Thursday, 14 August 2014

Financial reporting for intangibles: The Case of the Invisible Assets

"Financial reporting for intangibles: The Case of the Invisible Assets" is a guest post by Stanford luminary Efrat Kasznik (President, Foresight Valuation Group, LLC, Palo Alto, CA). It's based on an earlier piece published by our friends at Intellectual Asset Management Magazine (IAM) and it is our hope that we can get some genuine discussion going on this topic -- so watch this space.  Efrat writes:
Despite some far-reaching changes in recent years, including global harmonization of financial reporting and the move towards fair value reporting, accounting standards worldwide are still largely blamed for failing to measure and report intangible assets. Is there really a serious gap in asset reporting, as many observers claim, or does this actually represent an opportunity for companies to control and manipulate the reporting of their intangibles?

Google’s sale of Motorola Mobility’s mobile phone business to Lenovo for $2.9 bn earlier this year is a case in point, as it highlighted the confusion surrounding the valuation of Motorola’s IP assets at the time of the original $12.4 bn acquisition in 2012 [on Motorola's patent portfolio, see Neil's earlier posts on this blog, "Mega-Patent Portfolio Sales: Chimera or Here to Stay?", here and "Motorola Mobility: Has there been an impairment of goodwill in Google's acquisition of its patent portfolio?", here]. Financial markets and IP experts were embroiled in speculation about what exactly did Google pay for when buying Motorola, and how central was the IP, primarily Motorola’s massive patent portfolio, in driving the acquisition price. Looking at Motorola’s balance sheet on the eve of the acquisition did not offer any clues to untangling the acquisition price: according to US Generally Accepted Accounting Principles (GAAP), internally-grown “intangible assets” (the accounting terminology used when referring to intellectual property) are not reported as assets on the balance sheet of the company that created them.

The Google-Motorola acquisition demonstrates the tension between the value of intangible assets held by operating companies, and the way such assets are reported in financial statements. Google’s post-acquisition allocation of $5.5 bn to “patents and developed technology” may have come as a surprise to many observers who attributed a higher portion of the acquisition price to the IP assets. However, lacking any disclosure of the fair value of these assets in Motorola Mobility’s books prior to the acquisition, there was no way of telling what is the fair value of these assets, hence the wide gap between the price speculations and the actual price reported by Google.

Reporting gap or value opportunity?

Financial reporting is the main channel of communication between companies, shareholders and capital markets. In general, companies disclose financial information not only to report performance, but also as a way to manage investors’ expectations and impact the return on stock prices. There are two types of disclosures: mandatory and voluntary. Generally speaking, mandatory disclosures are any information disclosures required and regulated by the Securities and Exchange Commission (SEC) in the US and other regulators. Financial statements fall under this category, and the US GAAP define the scope and content of such statements. Voluntary disclosures, as the name implies, are not regulated and are not mandatory – anything else that companies choose to share with the market, whenever they want to share it. The annual reporting of the value of internally developed intangible assets falls under that second category. Intangible assets have to be fully disclosed only when they get acquired and paid for, either in a business combination (M&A deal) or in an asset purchase, when the purchased intangibles are valued and reported on the balance sheet of the buyer at their fair value.

In that regard, companies are free to report the value of their internally grown intangible assets any day of the year. They are just not required to do so on their balance sheets as part of the SEC-regulated financial reporting. Yet companies don’t voluntarily report the fair value of their intangible assets. So the lack of mandatory reporting seems to be causing a gap in information on some of the most valuable assets held by technology companies today.

Silence is golden: are companies better off not reporting their intangibles?

It is not at all clear that companies would readily switch to a system that requires them to disclose in full the fair value of their intangibles, as they do with almost any other type of assets. There could be several reasons for that:

(1) Market efficiency: there is generally no dispute as to the high value of intangible assets. The more interesting question is, are stock markets efficient enough to reflect the full value of intangible assets in equity prices, despite the lack of value disclosure in the books of reporting companies?

