by
Christoph Kuhner∗
Paper presented at the International Conference on “Managing Enterprises of the New Econ- omy by Modern Concepts of the Theory of the Firm” December 12-14, 2002, Mercure Hotel Hagen, Germany, sponsored by FernUniversität, Hagen, Erich-Gutenberg-
Arbeitsgemeinschaft, Cologne, Deutsche Forschungsgemeinschaft, Bonn, etc.
Abstract
Numerous empirical studies reveal that accounting numbers – equity as well as earnings’
measures - have lost value relevance, i.e. explanatory power for stock market capitalisation and/or abnormal returns, during the last decades. This effect is of particular significance after the rise of the New Economy in the early 90thies and at firms belonging to ‘new economy’
industries. On the grounds of this observation, commentators argue in favour of a change of the current accounting model. Proposed amendments include:
(i) widening of intangible asset recognition criteria, including the capitalization of R&D, ad- vertising and human resource expenditures;
(ii) measurement of intangibles at fair value;
(iii) a new set of ‘revenue accounting’ provisions, due to the observation that traditional reve- nue recognition concepts fail to capture the critical events of the value creation cycle at new economy firms.
From an industrial economics perspective, the focus of these proposals is on the balance sheet treatment of competitive advantages of the firm. From a normative viewpoint, the arguments in favour of these proposals are founded on the observation of a change in competitive envi- ronments due to the transition from old economy to new economy. The paper analyses whether these changes should imply a change in the current accounting system. Competitive advan- tages and their financial accounting treatment are analysed conceptually on the grounds of economic theory. The insights gained give rise to a certain scepticism concerning the neces- sity of a change of the current accounting model.
∗ Chair of Financial Accounting and Auditing, University of Cologne, Albertus Magnus Platz, D-50923 Cologne, Germany, e mail: kuhner@wiso.uni-koeln.de
1. Most, but not all intangible assets are information goods.
In accounting literature, there is a great amplitude of different definitions concerning intangi- ble assets. In this paper, we will define intangible assets along the following three criteria:1
- They lack of physical existence.
- They are not financial instruments.
- They are long term in nature.
SFAS 141, A 14 provides a list of examples of intangible assets, which may be apt to be rec- ognized separately from goodwill. The list is non-exhaustive, but includes the most significant items.2 It is possible to assign the assets included in this list to three different categories:
(i) Contractual rights concerning the use and the delivery of tangible assets and services
Examples are customer contracts, lease agreements, etc. Financial accounting for those items will not incur any special problems apart from those connected with the underlying positions.
(ii) Contractual and legal positions concerning competitive advantages due to the legal or contractual establishment of market entry barriers
Examples are non-competition agreements, licenses and royalty.
(iii) Positions concerning the use and the delivery of information
This category constitutes the bulk of the items mentioned in SFAS 142, Appendix F. In the terminology of Lev,3 intangibles, knowledge capital and intellectual capital are interchange- able terms. More carefully, it can be argued that most intangible assets are information goods.
At least four categories can be distinguished.
- Information goods for consuming purposes: all artistic related intangible assets
1 Kieso/Weygandt/Warfield, p. 600; similar in: SFAS 142, Appendix F.
2 See Appendix.
3 Lev (2001), p. 5.
- Information goods for purposes of technical production of physical assets: patented and unpatented technology, trade secrets, in process R&D.
- Information goods, which concern the technical production, transmission and trans- formation of information itself: Computer software, software for information transmis- sion via the world wide web and via electromagnetic waves.
- Information goods which concern the market transmission and transformation of in- formation (i.e. the release of information asymmetries and the lowering of transaction cost): Trade marks, trade dress, internet domains, “brand name capital”, reputation capital, customer relationship capital, employee relationship capital, market design of trading platforms, contract design, etc.
Consumption, production, transmission, the economic use and the technical use of informa- tion are most heterogeneous activities. It might be expected that the balance sheet treatment of these activities will reflect this heterogeneity.
2. Information goods cannot straight forwardly be categorized as “private goods” or
“privately owned economic resources”, nor as “public goods”.
