Getting a Grip on Accounting and Intellectual Property

By Roya Ghafele, Associate Economic Officer, Intellectual Property and Economic Development Department, WIPO ¹

Executive Summary

This article analyzes and explores the possibilities available to companies to report their IP under current financial reporting standards and presents alternative reporting models that IP-rich companies, be they large or small, may employ to enhance their reputation, image and worth in the market.

In most spheres of human endeavor, including business, one looks at the past to draw lessons for the future. As such, financial reporting is essentially a look into the past. Whereas the valuation of a business is an estimation of its future performance, accounting documents its historic achievements. Traditionally, the accounting profession has been eager to underline this distinction. An accounting statement should not contain any speculation and provide objective information. While accounting has consistently met this requirement, the statements it provides to management and the market are heavily biased by a tangible assets' perspective. Worldwide, the current accounting standards leave limited linguistic space to communicate the value of intellectual property (IP). There are few possibilities to demonstrate how the IP owned by a company, particularly that which has been generated internally, relates to its income streams.

As a result, the reported facts are precise but may lack practical significance. The consequences are far reaching: IP, being essentially left hidden in the dark, tends to be not taken fully into account while taking managerial decisions, competing for capital or acquiring market share.

Introduction

Periodically, a business has to take stock of its performance to see whether it is meeting its objectives, in terms of return on investment, profits and market share. The accounts statement of a company provides a numbers-based understanding of its performance and hence affects its valuation as a business. As such, accounting is a powerful tool since it continuously documents the financial situation of a company. The analysis of its periodic accounting reports influences not only the view of its own employees, managers, and owners but also the way it is perceived in the market, for example, by investors and shareholders. A company that beats investors' expectations, set at whatever level, is rewarded by a rise in its market value.

Accounting is however more than a marketing and public relations tool. It seeks to provide business with factual, precise, objective and comparable information. Even in the light of these performance goals, accounting needs to adapt to continue fulfilling its purpose. Under current accounting standards a firm's image is essentially characterized by its tangible assets. Intellectual Property, especially when internally generated, is inadequately addressed in the accounting statement or report. This has far-reaching consequences on how IP is considered at the firm level and how it is being approached by investors.

Overall, the situation is becoming even more challenging in an increasingly knowledge-driven economy, as the key economic resources underlying wealth production are no longer based on competitive advantages in access to and use of land, labor and/or capital, but relate to access to and use of new or original intangible assets, including IP. ²

How do Current Accounting Standards Approach IP?

Trends towards the recognition of IP gain momentum

The accounting profession itself is increasingly aware of the necessity to confront the knowledge-driven economy and recognizes that reporting systems have to be developed that reflect the increasing importance IP has. At various levels, nationally and internationally, there are ongoing scholarly and practical attempts to grapple with relevant issues such as how to identify an intangible, how to account for internally produced intangibles and the conditions under which intangibles may be revalued. Discussions also continue on how to bring these demands at grips with the particular situation SMEs are confronted with. (Scicluna 2002)⁵ For the present, it is generally recommended that companies should endeavor to issue voluntary IP reports, in addition to their financial reports.

Internationally recognized bodies like the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC), which are striving hard for the harmonization of accounting standards at the global level, have recognized the existing gap between the kind of information provided by accounting and the information needed by investors and managers.⁶ (FASB, 2001a &b, SEC, 2001) The concerns raised by the FASB have led to a revision of the way in which IP is treated in Mergers and Acquisition (M&A). The new approach to IP in M&As is generally considered to be a very progressive step as it allows, for the first time in the history of accounting, to separately list the respective IP of the firms involved in the M&A and to put a value on such IP.

Currently, this may well be the best way to approach IP. The paradigms of accounting are so strongly influenced by a tangible assets view that it may be very difficult to give credit to the characteristics of IP on the balance sheet. Most importantly, accounting has difficulties in determining the value of IP. The absence of organized, transparent markets has so far been considered as an additional impediment to measure the value of IP. Since accounting follows the paradigm of recording business items at their price in a commercial transaction, only IP that is licensed or sold can be reflected on the balance sheet. Given the inherent multiple challenges in accurately determining the value of IP, coupled with the volatility of the value of some IP, it is no wonder that the accounting profession (and the market) fears that the reporting of a firm's IP may be considered as too subjective and risky. Furthermore, accounting has always been, and still is, very reluctant to anticipate future gains, overstate the value of assets or include assets on the balance sheet whose value is more volatile.

