With intangible assets such as patents dominating so much of the modern economy, why are they still largely off the balance sheets of America's largest corporations?
Some headline-grabbing patent sales have reignited interest in the question. Among them: the $4.5 billion auction of Nortel's wireless patents on July 1 and Google Inc's $12.5 billion August 15 bid for Motorola Mobility Holdings Inc and its 24,500 patents and pending patent applications, and other assets.
Now Australian accounting standards setters, on behalf of a global group that includes the U.S. Financial Accounting Standards Board, may be moving the subject onto the global accounting agenda. The Australian accounting rule maker has recently surveyed corporations, auditors and regulators on the topic of intangible accounting and whether changes should be made.
In the United States, such intangible assets as brands, customer relationships, patents and other information technology are accounted for in one way if created in-house and another if acquired.
Intangible assets a company develops itself are valued at little more than the legal and filing fees, because the research is deducted as an expense, not capitalized. Assets that are purchased, on the other hand, like the patents Google will acquire with its Motorola bid, are recorded at fair value.
Critics say that the difference makes it difficult to compare corporate finances and often hides a company's most important assets.
FROM ZERO TO BILLIONS
The different treatment means a patent that was developed by one company and then sold to another can go from being valued at next to nothing, to being worth millions -- or even billions -- of dollars, almost overnight, said Esther Mills, president of Accounting Policy Plus, a New York-based adviser specializing in complex accounting issues.
Mills is among those who feel internally developed intangibles should be on the balance sheet, either at their fair market value or at an amount that more fully captures the costs of the research and development that went into producing them.
The accounting difference could result in distorted behavior, warns Abraham Briloff, a professor emeritus of accountancy at Baruch College, tempting companies to buy intellectual property rather than doing research themselves.
The value of patents purchased are subtracted from earnings over their useful life, but in industries like telecommunications where companies are valued on an EBITDA basis, those costs are likely to be largely ignored by analysts and investors. EBITDA is earnings before interest, taxes, depreciation and amortization.
Some accounting experts counter that moving patents and other intangibles to the balance sheet would be subject to abuse.
I could see this becoming a very good way to manage earnings, said Robert Willens, president of tax and accounting service Robert Willens LLC.
For example, companies could inflate profits by capitalizing both direct and indirect costs of developing intangibles, removing them from the income statement as an expense, he said.
Determining the proper value of an intangible is not easy and can be especially challenging in such situations as Google's. Beyond any value the Motorola Mobility patents may bring in terms of future cash flow, Google is also counting on them as a defense against competitor lawsuits. That's especially subjective and tricky to value, experts say.
The issue has become more important as the U.S. economy has moved more and more toward one dominated by intangible assets. According to Ocean Tomo, a Chicago specialist in valuing assets, 80 percent of the market value of the S&P 500 in 2010 could be attributed to intangible assets, up from 68 percent in 1995 and 32 percent in 1985.
Since 1999 a premium has been consistently paid for intangible assets, though it is lower today than it was at the height of the technology bubble in 1999 and 2000, according to the examination of more than 6,000 technology and telecoms mergers and acquisitions done for Reuters by data tracker Capital IQ.
A further look at just the 848 deals that put a measurable value on the intangibles acquired showed the premium paid for intangibles has varied over time but hit a recent high in 2010 when acquirers paid an average of 15 times the target company's intangible asset value.
A study by Carol Corrado of The Conference Board research association and University of Maryland professor Charles Hulten published in 2010 found that by the mid-1990s, companies had begun investing more in intangible assets than in tangible assets such as buildings and machinery. The gap has only grown since.
One reason for the disconnect between the economy and corporate accounting may be executives' lack of interest in fixing it.
Robert Herz, former chairman of the U.S. Financial Accounting Standards Board, said that in 2006 and 2007, when his group and the International Accounting Standards Board consulted with investors, managers and auditors about what the two standard setters should focus on, accounting for intangibles did not generally rank as highly as a number of other subjects.
New York University Professor Baruch Lev, who has studied intangible assets extensively, said the status quo protected managers to some degree. They have off-balance-sheet financings and off-balance-sheet assets and they're very happy to have off-balance-sheet intangibles, Lev said. Intangibles are risky, there is no doubt about it, and they might have to write them off, answer embarrassing questions. They ask, 'Why do we need this?'
Investors may be suffering for their poor grasp of intellectual property. James Malackowski, CEO of Ocean Tomo, pointed to the market-beating performance of his company's index, which comprises the 300 companies that own the most valuable patents relative to their book value. According to the firm's calculations, the Ocean Tomo 300 Patent Index has beaten the S&P 500 since in inception in 2007.
Because investors don't have sufficient data on who owns patents, and their value, he said, they are missing the true worth of many good companies.