CHAPTER 3

Intangible Assets

We have heard a clear and consistent message on financial instruments accounting—fix this once, fix it comprehensively, and fix it in an urgent and responsible manner.

—Sir David Tweedie*

The development of the intangible asset as an accounting standard is worth a study to understand how it is defined and to overrule the damage a casual inquiry may cause. Accounting standard IAS 38, the Intangible Asset, emerged in 1998. Every accounting standard offers a clear definition of each term it refers to. IAS 38 defines intangible assets, useful life, asset, amortization, and so on, but not the word “intangible” as such. Let us find how the balance sheet was an enabled instrument, but it turned out to be otherwise after the introduction of IAS 38. Let us look into the damage IAS 38 caused accounting firms. We will also find out why the term “intangible asset” is an oxymoron. The emergence of IAS 38, compared with its original avatar IAS 9 in 1978, Accounting for Research and Development Activities, was an upgrade caused by the rapidly changing industrial scenario during the period. Let us elaborate on its significance.

Accounting standards that are currently in use are IAS 38, Intangible Assets, and IAS 36, Impairment of Assets. These are issued by the International Accounting Standards Board (IASB). The IASB was founded on April 1, 2001, as the successor to the International Accounting Standards Committee (IASC). IAS 38 offers us a definition of intangible assets: “An intangible asset is an identifiable non-monetary asset without physical substance.”1

Its predecessor, IAS 9, Exposure Draft E9, Accounting for Research and Development Activities, was announced in February 1977. The resulting standard was approved for publication in March 1978. The World Economic Survey 1977 reports,

The year 1977 saw a difficult economic recovery for the developed economies. High rates of unemployment were accompanied by the persistence of excess capacity in most countries, and the hopes rested on a flourishing international trade in both manufactures and agricultural products, with capacity utilization in U.S. manufacturing industry still only 83%.2

IAS 9, 1977, and the Year of GRACE

In 1977, when IAS 9 was being approved for publication, the global scenario was something like this: The NAVSTAR global positioning system (GPS) was being inaugurated by the United States; the first commercial Concorde flight was on its way from London to New York; NASA was successfully testing the space shuttle; Apple II was the first mass-marketed personal computer; Microsoft was a two-year-old startup; Federal Reserve year-end interest rates stood at 7.75 percent; the Dow Jones Industry Average stood at 831; oil prices after the Yom Kippur war jumped to $14.95, four times that of 1973; downsizing programs involving billions of dollars in reengineering efforts were being undertaken in the auto industry; and there was rising government pressure3 in the United States to have fuel-efficient cars. Merger and acquisitions during the year were as follows: General Electric’s $2 billion purchase of Utah International, a company that mines coal and copper. Mobil Oil acquired Marcor for $1 billion, and Atlantic-Richfield’s $700 million buyout of Anaconda, the copper mining giant.

The year also witnessed the emergence of the Foreign Corrupt Practices Act (FCPA) in the United States after turbulent years on account of the Lockheed scandal. Scandals during the early 1970s triggered a peer review at Peat, Marwick, Mitchell, the audit firm of some of the companies involved and the largest of the eight major accounting firms of that time, by accounting firm Arthur Young. The review cleared Peat, Marwick, Mitchell of any misconduct.

The industry was looking for relief. Investment in R&D was seen as an absolute necessity on the one hand, with the concern that the expenses for it were eating into profits, on the other. During the discussion stage of the exposure draft (Exposure Draft E9, Accounting for Research and Development Activities) this was very evident. Many industries were feeling the pinch on costs eroding profits with no corresponding asset growth. Particularly affected was the aerospace industry in the United Kingdom. Yielding to pressure, the IASC issued a new exposure draft, ED 17, in April 1976. This required capitalization of development expenditures in certain cases. E9 was made final with minor changes as IAS 9 in March 1978. Further, in December 1993, the standard was renamed “IAS 9 Research and Development Costs.”