As it is well known, it might be difficult or even impossible to assign, enforce and protect property rights concerning information. Pieces of art or literature might be protected by copy- rights; patents or trade secrets might prohibit the use and the knowledge of technical innova- tions. However, not all information goods are apt to be protected (e.g. human capital, reputa- tion), and protection even if founded on a legal title will in many cases be far from perfect.4 Non-excludability of the use of information corresponds to non-rivalry: Transmission, techni- cal use and consumption of information goods is non-rivalling: information coded in digital data files can be used by arbitrarily numerous people without its quantity being diminished or impaired.
4 A case in point is NAPSTER. Moreover, e.g., anecdotal evidence indicates that many New Economy firms failed because they did not succeed in protecting their newly developed technology by globally enforceable pat- ents.
On the grounds of non-rivalry of consumption and technical use, information is often quali- fied as a public good. This qualification is not perfectly correct, because the market use of information follows substantially different rules: In competitive markets, the economic use of information by competitors may be considered as hyper-rivalrous, because first-mover effects are most significant: Consider only stock exchanges where even small quantities of relevant information may give rise to tremendous trading gains if privately hold; information which is common knowledge, however, has no value for the players. A piece of information may even be of negative value if the players are not conscious that it is, in fact, common knowledge of the market and, therefore, is embodied in the market prize. Similar phenomena may be ob- served at markets on which innovative products are traded and where the first mover “takes it all”: research and development, branding and advertising expenditures of the second and third movers may be irrecoverably lost.
It might be expected that financial accounting treatment will reflect these enigmatic qualities of information goods.
3. The importance of intangible goods as corporate value drivers has risen dramatically in recent years.
The importance of information for economic development has risen dramatically during the last decades: ‘industrial society’ is transforming into ‘information society’ and information as an economic resource is at the core of our perception of the New Economy.5 There are several causes for these fundamental changes:
(i) Due to digitalisation and computerisation, the cost of coding, transmission and copying have declined towards almost zero; the technical quality of transmissions and copies has risen in the same way.
(ii) Together with the accumulation of wealth, consumer goods are becoming more and more sophisticated; including more information components, software compo- nents as well as components of product and brand design.
5 For an overview of different perceptions of the New Economy see e.g. De Long /Summers (2001).
(iii) For the same reason, research and development is becoming more important.
(iv) Due to deregulation and privatisation, many long-term oriented research and de- velopment activities which traditionally used to be carried out by state institutions and non-profit organisations are nowadays privately organized by profit maximiz- ing firms. Therefore, the perception of the public that even long-term R&D pro- jects are privately owned and privately traded commodities has spread.
(v) In recent years, economic science as well as real world experience is discovering that one of the main sources of economic wealth is the release of information asymmetries between market players and the decline of market transaction cost.6 Transaction cost are declining e.g. because of the design of innovative contractual schemes (e.g. compensation schemes, market microstructure design, auction de- sign, mechanism design), because of signalling activities by corporate players (ad- vertising, branding, investing in reputation) and because of the Internet as a new and global trading platform.
4. Competition in markets for information goods of the New Economy has its own rules leading to an increase in unsystematic risk.
Research on competition and business strategies in the New Economy is at an early stage;
however, some general observations on the changing rules of competition can be made:7 - Rising importance of sunk costs in early stages of product life cycle: Particularly,
R&D, branding and advertising expenditures play a dominating role in the early stage of a New Economy product’s life cycle, thus enhancing the asymmetry between cash outflows in early stages and cash inflows in later stages. Early stage investing expen- ditures may be usually qualified as sunk, because in the case of failure, items such as R&D or brand building will not be recoverable.
6 See only the pioneering work of Jensen/Meckling (1976), pp. 305-60.
7 See, e.g. Lev (2001), pp. 21-49; Shapiro/Varian (1999); Varian (2001).
- Increasing returns to scale because of non-rivalrous usage of information goods: Be- cause of digitalisation, the cost of reproducing an information good for usage by cos- tumers are in most cases negligible. Together with huge amounts of fixed cost, this will result in tremendous returns to scale in the course of production and marketing.
- Network effects:8 Network effects arise if the consumer value of a commodity is rising with the number of its users. Network effects are omnipresent in the New Economy, as different technical standards (e.g. Netscape vs. Internet Explorer); different global trading platforms and different global communication platforms compete for a global public and the attractiveness of adopting a standard and of trading and communicating on a platform will increase as the number of its users increases.
