Sunday 18 May 2008

Reporting Intellectual Property - Mapping What Drives Value: Second Part

by Roya Ghafele, Ph.D.

Current accounting regulations allow only to fully understand how the IP relates to business if revenue streams can be directly related to a discernible, seperately identifiable asset. The worth of internally generated IP or IP that relates indirectly to business performance does not get reflected in accounting. The consequences of this are far reaching:

Firstly, the cost of capital increases, meaning that IP-rich companies may find it difficult to pass the funding hurdle, confirming that little has changed since Arrow[1] published his findings some forty five years ago showing that competitive markets fail to provide socially optimal levels of technology investment. Since IP is literally absent from the accounting, reporting and managerial discourse, investors find it difficult to access information on how a firm’s IP portfolio relates to its income streams. For this reason, risk rates associated with investments in knowledge-intensive sectors may not be adequately assessed and a higher premium may be charged when funding is provided on the basis of IP.

Secondly, the management of a company becomes a much greater challenge since adequate information on all the assets and liabilities of a company are not available.

As Dr. Harvey Bale, Director General of the International Pharmaceutical Association (IFPMA) argues: “Today, IP underpins between 50-70% of a country’s private sector gross earnings, so it is often decisive for the commercial success or failure. This stands in strong contrast to IP management skills of top management. Many chairmen or CEOs do not grab the simple distinction between patentability and freedom to operate. It is like not knowing the difference between profit and cash flow.”[2]

The internal management of IP is seriously hampered since its value is not made explicit on the balance sheet. Since the bulk of the space of the balance sheet is devoted to tangibles, managing intellectual property becomes a very intangible undertaking. The efforts put into this may at best be indirectly reflected, but do not directly become visible.

Thirdly, ratios, such as the market to book value are largely distorted, making it difficult for regulatory authorities and market participants alike to capture the worth of a company. Gillette, for example, which wealth mainly relies within its trademark portfolio, had a book value of 3 million USD, but was bought by Procter and Gamble for 59 million USD which makes up for a gap in the market to book value of 56 million USD that had never been reported anywhere.[3]

The information provided in financial reports frames perceptions and ultimately determines business behaviour. The current information gap, expressed in hidden information on the value of internally generated intellectual property may therefore seriously distort markets for innovation and creativity.

From multinational to micro-enterprise, no business can afford to ignore these issues forever, even though they have to learn to navigate the current business environment challenges without waiting for a quick fix or overnight reform.

An alternative reporting system may be a valuable compass helping companies to ship through troubled waters. While most influential financial standard setting institutions (such as the FASB – Financial Accounting Standards Board) continue to explore various options to better reflect the value of internally generated intangible assets, there is a clear need for further research on how to overcome the existing intangible/tangible reporting asymmetry through reporting systems that are not bound to the current logic of accounting.

[1] This post was first made publicly available in Know IP – The Stockholm Network’s Monthly IPR Journal Volume 3: Issue 4. May 2007. The Stockholm Network has given its kind permission to reproduce this paper on the blog.
Arrow K.J.: Economic Welfare and the Allocation of Resources for Invention. In: Nelson R.R. (ed.) The Rate and Discretion of Innovative Activity: Economic and Social Factors. Princeton University Press. Princeton 1962
[2] In Ghafele, Roya, Wurzer, Alexander Reboul Yves and Hundertmark, Stephan; Rethinking IP Education; Intellectual Asset Management Magazine December/January 2007 Nr. 21, p.28-40
[3] example given by the FASB (Financial Accounting Standards Board) at the United Nations Department of Economic and Social Affairs Conference, July 12-13 2006

1 comment:

Michael F. Martin said...

IP development (i.e., R&D) is no longer consistently vertically integrated in the U.S. since Bayh-Dole. The second and third of the three problems Roya identifies (difficulty in managing IP and accounting for IP) should have been solved (or at least improved) by separating R&D and commercialization into upstream and downstream firms. They weren't Why not?

Because the first problem (cost of capital) hasn't been solved. The R&D firms (a/k/a universities) aren't getting fair value for their inventing.

Now what if an intermediary capable of valuing R&D were to step in to facilitate transfers from R&D labs to universities -- and avoid the costly litigation that has thus far prevented such intermediaries from being succesful?