7(b). Other Intangible Assets
[Context] The AIMR position paper provides a summary of the section (pages 11-20) entitled "The Changing World and Its Implications for Analysis," which describes the effects on financial analysis and financial reporting of three major phenomena:
The world constantly is changing and everyone must adjust to accommodate those forces over which they have no control. The nature and implications of three major phenomena that are expected to affect financial analysis and analysts are considered here. Those matters also have considerable influence on the views and conclusions expressed later in the paper. . . . [Also included in 16(a), 18(a), and 19] [AIMR/FAPC92, p. vi]
Third, the accounting model used today was developed to fit enterprises whose economic activity was primarily in manufacturing or merchandising. Today, services of all types constitute a major portion of economic endeavors. Financial assets play a larger and larger role as more and more funds are saved and invested than ever before. The current accounting model has been challenged on many fronts. Our conclusion is, however, that it is fundamentally sound but there are many ways in which it could be employed more efficaciously than it is today. Much of the remainder of the paper is devoted to describing our suggestions for improvement. [Also included in 19] [AIMR/FAPC92, p. vi-vii]
[Context] Those two paragraphs introduce the following excerpts pertaining to the third major phenomenon listed. Excerpts pertaining to the other two phenomena are included primarily in 18(a)-International harmonization of standards and 16(a)-Databases.
Rise in the Proportion of Economic Activity Conducted by the Service Sector
Whether we like it or not, manufacturing and mercantile operations have become over time a smaller and smaller segment of the economies of the United States and many other developed nations. Much of the value added by business enterprises in those economies now comes from services: business and personal services, and financial services. These are businesses in which physical assets, plants, inventories, and the like, have little importance. In turn, traditional accounting-based performance measures have also suffer severely reduced usefulness. For example, return on invested capital is not a very meaningful measure in a law firm or accounting firm, or even an investment advisory firm, because so much of the capital is formed from human resources, inherently unmeasurable under current accounting precepts. [AIMR/FAPC92, p. 17]
Service firms can be divided into two different categories: financial services and all others. The latter encompasses a variety of activities. Included therein are professional services (legal, accounting, architectural, etc.), business services (telecommunications and cable television, waste removal, etc.), entertainment in all its myriad forms including sports, and educational services provided by a variety of vendors. All of these endeavors have common implications for financial reporting. First, the value of the service often may have little relation to the cost of providing it. A different perspective would be that certain services are unique or otherwise protected from competition, as in the case of cable television. Conversely, some other services are marketed to a competitive extreme. [AIMR/FAPC92, p. 17]
In all of these service companies, traditional measures of profitability, liquidity, productivity, solvency and efficiency have lost some of their usefulness. The share of economic resources represented by plant and other tangible assets has diminished in size and importance, displaced by intangible assets arising from monopoly rights and other singularities, market shares and brand names, contractual and other stable relationships with clientele, and a host of others. In many cases, the future cash flows of the service firm depend on retaining personnel who are trained and competent to provide the services to existing customers and, even more important, to bring new customers to the business. [AIMR/FAPC92, p. 17]
The problems in accounting for service-type firms are epitomized by the methods of accounting that apply to computer software firms. FASB Statement 86 sets standards for accounting for the cost of computer software to be sold, leased, or otherwise marketed. Its reasoning is in accord with traditional accounting thought, but its result is to place on the balance sheet as an asset an amount that depicts neither the value of the software nor the total cost of developing it. Software revenue recognition is addressed in AICPA Statement of Position 91-1. It applies accounting for contracts more or less successfully to computer software development, but it gives unsatisfactory answers to the unique problem of a software vendor's continuing obligations to customers after installation. We do not fault either the FASB or the AICPA. They did the best they could in applying the current accounting model to a situation it was not designed to fit. Nor do we believe that the current accounting model should be discarded for one that is radically different. We are at this time merely pointing out the strains on it from applying it to new and different business activities. Our suggestions for change appear later in this report. [AIMR/FAPC92, p. 17-18]
[Context] The following brief summary of the topic "Accounting for Intangible Assets," is from the "Executive Summary" of the report the AIMR's Financial Accounting Policy Committee (FAPC):
Current accounting for intangible assets has great potential for confusion. Purchased intangibles are initially recorded at cost and amortized over periods of time that often are arbitrarily determined. Self-developed intangibles are for the most part not recorded. Financial statement comparability between and among enterprises suffers accordingly. Our contemplation of this situation leads us to two major recommendations that we believe will increase comparability. Both recommendations are controversial and should be considered in the light of the full discussion of them in the report. [Also included in 7(a) and 8(c)] [AIMR/FAPC92, p. viii]
First, we advocate capitalization of all executory contracts with an initial duration of more than one year. We would include not only leases, but also employment agreements and similar contractual arrangements. Our recommendation does not advocate any change that would weaken the standards governing revenue recognition. [Also included in 7(a) and 8(c)] [AIMR/FAPC92, p. viii]
Second, we recommend that purchased goodwill will be written off at the date it is acquired. We believe that it is an important number, but only to depict a value at a particular date, a value that undoubtedly is subject to rapid and sizable change thereafter. We cannot see how its presence on the balance sheet is of use in estimating a firm's future cash flows or gauging its contemporaneous value. Therefore, we recommend banishing goodwill from an enterprise's list of assets, but preserving a record of it by having it show as a separate and distinct reduction of shareholders' equity. [Also included in 7(a) and 8(c)] [AIMR/FAPC92, p. viii]
[Context] It indicates the scope of the discussion of the topic and lists the report's major recommendations, providing an introduction to the following excerpts from the report.
