Accounting for Intangible Assets in times of crisis
Bill Gates of Microsoft made an interesting comment about intangible assets:
'The law requires circa 40 pages of figures in the annual company report but these figures represent only 3% of the company’s value and assets. The remaining 97% are the company's intangible assets'.
Historically, corporate success has been built on physical assets and improving manufacturing efficiency; this is in contrast with leading businesses in the new economy (think of Google, Facebook, biotechnology companies etc.) which use ideas and market positions.
The most important assets for many businesses are now brands, market positions, knowledge capital and people, which are rarely recognised in the financial statements.
Recognising intangible assets - the key questions
The reason that such intangible assets are rarely recognised is due to the difficulty in answering the following questions:
- How should these assets be valued? (e.g. how would you value the Facebook brand?)
- Can a company demonstrate that it has control over the future economic benefits from the asset? (e.g. what would happen if someone invented a better search engine than Google? Would users soon forget about Google?)
- Is it probable that there will be future benefits? (e.g. will research expenditure incurred result in future economic benefits?)
When money is spent to acquire a resource like labour or machinery or software etc. there are two ways of showing this spending: Either it shows as expenditure in the year it is spent and therefore profit is reduced (or losses increase) or you show this as an asset in the balance sheet until income is generated from this asset and in those years of income generation you then spread the cost of the asset against that revenue. This is why the three questions are important.
Example: pharmaceutical company
Would you invest in the following company based on the summarised financial information?
On the face of it, the financial statements are not very attractive as the company has reported losses of $46,273,000 million in the current year and it has net losses in its reserves of over $118 m.
But taking a closer look, the most interesting item on the company's financial statements is the research and development expenditure of $16,183,000.
In the preceding two-year period the company had incurred research and development expenditure of $11,426,000 + $12,710,000 = $24,136,000. There must be some value to that!
However, we are not allowed by accounting rules to show this as an asset; it must be 'expensed' in the year we spend the money.
The following news story was published in the New York Times in January 2014:
"Shares of a small biotechnology company nearly quadrupled Thursday after a clinical trial suggested the firm might have the first effective treatment for a fatty liver disease associated with the nation’s epidemic of obesity. Shares of the company, Intercept Pharmaceuticals, rose from $203.48, to $275.87, after a clinical trial of its drug was stopped earlier than expected because the drug was working so well. The trial was testing the drug, called obeticholic acid, as a treatment for nonalcoholic steatohepatitis, or NASH, which affects millions of Americans and can lead to cirrhosis and liver failure."
Should the research expenditure relating to this new drug have been recognised on Intercept Pharmaceutical's Statement of Financial Position as an intangible asset?
This is not as easy as it sounds. There are some very difficult questions to answer from an accounting point of view, in order to ensure the financial statements fairly present the financial position of a company:
- How would one value this potential new drug? (the amount of research expenditure incurred may not be representative of what the new drug is worth.)
- Can the company control the benefits from the new drug? (is its patent protected? If yes, when do the patents expire?)
- Is it probable that the future economic benefits from this new drug will flow to the entity? (notice that the word used in the press is 'might have', therefore this new drug is not yet official.)
Controversial accounting areas such as these require judgement so that the financial statements fairly reflect the results and financial position of the company.
Accounting standards like IFRS provide guidance, but to be able to interpret the financial statements you need to know what is allowed to be recognized and to what extent.
While IFRS may allow some capitalization of development expenditure as an asset, US GAAP is surprisingly much more strict and does not allow any research and development costs to be included as assets – all going to the income statement as above.
In times such as the current one with the crisis looming over most businesses, if the answers to the above questions cannot easily be given it will become probable that intangible assets that were accumulating will now suddenly become expenditures, driving profits down.
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