Intangibles

By Humphrey Nash

What are Intangibles?

Accounting intangibles are knowledge, personnel, skills and training, patents, copyrights, franchises, reputation, R&D, structure, relationships, morale, unity, brand name, experience, flexibility, creativity, product quality and value, customer base, communications, etc.   Intangibles are what Alfred P. Sloan referred when he said,

"Take my assets - but leave me my organization and in five years I'll have it all back."

Intangibles are 96% of the value of the world's most successful company -- Microsoft.   The rest is book value.

Importance of Intangibles

In bygone mercantile and manufacturing economies most value was tangible: land, building, equipment, inventory, or financial assets: stocks or bonds and the like.   In today's economy, much value, perhaps most new value, is intangible and can't be accounted for as traditional accounting tangibles.   The importance of intangibles is widely acknowledged, but identifying, measuring and reporting intangibles has raised questions.

An accounting system that ignores intangibles and ignores the future cannot maximize the future.   To the degree that retrospective accounting is used for decisions, it will deliver the wrong message and retard economic progress

"Historical-cost accounting convention generally requires investment in intangibles to be written off as current expense rather being recorded as assets on company balance sheets.   The immediate consequence is that book values depart ever further from true equity values and earnings are distorted because of mis-recording of expenses.   A further consequence is that earnings distortions tend to cause systematic distortions in management decisions, undermining shareholder values"              Bruce W. Morgan

Current Treatment of Intangibles

The cost of intangibles is generally treated as a current expense, not capitalized despite future utility or benefits that may arise.   The accounting message is that intangibles are of negative current value; the reality is that intangibles generally have positive present value because they are a major source of future value.   Traditional accounting sends the wrong message to management.   Even if management can see beyond short-term accounting, the shareholder may not and may pressure management or make incorrect decisions themselves.

The absence of intangible value in traditional accounting means that today's financial statements lack relevance.   The balance sheet may state "shareholder equity" at a fraction or a multiple of the intrinsic, economic or market value of a company.   The income statement may not be indicative of the economic or shareholder value added over the reporting period.

One possible traditional accounting treatment is to capitalize the expenses of intangibles and depreciate or amortize them over some future period.   This creates a problem in attempting to identify a variety and multitude of past intangible investments and to separate them from normal operational expenses.   Intangibles also must be somehow quantified and some depreciation or amortization method and some timeframe must be selected.   This is a tangled web.

Some intangible assets may have little or no cost but may have substantial future benefits.   These may be innovations, improved employee morale, favorable environmental conditions (business, tax, interest rates).   For these intangibles capitalization has little meaning.   Some intangibles are liabilities.   There may or may not be an associated current benefit which could be "capitalized" (immediately recognized).   The past cost or past benefit is not the issue.   The future is the issue.   Immediate recognition of both future assets and liabilities is the prospective accounting treatment.   The Present Value of Expected Cash Flows (PVECF) provides a complete and balanced recognition of the future and its values, including those arising from intangibles.

Prospective Treatment of Intangibles

How does the accountant measure intangibles within a prospective accounting system?

The cute thing is that he generally doesn't need to!   The current Solution of the Month (see end of essay for a reprint) describes briefly how a prospective model incorporates existing intangibles and captures new intangibles.

Prospective accounting models, such as AFTF, eliminate the need for capitalization (future matching) because matching is accomplished within present values.   By taking the present value of future cash flows, which includes the beneficial effects of intangibles, the cost and benefits are matched with due consideration to the cost of capital (discount rate used for present values).

Conclusions

It is clear from the description of intangibles in the first paragraph of this article that intangibles are the major value drivers of our new economy.   In order for accounting to contribute to the value creation process it is necessary for accounting to measure value, especially value arising from intangibles.

A prospective accounting model, such as AFTF, is relevant and complete.   These characteristics solve many of the thorny problems of traditional retrospective accounting.   In particular, the problem of intangibles is solved in a relevant, reliable, and feasible manner.

Problem of the Month

Traditional retrospective accounting ignores accounting intangibles.  This omission is well known and acknowledged and so are the effects of this omission.  One effect is that "There is a growing and dangerous gap between balance sheets and market valuations".  This gap is primarily a balance sheet failure.  To some degree the gap could represent a market valuation failure; if that is the case, it is a result of the lack of relevant and believable financial reporting.

Clearly accounting needs to be fixed, but there are difficulties.  One difficulty is identifying what these intangibles might be; they are hard to put your finger on.  Another difficulty is assigning a meaningful or reliable value to accounting intangibles.  For example, what value do you place on the intellectual or human capital of a corporation like Microsoft (the capital market's answer for Microsoft is about $10,000,000 per employee based on 50,000 employees!).

Solution of the Month

The solution to the problem of intangibles lies in the answer to the question; why are intangibles of value?  The answer is that intangibles eventually manifest themselves as tangible future cash flows.  Hence, all we need to do, to capture the value of intangibles, is to measure the effects of those intangibles.

AFTF is a prospective accounting model which eliminates the traditional concept of an asset.  AFTF assets and liabilities are defined in terms of the Present Value of Expected Cash Flows (PVECF).  In particular, assets are defined as the present value of expected cash inflows, regardless of whether the cash inflow arose from a traditional accounting tangible or a traditionally ignored accounting intangible.  Under AFTF, it is not necessary to distinguish tangible from intangible things.  In fact, the normal AFTF perspective attaches values to decisions not things.

For example, it may be decided to undertake a large new employee training program.  The benefits of such a program may be greater employee professionalism, enhanced employee creativity, increased productivity, fewer mistakes, improved communications, better morale and team spirit.  These benefits will affect future cash flows.  It may be difficult to assess those benefits but that assessment (cost/benefit analysis) is a prerequisite to making the decision to invest in training.  Hence, AFTF only requires what good management and an informed decision process already requires.  Good management should welcome prospective accounting; poor management must welcome prospective accounting.

AFTF is a disciplined prospective accounting model.  In particular, AFTF scales values to historic capital market valuations.  The "dual validation" guarantees this.  The "dual validation" also guarantees that the historic value of existing intangibles is captured since the dual validation requires that past cash flows be reproduced by the cash flow model.  New intangibles, like employee training, may be added.  If they are, they will emerge, under good management, as value added.