The UN World Economic Survey report of 1977, under the introduction “Disquieting International Trends,” stated,

There is a widespread uncertainty and unease about prospects for the world economy in the next several months and even a longer time span... It is primarily on an acceleration of productive investment activity that most of these countries are counting to reestablish a steady rate of growth; but the slow expansion of both domestic and external demand, coupled with the external uncertainties generated by exchange instability and protectionist tendencies, have discouraged new investment.4

With the rising pressure on industry to search for new avenues for production, the heavy investment in R&D, and a far from optimal industrial climate, it was natural for the industry to approach IASC. As an organization, IASC had seen several such deliberations and brought about a coordinated and inclusive approach to publishing the Generally Accepted Accounting Principles (GAAP). In 1977, it did this for IAS 9 R&D Activities.

Accounting firms had a grip over corporate affairs that can be summarized under the following five issue areas.

G-R-A-C-E

Governance

IAS 9, the instrument by which governance could be administered by the audit profession, stood up to the pressure. It was a commendable role IASC played over the years. The balance sheet had come to be relied upon as the most reliable record of activities transacted by individual companies globally.

Responsibility

Setting a precedent for taking responsibility, audit firm Peat, Marwick, Mitchell undertook the responsibility of clearing their name by appointing Arthur Young for the peer review of their auditing practices.

Authority

Industry was made aware that they had no other recourse than to get the approval from professional accounting bodies through published accounting standards for any inclusion or change of balance sheet items. This meant that a journal entry at the corporate level needed prior approval from the accounting governing body. Governance was at its best. The industries looking for approval for capitalization of R&D costs, be it aerospace, pharmaceuticals, automobile, hardware, were all for an end product that was a tangible item. Accounting firms armed with IAS 9 would have had no difficulty in verifying the product as well as the costs related to the R&D capitalization. IAS 9 had emerged after due diligence.

Credibility

Arthur Young, another major auditing firm, had gained the trust of society to audit the practices of another major firm. Society was naturally agitated over the several scandals that erupted during that period, forcing an FCPA to emerge.

Enabled Balance Sheet

It was at this time that the balance sheet emerged as an enabled instrument.

The year 1995, IAS 38, and the year of Nick Leeson: Looking ahead to 1995, when Exposure Draft E50 Intangible Assets was introduced, the year witnessed a boom in technology. The most reliable investment opportunities were in American Online (AOL) for the Internet, Micron Technology for semiconductors, Motorola for hardware, and Microsoft for software. The year also saw a Dutch firm, ING, buying up Baring PLC for a nominal amount of $1.60, after one individual, Nick Leeson, barely 28, brought down the bank with reckless gambling and speculation on the Tokyo Stock Exchange. He lost $1.3 billion, making the 220-year-old bank insolvent. It was also the year when Paul Allen invested $500 million in DreamWorks, the film studio founded by Steven Spielberg and two others. The U.S. space shuttle docked with Russian Mir space station for the first time. The year-end Dow Jones Industrial Average stood at 5117, oil prices were $16.75 average, and Microsoft Windows 95 and Internet Explorer were released.

In 1995, Boutros Boutros-Ghali, who was UN secretary-general, reading the World Economic and Social Survey, stated,5

At a time when the global economy is comparatively healthy, many regions are enjoying increasing prosperity and show an ability to sustain their growth: Simultaneously, for many of the world’s citizens, this is an era of hardship—and worse suffering seems to lie ahead. In a world that is tightly linked economically, this imbalance threatens the long-term welfare of both developed and developing economies—this survey poses fundamental questions about our priorities and our commitment to the future.

Commenting on the exchange rate crisis,

creditor Governments and financial community, including investors who lost considerable sums in the wake of the crisis, have asked whether better international surveillance of domestic policy might avert future crises. This is a question about information, analysis and the politics of policymaking; it is a complicated question that does not yet seem to have a clear answer.6

In this global context, 1995 also saw the introduction of exposure draft E50 for Intangible Assets. The stage was set to adopt new policies on changing the industrial scene. When IAS 9 Accounting for R&D activities was introduced in 1977, the emphasis was on products leaning toward blue-collared employment-oriented industries. By 1995, when the demand for a fresh look had arisen, the emphasis had shifted considerably toward brands, software, copyrights, patents, and so on. Dr Herve L. Stolowy and Dr Axel Haller, in their article on ED50 Intangible Assets,7 write about what transpired during the discussion stage. The primary concern was somehow to recognize brands as an asset so that their balance sheets would look healthier. At the same time, the fundamental problems faced to define intangible to move forward for publishing an accounting standard were evident, as the exposure draft defined intangible assets as identifiable, nonmonetary assets without physical substance. In European countries, such as France, the General Accounting Plan (Plan Comptable General, PCG) 1982 (CNC, 1986: I.33) defines intangible assets as being fixed assets other than tangible or financial assets. A fixed asset here is defined as an asset acquired for long-term use in the operation of the business. Therefore, intangible assets are only recognized by comparison with tangible assets, which correspond to real rights over tangible objects. However, the purpose was obvious: to know whether brands can be recognized in the balance sheet. In August 1997, IASC modified E50, which was reexposed as Exposure Draft E59 Intangible Assets. Finally, IAS 38 Intangible Assets was published in September 1998. This was a watershed definition of the role of governing bodies in the accounting profession.