- “Tipping markets” and the occurrence of “winner-takes-all”-competition: Tipping markets and winner-takes-it-all competition are the direct consequences of network ef- fects and increasing returns to scale: It is a well documented fact that in many New Economy markets (take only for example the markets supplied by Microsoft), only few or even one supplier will survive and, consequently, benefit exclusively from his or her monopolistic position.
The above-mentioned points imply that investments of individual firms in New Economy projects will be far more riskier than investments in traditional industries; at least, unsystem- atic risk will spread in comparison with the ‘tangible economy’; volatility of discounted cash flows will rise.
5. The proposition that, in general, investment in intangible assets is riskier than invest- ment in tangible assets is well rooted in economic theory of market equilibrium and competition.
New Economy projects will in many cases reveal a real option-like, even negative NPV-cash flow projection. Knowledge assets therefore will be, a priori, far more riskier than physical or financial assets. However, this viewpoint is not uncontested. Lev argues:
8 For the analysis of network effects see most influentially: Economides (1996); for application to the New Economy: Varian (2001).
„Surely, uncertainty about the future benefits of a clinically proven drug is not larger than the uncertainty associated with the expected benefits of commercial property in a newly developed area or of a loan granted to an enterprise operating in a developing country, which are both recognized as assets by GAAP.“9
It is obvious that the riskiness of different projects, intangible or physical, can only be deter- mined by analysing them individually. However, some heuristic conclusions can be drawn if the different functions of physical and intangible goods, which they perform in the course of the corporate value chain, is taken in account: Lev himself, in his definition of intangible as- sets, focuses on such a functional approach:
„(...) intangible assets are non-physical sources of value (claims to future benefits) generated by innovation (discovery), unique organizational designs, or human re- source practices.
The emphasis of this definition is on discovery, innovation, entrepreneurial creativity and uniqueness. In other words: on competitive advantage in comparison to other market players.
Valuing intangible assets, therefore, means valuing the competitive advantages of a firm, i.e.
to estimate the expected present value of the economic rent (quasi-rent) associated with the existence of competitive advantages.
Competitive advantages result from deviations from perfect competitive equilibria; they rep- resent options to capture economic rents by taking advantage from market imperfections. Al- though general equilibrium with perfect competition is a hypothetical state which, in reality, virtually never will be obtained, in market economies, in general, there will be a trend towards it. We can therefore generally characterize competitive advantages as ephemeral in nature, although their life period may be indeterminable ex ante: In the – hypothetical – state of neo- classical general equilibrium, no value at all will be attached to intangible assets which in substance constitute competitive advantages. In contrast, tangible assets will not lose value as markets move towards competitive equilibrium.
9 Lev (2001), p.124.
Acquisition of competitive advantages is at the core of entrepreneurial activity,10 and, in an equal way, valuation of competitive advantages is an entrepreneurial task.
6. Capitalization rules may be based on the paradigm of fair value measurement of as- sets and liabilities or on the performance-measurement-paradigm (matching of revenues and expenses).
Generally spoken, standard setters used to be reluctant to opt for recognition of intangible goods as assets on the balance sheet. To analyse this traditional reluctance, it might be useful to remember what are the ultimate reasons for capitalisation of assets: Why and when should an asset be capitalized in the balance sheet? This question was subject of most influential de- bates in accounting theory in the last century. Two, partly opposite, partly complementary viewpoints have emerged as results of these debates:11
1) The sum of capitalized assets should reflect as exact as possible the fair value of the marketable fortune of an enterprise.
If based on this paradigm, a capitalization rule for intangible assets would imply identification of all identifiable intangible assets and valuation at fair value.
2) Capitalized assets should reflect cash outflows, which are not designed to generate revenues in the current period but in future periods.
Following the last concept, i. e. the matching principle concept (“let expenses follow reve- nues”), capitalisation rules should guarantee a separation between operative and investment expenditures of a corporate entity for the purpose of timely performance measurement; invest- ing activities should be identified with sufficient reliability. Assets on the balance sheet should reflect the amount of capital expenditures invested in positive present value projects.
10 See, for example: Kirzner (1973).
11 See, e.g., Upton (2001), p. 13. The two competing paradigms were also at the core of the at the time most influential debates about static vs. dynamic interpretations of financial accounting in German literature, see seminally: Schmalenbach (1919), pp. 1-60.
7. Measuring the fair value of intangible assets implies fair value measurement of com- petitive advantages. The rise of the fair value paradigm as financial accounting concept will lead to a substantial change in the role of financial accounting and auditing.
