Accounting for Intangibles - The Income Statement is Not the Answer

I guess it’s time to talk about Accounting for Intangible Assets: There is Also an Income Statement by Stephen Penman. When this new paper first came out from the Center for Excellence in Accounting & Security Analysis at Columbia University, I decided to ignore it as an apology for current accounting standards–which are completely inadequate for the knowledge era.

But now the paper is getting more attention so I feel the need to answer it.

We are not talking about some theoretical accounting issue.  70% of the value of the average M&A deal is intangible. 60% of the average corporate investment is intangible. 50-80% of the average public company is intangible. That means that intangibles are ignored by accountants (the only real exception is in the case of a merger, when the lack of understanding ends up as 50% of the purchase price going to goodwill). None of this is helpful to the cause (and stated mission of Columbia’s center) of “excellence in accounting and security analysis.”

Penman’s argument explains all the reasons that intangibles cannot and should not be booked to a balance sheet today. These include:

• Intangible asset  is a “speculative notion” - This is a common problem for accountants. They cannot see an intangible so how can it be real?
• “Intangible assets involve using assets jointly” - This is a related problem. The utility of intangibles is related to their use in a system. (This is why we help companies model their IC as a system)
• The cost of intangibles “would be hard to identify” - This I don’t buy. Every day, accountants make a distinction between money spent on current operations (an expense) versus money spent on building future capacity (an investment).
• “Establishing an amortization schedule would typically be quite speculative” - He’s right. It would be. It’s one of the key reasons why we cannot create new accounting standards…yet.

I agree or at least am sympathetic to all his points. Actually, he left out the most important reason that a lot of intangible capital will never end up on the balance sheet: many assets (especially human and relationship capital) are not owned by the corporation. They don’t belong on the balance sheet.

But what’s the solution? Here’s where I disagree with Penman.

He makes the argument that the income statement is sufficient for understanding intangibles:

” This is the brilliance of accounting: rendering a performance measure from organizing assets under a business plan. With this summary measure,there is no need to identify intangible assets (or even to ask if they exist); one just observes earnings generated by the business plan.”

I call this the black box argument. Basically, if you pour money into intangibles (and companies do, to the tune of $1.6 trillion per year versus $1.2 trillion in tangibles), then you will see money come out on the bottom line.

This argument is basically justifying the status quo.

And we shouldn’t settle for the status quo.

Our corporations and our nation are at a crucial moment. We need innovation and growth in the worst way. That innovation and growth will come through the application of our knowledge. Knowledge is embedded in an organization in intangibles. It’s not just good enough to basically accept a model that cannot account for over half of the value of the average corporation.

So what’s the answer? Start simple and start with the most concrete information we have. What is that? The $1.6 trillion being spent every year by corporations on building their intangible capital infrastructure. Do it as a management report. Do it to learn about the levels of investment. Do it to begin to track the patterns of investment and performance over time.

For now, this information won’t be clean enough to be reported externally. But if I were an investor or an analyst, I would still ask the question: How are you spending your money on future capacity? How does your annual intangible capital expenditure break down?

This won’t affect GAAP (or IFRS either). But it will begin to get this important “asset” class into the mainstream business and financial discussion. And it won’t be a minute too soon.