Accounting of Intellectual Property Assets an Overview Guriqbal

Accounting of Intellectual Property Assets: an Overview Guriqbal Singh Jaiya Director. SMEs Division Guriqbal. jaiya@wipo. int 1

The Main Take Away While discussions continue on how to adequately account for IP assets, businesses are best advised to develop a voluntary annual IP report, so as to: (1) enhance their market position, (2) facilitate access to funding, and (3) improves overall decision-making and effectiveness of management! 2

Fixed Assets • Fixed assets (non-current assets) represent future economic benefits which are expected to be consumed at a slow pace (generaly over more than one financial year) • Every fixed asset can be considered an unexpired expense, and at balance sheet date a company must review to what extent the individual asset has been consumed during the accounting period 3

Fixed Assets (cont. ) Two central accounting issues: 1. How do we determine tha appropriate value of an asset at the point of acquisition? 2. How do we systematically recognise the expensing of the asset over time? 4

IAS 38 - Intangibles • An intangible is an identifiable nonmonetary asset without physical substance • Main characteristics: – They meet the definition of an asset – They lack physical substance – They are identifiable 5

IAS 38 – Intangibles (cont. ) • Definition refers to “identifiability” – Separability, or – Arising from contractual or other legal rights • Recognition criteria challenge - Degree of uncertainty with respect to the future economic benefits – Magnitude and timing of future economic benefits? – Control over economic benefits • The useful life of an intangible asset can be finite or indefinite 6

Intangible Fixed Assets • These are intangible resources such as scientific and technical knowledge, development of new processes or systems, intellectual property, privileged customer relationships, etc. • Typical examples: R&D, patents, brands, copyrights, computer software, licences 7

Definitions • Accountants – intangible assets • Economists – knowledge assets • Managers and lawyers – intellectual capital All are the same except for: • Legal – intellectual property, which is intangible assets legally secured for patents, trademarks, designs, copyrights, etc. 8

Classified Balance Sheet. . . Generally contains the following standard classifications: – Current Assets – Long-Term Investments – Property, Plant, and Equipment – Intangible Assets – Current Liabilities – Long-Term Liabilities – Stockholders' Equity 9

Cost Principle An asset must be carried on the balance sheet at the amount paid for it. The cost of an asset equals the sum of all of the costs incurred to bring the asset to its intended purpose, net of discounts 10

Traditional Distinction Between Capital and Revenue Expenditures Does the expenditure increase capacity or efficiency or extend useful life? YES NO Capital Expenditure Revenue Expenditure 11

Accounting of Intangible Assets Intangibles Purchased Specifically Identifiable Capitalize Internally. Created Goodwilltype assets Specifically Identifiable Goodwilltype assets Capitalize Expense, except direct costs Expense 12

How Accounting meets IP Copyright/Related Rights protects reproduction & performance in arts/software Patents protect products, business processes Industrial Design protects look of products, packaging, aesthetics Trade Secrets Mark/ Geographical Indication protects, logo, slogans, symbols protect business plans, know how, client portfolio, tacit knowledge, processes Only IP that generates direct cash flows in a commercial transaction is considered Protection against Unfair Competition 13

IP is an intangible asset, . . . Knowledge Content Transferability Background of users & context determine relevance of IP to business IP is transferable to a new or similar business context Perishability Over time IP may become outdated, e. g. technology cycles Nature of IP Spontaneity Successful IP creation is risky since there is a creative & a business element to it Non Rivalry in Consumption IP can be used simultaneously by different people without diminishing in its worth Partial Excludability IP guarantees a firm exclusivity and freedom to operate in the market 14

Why Measure Intangible Assets? (Purpose in order of popularity) 1. Monitor Performance (Control) Control Six Sigma, Balanced Scorecard, 2. Acquire/Sell Business (Valuation) Valuation Industry rules-of-thumb ($ per click, $ per client, brand valuation) 3. Report to Stakeholders (Justification, PR) PR IC supplements, EVA, Triple-bottom line, 4. Guide Investment (Decision) Decision None! (Discounted Cash Flow still best) 5. Uncover Hidden Value (Learning) Learning None! (Scorecards and Direct IC methods probably best) 15

… which Accounting finds difficult to grasp Rationale behind Accounting • Historically evolved to report tangible assets/liabilities • Quantitative stock of performance • Documentation of past financial position • Factual, precise, objective, comparable information • Determines perception of a firm’s management and other market participants Impact on Type of Language developed for IP • Silence about a lot of a firm’s IP due to inherent definitions and assumptions in accounting • Internally and externally generated IP is treated differently • Goodwill 16

How Accounting Concepts Impact Business Concept Internally Generated IP is immediately expensed, Acquired IP is valued at its acquisition cost, amortized or subject to an impairment test Fair value: “Amount at which an asset could be bought or sold in a current transaction between 2 willing parties, other than a liquidation. ” Intangible Asset: “… identifiable, controlled by an enterprise as result of past events & should generate future economic benefits for the firm. ” Goodwill: “price a market participant is ready to pay in excess of the value of a firm’s tangible assets. ” Impact The same IP may be perceived to be worth nothing or 100 Mn $ Implies a benchmark, yet worth of IP depends also on context & background Much IP won’t qualify since it has an indirect impact on cash flows Difficult to make worth of IP explicit & compare Goodwill of different firms 17

