What is the value of IP – and why does it matter?

By Gary Anders

Global mergers and acquisitions activity surged to record levels in 2021, fuelled by a wave of major deals.

Among the biggest transactions of the year was Discovery’s US$43 billion (A$58 billion) merger with WarnerMedia, a business owned by the US telecommunications giant AT&T.

In addition to the iconic Warner Bros. film studios business and its catalogue of thousands of movies and TV shows, the deal incorporates a powerful portfolio of famous entertainment, news and sports brands including CNN, HBO and TNT.

Discovery folded in its own stable of well-known TV brands including the Discovery Channel, Animal Planet and TLC.

To get the deal over the line, both parties needed to agree on fair values for all of their respective assets.

This included a huge list of intangible assets, such as registered trading names, digital copyrights, technology patents, designs and symbols, and other forms of intellectual property (IP).

Adding to the complexity of this enormous valuation exercise was the fact that most of the intangible assets wrapped up in the merger are not listed on either company’s balance sheets.

That is because, under the relevant international accounting standard IAS 38 and Australia’s equivalent standard AASB 138, entities are only encouraged, but not required, to disclose their intangible assets.

There is a range of reasons for that. First and foremost, internally generated intangible assets, such as brands, are not recognised under the standards as having an actual value.

The standards deem that a book value can only be placed on acquired intangible assets resulting from a business takeover or merger.

However, once recorded, the fair value of an acquired intangible asset cannot be increased over time. Furthermore, if an intangible asset has a finite life, it must be amortised.

Facebook, for example, has more than US$19.7 billion (A$27 billion) in intangible assets, including what it calls acquired users, acquired technology, patents and trademarks.

This figure has been fairly constant for more than a decade, but only because Facebook has kept adding new acquisitions to its books.

Keoy Soo Earn FCPA, regional managing partner for the financial advisory practice at Deloitte South-East Asia, says the growth in the overall value of intangible assets has been particularly prominent across the technology sector as we progress towards knowledge-based economies with greater dependency on intangible assets.

“A company that has gone through an acquisition will have it on their books, while a company that has grown organically will not have it on their books,” he says.

“The accounting standards don’t really recognise internally generated intangible assets.

“For example, in Coca-Cola’s books, the Coke brand is not recognised as an intangible asset. Likewise, at Pepsi, Pepsi’s brand is not recognised.

“But if Coke acquired Pepsi, then the value of Pepsi’s brand would appear in Coca-Cola’s consolidated books. The Coke brand would still not be there.”

Soo Earn says the financial statements in company annual reports, therefore, don’t give real visibility over the value of intangible assets.

“You cannot increase the fair value of intangible assets after an acquisition.

“It is quite difficult to understand, especially if you don’t have visibility on what the business has gone through – whether it’s organic growth or inorganic growth. One is on the books, and one is not.

“We say, price is what you pay, and value is what you get after you pay the price.”

The challenge of valuations

Ian Mackintosh FCPA, former vice chair of the International Accounting Standards Board, says that when a business takeover occurs, the acquirer needs to work out what intangible assets have been purchased and what has been paid for them.

“But the real difficulty in all of it is getting a valuation. The standard-setters, in dealing with this, are really worried about manipulation, and that people are claiming figures that aren’t at all realistic.”

Mackintosh says another issue revolves around companies generating their own intangible assets through research and development, but these can’t be capitalised on their accounts.

 

"The issue that I see with the traditional balance sheet approach to IP is that, due to accounting standards, it is not easy to recognise R&D and put it on the books until it's sold and recognised as part of the goodwill."

 

He uses an example of pharmaceutical companies working on the development of medicines.

“As you go, you’re not really sure whether it’s going to work or not and be worth anything or nothing, and if it does work, how much it’s going to be worth.

“There’s lots of suggestions around that – maybe you should be able to capitalise that sort of expenditure, then write it off if it doesn’t work.

“Then there’s suggestions that you should be able to separate expenditure for work undertaken for current activities and for future growth, which can be hard to define and measure.”

Mackintosh says intangible assets should be itemised on a company’s balance sheet in the notes to its accounts, “but it’s a lot of work, and there’s a lot of debate about how useful the information is at the end of the day.

“When you take over a company, you might use their list of clients. What’s that worth, and how long is it going to last? They are really difficult questions to answer.”

Jack Shan, principal patent attorney at law firm Davies Collison Cave, says patents, trademarks and other types of intellectual property are critical components of a business’s intangible assets.

He points out that intangible assets now account for about 90 per cent of the value of the entities within the S&P 500 Index of US-listed companies.

