Intangible Cost, Not Value

At the recent conference on Intangible Assets at the National Academies, the discussion “Intangibles in the Firm” consisted of two presentations, one by Baruch Lev, Professor of Accounting and Finance at the Stern School at NYU, and the other by Ron Bossio, Senior Project Manager from the Financial Accounting Standards Board.

It is not surprising that the organizers of the conference turned to two accountants to explain the “state of the art” of intangibles in the firm It was a natural decision. We rely on accountants to provide objective information about our organizations. Who better to help us understand this new “asset” class that makes up 80% of the valuation of the average company and fuels competitive advantage?

But the problem is that accountants have not been able to answer this question. Accounting was designed 500 years ago to track the movement of tangible goods. The system worked well throughout the industrial revolution because it provided a way to keep track of the full value chain of a tangible business—from construction of a factory to purchase of raw materials, creation and sale of finished goods, and collection of accounts receivable.

The value chain of an intangibles-intensive business, however, is much less visible in traditional financial statements. The intangible assets used to create services and knowledge are not on the balance sheet. So the first time a service may hit the financials is as revenue. Costs related to the delivery of a service or creation of a knowledge product are not tracked directly. They hit the income statement as operating expenses. So the cost of building intangibles is mixed in with the cost of operating both the tangible and intangible sides of the business.

At the National Academies, Baruch Lev asserted that the best way to develop standards for intangibles reporting would be to work industry by industry to develop models of what he calls the “structured input-output information on performance of the major drivers of enterprise value.” He supplies two examples of this kind of value chain analysis for the pharma/biotech and telecom/internet industries.

Lev’s argument mirrors those of many others when confronted with the challenge of capturing intangibles in accounting—“we need to understand intangible values before we can account for them.” I think that this argument misses the point. Companies (and their accountants) are not in the business of “valuing” assets.

Think about it. When a company builds a new manufacturing plant, the analysis is not around the value of the plant. It is about the expected cost and return. No one around the table says, “this plant will have a great re-sale value.” The important questions are about how to use the plant to create revenues and profits for the company. The accountants book all the investments and expenses at cost.

Treatment of intangibles should be the same. Managers, accountants, boards of directors and investors should not ask the value of intangibles but, rather, the accumulated cost and expected return. This argument was made very effectively in a Melbourne Institute Working Paper, Measuring Intangible Investment, by L. C. Hunter, Elizabeth Webster and Anne Wyatt.

I stood up at the National Academies conference and asked a question about this. I’m not sure the panel had thought about the issues in this way before so I would like to pose it again and, hopefully, open a conversation about where to go from here:

Aren’t we ignoring a hugely important set of information that is already in every accounting system: the cost of the investments that companies make every year in their intangibles?

Corporations around the world pay to hire people and train them. They pay to develop business processes, implement software (sometimes five times the cost of the software license itself) and perform R&D. They invest in their brands and customer relationships.

If we use macroeconomic data as a guide, the annual investment in intangibles now surpasses tangible investments in the U.S. But, with the exception of R&D, spending on intangibles is not broken out. It passes through the income statement where it is mixed in with true operating expenses.

Couldn’t/shouldn’t every company prepare a report of these intangible investments? It would detail out all the “expenses” that are in the current year’s financial statements that are actually “investments” in the company’s future that are expected to provide value beyond the current year? Accountants are used to this distinction between current costs and future investments; they would just be applying that distinction to create a supplementary report.

The income statement would not be changed. GAAP would be respected. But a company’s stakeholders would have a better view into the long term thinking and investing of its management:

• How are they preparing their people for the future?
• What are their key processes and how are they building them?
• What is their investment in innovation and research?
• How much do they invest in their brand and customer relationships?
• Are they investing in key partnerships?

I would call this something like the “Intellectual Capital Expenditure Report.” It would provide critical information that should be available to managers, boards of directors and investors. Once you get this data over a series of years, you could begin to look at the relationship between spending on intangibles today and increases in revenues and profits in future years. You could also create industry consortia that collect and provide benchmarking data to their members.

I think that having good information on the cost of intangible investments would be a boon for managers and investors alike. Do you agree? How can we get this going? I hope to hear from you by email or through comments on this entry.

This was originally posted by Mary Adams at the Hybrid Vigor Institute.