Accountants Recognize the Challenge • FASB & SEC recommend Voluntary IP Reports “Companies are encouraged to continue improving their business reporting & to experiment with types of information disclosed & the manner by which it is disclosed. ” • US GAAP allows to account IP explicitly in M&A FAS 141 & 142 require to identify each single asset & determine its fair value The amortization of Goodwill is replaced by an annual impairment tests • Basel Committee on Banking Supervision recognizes the inadequacy of “fair value” for financial assets “In the absence of active markets it will be difficult to obtain or calculate a reliable fair value for certain non-marketable financial instruments held at cost. ” 18

Explicit IP accounting gains momentum — Comparison of different Accounting Standards — German HGB Recognition of IP Acquired IP Internally Generated IP IAS/IFRS US-GAAP • Forbidden: § 248/2 HGB • Exception: acquired IP • Recognition of IP if IAS criteria are met: IAS 38 • Recognition of IP: Novel approach under FAS 141 &142 • Recognition of acquired IP: § 255/4 HGB • Recognition of acquired IP if IAS criteria are met: IAS 38 • Purchase Price distributed across all items: FAS 141 • Impairment Test of Goodwill: FAS 142 • Immediately expensed Trend towards the explicit recognition of IP increase 19

Advantages of Reporting IP F O R M A N A G E R S • Communicates the value of IP to investors • Shows what IP the company owns • Puts a value to the IP • Explains how the IP relates to business segments F I O N R V E • Get information on how IP drives growth S • Receive adequate inputs for earnings/sales forecasts T • Can better estimate risks/revenues of an investment O • Can better understand the nature of a business R • Increases predictability while decreasing volatility S 20

The IP Reporting Process Build IP Business Culture • Align IP portfolio to overall business strategy • Explain to all in the firm why IP matters Create IP ownership Create IP Ownership • Ensure market position through IP ownership Understand IP Ownership • Audit IP Report IP Generate Superior Results • Use a reporting • Set system ownership in demonstrating correlation to the value of expected IP to your • Establish an results business enabling IP policy and • Understand environment legal scope of IP $$$ or ¥¥¥ or £££ 21

Elements of an IP Report • Executive Summary How does IP relate to the bottom line of your business? How do you make money and what role does the IP play in it? • Relate your income streams to IP What were the returns from IP protected business segments? Does the IP help you to gain market share or profits? • Relate IP to your position in the Market How did IP give you an advantage over competitors? Do you have freedom to operate & exclusivity in the market? • Demonstrate your managerial skills How determined are you to extract revenue from IP? What experience do you have in managing IP? • Understand the legal scope of the IP rights What level of protection does your IP guarantee you? Is there a risk that you infringe the IP of competitors or that competitors (legally) steal your IP? 22

The Agenda A) The today’s rise of intangibles B) Consequences of the Non-treatment of intangibles C) Initiatives and actions undertaken (by companies/academics, and institutions) D) Policy indications E) Some open problems and conclusions 23

“The substantial foundation of the industrial corporation is its immaterial assets” “There may be peculiar difficulties in the way of reducing this goodwill to the form of a fund, expressing it in terms of a standard unit” Thorstein Veblen, 1904 24

Why did market values diverge from book values? What information does the market use that is not included in the financial statements? Reprinted from Baruch Lev’s Intangibles Management Measurement and Reporting, The Brookings Institution 2001 25

A) The Rise of an Interest in Intangibles • Change in the bases of creation of firm value - from industrial to post-(post-)industrial economy (e. g. advanced service firms) - post-fordist, interactive mode of production - decentralization/diffusion of knowledge • From unidimensional to multidimensional performance of an organisation • Obsolescence of traditional accounting systems (2004: Market-to-Book ratio 3) • Scarcity of data on intangibles in National Accounts 26

Goodwill and Intangibles • The Stock Market Perspective – If the market is efficient • The nature and treatment of intangible assets should be sufficiently disclosed to help users assess the treatment used – If the market is inefficient • Skepticism exists concerning analysts adjustments • Markets are affected by international and national political and economic factors – More disclosure means fairer stock prices 27

Goodwill • Only an issue when purchase method is used • Controversies – Should goodwill be included as an asset? – Should goodwill be amortized? • Accounting Methods – – Asset without Amortization Asset with Annual Impairment Testing Asset with Systematic Amortization Immediate Write-Off 28

Purchased Goodwill • Goodwill - the excess of the cost of an acquired company over the sum of the fair market value of its identifiable individual assets less the liabilities – Goodwill often results from such factors as: • • • brand recognition reputation market share earnings potential location customer list or base 29

Goodwill and Abnormal Earnings • The final price that a company will pay for another is the culmination of a bargaining process. – The amount of goodwill is subject to the negotiating process. – Goodwill is essentially the price paid for “excess” or “abnormal” earning power. 30

Amortization of Goodwill • Goodwill does not have a perpetual life, but it may be maintained by continuous efforts. • GAAP requires that goodwill be amortized and charged as an expense against net income for a period not to exceed 40 years. – Many companies use a much shorter amortization period. – Most companies use straight-line amortization. 31