“It’s important for companies to keep a register of their intangible assets. The issue that I see with the traditional balance sheet approach to IP is that, due to accounting standards, it’s not easy to recognise R&D and put it on the books until it’s sold and recognised as part of the goodwill.

“A significant share of a company’s value resides in intangible assets. So, it’s important to identify and manage these assets well.

“But there is very little correlation between the cost of developing something and its ultimate value. You could develop something for very little, and then it could be highly valuable. Or you could spend millions of dollars on an idea that nobody wants.”

Shan says that is where it is important to involve registered patent attorneys and trademark attorneys as part of the due diligence process, to gain a better understanding of the underlying assets’ value. Shan says not valuing IP potentially risks missing out on the real value of assets.

“The opportunity is to have a clearer understanding behind the drivers of value, which can then be reflected in the business strategy.”

The intangibles reporting gap

The University of Melbourne has recently conducted an investigation into disclosures of unrecognised intangible assets by Tier 1 Australian reporting entities for the Australian Accounting Standards Board.

It found that entities are generally not making voluntary disclosures of unrecognised intangibles, although there are more disclosures from sectors in which intangibles typically play a significant role in entity values, such as the pharmaceutical and information technology sectors.

Professor Michael Davern FCPA, chair of accounting and business information systems at the University of Melbourne, led the research team that published its findings in March 2021 in the report Disclosing Unrecognized Intangibles.

“We did quite an extensive search within Australia and found that there’s not much that’s being voluntarily disclosed in the way of unrecognised intangibles, which is very interesting,” Davern says.

“It’s OK when you’re recognising IP from an external acquisition point of view. It’s when they are internally generated things that they become a lot more problematic.

“How do you distinguish between research and development, which is creating valuable IP? The distinction can be subtle, and changes whether you can expense it or capitalise it.

“This is an area of longstanding debate in accounting, which I don’t think is ever going to be fully resolved.”

Davern says recognising intellectual property can sometimes also be a sensitive issue because companies don’t want to disclose what they are undertaking to the market because of the competitive nature of their IP.

“If you’re doing research, do you want everyone to know about that research and what the prospects are?

Probably not, until you’re ready to properly announce that to the market.”

Davern says not recognising intangible assets on a balance sheet may be fundamentally wrong, but the dilemma is to find a realistic value.

“The question comes from an investor perspective, which is ‘Who we are trying to serve, ultimately, in reporting?’ Is this something that we leave to investors to work out from other sources?

“The annual financial statements are not just relevant, they’re the trusted number.”

Yet, there are divergent views in the accounting world on how useful and accurate financial results statements and balance sheets are in helping individuals make informed investment decisions.

Baruch Lev, professor of accounting and finance at New York University’s esteemed Stern School of Business, says the treatment of intangible assets is at the heart of the issue.

Lev is co-author of the controversial 2016 book, The End of Accounting and the Path Forward for Investors and Managers.

“It’s not the intangible assets themselves, but the clumsy treatment by accountants of intangibles, the mindless expensing of all internally generated intangibles, and the capitalisation of singular acquired intangibles,” Lev says.

 

"The question comes from an investor perspective, which is, 'who are we trying to serve, ultimately, in reporting?' is this something that we leave to investors to work out from other sources?"

 

He notes that 70 per cent of all high-tech and science-based companies in the US report losses, even though the economy is doing well, and most of these companies have large valuations in the market.

“The reason they report losses is because of this expensing of intangibles. Half of this 70 per cent of the companies that report losses, if they didn’t expense intangibles, they would have reported profits.

“For me, I’m satisfied with just capitalising those intangibles. You capitalise investment in a building. Why shouldn’t you capitalise investment in a patent?”

Lev says all identifiable intangible assets should be treated in the same way as ordinary assets.

“Capitalise the cost, put it on the balance sheet and if, for example, in three, four years nothing comes out of it, then write it off.”

Relevance versus reliability

Davern has a contrarian view on the recognition of intangibles.

“Do we want to compromise the reliability of financial statements by introducing a valuation that may be a more representative number of what the true value might be? But it could be wrong.”

Davern says there is an ongoing relevance versus reliability trade-off in the financial reporting of intangible asset values.

“My view on that is that we want to be as relevant as we possibly can, but we shouldn’t throw the baby out with the bath water.

“Because, in the market for information, what we are providing in financial statements is the one reliable, trustworthy, credible source of information.

“If we sacrifice that in trying to increase the relevance of what we’re doing, then we’re in real trouble.”