FAS 141 & 142: Important steps towards the recognition of IP

All along, that is, before the introduction of FAS 141 and FAS 142 in the US General Accepted Accounting Principles (US GAAP), goodwill was the only vocabulary used by the accounting profession to speak about IP. Historically, goodwill has been primarily defined in residual terms, that is, as the price a market participant is ready to pay in excess of the value of a firm's tangible assets. (White G.I./Sondhi A.C./Fried C., 1994) The concept of goodwill is rather vague since anything that justifies a higher price for a company may be lumped under goodwill. This makes it rather difficult to compare the goodwill of different companies, let alone explicitly state the value added of IP.

FAS 141 and 142 revised the way goodwill is treated in Mergers and Acquisitions. Whereas historically the balance sheets of two merging companies were simply added together (called the "pooling of interest for business combinations" method), the newly introduced purchase method requires to identify each single acquired asset and determine its `fair value'. The overall purchase price must be distributed across all business items (intangibles and tangibles) that qualify as assets. Thus, companies have now the possibility to discern the assets lumped together under "goodwill" and value them separately.

FAS 142 abolished the amortization of goodwill. Companies need now to review, on an annual basis, the acquired IP and conduct an `impairment test'. It is currently being discussed as to what extent the International Accounting Standard Number 38 (IAS 38) "Intangible Assets" which still requires the amortization of goodwill over a period of 20 years can be aligned to US GAAP. (FASB Summary of Statements 141 &142) These recent regulatory changes have already had a significant impact on current market practices. For example, in Germany, they have created high demand for the valuation of brands. Since German companies registered in the US (notably most DAX listed firms) can make their income statement under US GAAP, incentives have been strong to report adequately valued trademarks on the balance sheet.

These modifications may be considered as important first steps towards a true and fair appreciation of IP, but further adaptations will be necessary to adequately reflect IP on the balance sheet. Apart from the fact that FAS 141 and 142 address M&A, a transaction in which SMEs may not be very often involved (if at all, SMEs are likely to be acquired by a larger enterprise), the implicit definitions in these paragraphs are not compatible with the characteristics of IP. Under FAS 141 and FAS 142, IP can be accounted for if it qualifies as intangible assets. Much of the IP held in a company will, however, hardly pass that test. According to IAS 38, "an intangible asset must be identifiable, controlled by an enterprise as result of past events and should generate future economic benefits for the enterprise."⁸

Why "fair value" may not tell you everything about IP

A lot of the IP that a company owns has an indirect impact on its cash flows. For example, IP protection often provides a firm exclusivity in the relevant market and/or the `freedom to operate'. Further, IP has an impact on a firm's services or products, its business processes, know-how or tacit knowledge. IP protects the various business segments of a firm, ranging from the looks of its products and packaging (Industrial Design), to its recognition in the market (Trademarks, Geographical Indications), to the protection of the new or improved functional features of products and services (Trade Secrets, Patents). It is primarily the winning interplay of these different factors that create cash flows. To what extent one or more IP items, jointly or severally, successfully contribute to maintain or enhance profits depends on the context in which the IP is used, the supplementary business assets (including human resources) to which the IP relates, and its fit to the firm's vision and overarching strategic goals. Defining only such IP that has direct revenue streams as intangible assets, means mentioning only IP that is being licensed, but keeping silent about the value added by much of a company's other IP that is used internally or in branding.⁹ (Sullivan P., 2000)

This is also one of the major reasons why the notion of fair value does not reflect the value of IP. Under US GAAP fair value is defined as "the amount at which that asset could be bought or sold in a current transaction between willing parties, other than in a liquidation."¹⁰ Accounting standards generally recommend a benchmark approach in order to determine the fair value of an asset.