Goodwill • Comparative National Practices – Conflict existed between U. S. and U. K. over benefits derived from immediate write-off • Problem magnified by increased merger activity • Conclusions – – Goodwill is not an asset under “separability” Goodwill meets the “reliability” criterion Goodwill meets the “relevance” criterion Accounting for goodwill should be flexible, but fully disclosed within competitive limits 32

Brands, Trademarks, Patents, and Related Intangibles • Should brands be capitalized? – Brand capitalization would • Restore equity • Enhance borrowing capacity • Facilitate takeovers without consultation with shareholders (U. K. ) • Avoid undervaluation of firms 33

Brands, Trademarks, Patents, and Related Intangibles • Methods of Accounting – Asset without Amortization – Asset with Systematic Amortization – Immediate write-off • “Current Cost” approach – U. K. • Capitalization without amortization if no limit to useful life – France • Brands are identified as intangible assets in Australia, France, and the U. K. 34

Brands, Trademarks, Patents, and Related Intangibles • U. S. – combination of asset-withoutamortization method and asset-withsystematic-amortization method depending on estimate of useful life • IFRS requires recognition of intangible assets for consolidated statements • U. S. and Canada must write off internally developed intangibles immediately 35

Brands, Trademarks, Patents, and Related Intangibles • International Accounting Standards – IAS 38 • Intangible assets only recognized if future benefits will flow to the enterprise and cost of asset can be measured reliably • Systematic amortization required for finite lives • Impairment testing for assets with infinite lives 36

Brands, Trademarks, Patents, and Related Intangibles • Conclusions – Problems are linked with the goodwill issue – Brand names qualify as assets under “separability” – Measurement of intangibles may not be “reliable” – Value-oriented approach to brands and intangibles should be used 37

A) The New Value Creation Process and Its Implications • Change in production processes: strategic phases are research, marketing and knowhow, and not so much manufacturing phases where intangible assets are key • Today main determinants of growth at firm (micro) and country (macro) levels are, therefore, intangible assets 38

A) Benefits of Intangible Investments Scalability, non-rivalry, non-scarcity • Large sunk costs, negligible marginal costs • Not subject to diminishing returns • Use by one user does not preclude the use by another user • Scalability only limited by the size of the market i. e. A computer operating system, a drug • Increasing returns to scale 39

A) Benefits (continued) Network Effect • Metcalf’s law – the value of the network increases geometrically with each new user • i. e. , software: • Window Office suite – the more users that can share documents the more valuable the software is • Instant messenger – the more people on your buddy list the more valuable it is to you. • The more travel agents and airlines that use Sabre the more valuable it became • Positive feedback loop – Napster, AOL, Win 95/98/2000 XP 40

A) Costs Unique to Intangible Investments Partial Excludability and Spillover • Difficult to exclude non-owners • Employee training benefits the employee and if the employee quits, the new employer gets the benefits • Non-patented employee know how • Electronic devices can be reverse engineered • New software functionality can be incorporated in rival products 41

A) Costs (continued) Partial Excludability and Spillover (continued) • Intellectual property laws for patents, trademarks, copyrights etc. vary from country to country • Not recognizing the value of an innovation and giving it away • AT&T – cellular telephony • IBM – PC architecture, cpu, DOS • Xerox PARC – Laser printing, Ethernet, GUI and the mouse 42

A) Costs (Continued) Inherent Risk • Intangibles are inputs into innovation and innovation is risky • 10% of patents account for 81 -93% of total patent value • Most new products fail • Earnings volatility (risk) is three times greater for R&D than physical investments Risk mitigation • Portfolio of patents • Many R&D projects • Research alliances 43

A) Costs (Continued) Non-tradability (except for intellectual property) • No organized and competitive markets • Measurement and valuation difficult without market prices • None or little value if projects abandoned • Result – most innovation in corporations and research centers • But, companies cannot use all of their innovations and there is no market for selling them(except patent licensing and royalties) 44

A) Problems encountered by firms capturing benefits from intangible investment… Economic attributes of intangible assets make it: – Difficult to exclude other users (public good problem) so firms cannot appropriate the full benefits from the investment (Geroski 1995) – Difficult to estimate ex ante the precise use of intangible inputs, potential products, and timing and magnitude of benefits – Difficult to write contracts for transfer or exchange of intangibles that are not embodied in a physical asset 45

A) Effect of uncertainty • Investment in intangibles is also associated with high levels of uncertainty/risk • While there is evidence that investment in intangibles leads to tangible investment, there is a lag between intangible investments and economic benefits (intangible investment occurs early in the life cycle) • To overcome problem associated with this risk, most accounting standards require expenditure on (particularly internally generated) intangible assets to be expensed considered more reliable 46

A) Measuring Intangibles Accounting and economic models relate inputs to output • For tangible assets you know costs (input), risk, and return (output) • For intangibles: • you don’t know the cost, risk, and returns • There may be no relationship between cost of input and value of output, but, you do know the risk is enormous. Without knowing how to measure intangibles you cannot understand them, and, therefore cannot manage them ! 47

