digging out this kind of information.”

Such disclosure could even be redundant, according to Andreas Ohl, a director in PricewaterhouseCoopers’ transaction structuring practice. “Some of the information that would be disclosed under the FASB proposal is already contained in SEC filings,” he says. “If we are looking at more than a boilerplate description, then a FASB requirement for more than mere disclosure would probably require a huge shift in Generally Accepted Accounting Principles (GAAP).”

Ohl says that if FASB requires all intangible assets to be reported as comprehensively as, for example, acquired brands currently are, then that would result in “a phenomenal amount of compliance work for companies. And in some industries brands are meaningless because other sets of metrics are utilized.”

In any case, Ohl says that right now, FASB’s preliminary consideration of disclosure of intangibles isn’t even on the radar screen of most companies. “I call it ‘the stealth proposal,’” he says. “Currently, most companies are occupied with [recently enacted rules] covering business combinations (FAS 141) and goodwill and other intangible assets (FAS 12). Proposed standards often don’t get much attention until they gain clarity and businesses realize how they may be affected.”

Accountants by nature are a conservative lot; after all the basics of the double-entry bookkeeping system developed by Luca Pacioli in the 1400s is still in use today. So if any structural change is made to the accounting model, it is likely to be done slowly and will be introduced in increments, if at all. As Wharton’s Ittner puts it, “If the additional disclosure is so good, why aren’t companies already doing it?”

Tell us what you think about measuring and disclosing intangible assets by sending your comments and ideas to respond@credit.wharton.upenn.edu All comments will be confidential.