An earlier part of this report, [pp. 17 and 18, quoted in 7(b)] discusses implications for financial reporting of the rise in the proportion of economic activity attributable to the service sector. One ramification is its exacerbation of the persistent and vexing question of how to account for intangible assets. Service businesses are, with certain notable exceptions such as telecommunications, generally labor intensive. These firms have few tangible assets and in many cases have balance sheets that under conventional accounting show meager or even negative owners' equity. In fact, however, they may possess sizable unrecorded economic resources in the form of anticipated future cash flows. Yet, under traditional accounting methods, the value of those future cash flows is recorded only when: (a) they are acquired in a purchase transaction with an unrelated party, or (b) the anticipated cash finally is received. On the other hand, equity investors and lenders are forced to acknowledge the value of future cash flows in order to make sensible investment and lending decisions in competition with other rational suppliers of capital. Our views on this matter are set forth below. [Also included in 7(a) and 8(c)] [AIMR/FAPC92, p. 29]
Nature of the Problem
All economic value must ultimately result in cash inflow(s). In fact, it is future cash flows to which both equity investors and lenders look for a return on and return of their investments. Tangible assets offer an additional measure of comfort in that they usually but not always have some value at liquidation even though it may be modest. Furthermore, tangible assets are, without significant exception, acquired in exchange transactions with outsiders and, except for business combinations, are usually acquired individually or in groups of related items. Even when acquired in a basket purchase, it usually is not particularly difficult to obtain competent data to allow their values to be reported separately. Therefore, ordinarily there is little problem in recording at least the initial values of tangible assets. The same is true of intangible assets (patents, franchises, etc.) purchased separately. [Also included in 7(a) and 8(c)] [AIMR/FAPC92, p. 29]
Major problems arise with accounting for intangible assets that either are self-developed or acquired in a business combination. Other problems emanate from intangibles whose sole value comes from their ability to enhance the cash flows of a going concern. For example, how are analysts sensibly to compare two firms, one of which has developed strong brand names through sizable expenditures none of which has been capitalized (say, the Proctor and Gamble Company), the other of which has grown by purchasing the brand names of others (say, RJR Nabisco)? How are analysts to find useful the financial statements of cable television and other media firms that have significantly negative net worths because they have borrowed against future cash flows and used the proceeds either to cover reported losses or to make payments to stockholders?7 [Also included in 7(a) and 8(c)] [AIMR/FAPC92, p. 30]
Sources of Future Cash Flows
Intangible assets comprise all sorts of contractual, institutional and informal arrangements, all of which are characterized by associated expectations of future cash inflows. Many of these values are attributable to human beings who are talented, well-trained, acculturated, or otherwise able and willing to contribute to the enterprise's economic well-being. Arrangements between the firm and its employees vary. Some, mainly senior managers and others who make unique contributions, serve under individual contracts. Some of those contracts may contain provisions that activate sizable payments at or after the individual's separation from the firm, so-called "golden parachutes" and similar arrangements. At the other end of the scale are collective bargaining agreements with unions and other worker organizations. In between are the ordinary day-to-day, month-to-month continuances of employment and service. [Also included in 7(a) and 8(c)] [AIMR/FAPC92, p. 30]
Future cash flows may also be attributed to franchises. That term is used in its broadest sense to include not only contractual arrangements, but also other exclusive accesses to customers. A brand name might be said to be a "franchise." For example, one thinks of the position of the Campbell name in canned soup, H.J. Heinz in ketchup or Bayer in aspirin. Another example of an exclusivity is a long-established reputation, such as those carried by the "Big Six" accounting firms, certain major law firms, advertising agencies, actuaries, consultants and a host of other professional services providers. Health care organizations are very likely to have franchises arising from both their reputations and their proximity to patients. A news distributorship in Manhattan, New York City, is worth more than one in Manhattan, Kansas. The examples could go on and on. [Also included in 7(a) and 8(c)] [AIMR/FAPC92, p. 30]
