Athena Alliance and
the Project on America and the Global Economy of the Woodrow Wilson Center
Held at the Woodrow Wilson International Center for Scholars
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Kurt Ramin, Commercial Director of International Accounting Standards Committee Foundation, presented the broad activities of the International Accounting Standards Board (IASB) in the area of financial reporting and intangible assets.1 After outlining the structure of IASB, he first described the Board’s current projects. Second, he spelled out some of the differences between the US Financial Accounting Standards Board (FASB) and the IASB – and the convergence between the two systems. Third, Mr. Ramin mentioned some of the work that the IASB is doing to develop standards in the field of intangibles. Specifically, he discussed how intangibles are currently treated under IAS 38 and how the forthcoming standards on business combinations will treat intangibles. He concluded with a description of how the new eXtensible Business Reporting Language (XBRL) might improve financial reporting.
In the discussion, Mr. Ramin and the participants noted that accounting rules have an enormous impact. Part of the Enron debacle could be traced to how little information Enron had to put in various financial footnotes to their reported accounts. The consequences of accounting standards can also have a significant impact on the process of innovation. For instance, under FASB rules, costs for research and development are expensed. That is, they are subtracted from reported earnings in the year in which they are incurred. Under IASB rules, however, only research costs are expensed, while development costs can be amortized or deducted over a number of years. Likewise the different treatment of internally versus externally acquired intellectual property could affect the R&D strategy and structure of a major company.
As the ongoing discussion over accounting for certain financial instruments, such as stock options, shows, accounting for intangibles is a complex and difficult activity. Establishing and enforcing the right rules will be critical to allocating capital to intangible as well as tangible investments.
The speaker at this policy forum was Mr. Kurt Ramin, the first Commercial Director of the International Accounting Standards Committee Foundation. A recognized expert on issues of the knowledge industry, Mr. Ramin served on the High Level Expert Group of the European Union on “The Intangible Economy Impact and Policy Issues.” A former partner at PricewaterhouseCoopers LLP, he has extensive experience as CFO to several different companies in the US and Germany. Mr. Ramin was expressing his personal opinions and not necessarily the opinions of the International Accounting Standards Board or the Foundation.
He was introduced by Dr. Kent Hughes, Director of the Project on America and the Global Economy at the Woodrow Wilson Center.
Mr. Ramin began by emphasizing the nature of the problem, including a large amount of the general catch-all accounting category “goodwill” still left in the financial system. He then went on to outline the structure and work of the London-based International Accounting Standards Board (IASB) and its organizational relationship with the Foundation. He emphasized the truly international nature of the Board and noted that a range of countries are represented on the various decision-making bodies of the IASB. He also noted that the Board of Trustees of the Foundation is deliberately geographically balanced, with Paul Volcker, former Chair of the US Federal Reserve Board, serving as Chair of Board of Trustees.
Mr. Ramin briefly discussed the various ways in which the standards under development by the IASB are beginning to be used. He reminded the participants that the European Commission requires listed EU companies to prepare consolidated accounts using the IASB’s International Financial Reporting Standards (IFRS) by 2005.
Mr. Ramin touched on broad activities of the IASB. Current projects include:
issues of first-time adoption of the new International Accounting Standards (IAS);
general and specific improvements in standards on financial instruments;
issues of business combinations, including accounting for intangibles; and
share-based payments; and,
the convergence of standards, especially between the IASB and the FASB.
The business combinations project is divided into two. The first set of standards (Business Combinations 1) will come out in March 2004. It will be followed by Business Combinations 2 in September. The project on business combinations will set definitions, outline application of the purchase method based on fair value, set standards for accounting for goodwill and intangible assets and for the treatment of liabilities, and define measurement of the identifiable net assets.
As part of these standards, intangible assets will generally be amortized over a definitive life. However, if the assets do not have a definitive life, an impairment test will be used instead. Of course, the assets must be measurable and meet other tests that define an asset. The big change from previous practice is that pooling of interest in acquisitions will not be allowed. As a result, companies will be forced to identify and value specific intangible assets. According to Mr. Ramin, a new industry appears to be developing to help companies value these assets more carefully.
In developing these business combinations standards, IASB is coordinating with the International Valuations Standards Committee, especially on using the same definitions and measures.
Mr. Ramin then went on to touch upon the issue of share- based payments (commonly referred to in the US as stock payments and stock options). The IASB is moving to require that these payments be recognized in financial statements as an expense. The final standard is expected in December. It will have significant differences from the current FASB standards.