A) The Logic of Traditional Accounting - ECONOMIC TRANSACTION AS THE “ENGINE” OF TRADITIONAL ACCOUNTING - ECONOMIC TRANSACTION SETS ACCOUNTING VALUE PRICE HISTORIC COST/FAIR VALUE - MEASUREMENT CATEGORIES LINKED MAINLY TO “FORDIST” INDUSTRIAL ACTIVITY - MEASUREMENT OF PERFORMANCE & SURPLUS IN A SHAREHOLDER PERSPECTIVE 48

B) Traditional Accounting for Intangibles (e. g. International Accounting Standard 38) • General suspicion • Recognition issues (R&D, Brands, Training) • Conservative measurement criteria: - General principle: Immediately expensed as a period cost - If recognised as an asset, then valued at Cost or Revalued Cost (not value) - Amortisation over a short period of time • No attention to the intangible drivers of value 49

B) Accounting for Goodwill • Most countries treat goodwill as an asset subject to systematic amortization – Maximum amortization periods of 5 to 40 years apply in some countries • U. S. and IASB treatment is an annual impairment test of goodwill • Some countries use immediate write-off method against reserves – Not permitted in U. S. , Australia, Japan • Some countries retain goodwill as a permanent asset 50

General Guide for Financial Accounting (GAAP) • Generally • Accepted • Accounting • Principles 51

What is financial accounting supposed to accomplish? Provide the most useful financial information for… Decision Making 52

Primary Accounting Setting Body in the USA • Financial • Accounting • Standards • Board 53

U. S. Government Agency That Oversees Financial Markets • Securities • Exchange • Commission 54

Remember… GAAP Are the Rules The FASB makes the rules. The SEC enforces the rules. 55

Statement 141: Business Combinations • All business combinations initiated after June 30, 2001 must use the PURCHASE METHOD • Pooling-of-Interests method is no longer permitted 56

Statement 141: Business Combinations • Requires disclosure of the primary reasons for a business combination and the allocation of the purchase price paid to the assets acquired and liabilities assumed by major balance sheet caption. 57

Statement 141: Business Combinations • Application of the purchase method requires identification of all assets of the acquiring enterprise, both tangible and intangible. • Any excess of the cost of an acquired entity over the net amounts assigned to the tangible and intangible assets acquired and liabilities assumed will be classified as goodwill. 58

Statement 141: Business Combinations • Fair Value is defined in SFAS No. 141 & 142 as “The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. ” • It is more of an “Investment Value” concept as the benefits of synergies and attributes of the specific buyer and specific seller are included. – The ability of a controlling shareholder to benefit from synergies and other intangible assets that arise from control might cause the fair value of a reporting unit as a whole to exceed its market capitalization. 59

Intangible Asset Recognition • An intangible asset shall be recognized as an asset apart from goodwill: – If it arises from contractual or other legal rights – If it is separable; that is, it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented or exchanged. 60

Intangible Asset Recognition • An acquired intangible asset (other than goodwill) with an indefinite useful economic life should not be amortized (regardless of whether it has an observable market) until its life is determined to be no longer indefinite • If no legal, regulatory, contractual, competitive, economic, or other factors limit the useful life of an asset, the useful life of that asset should be considered indefinite. 61

Intangible Asset Recognition • “The accounting for a recognized intangible asset is based on its useful life to the reporting entity. An intangible asset with a finite useful life is amortized; an intangible asset with an indefinite useful life is not amortized. The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity. ” 62

Intangible Asset Recognition • A number of pertinent factors that should be considered in deciding the useful life of an asset: – • • • Expected use of the asset by the entity Legal, regulatory, contractual limits to useful life Ability to renew/extend contractual or legal life Effects of obsolescence, demand, competition and other economic factors • Level of maintenance expenditures required to realize expected future cash flows • Useful life of another asset (or asset group) to which useful life of intangible relates 63

Intangible Asset Recognition • Separable intangible assets that have finite lives will continue to be amortized over their useful lives. • A recognized intangible asset that is not amortized must be tested for impairment annually, and on an interim basis if an event or circumstance occurring between annual tests indicates that the asset might be impaired. 64

Intangible Asset Recognition • The FASB has classified intangible assets into five categories: • 1. Marketing-related intangible assets • 2. Customer-related intangible assets • 3. Artistic-related intangible assets • 4. Contract-based intangible assets • 5. Technology-based intangible assets 65

Marketing-Related Intangible Assets • Trademarks, trade names • Service marks, collective marks, certification marks • Trade dress (unique color, shape or package design) • Newspaper mastheads • Internet domain names • Non-compete agreements 66

Customer-Related Intangible Assets • Customer Lists • Order or Production Backlog • Customer Contracts and Related Customer Relationships • Non-Contractual Customer Relationships 67

Artistic-Related Intangible Assets • Plays, operas, ballets • Books, magazines, newspapers, other literary works • Musical works such as compositions, song lyrics, advertising jingles • Pictures, photographs • Video and audiovisual material, including motion pictures, music videos, television programs 68

Contract-Based Intangible Assets • Licensing, royalty, standstill agreements • Advertising, construction, management, service or supply contracts • Lease agreements • Construction agreements • Franchise agreements • Operating and broadcast rights • Use rights such as drilling, water, mineral, timber cutting and route authorities • Servicing contracts such as mortgage servicing contracts • Employment contracts 69