In many cases expectations of future cash flows may dissipate in the face of competition and are able to continue to flourish only if the enterprise continues to support them with attention and expenditures. Alternatively, exclusive rights may be obtained either under law (patents, copyrights, trademarks, etc.) or by contract. An enterprise may contract for a franchise (in the narrow sense of the word) for human services, for services to be provided by another organization, or for the rights to use real assets (plant and equipment) for limited periods of time. [Also included in 7(a) and 8(c)] [AIMR/FAPC92, p. 30]
All of the above are intended to be an illustrative but not exhaustive list of the incredible variety of sources of intangible value. All of them illustrate cases of valuable assets that, with two exceptions, are not recorded. One exception is when the asset is purchased in an arms-length exchange transaction. The other exception is for certain lease agreements that meet one of the conditions that qualify them as capital leases. [Also included in 7(a) and 8(c)] [AIMR/FAPC92, p. 31]
Discovery Values
Some years ago, the SEC initiated an experiment with "reserve recognition accounting" for oil and gas producing firms.* [*Note added by staff--While oil and gas reserves are more like inventory--product or raw material still in the ground--than like most intangible assets, they have, as the AIMR report emphasizes, essentially the same recognition and measurement problems as intangible assets.] . It never got beyond the stage of supplemental data and it entailed many practical and conceptual problems. Yet many analysts found that the information it generated, although primitive, was both unique and useful for valuation purposes. Portions of it remain in the disclosure requirements for oil and gas producing activities under FAS 69. AIMR would like to see additional research on reserve recognition accounting as a prelude to a reconsideration of it as a possible replacement for current methods. [AIMR/FAPC92, p. 32]
Both the "successful efforts" and "full cost" methods in use today are seriously impaired by their implicit assumption that part or all of the cost of exploration is a decent measure of the value of that which is discovered. Reserve recognition accounting, if feasible, would bring financial reports closer to the economic reality of how wealth is created not only in the oil and gas industry, but also in other types of enterprise in which significant values are created by "discovery." It has the strength of focusing on and reporting how discovery creates wealth and how other activities, such as production, refining, and delivery, enhance it. [AIMR/FAPC92, p. 32]
Costs to Create Intangible Assets
We are not enamored of recording self-developed intangible assets unless their values are readily apparent. We consider the cost of creating them to be so often unrelated to their actual value as to be irrelevant in the investment evaluation process. Furthermore, it usually is next to impossible to determine in any sensible or codifiable manner exactly which costs provide future benefit and which do not. For example, even though we would record the contractual amounts of employment agreements, we would not go so far as to capitalize the costs of training and developing human resources. [Also included in 7(a) and 8(c)] [AIMR/FAPC92, p. 32-33]
We cannot quarrel with capitalization of the costs of intangible assets that are purchased. In that case, the cost is the value of the asset: no heroic or outlandish assumption is required. However, to approach comparability with firms that have created similar intangibles with their own resources, we recommend amortization of the purchased variety over economic lives that we expect will be short. In most cases a purchased intangible will maintain its value only if it is tended and cared for by the type of expenditures that create self-developed ones. A better way of looking at it is that if the purchased intangible is not maintained, it will be exhausted quickly not to be replaced by a self-developed one. [Also included in 7(a) and 8(c)] [AIMR/FAPC92, p. 33]
We reiterate our strong feeling that goodwill should not be recognized except briefly and only when it is determined by the exchange price for an entire enterprise. [Also included in 7(a) and 8(c)] [AIMR/FAPC92, p. 33]
The Importance of Cash Flows