A benchmark, however, provides little information about the relevance of IP to a particular company. Whereas some assets are general in use, others are special in application. There is no "one size fits all" approach to determining the value of IP. Context is an essential criterion to grasp the true value of IP. Take the example of a patented drug. Whereas it may be of immense value to a pharmaceutical company, which has the necessary knowledge and experience to make use of it, it may be of very little value to, say, a car manufacturer who has no use for it. This distinguishes IP fundamentally from many tangible assets, which are much easier to interchange and are usable in various contexts. (for example, buildings, phones, cars, cameras or machine tools may be used, as such or with some modifications, by many different categories of users.)

A benchmark is also difficult to establish in the absence of active markets. It is relatively easy to determine the value of real estate through a benchmark since the markets are well established and the valuation criteria generally accepted. The markets for IP are, however, much less established and often opaque. Within the context of financial assets this has been recognized by international bodies such as the Basel Committee.¹¹

Acquired and internally-generated IP is treated differently

In the absence of satisfactory answers to these issues, accounting has so far developed a very scarce vocabulary and syntax to communicate the value of IP to investors and managers. In accounting, the financial position of a company is phrased in terms of profits or losses, assets or liabilities. Among these variations, the combinations that accounting currently allows to phrase IP are rather unsatisfactory and even the internationally most widely-accepted standards, the US GAAP and the International Financial Reporting Standards (IFRS) (formerly called the International Accounting Standards - IAS¹²) are not well equipped to deal with IP.

Internally generated IP is treated as an immediate expense. The same applies to Research and Development (R&D) related to the creation of IP. This means that the balance sheet offers distorted information on how IP is made. The costs incurred for the creation of IP are reported at one single point in time, while the IP is accounted for only in the context of a commercial transaction. However, this approach is not exclusively reserved for IP, but reflects the general way in which the accounting profession approaches a business.

Unlike internally-generated IP, acquired IP is reflected on the balance sheet; for example, according to US GAAP, IP is valued at its acquisition cost and amortized over a maximum period of 40 years. However, this may lead to serious confusion; whereas internally-generated IP is considered to be worth nothing, the IP that change hands may be worth hundreds of millions of Dollars. Thus, a company which decides to sell or license internally generated IP appears to create profits virtually out of nothing, as the IP that generated these profits does not appear on its balance sheet. To outsiders, this might look like magic, whereas it is nothing but the expression of unfortunately stated information. (Licensing Executive Society, 2002)

What Impact Does it Have on SMEs?

IP exists independently of a product or service, and, therefore, is valuable to a business whether there exists an adequate reporting system or not. However, profits and losses currently reported by a business may not adequately reflect its economic profitability if IP is responsible for the success of the business model and/or its business strategy. As IP is not explicitly stated on the balance sheet and investments in creating IP are usually expensed as they occur, both the earnings and the book value of equity are understated by the accounting model. (Caninbano L./Garca-Ayuso M./Sanchez P., 2000; Lev B./Zarowin P., 1999; Brown S./Lo K./Lys, 1999) The consequence of this is twofold. Firstly, the cost of capital increases, meaning that IP-intensive SMEs may find it even more difficult to pass the funding hurdle. Secondly, the management of a company becomes a much greater challenge since adequate information on all the assets and liabilities of a company is not available. (The chart "Advantages of Reporting IP" illustrates how IP accounting can ease the task for managers and investors.)

Costs of capital increase

For investors "no news is bad news." Investors charge a premium in deals where the risk rate cannot be adequately determined, increasing henceforth the costs of borrowing money for the creditor. After all, almost all those who invest in a business do so in an honest attempt to make more money than may be possible through alternate legitimate means, such as earning interest on the sum invested in a bank deposit or shares. The perception of risk is, however, not caused by the underlying IP, but by a financial reporting system that provides investors with insufficient financial information about such IP. In this situation all firms, including SMEs, find it increasingly difficult to pass the funding requirements of financial institutions. Due to current reporting standards, IP is absent from the discourse in accounting and financial circles. Since information about IP is not adequately communicated, there is a lack of awareness and a high degree of skepticism surrounding the possibilities of financing on the basis of IP. This results in ensuring that investors continue to adhere to their traditionally reluctant approach to funding of SMEs on the basis of their IP.