Technology-Based Intangible Assets • Patented technology • Computer software and mask works • Unpatented technology • Databases, including title plants • Trade secrets, such as secret formulas, processes, recipes 70

GAAP FASB Statement No. 142 Goodwill and Other Intangible Assets (June 2001) This statement carries forward without reconsideration the provisions of Opinion 17 related to the accounting for internally developed intangible assets. This statement also does not change the requirement to expense certain acquired research and development assets at the date of acquisition as required by FASB Statement No. 2. AICPA APB Opinion 17 (August 1970) A company should record as expenses the costs to develop intangible assets which are not specifically identifiable. 71

Statement 142: Goodwill and Other Intangible Assets • This Statement addresses how intangible assets that are acquired individually or with a group of other assets (but not those acquired in a business combination) should be accounted for in financial statements upon their acquisition. • This Statement also addresses how goodwill and other intangible assets should be accounted for after they have been initially recognized in the financial statements. 72

Statement 142: Goodwill and Other Intangible Assets • Goodwill and intangible assets that have indefinite useful lives will not be amortized but rather will be tested at least annually for impairment. • Intangible assets that have finite lives will continue to be amortized over their useful lives, but without the constraint of an arbitrary ceiling. 73

Statement 142: Goodwill and Other Intangible Assets • Goodwill be tested for impairment at least annually using a two-step process that begins with an estimation of the fair value of a reporting unit. – The first step is a screen for potential impairment, and – The second step measures the amount of impairment, if any. 74

Statement 142: Goodwill and Other Intangible Assets • This statement requires disclosure of information about goodwill and other intangible assets in the years subsequent to their acquisition. Information to be disclosed: – The changes in the carrying amount of goodwill from period to period, – The carrying amount of intangible assets by major intangible asset class for those assets subject of amortization and for those not subject to amortization, and – The estimated intangible asset amortization expense for the next five years. 75

Statement 142: Goodwill and Other Intangible Assets • The provisions of this Statement are required to be applied starting with fiscal year beginning after December 15, 2001. • This Statement is required to be applied at the beginning of an entity’s fiscal year and to be applied to all goodwill and other intangible assets recognized in its financial statements at that date. 76

Impairment of Goodwill and Other Intangible Assets • SFAS No. 142 mandates that goodwill and intangible assets without a defined live shall not be amortized over the defined period; rather they must be tested for impairment at least annually at the “reporting unit” level. 77

Impairment of Goodwill and Other Intangible Assets • All acquired goodwill should be assigned to reporting units. This will critically depend on the assignment of other acquired assets and assumed liabilities. • The amount of goodwill allocated to a reporting unit is contingent upon the expected benefits from the synergies of the combination. This goodwill allocation is required even though other assets or liabilities of the acquired entity may not be assigned to that reporting unit. 78

Impairment of Goodwill and Other Intangible Assets • The measurement of the fair value of intangibles and goodwill can be performed at any time during the fiscal year as long as the timing is consistent from year to year. 79

Impairment of Goodwill and Other Intangible Assets • The annual impairment test is to be accelerated and goodwill of a reporting unit should be tested for impairment on an interim basis if an event occurs that would more likely reduce the fair value of a reporting unit below its carrying value. 80

Impairment of Goodwill and Other Intangible Assets • Impairment Test Triggering Events: – A significant adverse change in legal factors or in the business climate – An adverse action or assessment by a regulator – Unanticipated competition – A loss of key personnel – A more-likely-than-not expectation that a reporting unit will be sold or otherwise disposed of – The testing for recoverability under SFSA No. 144 of a significant asset group within a reporting unit – Recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of re reporting unit 81

Goodwill Impairment Test • The Two-Step Impairment Test: • Compare estimated fair value of each reporting unit to the carrying amount of the unit. – If FV > Carrying Amount, no need to perform Step 2 – If FV < Carrying amount, then Step 2. 82

Goodwill Impairment Test • If the carrying amount of a reporting unit goodwill exceed the implied fair value of that goodwill, then an impairment loss must be recognized for an amount equal to that excess. – In order to determine the implies fair value of the goodwill, all assets must be valued. – The impairment loss cannot exceed the carrying amount of the goodwill. Only the value of goodwill is adjusted through this process. – The adjusted carrying amount of goodwill be its new accounting basis. – Goodwill cannot be increased to its original carrying amount in the future. Once written down, it stays down. 83

Goodwill Impairment Test • Ex: Assume a company has a reporting unit with a fair value of $10, 000 including goodwill of $3, 000. further assume that the relative fair values of the assets have been valued and recorded on the books of the acquirer as: • _______________________ • Recognized tangible assets $5, 000 • Recognized identifiable intangible 2, 000 assets (with definite life) • Goodwill 3, 000 • ===== • $10, 000 • _______________________ 84

Goodwill Impairment Test • After one year assume the carrying amount of certain assets after amortization are: • _______________________ • Recognized tangible assets $3, 500, 000 • Recognized identifiable intangible 1, 500, 000 assets (with definite life) • _______________________ 85