IAS 38 defines intangible assets as an identifiable nonmonetary asset without physical substance. Further, IAS 38 outlines the identifiability and recognition criteria. The urgency with which industry needed to recognize intangible assets was quite palpable in the changing scenario.

The year 1995, which saw the beginning of the tussle between hardware and software technology, could be termed as the year of Windows 95 and Nick Leeson, for better or worse. During the year there were disturbing reports on brand-related initial public offerings (IPOs), with several warnings filed with the U.S. Securities and Exchange Commission (SEC) but hidden from private placement memorandum. Offshore tax havens were used liberally to establish companies without disclosing the ownership information while filing the court papers. The World Economic and Social Survey 1995 made a chilling statement:

Traditionally, the major financial intermediaries have been fractional—reserve banks and thrifts, whose assets and liabilities are, except in bankruptcy, redeemable at par. The assets and liabilities are not directly traded on secondary markets and hence are not “marked to market.” In other words, the “prices of loans and deposits on the banks” books are always at par, notwithstanding interest rate changes… If the market’s share of total finance were small, this would not matter but traditional par-value banking is gradually being eclipsed by the so-called share of “mutual fund” banking which deals only in securitized assets.8

The erosion of balance sheet assets had already begun in 1995. Further, the urgency of inflating the balance sheet figures has been a dominant factor.

During the discussion stage of E50 (Intangible Assets), brand value is used as a tangible asset was quite apparent. Because of this importance of brands for the economic development of certain businesses, the accounting treatment of brands has been a matter of debate and controversy in many countries, such as Australia and the United Kingdom for instance, where companies, such as Grand Metropolitan and Rank Hovis McDougall, decided in 1988 to include the value of brand names, either purchased or internally developed, in their consolidated Balance Sheets.9

It shall be noted, the use of the intangible asset in a balance sheet was 10 years ahead of official release. The definition, therefore, becomes a crucial aspect of governance.

Asset is a tangible item with a specific useful life attached to it, but the very term “intangible” means everlasting and imperishable. IAS 38 defines all used terms, such as useful life, asset, amortization, as they all are in business parlance at the time of publication. All except one, “intangible.” Perhaps they meant “invisible” instead. An intangible asset is an oxymoron. Intangible is antimatter and an asset is matter. They are opposite poles.

The intangible asset was the first licensed clearance for breaking the age-old par-value banking. Mutual funds were vehicles to invest in “tangible asset-based vehicles” but with the emergence of non-bank financial system, mutual funds started investing in companies that had more intangible packaged assets with inflated value in every step of the value chain.

During the financial crisis of 2008, Timothy Geithner, then president and CEO of the Federal Reserve Bank in New York, said, “The scale of long-term risky and relatively illiquid assets financed by very short-term liabilities made many of the vehicles and institutions in this parallel financial system vulnerable to a classic type of run.”10

There was an urgent need to assess the future economic benefits of such assets. Hence, IAS 36 Impairment of Assets was published on July 1, 1999. An asset is impaired when its carrying amount exceeds its recoverable amount. However, if IAS has been following a strict chronological system, impairment must have influenced an intangible asset to emerge with a handicap.