Fair value of an asset represents the amount at which that asset could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidation sale.12 In the absence of quoted market prizes, fair values have to be estimated e.g. by discounted cash flows or by option pricing models.
At least in the US, in recent years there has been evidence of a turn-around towards a more fair-value based measurement of assets and liabilities in financial accounting. Fair value was introduced in SFAC No. 7 as measurement objective for present-value-based accounting measurements. Intangible assets which are acquired together with corporate entities are to be measured with their fair values according to SFAS 141, fair values are the benchmark for measuring the value of intangible assets with indeterminate lives and of acquired goodwill according to the impairment test SFAS 141/142. Thus, for many balance sheet items, accrual accounting via direct fair value measurement replaces more and more accrual accounting by amortization of expenditures over the estimated useful lifetime of an asset. The key argument in favour of this treatment is that, for many intangible assets, useful life is not determinable.13 Measurement of fair values for positions which cannot straight-forwardly be replicated by items traded in capital markets implies entrepreneurial judgment: It has been pointed out that the huge majority of intangible assets consists of competitive advantages. In opting for fair value measurement of intangible positions as an element of GAAP, standard setters initiate a fundamental change in the role of certified public accountants and auditors: In the future, auditors will be more and more required to testify entrepreneurial judgments by testifying fair values of information goods and competitive advantages. Also on the grounds of the recent experiences,14 one might be sceptical about whether such a change in the role of the account- ing and auditing profession will strengthen the quality and integrity of financial accounting.
12 See, e.g.: SFAC No. 7 (glossary).
13 See, e.g.: SFAS 142, par. B79-B94.
14 See, e.g., Coffee (2001).
8. From a matching-principle viewpoint, capitalizing expenditures for intangibles as de- layed charges would imply exact measurement of changes of the firms’ intangible capital
From a matching principle point of view, capitalization of intangible assets requires the iden- tification of the investing character of cash outflows with sufficient reliability. Consider for example expenses for branding and advertisement: Not at all obvious is the answer to the question whether they generate surplus cash flows in future periods or whether they are spent in order to maintain the existing brand name capital of the corporation. With respect to tangi- ble assets, e.g. property and equipment, this question can be answered in a much more straightforward way.
Consequently, capitalization of internally generated information goods would imply judg- ments about value impairment or value enhancement of the information capital stock in a pe- riod as a whole.
Example: Consider an entity, which in 2002 spent 1.000.000 € for purposes of adver- tising their existing brands. The advertising expenditures are intended to sustain the public’s long-term perception of the brand name. Should an intangible asset be recog- nized and valued at € 1.000.000,- ?
Answer. It depends. And it depends not only on the question whether the advertising activity is successful or not. It depends also on the question whether due to the advertising campaign, the value of existing brand name capital of the firm is enhanced, i.e. whether the resources spent on advertising and branding are sufficient to counter the periodical impairment of brand name capital.
Example: Imagine that our corporation, indeed, had spent 1.000.000,- € on branding and advertising. But, however, to maintain the achieved level of public attention in re- cent periods, an expense of 3.000.000,- € would have been necessary. Should the cor- poration recognize a liability of 2.000.000,- (“provision for omitted branding expendi- tures”)?
US GAAP excludes generally the recognition of such provisions as they do not match the definition of a liability: They do not imply a present obligation, that means: a legal or eco-
nomic commitment to deliver cash or assets or services to a third party. German law, for ex- ample, allows recognition of similar provisions under certain circumstances.15
The example demonstrates that, from a capital maintainance perspective, a rational capitaliza- tion rule for items such as branding and advertising expenditures, human capital expenditures or research and development expenditures would imply more or less precise measurement of the annual changes in the firm’s brand name capital, human capital and R&D capital, a task which, if performed or supervised by public accountants, might qualify as an abrogation of knowledge in the Hayekian sense.16
9. Accounting numbers have lost value relevance. This phenomenon is frequently attrib- uted to the incomplete recording of intangible value drivers in financial statements.
Standard setters’ reluctance to change capitalization rules for intangible assets is, how- ever, well founded on economic grounds.