Goodwill Impairment Test • Assume that an impairment test is performed at this time one year later and the fair value of the reporting unit is $9, 000. A new asset allocation must be performed to determine the new goodwill amount: • _______________________ • Recognized tangible assets $3, 800, 000 • Unrecognized tangible assets 1, 000 • Recognized identifiable intangible assets 1, 400, 000 • Unrecognized identifiable intangible assets 800, 000 • Goodwill 2, 000 • ______ • Fair Value of the reporting unit $9, 000 • _______________________ 86

Goodwill Impairment Test Net Carrying amount Fair Value Impairment Amount SFSA Citation (Taiwan) Recognized tangible assets $4, 000 $3, 800, 000 200, 000 142 Unrecognized tangible assets 0 1, 000 0 Recognized identifiable intangible assets (with a defined life) 1, 800, 000 1, 400, 000 Unrecognized identifiable intangible assets 0 800, 000 0 Goodwill 3, 000 2, 000 1, 000 Total $10, 000 $9, 000 $1, 600, 000 144 142 87

B) Consequences of Accounting Standards Current GAAP • Except for R&D almost no reporting and disclosures on intangibles • Required capitalization of software development costs is often ignored • Result • Investors and some levels of management are kept in the dark about investment and return on intangibles • Asymmetry of information • Abnormal gains to those that know the potential return on intangibles – insiders • As investment in intangibles increases, volatility and risk increases, asymmetry of information increases, and insider gains increase 88

B) In company reporting, once upon a time there was Goodwill. . . Purchase price – Fair value of net assets = Goodwill - Poor (synthetic) representation in cognitive terms of the intangibles possessed by an organisation - Residual value used to represent all the “unidentifiable”/“unseparable” intangibles of the acquiree - Managerial and users’ need for a more analytical knowledge, control, and representation of intangible elements of a firm’s wealth (brands, organisational capabilities, IPR, etc. ) and of its drivers 89

B) Unmeasured intangible inputs and outputs in the economy • Problem: Changing composition of investment is not reflected in financial reporting • Problem: Accountability of management for actions/decisions in managing the firm’s resources • Problem: Lack of data for analysis and rational resource allocation info. asymmetry 90

B) Micro-Economic consequences • Serious economic consequences for the firm from the poor accounting treatment of intangibles • The non-measurement of intangibles at the company level has adverse economic effects in terms of: - Investment decisions - Level of information asymmetry concerning a firm (volatility of share prices & insider trading) - Internal/management information systems 91

B) Intangibles at a macro level • Intangibles as connecting tissue, the “glue” that allows the homeostasis of the economic system • We need to better understand how tangibles and intangibles combine to create collective value • Intangibles are not measured or quantified – more often under-measured – at a macro level • Potentially serious consequences at a policy level wrong indicators wrong diagnosis of a country performance and policy recipe 92

Current US GAAP Criteria to be considered an asset • Defined and distinct • Effective control • Possible to predict future economic benefits • Possible to determine impairment Asset Examples: • Property, plant, equipment • Financial assets • Purchased identifiable intangibles such as patents, trademarks, copyright and mailing lists • Purchased goodwill 93

GAAP (continued) Internally developed intangibles • Expense when incurred (Except for software when certain conditions are met) Examples: • R&D • Training • Advertising Inequity in accounting treatment – intangible assets have future economic benefits—the matching principle is violated. 94

Relevance Reliability Comparability Consistency 1. Provides a basis forecasts 1. Is verifiable Different companies use similar accounting PRINCIPLES Company uses same accounting METHODS from year to year 2. Confirms/corrects prior expectations 3. Is timely 2. Is a faithful representation 3. Is neutral Characteristics of Useful Information 95 95

Basic Terms v. Relevance - information makes a difference in decisions v. Reliability - information must be free of error and bias v. Comparability - ability to compare information of different companies because they use the same accounting principles v. Consistency - use of same accounting principles and methods from year to year within the same company 96

GAAP (continued) Inequity between: acquired intangibles—capitalized and internally developed intangibles – expensed Cannot compare a company that acquired intangibles with another company that internally developed intangibles even though cost and benefits between the two companies are identical 97

Constraints in Accounting Permits companies to apply GAAP without hurting the usefulness of information • Materiality - The constraint of determining whether an item is large enough to likely influence a decision. • Conservatism - The approach of choosing an accounting method, when in doubt, that will be least likely to overstate assets and net income. 98

B) The Issue Improving information used by decision makers for the optimal investment in intangibles: • Investors and creditors – which companies to invest in or liquidate? • Business managers – which projects to invest in or drop? • Government policy makers, Regulators, and Standard Setters– what research needs to be funded and should increased information reporting and disclosure on intangibles be mandated? 99

B) Costs of Non-measurement - Firm level: risk of poor or wrong strategies - Industry level: misallocation of resources within and between industries; skill bias - Capital market level: under- or overvaluation of companies; misallocation of resources; volatility - Country level: policy making based on imperfect set of indicators may result in inappropriate policies 10

C) A series of initiatives: company and academic reactions • In 1992 Kaplan and Norton propose the Balanced Scorecard non-financial measures break in • In 1994 Skandia starts the production of an Intellectual Capital Statement • Many measurement and reporting models are put forward by practioners, academics, companies 10

C) A framework of analysis 10

Balanced Scorecard, Norton & Kaplan 1992 Financial Perspective (goals and measures) Internal business perspective (goals and measures) Customer perspective (goals and measures) Innovation and learning perspective (goals and measures) 10