The purpose of international accounting standards is “to develop IFRS® Standards that bring transparency, accountability, and efficiency to financial markets around the world. Our work serves the public interest by fostering trust, growth, and long-term financial stability in the global economy.”11 What really emerges out of the standards is a. auditors’ responsibility and b. public perception of or confidence in the balance sheet. As a going concern, auditors are fairly protected, which is not the case when a major scandal breaks out. Society naturally questions how and why the auditors did not ferret it out. Intellectual property, for example, could be a matter of dispute if the individual who created it challenges ownership. The valuation of an intangible asset could be one figure for the balance sheet purposes but could be a highly padded up figure for a private equity investor. In such cases, risks associated with internally generated intangible assets could be high. Purchased intangible asset is an asset generated out of a transaction where the market would decide the price, taking into consideration the risk factors and future economic benefits. It is not the case with an internally generated intangible asset. It has a sting in the tail that was not deliberated threadbare during the exposure drafts discussions or at the review stage of IAS 38. The conditions are entirely different in capitalization between 1977 and 1995. There was no need to displace IAS 9 and substitute with IAS 38, enlarging the scope of assets covered. Such intangible assets could have remained or made use of, as off–balance sheet assets, without bringing them into the books of accounts. Even now, strictly an intellectual property right (IPR) is a work-in-progress and gets validated only if a patent is obtained. The balance sheet must be fortified to exclude non-transactional entries. The balance sheet is a simpleton, like a foolish or gullible person, ready to accept what one offers. One can’t keep adding frivolous ideas to it hoping that accounting standards would help remove inconsistencies. Inventory accounting also has several methods of valuation. Select one and keep it simple. Leave the balance sheet alone.

It is not the responsibility of an accounting governing body to accommodate any industry, which is a state subject. That could create a conflict of interest by which incentives and concessions to promote a favored industry could emerge from time to time, although some professors look upon it favorably. “Knowledge-based assets make up a growing proportion of economic valuation, but people believe that current accounting models really don’t capture their worth,” says Wharton accounting professor David F. Larcker. “For example, despite the fact that (a company) may have intellectual property (IP) that holds significant value, the IP may not, in fact, have ever been cataloged or identified.”12 Even so, it is not on the accounting profession to accommodate such assets, which are misused by unscrupulous many.

The balance sheet is an instrument meant for transactional entries that attempts to put in the off–balance sheet entries to be avoided. The problem is, the balance sheet has become the only instrument all stakeholders, including society, depend upon. The balance sheet is no longer a trustworthy document, despite adding accounting standards upon accounting standards to justify its continuity. We need to wean off dependence on the balance sheet and create one trustworthy document everyone can rely on. Balance sheet analysis is a waste of time.

Sir David Tweedie, IASB chairman at the time of constituting the Financial Crisis Advisory Group (FCAG), said, “We have heard a clear and consistent message on financial instruments accounting—fix this once, fix it comprehensively, and fix it in an urgent and responsible manner.”13 It is doubtful. There is a fundamental flaw in the financial instrument, for it is limited by quantitative elements whereas qualitative elements go beyond auditors’ scrutiny. This is beyond the comprehension of any stakeholder.

It is management’s responsibility: The accounting firms that commented upon the consultation paper “Consultation Paper Review of the OECD Instruments on Combating Bribery of Foreign Public Officials in International Business Transactions Ten Years after Adoption” said, “It is management’s responsibility, with the oversight of those charged with Governance, to ensure that the entity’s operations are conducted in accordance with laws and regulations. The responsibility for the prevention and detection of non-compliance rests with management.”14 The audit inadequacy lies in the type of material events that are not transparent. Responsibility is shirked and the perpetrators go scot-free. Big firms have not glorified themselves by having management acknowledge responsibility, be it ethical or fiscal. They remain clueless in deciphering what’s happening within the four walls of the management, though not for a want of good intentions.

A conference proposal paper says15:

In fact, it is not clear that the so-called GAAP standard is even particularly meaningful anymore: companies continue to search for beneficial ways in which to disclose information about themselves with or without formal sanction... Nakamura estimated the value of U.S. gross investments in intangibles in 2000 to be at least $1 trillion annually. More recently, Corrado and Hulten (2010) estimate that in 2007, by omitting investments in intangibles, $4.1 trillion was excluded from published national accounts data in the U.S.

Big firms excuse themselves when companies keep asking for greater disclosure of their capability. It’s not their failure alone but that of the accounting profession in neglecting to create a robust instrument. The millennium merger of AOL takeover of Time Warner is a case in point, creating a $335 billion company, proving that in a world ruled by finance, intangible assets rather than real assets are the indicator of real wealth. What’s true in such a scenario is that the real finance is completely mopped up by speculative enterprise, a privileged area of the government notwithstanding, denying the much-needed funds for priority spending, globally. Intangible asset is indeed a croupier’s delight.