At the stock exchange, sectors that strongly depend on IP, like high technology or pharmaceuticals, are considered more risky and the stocks are more volatile than those of tangible assets based industries. Besides technological risk factors that are inherent to innovation, this can be explained by inadequate capital market communication about IP. Since accounting is not tailored to IP, investors are provided with little or inadequate information on a firm's IP assets and liabilities. It is, therefore, difficult to adequately assess the risks and benefits of an investment. The information vacuum on IP distorts widely used performance measures. Commonly used valuation ratios such as the price/earnings ratio, the price/sales ratio or the market/book value may be considered distorted due to the inadequate reporting of IP. These ratios are calculated on the basis of the data provided in the balance sheet. Since IP is missing in the financial report, the calculations do not well reflect the profitability of a business. (Lev B./Sarath B./Sougiannis1999)

IP management is hampered

The scarce reporting of IP influences also the managerial process. Since the bulk of the space on the balance sheet is occupied by tangible assets, the focus of management is concentrated on these assets, which, in an increasingly knowledge-driven economy, are no longer the main determinants of the success of an increasing number of businesses in not only high-tech industries, but in all knowledge intensive and/or creative industries.

"Companies today are spending a majority of their time managing a minority of their assets (the tangible one's)" explains Roger Carlile, "with the pressure on management for bottom-line results, it is difficult to persuade CEO's to spend money on installing processes for managing IP company wide if they can not see any value."¹³

The lack of visibility of IP on the balance sheet makes it very difficult for management to shift the focus to developing and honing their IP strategies. A study conducted by the management consulting firm McKinsey & Company found that in the US companies create on average not more that 0.5% of their operating income from the licensing of IP. McKinsey, however, calculates that firms could earn up to 10% of their revenues from the sale or licensing of IP. (Elton J./Shah B./Voyzey J. 2002) Rivette and Kline estimate that 67% of US companies own IP that is in no way commercially exploited, underlining the gravity of inadequate communication. (Rivette K. G./Kline D. 2000)

So, What can SMEs do?

Communicate, communicate, communicate!

International accounting regulations are most comprehensive in the area of intangible assets and increasingly difficult to understand even for accountants themselves. While mathematical language is precise, clear and brief, it takes away the nuances and detail that is so relevant for adequately communicating the value of IP to all concerned. While discussions on accounting reforms continue, SMEs that rely heavily on the use of IP are best/advised to voluntarily disclose their information on IP that they own or have access to through licensing, franchising, merchandising or leasing. An IP report issued together with the accounting reports can be considered as a good interim solution to overcome the current communication gaps. The advantages of issuing an IP report by far outweigh the related costs. To start with, the process of creating an IP report itself results in developing a new mindset in the management. An IP report is a potentially powerful tool that can be used to significantly improve a firm's perception of itself and, hence, contribute to improving its position in the eyes of investors and other players in the market.¹⁴

The points listed below should serve as a useful guideline for the creation of a simple IP report. Please note that an IP report should not disclose any trade secrets or other information that is required to be kept secret. It should not merely list the IP, but seek to explain how a firm's IP relates to its business strategy, for example, how it provides it with exclusivity in the market, access to scarce resources or to new markets. It is equally important to do an IP audit, which requires, amongst other things, the determination of the legal scope of the protection of the IP and seeks to understand how top executives are currently approaching the management of IP and what needs to be done in the foreseeable future to get the best out of the IP of the enterprise. Whereas many SMEs may be able to easily develop a simple IP report themselves, they are advised to consult an IP professional for undertaking an annual IP audit.

Guidelines for preparing an IP report

• Provide a narrative summary:

- Analyze and explain the basic business model, plan and strategy and show how the IP contributes to the bottom line of your business.
- How do you make money and what role does the IP play in it?

• Relate your income streams to your IP :

- What were the returns from IP-protected business segments?
- How do your trade secrets / patents contribute to the new / improved / superior / better- functionality or features of your services/products as compared with those of your competitors?
- How do/does your trademark(s) contribute to your company's or your company's products' / services' image, recognition, reputation or branding strategy in the market in developing customer loyalty or attracting new customers?
- Do you use industrial designs to protect the unique look or packaging of your products?
- How do your trade secrets, such as know-how or business ideas, make your company unique?