Skandia Navigator, Edvinsson & Malone 1998 FINANCIAL FOCUS CUSTOMER FOCUS HUMAN RESOURCE FOCUS PROCESSES FOCUS INNOVATION AND DEVELOPMENT FOCUS OPERATIVE ENVIRONMENT 10

Intangible Assets Monitor, Sveiby 1997 INTANGIBLE ASSETS 10

Value Chain Scoreboard, Lev 2001 10

C) A series of initiatives at an institutional level • Half ’ 90 s: OECD Studies • 1999: International Conference in Amsterdam (OECD + Dutch and Danish Governments) • 2000: European Commission’s High Level Expert Group on the Intangible Economy • 2001 -2003: Research projects Prism and Meritum/E*Know-net funded by the Commission Meritum Guidelines on ICR 10

C) A series of initiatives at an institutional level (cont’d) • 2002: International Conference in Madrid (Autonomous University Madrid + Spanish Government + OECD + European Commission) • 2002 -2003: Official Study for the European Commission on the measurement of intangible assets (Ferrara+New York+Melbourne) • 2004: International Conference in Helsinki (Sept. ) + OECD Forum in Paris (Oct. ) 10

C) A series of initiatives at an institutional level (cont’d) • 1997 -2003: Danish Guidelines on IC Reporting as a result of a Government-driven project • 2002 -04: Various documents on intangibles by the UK Department of Trade and Industry • 2003: Letter on Intangible Economy signed by the UK, German and French Governments • 2004: German Guidelines on IC Reporting by the Ministry of Labor 10

C) A series of initiatives at an institutional level (cont’d) • June 2004: The Japanese Government issues a White Paper about making economic policy in the knowledge era strong emphasis on intangibles and intellectual capital reporting • April 2005: A new policy by the city's Pudong New Area recognition of human resources as capital contribution up to a maximum of 35% of the enterprise's registered capital, and a report and filing system for enterprise annual reviews (for both domestic and foreign companies) 11

C) A series of initiatives at an institutional level (cont’d) • 2004 -05: High Level Expert Group set up by the DG Research of the European Commission with the task of producing an official report on Intellectual Capital Reporting especially for research-based SMEs • 2005: Action Plan of the European Commission on business-related services strong recommendation to these co’s to prepare an intangibles-based report 11

C) A series of initiatives at an institutional level (cont’d) • June 2005: World Bank has organized a Conference on “Intellectual Capital for Communities in the Knowledge Economy: Nations, Regions and Cities” held in Paris • 20 -22 Oct. 2005: OECD will hold an International Policy Conference on Intellectual Assets in conjunction with the University of Ferrara (www. ferraraonintangibles. net) 11

C) Official Study for the European Commission A 2003 STUDY ON “THE MEASUREMENT OF INTANGIBLES” MADE BY THE UNIVERSITIES OF FERRARA, NEW YORK AND MELBOURNE FOR THE DG ENTERPRISE. Available at: http: //europa. eu. int/comm/enterprise/services/ business_services/index. htm 11

C) Definitions of Intangibles • Far too many definitions & different classifications and taxonomies of intangibles (micro & macro) • Need for reducing them through consensus • In the Study intangible assets defined as a source of future benefits that is without a physical embodiment: • Intellectual property is an intangible asset with legal rights • Includes innovation-related intangibles (patents), but also market-related (brands), human resource (compensation systems, training policies), and organizational intangibles (internal structures, systems and processes) • “Hard” intangibles (tradable) vs. “Soft” intangibles 11

Objectives of Financial Reporting FASB Concepts No. 1 Financial reporting should provide information: • That is useful to potential investors and creditors and other users in making rational investment, credit and similar decisions. • To help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts and net cash inflows to the enterprise. • About the economic resources of an enterprise, the claims to those resources, and the effect of transactions, events, and circumstances that change its resources and claims to those resources. 11

C) New measurement & reporting models for Intangibles • Various innovative methods for the recognition, measurement, and disclosure of intangibles and intellectual capital (IC) have been analysed • A taxonomy of the different new methodologies (holistic vs. atomistic; monetary vs. non-monetary) • The rise in company practice of IC statements • Analysis and comparison of the four main Guidelines on IC statements proposed so far (Meritum, Nordika, IFAC, and DATI) • Exploration of the relations between IC statements & Corporate Social Responsibility (CSR)(e. g. GRI) 11

C) A working definition of IC Intellectual Capital – IC – is the internal (competencies, skills, capabilities, etc. ) and external (image, brands, customer satisfaction, etc. ) stock of intangibles of an organisation, which allows the latter to transform a bundle of material, financial and human resources in a system capable of creating stakeholder value through the pursuit of sustainable competitive advantages (Zambon, 2000) Organisational knowledge becomes IC only when it is durably and effectively internalised or appropriated by an organisation 11

IC as New Concept for Representing & Managing Intangibles A concept that encompasses the various types of intangibles, including social and environmental intangibles - a “new” notion of the wealth of an organisation - thrust towards information relevance instead of reliability in reporting - a concept in evolution different accents - a concept on whose basis company reporting might be reformed? 11