The discussion above makes it clear that intangible assets derive their value from the prospects they engender for future cash flows and that it is difficult or impossible in many cases to obtain a sufficiently reasonable measure of their value to place on the balance sheet. Therefore, it is important in extremis for financial reports to disclose clearly the amounts and sources of past cash flows. The ultimate test of the value of an intangible asset is whether or not it contributes to the stream of cash entering the firm. This is exactly the reasoning implicit in FAS 2, "Accounting for Research and Development Costs." Because the expectation of future benefits from research expenditures is so uncertain, their value cannot be recorded in advance. We must wait until they are received in cash. [Also included in 7(a) and 8(c)] [AIMR/FAPC92, p. 33]
Not only do we have to know the source of cash flows from intangible assets in detail, we also have to know how likely it is that they will continue and at what rate. While the flows continue we need to know what is being done with them. Are they being distributed or reinvested? Are the reinvestments in kind or are they a divergence from past practice? Much of the needed cash flow information requires both disaggregation of historic data and candid management discussion of the future. We speak later in this report at greater length about other aspects of the usefulness of the cash flow statement. [Also included in 7(a) and 8(c)] [AIMR/FAPC92, p. 33]
Conclusions about Intangible Assets
Our overall conclusion on intangible assets can be summarized as follows. It is an area fraught with difficult conceptual and implementation problems and we do not have a monopolistic position with respect to their solutions. However, we believe that financial reporting can be modified so as at least to recognize more of the economic reality of intangible assets than it does now. We recommend the following: [Also included in 7(a) and 8(c)] [AIMR/FAPC92, p. 33]
1. Assets and liabilities should be recognized for the present values of future cash flows when: (a) they are the result of contractual arrangements, and (b) the cost of providing the service does not directly determine its selling price.
2. Goodwill should not be recognized except briefly as it is determined by the exchange price for an entire enterprise because: (a) its determination (except at the rarely-encountered moment of an exchange) is the stuff of financial analysis, not accounting, and (b) its value at that moment is fleeting and has no necessary or causal relationship to its value in the future.
3. Reserve recognition accounting should be reconsidered, supported by adequate prior research.
4. Past cash flows are extremely important and should be reported in terms of: (a) their source, (b) the likelihood of their continuance, and (c) the means to replace them when it becomes necessary. [Also included in 7(a) and 7(c)] [AIMR/FAPC92, p. 34]
__________
[Context] Meeting of the Investor Discussion Group on October 16, 1992. When discussing the types of information they use and the adjustments they make to that information to achieve their objectives, investors were specifically asked about goodwill and other intangible assets.
Participant I-1
What about amortization of things other than goodwill (software, for example)? [Also included in 1(b)] [TI 10/16, p. 34]
Participant I-5
Software of course depreciates. Amortization of film inventories counts, it's critical. [Also included in 1(b)] [TI 10/16, p. 34]
Committee/Staff/Observer
So you differentiate goodwill from other intangibles. [Also included in 1(b) and 7(a)] [TI 10/16, p. 34]
Participant I-5
Goodwill is an easy one. Other intangibles, you have to think about. Goodwill is virtually automatic. [Also included in 1(b) and 7(a)] [TI 10/16, p. 34]
[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of goodwill.
Participant C-11
I write it off. There are problems with other intangibles also, for example, mortgage servicing. I'm going to have very different points of view of the value of servicing if a company has an awful lot of that, and a lot of the amortization relates to that. We've had a problem just this last year, there were a lot of companies that had to write off some of these service intangibles. [Also included in 7(a)] [TC 2/2, p. 43-44]
[Context] The papers are a summary of a committee and staff members' discussions with selected sell-side analysts from Goldman Sachs.
[One analyst] would like more data on off balance sheet items and admits that she eliminates goodwill from the balance sheet. She does admit, however, that other intangibles may have some value. [Also included in 1(b), 5(b), and 7(a)] [GOLDMAN, p. 2]
7(c). Other
[Context] The papers are a summary of a committee and staff members' discussions with selected sell-side analysts from Goldman Sachs.
[One analyst] believes accounting should strive to avoid volatility in earnings and he stated that the pooling concept makes numbers hard to compare. He believes there should be one standard for accounting and specifically mentioned his unhappiness with the choice of either of LIFO or FIFO. He tends to look at five years back and projects two years forward. [Also included in 1(a), 1(b), and 8(a)] [GOLDMAN, p. 3]