Following up on that point, Mr. Ramin spelled out some of the differences between FASB and the IASB. US standards – Generally Accepted Accounting Principles (GAAP) – are actually now rule-based rather than principle-based. IAS and IFRS started off as principle-based. However, the number of pages of these standards has grown, now running to some 1600 pages, as problems with creating flexible principles surfaced. Still, IAS/IFRS remain a more narrow set of principles than the GAAP rules.
Another major difference between GAAP and IAS/IFRS concerns valuations, especially in business combinations. Fair value, as opposed to historic cost, is an overriding principle within IAS/IFRS, including the revaluation of property, plant and equipment. Standards concerning the basis of consolidation are also different, with IAS/IFRS looking at control rather than the GAAP rule of majority voting rights.
An important difference with respect to intangibles is in the area of research and development (R&D). IAS 38 allows a company to capitalize the development costs part of R&D whereas GAAP requires all of R&D to be expensed.
Both IASB and FASB have more detailed summaries available on the difference between IAS and GAAP. These summaries are available from IASB and FASB – see http://www.iasc.org.uk and http://www.fasb.org.
Various joint projects between IASB and FASB focus on these convergence issues. Two specific differences that will be subject to discussions between FASB and IASB concern segment reporting and post-employment benefits.
IASB’s goal is to have IASB and FASB standards similar enough that the 1200 plus non-American companies currently listed on American exchanges would not have to translate their European reports into American standards. To see the current differences, Mr. Ramin referred participants to 20F filings by European companies with the Securities and Exchange Commission.
Mr. Ramin then went on to detail IASB’s approach to intangible assets, as described in IAS 38. He emphasized that this standard will effectively be changed as the new standards concerning business combinations are developed.
For the IASB, an intangible asset is “an identifiable, non-monetary asset without physical substance held for use in the production or supply of goods or services, for rent to others, or for administrative purposes.” To determine an asset’s fair value, IAS 38 requires the price be that which would be used in an arm’s length transaction. The impairment loss is that which exceeds its recoverable amount.
IAS 38 governs both intangible assets internally generated and those externally generated but separate from goodwill. Something is only recognized as an asset if it is identifiable, controlled, has probable future benefits specifically attributable to the asset, and its costs can be reliably measured. The criteria of identifiable is often the most difficult; it is hard to describe the specific unit that is being classified as an asset or link it to a specific marketable product or process.
If the item cannot be recognized as an asset, its cost must be expensed as incurred if it is an internally generated item or included in the category of goodwill if it is purchased in an acquisition. Therefore, research (but not development), start-up, training and advertising costs must be treated as expenses.
In addition, IAS 38 specifically prohibits the recognition as assets of internally generated items such as brands, mastheads, publishing titles, and customer lists and items similar in substance. Thus, the costs of these items must also be expensed.
Intangible assets can be measured either using historical costs or fair market value. Currently, amortization assumes a rebuttable presumption that the useful life of the asset will not exceed 20 years. If a longer period is used, an annual impairment test is allowed.
The result of these standards will be greater emphasis on disclosure of intangible assets and more attention to their fair market value and useful life.
In general, a three-pronged approach is needed in the entire area of corporate reporting.2 The first is global GAAP. According to Mr. Ramin, this is achievable as we are right on the verge of convergence of standards. The second is industry-specific standards. This is especially important for intangibles, which are different in each industry. Third is the need for greater company-specific reporting.
Mr. Ramin then went on to describe the potential of eXtensible Business Reporting Language (XBRL) for improving financial reporting. XBRL allows for information to be tagged at the lowest possible level. The data can then be combined in whatever manner is most useful. Likewise, aggregated information can be disaggregated as necessary. Different data can be combined in different ways for different reporting purposes. Such tagging also improves data comparability, in part by forcing some common definitions. In addition, XBRL will allow for conversion of data – an especially important problem in the multi-lingual European environment. (For more information, see http://www.xbrl.org.)
With the push for greater disclosure, the ability to consolidate and disaggregate the data in various ways will be more and more important. For example, in the Enron case, the ability to disaggregate the data using XBRL would have been helpful in seeing through the various complex financial transactions.
Combining and linking data at the company and industry level is especially important for understanding intangibles. Taxonomies are needed for different industries – and are being created using XBRL tags based on the IASB standards.
Thus, according to Mr. Ramin, we are well on the way to more meaningful reporting data, including reporting on intangibles.