C) Towards a New Reporting Tool Intellectual Capital (IC) Statements or Report on Intangibles Based on indicators many without a financial nature The partitioning of IC into three interrelated sections is quite widely accepted: Human Capital, Organizational Capital (including Innovation Capital), Relational Capital visualized/measured through indicators and parameters 11

C) Guidelines on IC statements: some emerging convergences and differences - International Federation of Accountants (IFAC) – Study no. 7 (1998) - Danish Agency for Trade and Industry (DATI) Guidelines (2000, but new edition 2003) - Nordika Project Guidelines (2001) - Meritum Project Guidelines (2002) - “Intellectus Model” (Spain) (2003) - German Guidelines (2004) - Japanese Guidelines (2005) Other documents deal with some aspects of IC reports, but without focussing on them (e. g. , GRI, EFQM, ISO) 12

C) INTANGIBLES AND INFO. USERS: THE CASE OF FINANCIAL ANALYSTS ü In 2001, the Italian Association of Financial Analysts (AIAF) set up a study group on Intangibles ü In January 2002, a model has been developed – in collaboration with the University of Ferrara – to measure the level of disclosure on intangibles by companies in their external reports ü This model has now been refined/extended in order to represent/rank European companies on the basis of their level of disclosure on intangibles 12

C) The Basic Framework for Ranking the Level of Disclosure on Intangibles (AIAF 2002) LEVELS OF COMMUNICATION ON INTANGIBLES Level 3 Extended information FIVE DIMENSIONS OF COMMUNICATION Level 2 “Reasoned” information Organisation Innovation & IPR Human resources Level 1 “Minimum” information Customers & Market Strategy Actual Forecast NATURE OF INFORMATION 12

IC Statements and Environmental and Social Reports: The case of GRI • The Global Reporting Initiative (2002) is: - a reporting framework for non-financial aspects - based on the three-dimensional concept of “sustainability” (economic, environmental and social) so called triple bottom line - evidence of an overlapping between IC statements and social & environmental reports (e. g. , indicators on employees’ training and education, supply chain management, quality of management, investment in R&D, stakeholder engagement) 12

An Intangible Perspective on CSR and Stakeholder Value THE BASIC IDEA SOCIAL CAPITAL & ENVIRONMENTAL CAPITAL AS PARTICULAR INTANGIBLES TO BE MANAGED BY COMPANIES (AND PUBLIC SECTOR ENTITIES) 12

The Integrated Reporting System Collectivity SOCIAL REPORTING Intangibles / Intellectual Capital Reporting ENVIRONMENTAL REPORTING Society TRADITIONAL FINANCIAL REPORTING Investors/Auditors/Financial Analysts 12

D) Main Policy Implication • Urgent to better measure intangibles both at micro and macro level • Priority: better measurement at firm level because good indicators at micro level allow also to build better indicators at macro level 12

D) Intangibles Reporting: policy recommendations • Policy aim: Develop and promote a new, integrated, reliable and verifiable company disclosure system which is based on intangibles • What is needed is CONVERGENCE between existing methods and reports 12

D) Intangibles Reporting: policy recommendations (cont’d) • Identify a standardised set of intangibles indicators serving as minimum common information denominator • Consistent data at micro level as foundation for more aggregated analyses in this respect we need rather detailed categories in the prospective intangibles taxonomy 12

D) Intangibles Reporting: policy recommendations • Provide incentives to firms to adopt a new reporting system based on intangibles, as well as to use and reveal that information • Favor the emergence of a generally agreed taxonomy and definition of intangibles • Encourage voluntary experimentations & exchange of best practices good IC reporting guidelines are already in place 12

D) Intangibles Reporting: policy recommendations (cont’d) • Induce information system/software providers to develop the collection of data on intangibles e. g. XBRL • Promote the gathering of the reported information on intangibles in a systematic and coherent way (cf. US Edgar) • Support ad hoc research 13

D) Intangibles reporting: policy recommendations (cont’d) • Convergence to be searched for with statistical • • offices, but starting point of intangibles information should be corporate reporting a delta, not a substitute Drawing on other forms of voluntary/ supplementary reporting (such as social, environmental, sustainability reports etc. ) for inducing companies to produce information on intangibles Looking for synergies in the efforts e. g. OECD + European Commission + US Institutions + Japanese Institutions 13

E) Some questions on IC Reports Despite their value and innovativeness, IC reports face some criticisms concerning their: - consistency - reliability/subjectivity - thoroughness - meaningfulness: a) high subjectivity in the choice of the useful indicators b) indicators do not possess additive properties c) high specificity of indicators 13

E) Some questions… (cont’d) However, some open problems: - Value in absence of a market price (value in use vs in exchange) (i. e. , credibility and meaningfulness) - Specificity vs Generalisability (i. e. , consistency & comprehensiveness problems) - Regulation vs Voluntary Compliance - Atomistic vs Holistic measurement approach - Common vs Different Measurement Units - Relevance vs Reliability - Users stakeholders? 13

Final consideration We face a major PARADOX: - The more the system is based on intangible assets, the stronger it is (because intangibles are major determinants of growth and value creation). - However, at the same time: the more the system is based on intangibles, the more vulnerable it becomes. The challenge we all face is to learn how to measure and report in this intangibles environment 13