The Accounting Cycle: Wash, Rinse and Spin Oh, the Intangibility of Intangibles!
By: J. Edward Ketz (http://accounting.smartpros.com/x29141.xml)

Feb. 5, 2001 (SmartPros) The research into business combination accounting by the Financial Accounting Standards Board, in particular, the examination of what to do with goodwill, raises the issue of accounting for so-called intangible assets. There is no question that trade names, trademarks, and research and development have value. The issue, however, is how to present the items on an entity's balance sheet.



If we didn't care about reliability, I suppose we could allow managers to value these items any way they choose. But, investors and creditors do care whether these numbers are meaningful and useful. When they witness a line item in the asset section of a balance sheet that shows a certain account with an associated dollar amount, investors and creditors want to be reasonably sure that the asset exists and that its measurement is reasonably accurate given the method employed and given the limitations of accounting in the real world. They don't need fluff.

The argument to measure intangibles at their fair market value is appealing. Current market values would give some idea of what the asset is worth to the company. Such current market values depend on a market that encompasses trading of intangibles and such markets either don't exist or are quite thin, causing the valuation method to be unreliable. Impairment tests are similarly flawed.

Another way of saying this is that the numbers are virtually unauditable. If I were the partner in charge of an audit, I would have some trepidation signing off on the valuation of intangible assets because, if the firm faced financial distress in the future, my reputation would be on the line. I wouldn't relish the prospect of defending the valuations in a court of law.

Consider the valuation of goodwill with the excess earnings approach. The basic idea is that the business generates above average earnings and accordingly receives a market premium.  In this case goodwill equals the discounted value of the excess future earnings (sometimes called abnormal earnings). Fine so far, but let's ask some practical questions. What is normal earnings and how do you measure them? How well can managers forecast their normal and excess earnings? Since very high earnings will attract entrants into the industry, how far into the future will these abnormal earnings exist? What is the appropriate discount rate to use when discounting these earnings? In sum, to value goodwill you have to know the future, you have to be able to distinguish normal from abnormal earnings, you have to know when to terminate the flow of excess earnings, and you have to know the correct discount rate to use. Fat chance!

A number of years ago, Don Kirk, former chair at the Financial Accounting Standards Board, stated, "Balance sheets ignore certain intangibles, but the reporting issues of trying to recognize them are, in my mind, insurmountable." Kirk was correct in this observation, and nothing has happened since then to change its thrust.


Questions:

  1. Why don't accountants use market value to put a value on intangible assets in the balance sheet?
  2. Are some intangibles different from others in this respect?  Can there be objective standards applied to the valuation of some intangibles, that would, nevertheless, allow for a better valuation?
  3. What do you think of Damodaran's technique for valuing R&D?
  4. Can you think of other ways to (relatively) objectively approximate the market value of intangibles?