Dr. Kenan Jarboe, President of Athena Alliance, moderated the Q&A session. He opened with a question about the seriousness of the conceptual problems. A case in point is the difference in treatment between an intangible asset internally generated and one that is acquired from outside. He quoted from the April 2002 FASB Special Report on the new economy that there is no conceptual rationale for treating the two differently. That same report notes that “the rationale underlying FASB Statements 2 and 86 and IAS 38 does not provide a useful conceptual basis for a reconsideration of accounting for intangible assets.3 He also noted that the Garten Task Force on Strengthening Financial Markets essentially concluded that intangibles could not be measured, only disclosed. Given this lack of conceptual underpinnings, can we really hope to make progress in accounting for intangible assets?
Mr. Ramin stated that the first goal was to identify the intangibles. Progress has been made on the issue of amortization of goodwill – so that it is not simply uniformly written down over the life of an asset, typically between 20 to 40 years. However, more steps may be needed to force disclosure, which will aid in the identification process. It was noted that FASB had a disclosure project underway which was curtailed due to a lack of resources. The new IASB business combination standard will have the end result of forcing more disclosure.
A participant noted that the ability to generate revenues is already a criteria for determining an asset. Why is that revenue not used for the valuation of intangibles, even for internally generated assets? Mr. Ramin responded that the problem was the reliability of the data. Part of the problem is the mixed accounting model where some values are at fair market value while others are at historical costs. He believes that fair value should be used for all valuations.
Another participant, however, took exception to the use of fair value for intangibles. Fair value requires an estimate of future cash flows – which can change radically and differ from expert to expert. The value of the asset can fluctuate widely, making mush out of financial statements and further infecting the system with uncertainty. The result is greater investor confusion. Mr. Ramin’s response was that while it was very difficult to put a fair value on intangibles, the mixture of historical and fair value produces greater confusion for investors by creating data incomparability.
The question was raised about whether the financial markets are already capturing the imputed value of intangibles – whether or not they show up in the balance sheet or as an accounting footnote.
With regard to footnotes, the observation was made that the degree of information complexity is increasing. The business environment and financial transactions are increasingly complex. Information that is disclosed in footnotes is often sketchy and hard to integrate with other financial data. The problem, as one participant phrased it, is not one of creating additional complexity, but revealing complexity.
One participant reminded the group of the different purposes of the information – especially for accounting and for financial analysis purposes. In the case of accounting, there needs to be a clear, understandable set of books in order to avoid the apples and oranges comparison problem.
Mr. Ramin observed that the system of multi-level reporting, as embedded in the XBRL system, may help overcome that problem.
The group then discussed the problems and differences of mark-to- market and fair value. In the case of some assets, such as financial instruments, a market exists that can be used to calculate value. For many intangible assets, no such markets exist.
In addition, even where a market for assets exists, it may give differing values due to short-term factors. The example of real estate values was given where the actions of the Federal government in settling the S&L issue drove down the value of real estate as the market was flooding with liquidated properties. Mark to market in this case would have resulted in a write-down in the American economy of 20% to 30%. However, another participant argued that if there had been a fair valuation process in place, the problem would have been manifest, and possibly avoided.
The other problem of mark-to-market concerns the thinness of some markets. For example, Enron was trading in a spot market for electricity, whereas most electrical contacts are long-term. To avoid volatility, especially in thinly traded markets, one participant suggested using moving averages or range of values.
The issue of companies’ responses to these changes was raised. Will the structure within a particular industry change as it becomes more or less advantageous from a financial accounting standpoint for a company to hold intangible assets?
It was noted that such responses may vary from industry to industry. The key is to identify the nature of a particular intangible asset and then determine how that asset is used in various industries. The rules need to be tied to the asset, not the industry.
One participant pointed out that the value of an intangible asset is not just based on factors within the company, but also external factors. A company located in an area known for specialized knowledge in that company’s product might be valued higher than one located elsewhere. How can those types of assets be valued?
Mr. Ramin responded that the approach for accounting is to break the situation down into units of value. The accounting problem concerning intangibles is in identifying the units. It was pointed out that these items used to be handled in the general category of goodwill – and that the task now is to add specificity. A number of countries are undertaking efforts to identify specific intangibles. But the problem remains difficult.
It was pointed out the differences between company-based intangibles and community-based intangibles are often referred to as social capital. Social capital, especially in innovative localities such as Silicon Valley, is a very real asset, but very difficult to capture in an accounting sense.
