Counting Intangibles

The International View

May 02, 2003

The Project on America and the Global Economy (PAGE) together with the Athena Alliance co-hosted the second in a series of sessions on accounting standards for intangible assets in the post-Enron era. The focus on intangibles and accounting is part of a broader PAGE initiative that is designed to explore the outlines of the American and global economies in the early 21st century. Kent Hughes, director of PAGE served as moderator and Kenan Jarboe, President of the Athena Alliance, coordinated the questions.

The May 2, 2003 session focused on the work of the London-based International Accounting Standards Board (IASB). To secure a better understanding of international developments, the co-hosts turned to Kurt Ramin, Commercial Director of International Accounting Standards Committee Foundation. Ramin emphasized the truly international nature of the board by noting the range of countries represented on the various decision-making bodies of the IASB. For instance, Paul Volker, formerly Governor of the Federal Reserve Board, currently serves a chair of the IASB's Trustees.

In his talk, Ramin touched on three broad activities of the IASB. First, Ramin reminded the participants that the European Commission requires all listed EU companies to prepare consolidated accounts using the IASB's International Financial Reporting Standards. Second, he spelled out some of the differences between America's Financial Accounting Standards Board (FASB) and the IASB. Third, Ramin mentioned some of the work that the IASB is doing to develop standards in the field of intangibles.

The financial press frequently reports that FASB relies on detailed reporting standards while the IASB relies on broader principles. In practice, Ramin noted that the IASB principles had become considerably more detailed over time with the full set of standards now running to some 1600 pages. In addition, there has been a growing convergence between the two systems. Active discussions are underway to either harmonize standards or develop functional equivalents. Ramin and the IASB's goal is to have IASB and FASB standards similar enough that the 1200 or more European companies currently listed on American exchanges would not have to translate their European reports into American standards. To see the current differences, Ramin referred participants to 20 F filings by European companies with the Securities and Exchange Commission.

In the treatment of intangibles, the IASB is considerably ahead of its American counterpart. FASB intends to work in the intangibles area but is currently focusing on better defining the accounting treatment of various financial instruments.

For the IASB an intangible asset is "an identifiable, non-monetary asset without physical substance held for use in the production or supply of goods or services, for rent to others, or for administrative purposes." To do determine an assets fair value, the IASB looked to the price as determined in an arm's length transaction. The IASB approach could be applied to patents – an identifiable asset that could be linked to a marketable product or process. There are other assets that are much more difficult to identify with a single product. For instance, the key to many companies is having a team that can successfully innovate, maintain quality or discover new markets. Yet there may not be an easy way to determine the team's market value.

In the discussion, Ramin and the participants noted that accounting rules have an enormous impact. Part of the Enron debacle could be traced to how little information Enron had to put in various financial footnotes to their reported accounts. The consequences of accounting standards can also have a significant impact on the process of innovation. For instance, under FASB rules costs for research and development are expensed, that is they are subtracted from reported earnings in the year in which they incurred. IASB rules, however, expense only the research costs while the development costs can be amortized or deducted over a number of years. Because the impact of development costs on earnings is spread out over a number of years, the company operating under IASB rules will show greater earnings in its first year. If the American company is concerned about reporting higher quarter to quarter earnings they may decide to reduce costs that must be expensed and instead buy additional capital equipment that can be depreciated over time.

Participants also noted that FASB's different treatment of internally versus externally acquired intellectual property could affect the strategy and structure of a major company. The discussion revolved around a hypothetical pharmaceutical company. If the company develops a new drug internally, it cannot take a yearly charge against earnings to reflect the declining value of the patent. The situation can be quite different, however, if a company buys a small, innovative company with a valuable patent. Anything the company pays beyond the book value (including the buildings, equipment, and accounts receivable) will be recorded as goodwill – a broad category that includes many intangibles. In this case, FASB allows the company to reduce taxable earnings (and hence increase cash profits) by amortizing (or deducting against earnings) the goodwill over time. In effect, the interaction of the accounting rules and the tax code encourage a firm to rely on outside research rather than innovating itself.

In the United States and around the world, accounting standards are under renewed scrutiny. In a complex global economy, a single approach to accounting may conceal as much as it reveals. Establishing and enforcing the right rules will be critical to allocating capital to intangible as well as tangible investments.