Results from academic research done at the Stanford Graduate School of Business (GSB) show that the markets rely on signalling, like R&D expenses, to value intangibles, although it is more costly for companies and analyst to signal/interpret that value. Below are some of the findings highlights:
• Equity values appear to reflect information on the value and productivity of R&D investments
• Stock prices reflect value estimates of unrecognized brands and trade marks
• Firms with unrecognized intangibles spend more free cash flows on “signalling” activities (e.g., share buybacks), suggesting greater concern about equity undervaluation
• Greater analyst coverage and greater “analyst effort” are required for firms with unrecognized intangible assets.
An early case of
information asymmetry?
(2) Information asymmetry: it is well documented in academic studies that managers thrive in situations of information asymmetry, as they can leverage that to their benefit. The fact that managers have better information than the market on the value of their IP assets gives them an advantage as they can control the extent and timing of that information disclosure. For example: one academic study shows that “insider” stock gains in R&D-intensive firms are substantially larger than insider gains in firms without R&D. This suggests that R&D is a major contributor to information asymmetry, and that insiders take advantage of this information asymmetry.

(3) Value fluctuations: markets don’t do well with wide fluctuations in financial reporting. In order to smooth out these fluctuations, accounting rules create intermediary assets and liabilities that act as a “buffer” to absorb the annual changes so they don’t fully hit the income statement as they occur. This usually requires setting up an elaborate accounting system to smooth out the volatility, as is done in accounting for pensions, for example. Intangible assets will fluctuate in value if valued annually, as they are subject to high risk and uncertainty (litigation challenging validity, uncertain royalty flows). Companies may not happily embrace this type of onerous disclosure, as IP assets may just be too volatile for the accounting system to handle. 
While the financial reporting system is far from perfect, one could argue that it actually works to the benefit of corporations as they have greater control on how and when they report their intangible assets. Whether markets as a whole are better off or not, is a different question. Many stakeholders are struggling with understanding the value of intangibles, as the existing financial reporting systems do not provide a sufficient solution for that information gap.

5 comments:

Anonymous said...

Perhaps the markets simply can't solve this on their own. Invisible assets are going to have very large fluctuations in value which has the potential to wipe millions/billions off the value of companies very quickly. Stakeholders don't know how to deal with that. I'm not an economist but it seems to me that the new virtual or cryptocurrencies could be part of the solution where they define a parallel component of value. A company would be worth $1m and 1m crypto's of invisible assets, but governments would actively manage the value of crypto's to ensure their value was not affected by irrational market worries.

Ken Jarboe said...

We need to understand the difference between reporting intangibles and incorporating them on the balance sheet. It is not necessary to place a market value on a company's intangibles in order to report them. Investors should have information on intangibles which allow them to come to their own valuation judgements. The example of R&D spending cited in the article is one such case. It is not necessarily important to put a value on the output of that R&D but it is necessary that investor know what is being spent. Likewise non-financial metrics on intangibles (such as employee turnover) would also be useful.

Efrat Kasznik said...

Dear Anonymous (Aug. 15th):

Thank you for your comment! While virtual currencies have certainly come a long way, stock market trading is bound to be driven by real currencies for many years to come. In my humble opinion, assets reported in "parallel components of value" will cause more problems than they might be solving. Nice idea, but a bit ahead of its time...

Efrat Kasznik said...

Ken,

Thank you for your comments! You bring up a few important things.

I started off the post by making a distinction between mandatory (=balance sheet) and voluntary (=anything else that's off balance sheet) disclosures. The point I made is very simple: companies are not bound by mandatory disclosure requirements to report the value of their intangible assets on the balance sheet, but they still have the option to disclose the value of these assets in any other way, monetary or not (to your point on non-monetary metrics), through some voluntary disclosure. Yet, companies don't rush into voluntarily disclosing the value of their IP. The question then is, why?

The answer I am trying to propose has three parts: (1) companies actually benefit from information asymmetry, ie, knowing more about the value of their IP than the market (2) the markets make up for it in other ways, like interpreting R&D expenses (to your point!) (3) the accounting system cannot really handle the fluctuations in these assets' valuations.

Aritra Chatterjee said...

Thanks for the wonderful article and comments.

A possible solution to the equation might be insurance! Putting an insurance wrap on the valuation of such assets transforms intangibles to "hard" asset based on which different financial structures can be designed. Once you raise financing on such assets it is reflected on the balancesheet and some of the problems you mentioned in your article does not exist any more. Debt, equity and hybrid structures are possible to frame on such insurance.

Question is does such insurance exists today? Infact yes, there are few large insurers and reinsurers (like my employer) have started offering such solution and we are excited to solve this impasse in corporate finance which existed for so long.

How does it work? Insurance pays a fixed amount to the financier once insured intangible assets are transferred to insurer upon bankruptcy of the operating entity.