They May Exist, but You Can\'t Touch

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A Review of How the Post-Sarbanes Environment has Impacted the Importance, Presentation, and Valuation of Intangible Assets

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They May Exist, but You Can\'t Touch

  1. 1. They May Exist, But You Can’t Touch A Review of How the Post-Sarbanes Environment has Impacted the Importance, Presentation, and Valuation of Intangible Assets Jerrad Howard This Creation is © Jerrad T. Howard. All Rights Reserved.
  2. 2. Interactive Exercise Which would you prefer to purchase given price and features (ie. size, color) are equal? Why? Apple iPod Microsoft Zune
  3. 3. Abstract Why Should We Value Intangibles? What are the current valuation techniques? How are current entities representing Intangibles to investors? How Do International Standards Differ?
  4. 4. How Important Are Intangibles? • Lev, 2001: Intangibles have changed the nature of the Corporation Itself • IM&A, 2005: 60 to 80 % of Company Assets are Intangibles. • Federal Reserve: US Corporations spend $1 Trillion Annually on Intangible Investments, equal to Tangible Investments
  5. 5. An Example Of Unaccounted Value • Coca-Cola President once claimed that if all physical assets were destroyed, the Company could survive… if Intangibles were not impaired • Senkus, 2005: Coca-Cola’s 2003 Financial Statements are misleading: • Listed Assets of $25.3B • Stock Valued Company at $112B
  6. 6. Examples of Intangible Assets And Their Impact on Business  Goodwill and Brand Reputation  Patents  Trademarks, Trade names, and Slogans  Trade Secrets  Other Internally Generated Items IE. Customer Lists & Licensing Agreements
  7. 7. Examples of Valuable Intangibles  American Airlines SABRE Reservation System 1996: Worth $3.3B to a $6.5B Firm 1960: Developed with RnD of $40M  International Pulp & Paper Company Re-emergence from Bankruptcy  CISCO Market Performance vs. GM GM, 2000: $88.19B  CISCO, 2000 : $555.44B
  8. 8. Cydney Tune’s Arguments for Recognition of Intangible Assets • Tune (IM&A, 2005): SOX should require valuation of Intangibles • Disclosures have increased, but no values • MGT is resistant to disclose any information • Should at least require – IP Risks – Prosecution – License Agreement Expiration – Expiration of Protection – Material Handling – Current Strategy
  9. 9. Hoffman’s (2005) Arguments for Recognition of Intangible Assets • Previous lack of recognition due to inability to value • Lack of Intangible Recognition causes: • Increased Cost of Capital • Misleading Results and Conclusions • Lost Economical Growth
  10. 10. Lev Arguments for Recognition (cont.) • Lev, 2001: Intangibles are the main driver of corporate success. • Omission has reduced effectiveness of Financial Statements. • Redaction of these “Investments” misleads Investors regarding future cash flows. • Deng, Lev, Narin, 1999: Patent Citations influence on future earnings • Patent Attributes have high correlation with – Market to Book Ratios – Future Estimated Stock Performance
  11. 11. Disclosure vs. Recognition • Difference Between Recognition and Disclosure • Why would simply disclosure not be adequate? • IM&A, 2005: Companies are not maintaining value schedules. – Tune: Refuse to disclose because could negatively impact investor decisions – Disclosures may release confidential information, but Recognition of Dollar Values wouldn’t • Information regarding intangibles is hard to comprehend.
