Baruch Lev has a book called Intangibles: Management, Measurement, and Valuation. Published in 2001 by Brookings Press, it's a brilliant orientation to the relatively new field. I've run through the main points here.
The tone of the book is scholarly, and he looks objectively at the valuation of intangibles from three main viewpoints: the financial industry, the company management, and the regulators/policymakers.
The text is footnoted and referenced throughout, and an Appendix aggregates a few comments on the content of his work.
FRAMEWORK
Dr. Lev first describes intangibles as arising from one of three Nexuses:
- Discovery/R&D
- Unique Organizational Designs
- Human Development
(Wayne Upton points out in an Appendix called 'Comments' that, in general, "assets are defined to represent future economic benefits, be a consequence of a past transaction or event, and be controlled by the entity.")
Lev points out that we're at a historically significant time, where the globalization of the economy coupled with technological advances make intangibles more relevant because there's a new urgency to innovate, and intangibles drive innovation.
He then characterizes intangibles in terms of their economic benefits and drawbacks for a firm.
He explains that as things are now, those things that would be intangible assets are usually accounted for as expenses, and to change this so that intangibles are recorded as assets has many ramifications that further inform the situation.
He has some examples as to the pervasiveness and impact of this valuation and reporting issue, and makes some suggestions as to how to approach the issue.
WHAT IS THE IMPACT?
Though he breaks it out in different ways, and in more categories, fundamentally there are two main financial/economic/regulatory impacts described by Dr. Lev:
(1) Less confidence in capital markets.
Insiders have much more information about intangibles than outsiders do. The reason why insider trading is regulated is because information asymmetries tend to wreck confidence in capital markets. Market-makers increase the bid/ask spread in order to protect themselves - sometimes to the point where a market can't be made.
(2) Suppressed economic growth.
The increased bid/ask spread implies increased transaction costs. High costs need to be covered by a commensurately higher return on investment. A high ROI means a higher cost of capital, and when cost of capital is excessive this limits investments and growth. There's a study quoted that shows a higher cost of debt as well.
CHARACTERISTICS OF INTANGIBLES
Intangibles have characteristic benefits and drawbacks:
Benefits
1. Non-scarcity.
There is no rivalry for these assets; zero opportunity costs. Because of this, there is increasing returns to scale.
2. Network Effects.
The bigger the network, the better: there is a positive feedback loop. Networks sometimes have a tipping point, and they're facilitated by standardization.
The self-limit to the benefits in actual operation are the size of the market in which the asset is expected to generate economic gain, and that there is generally a limited capacity to manage the intangibles.
Drawbacks
1. Excludability
Non-owners enjoy the firms investment in intangibles (spillovers). There are no legal controls that fully address this issue, and even things like patents need defense, and expire eventually.
2. Risk
A few innovations are wildly successful, but most really don't yield at all. Risk tends to be highest at the earliest stages of creating an intangible asset and decreases as the asset is instantiated.
3. Markets
There isn't a market for intangibles as there would be for intangible assets, which means that any valuation is not externally validated. One of the inherent problems in this area is that it's not possible to write "complete contracts" that specify outcomes.
WHY HASN'T IT BEEN "MADE SO"?
1999 FASB intended to change the rules regarding R&D, but encountered pushback because if R&D is expensed then returns look like unencumbered growth, whereas if they're made as assets, and they fail -- remember intangibles have high risk -- then people are more likely to go back and question the original R&D investment decisions in the first place, which aside from being cumbersome, increases the potential for lawsuits. Further, some executive compensation is tied to Return on Equity or Assets, and accounting for R&D costs as expenses will inflate those ratios.
However, R&D is typically at least recorded as a line-item expense. Unfortunately other intangible assets usually are not.
TO DO LIST
Dr. Lev outlines a Value Chain Scoreboard. He develops this as an internal implementation in advance of necessary regulatory reform. He suggests focusing on information systems that gather information on specific areas: Discovery and leaning, Implementation, and Commercialization.
There's a considerable amount of discussion in his book, which I strongly suggest you go ahead and buy if you're considering implementations based on his suggestions. The relevant points are that by focusing on research, organizational structures and processes, and human development and relationships, the intangible assets of an organization can be catalogued and necessary tracking systems can be designed.
Further, he points out that the degrees to which risks and excludability issues are managed are very relevant to financial valuation in particular.
MORE GOODIES
And that's not all!
Appendix A gives an overview of relevant FASB regulation.
Appendix B talks about best practices in intellectual capital management.
And a section called 'Comments' offer tremendous insight by Brookings participants:
- Brian Hackett is concerned with how valuing intangibles relates to changes within the firm. "What gets measured gets done."
- Stephen Gates is similarly concerned with Organizational Development and Human Resource issues, pointing out that with regulatory requirements for measurement in this area, further research can point to better understanding of effective practices.
- Boyan Jovanovic looks from the market side at market-to-book value relationships in mathematical form, describing the effect of periods of technologically upheaval as well as learning curves. He summarized, "Lev's... broad message is exactly right: measure our intangible capital properly, and do it soon."
- Jack Triplett has a very interesting discussion from the policy viewpoint, including how intangibles are described and accounted for in the governmental system. He also points out a discontinuity between attaining monopolistic revenues via intangible structures vs. actually improving national productivity. (See Redefining Progress for issues about productivity measures.)
- Wayne Upton puts Lev's work in context with three reform proposition types: separate measurement systems that would be in lieu of current financial reporting; an optional supplemental system; or a required addendum to the initial system. He asserts that Lev is in the second category having earlier been in the third; he suggests Total Value Creation by Canadian Institute of Chartered Accountants as a good example of the first.
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