Accounting rules, so the well-known complaint, have ignored in many respects the dramatic changes of economic environments and remain at an inferior stage of development.17 The complaint is supplied by numerous empirical studies which (i) indicate that the book to mar- ket ratios have declined dramatically during the last years and thus, the balance sheet equity numbers are failing more and more to represent the real value of a company, and which (ii) indicate that accounting numbers and particularly earnings figures have lost ‘value relevance’, i.e. predictive power for the explanation of abnormal returns.18
However, standard setters remain reluctant towards a radical change of capitalization rules for information goods. The rule that internally generated intangibles shall be capitalized only un- der very restrictive circumstances was modified partly19 but is not challenged substantially, up to now.
15 § 249 (2) Commercial code: “Provisions may be recognized for present or former years’ expenses which are precisely determined by their type and are probable or certain at the balance sheet date but uncertain in respect of the amount or timing of the corresponding cash outflows.” However, in the example presented, recognition would be not allowed because of the uncertainty of future cash outflows.
16 For the concept of arrogation of knowledge see e.g. Hayek (1974).
17 See, e.g., Lev (2001) pp. 79-103; Lev/Zarowin (1999), pp. 353-385.
18 See, for example, Francis /Schipper (1999), pp. 319-352.
19 Restrictions governing the recognition of internally generated assets are, e.g., part of financial accounting according the German Commercial Code (HGB, § 248(2)), of US-GAAP: SFAS 142.10, of IAS 38, 39-52.
The reason for this is, after all, the lack of reliability20: Following the conceptual framework of the FASB, capital expenditures should not qualify for capitalization if the future cash flows they generate are too uncertain. Uncertainty of the future cash flows can be measured by their expected volatility (variance/standard deviation). Reliability of book values as a signal for fundamental value is declining with rising volatility of the discounted cash flows (i. e. funda- mental value), they generate.21 Following the FASB, recognition of an asset requires a certain minimum threshold of reliability, i.e. a maximum threshold for the variance of the expected value of future cash flows, it generates.22 Thus, certain investing expenditures may not qualify for capitalization, even if they generate positive NPV and even they can be classified as iden- tifiable assets on the grounds of identifiable future benefits they generate.
Economic characteristics of intangible assets are, among others, non-perfect excludability of usage, enhanced importance of sunk cost, economies of scale and network economies. After all, the most significant argument in favour of an accounting treatment of intangible assets differing from tangibles is their characteristic as competitive advantage: They vanish with the move towards perfect competitive equilibria and, thus, reveal a fundamental difference in comparison to tangible economic “resources”. Accounting for intangible assets is therefore an entrepreneurial task.
20 „Reliability is the quality of information that assures that information is reasonably free from error and bias and faithfully represents what it purports to represent.” SFAC No. 2, glossary.
21 For a theoretical foundation see, e.g., Kirschenheiter (1996), pp. 43-60.
22 „(...) almost everyone agrees that criteria for formally recognizing elements in financial statements call for a minimum level or treshold of reliability of measurement that should be higher than is usually considered neces- sary for disclosing information outside financial statements (...).“ SFAC No. 2, Par. 45
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Appendix : List of intangibles to be recognized separately from goodwill according to SFAS 141, A 14
a. Marketing related intangible assets (1) Tademarks, tradenames
(2) Service marks, collective marks, certification marks (3) Trade dress
(4) Newspaper mastheads (5) Internet domain names (6) Noncompetition agreements
b. Customer-related intangible assets (1) Customer lists
(2) Order or production backlog
(3) Customer contracts and customer relationships (4) Noncontractual customer relationships
c. Artistic related intangible assets (1) Plays, operas, ballets
(2) Books, magazines, newspapers, other literary works
(3) Musical works, such as compositions, song lyrics, advertising jingles (4) Pictures, photographs
(5) Video and audiovisual material, including motion pictures, music videos, tele- vision programs
d. Contract based intangible assets
(1) Licensing, royality, standstill agreements
(2) Advertising, construction, management, service or supply contracts (3) Lease agreements
(4) Construction permits (5) Franchise agreements
(6) Operating and broadcast rights
(7) Use rights, such as drilling, water, air mineral, timber cutting, and route au- thorities
(8) Servicing contracts, such as mortgage servicing contracts (9) Employment contracts
e. Technology based intangible assets (1) Patented technology
(2) Computer software and mask works (3) Unpatented technology
(4) Databases including title plants
(5) Trade secrets such as secret formulars, processes, recipes
