Intangible assets: A ticking time bomb. (Chief Concern).
Intangible assets are a firm's nonphysical sources of value, such as its patents, brands, trademarks, copyrights, customer lists and other intellectual capital. According to a recent study by the Brookings Institution, such assets represent nearly 70 percent of all corporate wealth today--and yet they rarely show up on the balance sheet.
It is this enormous reservoir of "hidden" wealth--the principal asset base, in fact, of most American businesses today--that the Securities and Exchange Commission and the Financial Accounting and Standards Board now insist must be disclosed so that investors can obtain a more accurate picture of a company's financial health and future prospects.
Under the new accounting standards, all acquisitions must be reported under the "purchase method" of accounting. Accordingly, any acquired intangible assets, such as assets, that have a "separable" identifiable value as well as a "finite" life-span must now be reported separately from goodwill, properly valued and then amortized over their useful lives.
The goodwill portion of the purchase price, on the other hand-the portion not based on the target firm's tangible or identifiable, intangible assets, as the Financial Accounting Standards Board defines it-need no longer be amortized.
And therein lies the incentive for financial manipulation. Most firms are extremely reluctant to report an item that may negatively impact earnings, such as the intangible assets now subject to amortization. As a result, companies and their auditors find themselves pressured to either underestimate the value of their amortizable intangible assets, or to simply attribute them all to "goodwill" and not amortize them at all.
According to one appraisal industry trade publication, "Companies are now fighting tooth and nail to maximize goodwill and minimize other intangible assets in reporting an acquisition," because "every dollar allocated to goodwill does not impact future earnings, while every dollar allocated to intangibles will result in a future charge to earnings and a reduction in earnings per share." This desire to maximize goodwill and minimize other intangibles, however, could easily create big problems down the road.
For example, imagine you're the CEO of a medical device company and you've just completed the acquisition of a smaller competitor. Although the fair value of the acquired firm's tangible assets was only $300 million, you convinced your board that an $800 million purchase price was reasonable, given the target firm's proprietary technology, sales growth and leading market position. What's more, you assured the board that since your accountants planned to allocate the vast majority of the $500 million premium to "goodwill," the firm would be able to minimize any earnings hit from amortization charges.
Six months later, however, the SEC comes knocking at your door. It challenges your goodwill allocation, pointing out that a major portion of the acquired firm's revenues were derived from products highly dependent upon patent protection for their success.
In the end, the SEC determines that you should have allocated $200 million of the $500 million premium to these acquired patents, and then amortized the value of those patents over their useful lives.
So now you must go before the board and explain to them why the company will be forced to pay a hefty SEC fine, restate its financials, reduce earnings estimates and suffer the major hit in stock price that is likely to result when investors hear about this reporting "error." Not fun at all.
Multiply the above scenario by the several thousand firms each year that engage in mergers or acquisitions, and you start to comprehend the scope of the problem.
In dealing with these new SEC rules, therefore, it's critical that CEOs avoid employing "financial engineering" techniques that lack substance or mislead investors. In fact, proper compliance with these rules is in the best interests not only of investors, but of companies themselves.
After all, had the CEO in our imaginary acquisition scenario properly identified and valued the target firm's intangible assets prior to the deal in anticipation of having to meet the new reporting requirements, he or she would have been able to factor in the expected post-deal amortization costs when pricing and structuring the deal. What's more, this due diligence may have also revealed that some of the target firm's key patents were due to expire soon, knowledge the CEO could have used to possibly reduce the deal's purchase price.
Intelligent compliance with the rules also would have enabled this company to avoid some of the longer-term risks of undervaluing its intangibles. An artificially low valuation for acquired patents, for example, could come back to haunt the firm during subsequent patent licensing negotiations or infringement litigation unless it can show an appropriate rationale for those earlier numbers. Or the "goodwill" that the firm was so eager to record for its intangibles might itself have to be written down as a result of the annual "impairment" tests that are mandated under the new rules. Worse still, these impairment write-downs, if large enough, could even place the firm in violation of its credit agreements by cutting the book value on which its loan covenants are based.
To be sure, the amortization costs incurred under the new rules can reduce reported earnings. But investors often discount such noncash charges anyway. What they do not forgive are surprise earnings restatements that suggest that a firm's financial reporting is confused at best and deceitful at worst.
The irony is that the new reporting rules actually present CEOs with a tremendous opportunity to restore investor confidence. By going beyond the bureaucratic letter of the rules and embracing their spirit of transparency and investor empowerment, CEOs can demonstrate to investors how the company's principal (i.e., intangible) assets support its business strategy and enhance its commercial success in the market.
CEOs could, for example, provide metrics that show more clearly how their firm's patents protect earnings in core markets, boost return on research and development investment and create a more sustainable competitive advantage for the company.
How effective is the firm's R&D program, for example, as measured by the percentage of its patents successfully commercialized? What's the value of these patents in the marketplace, as indicated by the increased market share and margins of the product lines they protect? And how strong and diversified is the company's team of inventors, as shown by their patenting productivity compared to that of inventors from competing firms?
These are the sorts of disclosures that could give investors real insight into a company's true financial health and future prospects. That's because in today's knowledge economy, intangible assets play a critical role in firm competitiveness and the creation of shareholder value. Savvier CEOs understand this, of course, and strive to foster the continuous development, protection and renewal of proprietary intellectual assets. In fact, many leading companies have formed intellectual property management subsidiaries to focus that effort.
But whether or not companies embrace intangible asset reporting with that degree of strategic vision, one thing is certain: There's simply too much at stake for the SEC--and for investors themselves--to allow the current reporting confusion and lack of transparency to continue much longer.
After all, the balance sheet problems uncovered at Enron and other firms threatened the assets of only a few large corporations. The muddle over intangible asset reporting, on the other hand, could involve thousands of public companies in America. And now is the time for CEOs to take clear leadership on this issue.
Daniel M. McGavock is the president of Chicago-based InteCap, a financial consulting firm specializing in the valuation and strategic management of intellectual property. Send comments to firstname.lastname@example.org.