This is one of a series of articles, Covering Financials, focused on financial accounting disclosures and how you as a journalist can interpret and report on them. The first four articles (see related links) introduce the financial accounting concepts utilized in this and future articles. If you have a topic you are interested in, post your request in the comments or email me at firstname.lastname@example.org.
Controversy With Intangible Asset Accounting
Many capital market participants are dissatisfied with intangible asset accounting. The crux of the issue: Intangible assets are the most valuable assets for many entities yet the accounting often doesn’t record them as an asset. Instead, costs associated with creating an intangible item are expensed as incurred. Alphabet Inc.’s value stems from its Google search engine and user base, both intangibles, not from its property, plant and equipment (PPE). Yet Alphabet’s 2015 balance sheet lists PPE at $29.0 billion and intangible assets at only $3.8 billion. Interbrand, a consulting group, values the Google brand at over $120 billion implying substantial unrecorded intangible assets. The same idea applies to The Coca-Cola Company. Its value stems from its brand, including its trademark, and from its secret formula, not from its bottling plants or other PPE. Yet, looking at The Coca-Cola Company balance sheet for 2015, the company only records trademarks at $6.0 billion while PPE is $12.6 billion. Estimates of trademark and brand value for Coca-Cola reach $80.0 billion.
Investors clearly value intangibles. As a recent PwC publication highlights, the shift from brick-and-mortar business models to technology-based business models implies that up to 84 percent of market value of the S&P 500 entities is intangible, an increase from 32 percent only 30 years ago.
The accounting for intangibles is controversial to the point that a recent book entitled, “The End of Accounting and the Path Forward for Investors and Managers,” written by two academics, asserts that financial accounting needs to record more intangibles as assets in order for accounting to be relevant to investors. Let’s explore accounting for intangibles.
Current Accounting for Intangibles
Intangibles are of the following types:
- Marketing related (e.g. trademarks, tradenames, domain names, noncompete contracts)
- Customer related (e.g. customer lists, contractual and noncontractual customer agreements and relationships)
- Artistic related (e.g. copyrights to photos, plays, lyrics, movies)
- Contract related (e.g. franchise arrangements, service agreements, broadcast rights, airport gate rights)
- Technology related (e.g. technology patents)
If someone purchases an intangible, the company records this as an asset at its cost. This accounting is identical to many other assets including PPE accounting. But if an intangible, such as a customer list, is created within an entity, the entity expenses the costs and doesn’t record an asset. Contrast the accounting for internally generated intangibles with internally generated plant and equipment. In the latter case, construction in process is an asset, as described in last week’s article, “Property, Plant and Equipment (PPE).” But constructing an intangible is recorded as an expense, not an asset.
Why does the FASB require that internally generated intangibles be expensed? The FASB’s thinking is pragmatic. If an intangible is purchased, then there is an objective purchase price, so the FASB is comfortable with entities using it to record an asset. However, internally created intangibles don’t have a purchase price. With no purchase price, managers will struggle to determine whether future benefits from internally generated intangibles exist or not. If they do exist, they may not be readily measurable. It would simply be too easy for managers to spend wealth claiming to create an intangible asset when instead it is worthless. The FASB does not hold these concerns when an entity internally constructs a tangible asset, such as a building, so PPE construction in process is an asset while internally generated intangibles are not. In other words, more for pragmatic reasons than any other, the FASB requires internal costs spent on intangibles to be expensed (no asset recorded).
Because of the extensive value attached to intangibles (recall the graph) and because of intangible accounting, accurately comparing balance sheets and income statements across entities can be challenging. Imagine two competitors investing substantial amounts in customer lists. If one entity buys the list it records an asset while if the other entity develops a similar list internally it expenses all costs incurred. During this investment time period, one competitor has more assets and higher income than its competitor. However, both are essentially pursuing the same economic outcome, acquiring a customer list. The results can be acute. In the early 2000s, Amazon, Inc. invested in its website. As an investment in an internally developed intangible, Amazon expensed all costs related to the website. Those costs were so high that it disclosed a shareholders’ deficit (negative shareholders equity) in its balance sheet year after year. Yet, at the same time, the market price of Amazon’s stock was high, reflecting the asset value of the website and online business model.
Many investors claim intangible accounting is worse than I’ve described. They note that the FASB concluded that some costs directly related to internally generated intangibles are measurable, and the FASB allows those to be recorded as assets. Unfortunately they are often small amounts. As an example, suppose an entity invests $1 billion and discovers a drug that cures all human cancers. Clearly that cure would be worth billions of dollars. The entity would of course patent the cure. Suppose it costs $10,000 in attorney fees to file for the patent. While the company would expense the $1 billion as research and development, the $10,000 is measurable and recorded as an asset. Thus the balance sheet would list an asset for $10,000 representing an investment of $1 billion for a drug that cures cancer worth multiple billions of dollars. Eventually the drug’s value will show up in the financial statements via higher sales revenues, net income and operating cash flows, but that could be years into the future. Perversely, the more aggressively an entity invests in creating its own intangibles, the lower its net income (or larger its net loss in many cases). A large net loss may signal a positive economic event.
Accounting for Intangibles Recorded as Assets
If an intangible item is recorded as an asset, then it will be amortized (depreciated) if it has a finite useful life. Some intangible assets are renewable indefinitely into the future so they are not amortized. Patents have finite useful lives because they are only in force for up to 20 years in the U.S. Copyrights and most licenses also have finite useful lives. In contrast, trademarks and domain names may be indefinite because they can be perpetually renewed. They cannot be amortized because their useful life is indefinite. Like any asset, intangibles can be impaired if they lose their value. Generally, however, the accounting for intangible assets after they are initially recorded may not matter much because most intangibles aren’t recorded as assets to begin with.
A Perspective for Article Ideas
As a business journalist, understanding the accounting for intangibles can help you better understand how to read and use financial statements. For starters, the financials do not include most intangibles as assets. That implies that ratios such as return on assets, return on equity or debt to equity are skewed and perhaps misleading. It may mean that entities look like they are near bankruptcy when they are actually creating intangibles of considerable value. It also means that managers will attempt to communicate how their activities are creating value since the financials, in the view of many capital market participants, are not reflecting entities’ economic performances. You may find that articles comparing financial statements to intangible asset economic activities garner an interested readership.