• Relate the IP to your position in the market:

- Does the ownership of IP help you to gain/secure/improve your market share or profits?
- Are you using IP as an entry barrier to keep competitors out of a particular market?
- Does the IP of your competitors pose a threat to your business?
- Do you have "freedom to operate" in using your own new ideas, concepts, inventions and innovations, without being required to take prior permission (which may involve making a payment) of someone else (say, a competitor) to develop a new/improved product/service or add new features to an existing product/service?
- Does your IP provide you with some form of exclusivity in the market, and, if yes, for how long?

• Demonstrate your managerial skills:

- Are you pursuing a systematic strategy to exploit the commercial benefits of your IP?
- Have you understood how the exploitation of your IP relates to other complementary business assets that may be critically needed?
- How is your R&D focus aligned to your IP strategy and to your commercial goals?
- How do the financial plans for managing your IP relate to your overall financial and business goals?
- How determined are you to extract (further) revenue from your IP?
- What experience do you have in managing IP?
- How are you leveraging your IP to develop new relationships and business partnerships?

• Understand the legal scope of the IP rights :

- What level of practical protection does your IP have in a given business environment?
- Can you operate in the market without infringing the IP rights of other market participants?
- How likely is it that competitors will legally steal your ideas or creative expression or find legitimate ways to circumvent your IP and thereby effectively free ride on your creativity and innovation?
- What is the risk of pirates and/or counterfeiting negatively impacting your market share, and to what extent?

References

Basel Committee on Banking Supervision: Report to G7 Finance Ministers and Central Bank Governors on International Accounting Standards. Basel 2000, http://www.iasplus.com/resource/basel1.pdf

Brown S./Lo K./Lys T.: Use of R2 in Accounting and Research: Measuring Changes in Value Relevance over the Last Four Decades, Journal of Accounting Economics 1999/28.2

Caninbano L./Garca-Ayuso M./Sanchez P.: Accounting for Intangibles: A Literature Review. Journal of Accounting Literature 2000/19

Carlile R.: Interview in: Intellectual Property: Managing all-important intangibles of the information age. www.jang.com.pk/thenews/investors/may99/temp/temp6.htm

Elton J./Shah B./Voyzey J.: Intellectual Property: Partnering for Profit. McKinsey Quarterly 2002/4, http://www.mckinseyquarterly.com/article_page.asp?ar=1248&L2=21&L3=35&srid=9&gp=1

FASB (Financial Accounting Standards Board): Improving Business Reporting: Insight into Enhancing Voluntary Disclosures, Steering Committee Report, Business Reporting Research Project. 2001 a

http://www.fasb.org/brrp/brrp2.shtml

FASB (Financial Accounting Standards Board): Business and Financial Reporting, Challenges from the New Economy. Special Report. Financial Accounting Series. 2001 b

http://www.fasb.org/articles&reports/new_economy.shtml

FASB (Financial Accounting Standards Board): Summary of Statement Nr.142 "Goodwill and other Intangible Assets", http://www.fasb.org/st/summary/stsum142.shtml

International Accounting Standards 38, London 1998, http://www.iasplus.com/standard/ias38.htm

International Intellectual Property Institute: Accounting Standards in the New Economy:

Executives Address Reporting the Value of Intellectual Property, Washington D.C., May 1 2002, http://www.usa-canada.les.org/membersonly/committees/professional/financial/IIPIAccounting.pdf

Lev B./Sarath B./Sougiannis T.: R&D Reporting Biases and Their Consequences. New York University 1999, http://pages.stern.nyu.edu/~blev/research.html

Lev B./Zarowin P.: The Boundaries of Financial Reporting and How to Extend Them. Journal of Accounting Research 1999/37.3

Licensing Executive Society: Transcription notes of the F-16 Committee Meeting: Reporting Intellectual Property, Washington, D.C., May 2, 2002,

http://www.usa-canada.les.org/membersonly/committees/professional/financial/F_16.pdf

Moehrle Stephen R./Reynolds-Moehrle Jennifer: Say good-bye to Pooling and Goodwill Amortization, Journal of Accountancy 2001/9 http://www.aicpa.org/pubs/jofa/sept2001/moehrle.htm