G-R-A-C-E 2

To summarize the trend during this period, in 1995, intangible assets came into a period that we may call G-R-A-C-E Version 2.

Governance

The audit profession lost its control of governance over the accounting standard on account of IAS 38 being published without the keyword being defined.

Responsibility

The Big 4 firms shirked responsibility and meekly told the OECD that it was management’s responsibility, the blame for oversight belonging to those charged with governance. The age-old dictum the auditor relies on to say we are a watchdog, not a bloodhound, is highly questionable, for the demands for scrutiny of corporate affairs have gone much beyond mere audit of books of accounts. The duties of the watchdog need to be thoroughly analyzed, on account of the rapid change effected by the multivarious functions of management that are qualitative.

Authority

From 1988, the industry tried to rule over the balance sheet that the audit profession lost its hold on, on account of IAS 38. In 2007, this led to the omitting of investments in intangibles, and $4.1 trillion was excluded from published national accounts data in the United States. The audit profession had become irrelevant.

Credibility

In 1977 Peat, Marwick, Mitchell took on responsibility and called upon another major firm, Arthur Young, to conduct a peer review of their auditing methodology. Today it has become the story of “He that is without sin among you, let him first cast a stone.” There’s no audit firm without a blemish. The audit profession after IAS 38 has lost its credibility as it now allows “management” to decide on journal entries.

Erosion of Balance Sheet

There was no hole in the balance sheet in 1977. By 1998, craters have been normalized. Excluding $4.1 trillion from published national accounts data in the United States is crater enough. The audit profession has lost its identity.

Notes

1. International Accounting Standards Board. “IAS 38 Intangible Assets.”

2. Department of International Economic and Social Affairs. 1978. World Economic Survey, 1977 (New York, NY: United Nations). E/1978/70/Rev.1: ST/ESA/82.

3. The crisis also prompted a call for individuals and businesses to conserve energy—most notably a campaign by the Advertising Council using the tag line “Don’t Be Fuelish” (https://www.cs.mcgill.ca/~rwest/wikispeedia/wpcd/wp/1/1973_oil_crisis.htm).

4. Department of International Economic and Social Affairs. World Economic Survey, 1977, p. 1—Introduction—Disquieting International Trends.

5. Department for Economic and Social Information and Policy Analysis. 1995. World Economic and Social Survey, 1995 (New York, NY: United Nations). E/1995/50/ST/ESA/243, Preface.

6. Ibid., p. 5.

7. H.L. Stolowy, A. Haller. 1996. “Accounting for Brands in ED50 of IASC (Intangible Assets) Compared with French and German Practices—An Illustration of the Difficulty of International Harmonization.” Presented at the 19th Annual Congress of the European Accounting Association Bergen, Norway, May 2–4, 1996, p. 3.

8. Department for Economic and Social Information and Policy Analysis. World Economic and Social Survey, 1995, pp. 77–78.

9. H.L. Stolowy, A. Haller. “Accounting for Brands,” p. 7.

10. T.F. Geithner. 2008. “Reducing Systemic Risk in a Dynamic Financial System.” https://www.newyorkfed.org/newsevents/speeches/2008/tfg080609.html.

11. IFRS mission statement. https://www.ifrs.org/.

12. Knowledge@Wharton. February 13, 2002. “Valuing the Invisible: How to Manage Bankruptcies of Knowledge-based Companies.”

13. P. Smith. 2009. “Immediate Response to US ‘Unnecessary.’” https://www.accountancydaily.co/immediate-response-us-unnecessary.

14. OECD. 2008. “Review of the OECD Anti-Bribery Instruments: Compilation of Responses to Consultation Paper.” http://www.oecd.org/daf/anti-bribery/anti-briberyconvention/40773471.pdf.

15. Athena Alliance. 2011. “Global Competition and Collaboration.” In: New Building Blocks for Jobs and Economic Growth: Intangible Assets as Sources of Increased Productivity and Enterprise Value. http://www.oecd.org/sti/inno/48918196.pdf.

*Immediate Response to US “Unnecessary.” https://www.accountancydaily.co/immediate-response-us-unnecessary