  12. 12. Disclosure vs. Recognition (cont.) • Grooves, 1994: Disclosures are of little-to-no meaning to investors. • Financial Statements are Cumbersome • Investors place more emphasis on recognized items. • Lev, 2004: Investors are failing to comprehend Intangibles’ information under current practices • Over-valuing: Dot-Com Entities • Under-Valuing: Research-Intensive Entities
  13. 13. Basu’s Arguments Against Recognition of Intangible Assets (Basu, 2008) 1. Current day importance of Intangibles is nothing unique. • Today’s fierce competition and business environment is unique 2. All tangible and profit-generating ideas were once intangible in nature. • Marketing and Manufacturing Processes do not take physical embodiments 3. Assets only have worth in that they generate wealth • Reilly & Schweihs, 1998: Intangibles generate wealth by use of; forbearance of use; and ownership
  14. 14. Basu’s Arguments Against Recognition of Intangible Assets (cont.) 4. Intangibles provide highly uncertain, volatile, and ambiguous future benefits. • Hypocritical given current macro-environment and FASB treatment of Securities • Lev’s research also indicates R&D risks are exaggerated 5. Intangibles are prone to obsolescence or legal challenge, and are unable to be separated from tangible assets. • Why does this matter? Further developments on Capital Assets are allowed to be Capitalized.
  15. 15. Basu’s Arguments Against Recognition of Intangible Assets (cont.) 6. Intangibles have a cumulative effect, continually building upon themselves. • Similar to Point 5: Why can we not capitalize future developments? 7. Income earning potential matters rather than their valuation on the balance sheet. • Then why value anything using FASB standards?
  16. 16. Why Current Standards Aren’t Cutting It • Current Standards Ignore Intangible Impact on Business • FASB S2 Requires R&D Expenditures to be Expensed immediately during period incurred • Shelf-Loading of Expenses is misrepresenting Earned Revenue • Treating as Investments with no future benefits • Aggregated Allowed, No Meaningful Segregation on individual expenditures • Lev & Sougiannis, 1996: Individuals try to dissect R&D Expenditures to find future value but FAIL
  17. 17. Why Current Standards Aren’t Cutting It (cont.) • FASB S142: Recognition, Impairment Testing, and Useful-Life of Acquired Intangibles • Segregation into Definite- & Indefinite-Life Assets • Indefinite-Lived and Goodwill Impairment Test Annually • “Intangible assets are an increasingly important economic resource for many entities” • Still fails to recognize Internally Generated Intangibles • Kabir, 2008: Lack of Standards have hampered development of Intangible Marketplace
  18. 18. Valuation Techniques • Irrespective of claims, Intangibles have adequate valuation techniques • Most often employed are: – Cost Method – Market Method – Income Method
  19. 19. Cost Method  Intangible Asset is Valued at the Cost to Replace.  Replacement Cost = Reproduction Cost – Incurable Functional & Technological Obsolescence  Evaluate Impairment to Ascertain FMV  Fair Market Value = Replacement Cost – External Obsolescence – Curable Functional and Technological Obsolescence (Pratt & Niculita, 2007). 
  20. 20. Cost Method (cont.)  In order to use, may have to expend resources  Cost < Future Economic Benefit = Curable  Cost > Future Economic Benefit = Incurable  Replacement Cost = Amount to purchase Similar Asset  Reproduction Cost = Amount to imitate Asset  4 Components of Reproduction and Replacement  Direct costs  Indirect costs  Developer’s profit  Entrepreneurial incentive
  21. 21. Income Approach  Value established by the Present Value of Future Income from three roles  Lacks Structure as to what “Future Income” is  Net Income Before Taxes  Net Income After Taxes  Operating Cash Flows  Net Operating Income  May Capitalize One Year of Income, Many Years of Income, of an Average of Annual Income Expected
  22. 22. Income Approach (cont.) • Investor should review: – Opportunity Cost Associated – Time Value of Money – Term of Investment – Risk Associated • Must Ensure not “double booking” between various intangibles • Prone to Use with Customer Lists, Favorable Supply Contracts, and Proprietary Technologies
  23. 23. Income Approach (cont.) • Approach is Cumbersome and Questionable – Projecting Cash Flows is inherently risky – Intangible coupling makes it much more difficult • GAAP is not accustomed with utilizing Future Economic Value • Manufacturing Plant represented at net Historical Value, not future cash flows from production
  24. 24. Market Approach • Value is derived from similar transactions regarding intangible assets. • Must compare viability of asset and industry • Pre-Disposed to use with Licenses, Permits, and Technology such as Airline Reservation Systems • Best and Most Simplistic Model • Difficult to obtain information because Intangible Asset transactions are rare and normally not public knowledge.