Page N.: IP-backed Securitisation: Goldmine or Hype? In: Intellectual Asset Management 2003/2

Rivette K. G./Kline D.: Rembrandts in the Attic. Unlocking the Hidden Value of Patents. Cambridge MA 2000, Harvard Business School Press

SEC (Securities and Exchange Commission): Strengthening Financial Markets: Do Investors Have The Information They Need? A Report by the SEC Special Task Force. 2001

http://www.mba.yale.edu/news_events/sec_exec_sum.htm

Scicluna B.: Accounting by Small and Medium Sized Enterprises. http://www.miamalta.org/MagJUne02Page05.htm

Sullivan P. H.: Value Driven Intellectual Capital. How to Convert Intangible Corporate Assets into Market Value. New York 2000. John Wiley

White G.I./Sondhi A.C./Fried D.: The Analysis and Uses of Financial Statements. New York 1994. John Wiley

Woodward C.: Accounting for Intellectual Property, London 2003, PriceWaterhouseCoopers, http://www.pwc.com/gx/eng/ins-sol/publ/ipvalue/pwc_2.pdf

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¹ The opinions and views expressed in this article are solely those of the author and should not be attributed to WIPO. Any comments or suggestions pertaining to this article may be sent to: roya.ghafele@wipo.int. Many thanks to Guriqbal Singh Jaiya, Christopher Kalanje and Esteban Burrone for thoughtful comments and ideas which strongly enhanced the value of this article.

² PWC estimates that in 1998 intangible assets accounted for 78% of the total value of S&P 500 listed companies. http://www.yesmfs.com/EnglishVersion/GeneralDemo/GDCi.htm

⁵ At the international as well as at the national level discussions continue on how to simplify accounting standards in order to make them more accessible for SMEs. The Commission on Investment, Technology and Related Financial Issues of the United Nations Conference on Trade and Development (UNCTAD) has established a Working Group on the subject matter. At the national level, countries such as Malta or the UK have equally initiated studies exploring the accessibility of accounting standards for SMEs.

⁶ In 2001 the FASB stated that: "Companies are encouraged to continue improving their business reporting and to experiment with types of information disclosed and the manner by which it is disclosed." FASB (Financial Accounting Standards Board: Improving Business Reporting: Insight into Enhancing Voluntary Disclosures, Steering Committee Report, Business Reporting Research Project.)

⁸ International Accounting Standards Committee: International Accounting Standards 38, London 1998, can be found for example at: http://www.iasplus.com/standard/ias38.htm

Under US GAAP intangible assets are understood in much the same way.

⁹ For this reason we have chosen to refer to IP, rather than "IP assets" which as a terminology derives from traditional accounting notions.

¹⁰ Definition taken from FAS 141 & 142. IAS 39 considers the notion of fair value in much the same way.

¹¹ The Basel Committee for the Review of Banking Regulations concluded that:  "In the absence of active markets it will be difficult to obtain or calculate a reliable fair value for certain non-marketable financial instruments held at cost...it concluded that it does not believe the time is right to proscribe full fair value accounting... for all financial assets and liabilities." Basel Committee on Banking Supervision: Report to G7 Finance Ministers and Central Bank Governors on International Accounting Standards. Basel 2000, p.3, http://www.iasplus.com/resource/basel1.pdf

¹² See http://www.cpaaustralia.com.au/01_information_centre/17_standards/1_17_2_0_ifrs.asp

¹³ Interview with Roger Carlile, partner at the accounting firm KPMG. In: Intellectual Property: Managing all-important intangibles of the information age. www.jang.com.pk/thenews/investors/may99/temp/temp6.htm

¹⁴ Lev demonstrated how relevant capital market communication on a drug approval impacted the share price of pharmaceutical companies. When the drug approval was released without any further statements the share increased by 0.51%, when it was accompanied by qualitative information the share rose by 1.13% and when quantitative information was added it went up by 2.01%. In Lev B.: Communicating Knowledge Capabilities. New York University 1999, http://pages.stern.nyu.edu/~blev/research.html