VideoHold the hosannas for Edmund Jenkins and the Financial Accounting Standards Board. Yes, the accounting world's grandees may have bowed to political reality when they eased their stance on accounting for business combinations, but their new thinking about goodwill could make life difficult for corporate executives in other ways.
Since FASB first proposed doing away with the pooling-of- interests accounting method two years ago, it has been attacked by finance executives, corporate lobbyists, and congressional critics alike. Chairman Jenkins was messing with the New Economy--throwing cold water on the hottest M&A market in history. If forced to amortize goodwill (the excess of purchase price over the fair value of an acquired company's assets), under the purchase method of accounting, acquisitive companies such as Cisco Systems, General Electric, and Medtronic would have to take billions of dollars of charges to earnings.
By way of compromise, FASB's new rules, issued in a February 14 exposure draft, allow goodwill to be recorded as a nonwasting asset on the balance sheet. Companies will not have to amortize the balance to earnings over a 20-year period, as FASB proposed in its 1999 exposure draft. Instead, they will periodically test the asset for impairment, and if it is determined that the value of a reporting unit with acquired goodwill has indeed been impaired, companies will be forced to take a write-down.
The problem is that those potential write-downs are likely to generate a lot more negative reaction in the market than simple, scheduled amortization charges. In addition, FASB's proposal is certain to increase the pressure on companies to assess the value of their intangible assets, whether acquired or internally developed, and to report their findings to investors--if not in the form of balance-sheet itemization, then in footnotes or other supplemental disclosures.
The pressure for more disclosure is already significant. A growing number of academics, consultants, and regulators see the lack of information on intangible assets as a major deficiency in the GAAP regime. They argue that those assets increasingly drive the value of corporations, and yet currently receive next to no recognition in financial disclosures. "In the last 15 to 20 years, most of the value and performance of companies have come from intangible assets," asserts New York University accounting and finance professor Baruch Lev, who has developed a method for valuing intangibles that has served as the basis for three CFO Knowledge Capital Scoreboards. "It's distressing that other than research-and-development costs, there is no information provided on them."
To rectify that deficiency, both the Securities and Exchange Commission and FASB have convened commissions to study the issue and propose ways to improve disclosure. And last year, the Brookings Institution organized a task force of around 50 people from various constituencies to examine how public policies influence the ways that corporations measure, monitor, and invest in intangible assets. In addition, consultants such as Bob Herz, who along with three other partners at Pricewaterhouse-Coopers published the book The Value- Reporting Revolution last month, are pushing companies to embrace better reporting practices for intangible assets. Why? "We think that to the extent that companies develop the metrics and communicate them to the market, they'll get better stock valuations, because of the added transparency," says Herz.
Corporate executives, however, see more to lose than gain from increased transparency. Intangible assets essentially represent the secrets of a business enterprise--the key resources and factors that enable it to compete effectively in the marketplace. If the company shares those secrets with investors (and with competitors), it could hasten the erosion of those very intangibles. Furthermore, the added transparency could open up a whole new avenue of attack for plaintiff's lawyers. If corporate disclosures of intangible values prove wrong--and it is easy to be wrong about intangible values--shareholders will have plenty of ammunition for lawsuits. "We're confusing people enough already with our disclosures," says one senior financial executive of a Fortune 100 company. "This would only exacerbate the situation."
INTO THE VACUUM
There is no denying the importance of intangible assets, however. Since 1980, the average ratio of market capitalization to book value for U.S. companies has swelled from just over 1 to more than 5--even after the recent swoon in stock prices. To be sure, differences in market and book value are rough estimates of the value of intangibles, points out NYU's Lev. But, on average, intangible assets now represent about 80 percent of the market value of public companies. One possible explanation for the growth, of course, is that a whole lot of irrational exuberance has inflated corporate stock prices far beyond the value of the assets that the shares have claim to. The more likely explanation, however, is that financial statements prepared according to GAAP fail to reflect the true value of a company's assets and operating performance.
In an increasingly competitive, knowledge-based economy, intangible assets, such as brand awareness, innovation, and employee productivity, have become the key determinants of corporate success. And given that the investments companies make to build those intangible assets--such things as advertising, employee training, and R&D--are flushed through the income statement, balance sheets are increasingly a poor reflection of the value of companies' businesses. "The traditional accounting system is focused on transactions and historical costs," says Sharon Oriel, director of intellectual asset management for Dow Chemical Co. "To determine the future value of a company, you don't look at past history. You need new measures to project forward."
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