It was also noted that Enron was not simply an accounting problem but one of corruption and malfeasance. Enforceability of the rules is crucial, not just the understandability of the data.
A question came up about the IASB’s methods for calculating the value of fixed-price stock options, such as concern over use of the Black-Scholes model. Mr. Ramin stated that IAS requires use of fair value, but the specific requirements of the standard are still being developed. It was noted by one participant that FASB is just beginning to look at the specifics of the fair value method. A discussion followed of the various methods for calculating options, including problems of non-transferability of the option and lack of vesting.
The complexity of option pricing models raised an important question of transparency. Concern was raised as to whether investors and analysts would be able to “look through” the financial statements in order to be able to understand the assumptions and rationale for how certain assets were valued. Multilevel reporting helps in this area by giving investors and analysts better tools for understanding the financial details of a company. However, it may also raise the level of complexity. As a result, the role of the analyst as an information intermediary may increase in importance as we increase the complexity of the reporting system.
It was noted that the standard data building blocks as in the XBRL system would allow for multiple and competing reports by various analysts. The richness of the information would therefore be enhanced.
A question was raised about what is happening in other countries. Mr. Ramin noted that various countries have undertaken projects on intangibles for various reasons. For example, the European Union effort was focused on intangible measures in national economies, especially on knowledge workers, and on policymaking options.
One participant raised the issue of measurement and management (“what gets measured gets managed”). The concern is that intangibles are part of the larger system that may never be measured, especially the value of relationships – both internal and external. Thus, the value of the team is different from the value of the individual members – and the value of the team may never be adequately captured.
At this point, the discussion returned to the issue of how that measurement is defined, specifically as an asset or as an expense, and how companies react to those definitions. The case was raised of R&D. As discussed earlier, internal R&D is an expense. The results of external R&D, such as a patent, are assets that can be amortized over a number of years. This different treatment of internally versus externally acquired intellectual property could affect companies’ strategies and structures with respect to outsourcing R&D.
Participant discussed whether companies in some industries have spun off their R&D functions. The example was raised of a hypothetical pharmaceutical company. If the company develops a new drug internally, it cannot take a yearly charge against earnings to reflect the declining value of the patent. The situation can be quite different, however, if a company buys a small, innovative company with a valuable patent. Anything the company pays beyond the book value (including the buildings, equipment, and accounts receivable) will be recorded as goodwill – a broad category that includes many intangibles. In this case, GAAP allows the company to reduce taxable earnings (and hence increase cash profits) by amortizing (or deducting against earnings) the goodwill over time. In effect, the interaction of the accounting rules and the tax code encourage a firm to rely on outside research rather than innovating itself.
It was noted that the structure of R&D activities will follow the efficiencies of the transactions. Organizations form because internal transactions are more efficient than external. However, if there is an efficient market for intangibles, such as R&D, those assets will be acquired from outside.
The difference between FASB and IASB was once again noted. Under FASB rules costs for R&D are expensed, that is, they are subtracted from reported earnings in the year in which they are incurred. Under IASB rules, however, only the research costs are expensed while development costs can be amortized or deducted over a number of years. Because the impact of development costs on earnings is spread out over a number of years, the company operating under IASB rules will show greater earnings in its first year. If the American company is concerned about reporting higher quarter to quarter earnings, they may decide to reduce costs that must be expensed and instead buy additional capital equipment that can be depreciated over time.
One participant noted that this example points out the need to look at different industries. Some industries are more reliant on intangibles than others.
The discussion ended with the observation that accounting standards are under renewed scrutiny in the United States and around the world. One participant noted that degree of discussion over the pricing of financial instruments highlights how far we have to go with the problem of intangibles. Options, for all their complexity, are relatively well studied and well understood – especially when compared to other intangibles. It is therefore that much more difficult in defining and accounting for these other intangibles.
In a complex global economy, a single approach to accounting may conceal as much as it reveals. Multiple approaches and rules may be needed. Establishing and enforcing the right set of rules will be critical to allocating capital to intangible as well as tangible investments.
1. Please note that Mr. Ramin was expressing his personal opinions and not necessarily the opinions of the IASB or the Foundation.
2. Taken from Samuel A. DiPiazza, Jr. and Robert G. Eccles, Building Public Trust, John Wiley & Sons, New York, 2002.
3. Wayne S. Upton, Jr., Business and Financial Reporting, Challenges from the New Economy, Special Report, Financial Accounting Series No. 219-A, Financial Accounting Standards Board, April 2001, p. 108.
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