Valuation of Intangibles, a blessing not so disguised….

In wake of knowledge based economy, intangibles have become critical to the success of business. This can be well reflected by the new business models which are mostly centered on intangible assets.

Webster’s dictionary defines intangible as an asset that is not corporeal. On the other hand, The Economist offers a very amusing definition “An intangible is anything in a firm that generates value that you can’t drop on your foot.” Traditionally, accountants have thought of intangibles in terms of intellectual property, such as patents, trademarks and copyrights, and the intangibles bundled in goodwill, such as customer lists, business locale, and reputation. In today’s business environment, the concept of intangibles has expanded to include intellectual capital, particularly the important contributions made by innovation and human resources. Unfortunately, traditional management accounting systems provides little information that is useful for managing these assets and evaluating their performance. . (Stallworth L.H; Gregorio W.D; 2004).

However the importance of intangibles seems to grow exponentially in near future. Past researches studying the relationship between recognition/Valuation of intangibles and stock prices, states that a positive relationship exists between them. Further, the market capitalization of the average company on the BSE is three times the value of the book assets. The major factor that causes market value to exceed book value is the presence of intangibles, not irrational exuberance.

One of the most imp reasons for existence of bubbles such as dot com or IT bubble, sited by T.K Kumar (2005), is the false expectations on part of investors which are more or less a result of their own perceptions of the intangibles due to the lack of systematic and appropriate information on intangibles.

Further by incorporating  intangibles as a part of the charter and working agenda, the firm in a way declares to the shareholders, that board recognizes the underlying, reputation and value disciplines reflected throughout the organization.

However despite the growing concern and importance of intangibles, it’s recognition and valuation remains questionable. (FASB, 2000) it self recognized that the companies are currently disclosing voluntary useful information on their financial position “although there is a general lack of meaningful and useful disclosures about intangible assets”. So the question arises whether the accounting rules developed for the brick and mortar economy can as well apply to the knowledge based one.

Past researches such as Lev and Zarowin [1999] argue that non recognition of intangibles on the balance sheet has caused a significant decline in the relevance and usefulness of accounting reports. It is being widely being held that accounting information is loosing quite a bit of it’s relevance due to the increased importance of intangibles, which are not recognized as assets under the current assets. (Wallman, 1995; lev and Zarowin, 1999).

The critics of current accounting practices are far and wide; often resulting from the differential treatment of the intangibles. Such as FASB doesn’t require the valuation of self developed intangibles. However when a company purchases intangibles or purchases a target company with intangibles, an entirely different set of rules apply. FAS 141 mandated the use of purchase method i.e. purchasing company must assign a value to all the intangible and tangibles assets purchased and record these assets on their balance sheet.

Researchers are of the view of application of the value relevance approach, which suggests that the measurement and capitalization of intangibles should be unambiguously preferred to the expensing of intangibles.

However it is easier said than done, valuation of intangibles has remained one of the most controversial topics; there is not set economic valuation method for corporate intangibles. However lack of methodology is certainly not the excuse for ignoring the intangibles. John Holland (2004).in his book recommends in particular that financial statements should contain ‘structured and routine value-creation information expressed as a story’. This will help to achieve a ‘level playing field’ for all investors. Further more scorecards are increasingly being used as tool to value intangibles. Scorecard methods assume that organization performance is in large part a result of how well intangible assets are managed. Scorecards typically include both quantitative and qualitative measures of inputs – in terms of investments and activities — and outputs, or performance measures, and assess the extent to which an organization is achieving its strategic mission. The scorecards can be used by managers to evaluate organizational performance internally, and can also be used as a framework for external disclosure to investors. (Stallworth L.H; Gregorio W.D; 2004). Lev’s Value Chain Scoreboard (Refer Appendix i) is one example of the use of scorecards for valuation. It is a structured reporting system designed to provide information about investments in intangibles and their impact on the company’s capabilities and performance (Lev 2001). It can be used both internally by managers and externally as a framework for disclosure to investors. Another scorecard developed is, by Sveiby, the Intangible Assets Monitor (Refer Appendix ii) as a framework to measure and present information about intangible assets (Sveiby 1997). It classifies intangible resources into three categories: Individual Competence, Internal Structure and External Structure. Performance indicators are identified for each category to monitor the growth, renewal, efficiency, and stability or risk of loss of intangible assets.

However it is important for each organization develops its own set of measures that are specific to its strategy and mission. The key is however lies in selection of indicators.

REFERENCES

1. FASB(2000), Business Reporting Research Project, First draft, Steering Committee Report, FASB, Norwalk, CT
2. Holland J,(2004), “Corporate Intangibles, Value Relevance and Disclosure Content”, Institute of Chartered Accountants of Scotland, Edinburgh, and pp119.
3. Kumar, T.K (2005),”Disclosure Norms for Intangible Assets: Suggestions for Improving the Valuation of Intangibles.”, IIMB Management Review, Vol. 17, p71-78.
4. Lev, B. (2001). “Intangibles: Measurement, Management and Reporting.” Washington, DC: Brookings Institute Press.
5. Lev, B., and P. Zarowin. (1999), “Boundaries of Financial Reporting.” Journal of Accounting Research, Vol. 37, p 353–85.
6. Stallworth, H. L and Gregorio. D.W, (2004),”Developing scorecards to track intangibles.” Journal of Accounting & Finance Research, Vol. 12,p10-18
7. Sveiby, K. E. 1997. “The New Organizational Wealth: Managing and Measuring Knowledge-based Assets”. San Francisco, CA: Berrett-Koehler Pub.
8. Wallman, S.M.H (1995),”The future of accounting and disclosure in an evolving world: the need for a dramatic change”, Accounting Horizons, Vol.9, p.81-91.