  25. 25. Senkus’ (2005) Suggested Models I. Accounting Approach : Amount Paid Less Cost of Developing Asset II. R&D Investments III. Wages Paid to “Creative” Employees IV. Operational Profit Margin: Sales Less COGS
  26. 26. Senkus’ Suggested Models (cont.) V. Non-Fiscal Approach: Value is assigned based on future potential wealth • Similar to Income Approach VI. Residual Value Method: Market Value of Entity less Value of Net Assets.
  27. 27. Review of Financial Statements Focused on 4 Companies 2002 and 2008 Financials
  28. 28. • 2003 10K Report Highlights • Risks Associated with IP Rights • Brand Awareness of 80-92% of Population • Reach 2.7 B People Monthly • IP Rights  Patents and TMs Held • Product Formula not Patented to Protect Trade Secret  Only known by a few internal employees • Employees Associated with R&D  5 • GW Impairment Changes  Saved $$$ • Intangibles broken out
  29. 29. • 2008 10K Report Highlights and Changes • Increased Number of Patents and TMs • Lists R&D Expense for 3 Previous Periods • Increased Disclosures RE Risks Associated • Complete Break Out of Intangibles, Useful Life, Amortization Schedule for future 5 Years • Disclosure of Method for Valuation  – Income Approach with Appropriate Risk Discount Rate – Market Approach • Show Payments for Intangibles in Cash Flows
  30. 30. • 2002 10K Report Highlights – Licensing Agreements: % of Revenue – Amortization Schedules for GW and Intangibles – No Specific Record of Depreciation or Amortization of Intangibles – No Information Regarding R&D
  31. 31. • 2008 10K Report Highlights – Break out Revenue from Licensing Agreements Individually – Include Sum of R&D Expenses – “Inherent Risk Abroad Based on Ability to Enforce IP Rights” – Note #9: Breakout of Indefinite- and Definite-Lived Intangibles and Amortization Schedule for Future 5 Years
  32. 32. • 2002 10K Financial Statements – FASB S142 in effect, but will not follow until 2003 – Instead, Goodwill and Intangibles Amortized over Straight-Line Useful Life – Values of Goodwill and Intangibles deduced from Undiscounted Cash Flows and Future Projects – Capitalize Internally Developed Software and Amortize over 3 Years – 2003 will result in Goodwill Recapture of $250M
  33. 33. • 2008 10K Financial Statements – Following FASB S142, Previously used SL Amortization – Evaluate Value of Intangibles by Acquisition Price, taking into account Business Use • Based on FMV of Discount Cash Flows & Market Approach – Future Operations Risk Based on Intangibles – No Breakout of R&D Expense or Amortization STILL
  34. 34. • 2002 Pepsi 10K Statements – Definition of Intangible Lifespan basis • Significant Market Share • Stable Macro Environment • History of Strong Cash Flow – Value using Undiscounted Cash Flow Method – Demonstrated Retroactive Influence of S142
  35. 35. • 2008 Pepsi 10K Statements – Break Out R&D Expenditures – Capitalizing Software Development – Provide 5 Year Amortization Schedule – Fair Value Analysis Based on: • Market Participants • Consumer Awareness • Brand History • Future Expansion • Discounted Future Cash Flows
  36. 36. International Accounting Standards • IAS 38: Intangible Assets • Recognize Asset when purchased or self-created – Probable that future economic benefits will occur – Cost can be measured reliably • If Fail To Meet These Requirements, Expense • R&D – Research is Expensed Immediately unless acquired – Acquired Research is Capitalized – Design Expenses may be Capitalized • May Not Recognize Brands, Customer Lists
  37. 37. Conclusion • While Principles Reflect Conservatism, Standards are Out-dated • Adequate Valuation Techniques Do Exist • While Financial Statements are becoming more transparent, It is still not enough. • IAS 38 has established adequate principles far beyond US GAAP

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