Accountants still sometimes talk about assets as “something you can drop on the floor.” If you can drop it on the floor it is solid, with shape and form. Therefore it can be measured and weighed. Further, it is either made or bought, so there is a known cost attached to it.
Coming to terms with a still relatively new class of asset that is hard to measure, either physically or financially, has been a long, hard process that was resisted for many years. Ultimately, however, even the most conservative accountants have had to acknowledge that enterprises have value beyond the tangible and that the intangible component has intrinsic value. This grudging acceptance has been enshrined in accounting standards that guide the preparation of financial statements, specifically in the case of business acquisitions. The problem is that the change has been piecemeal, resulting in some peculiar inconsistencies.
In 2005 Procter & Gamble bought The Gillette Company for $53.4 billion. The standard (ASC 805 and IAS 3) regulating how such a purchase should be accounted for stipulates that intangibles included in the purchase price be identified, measured and added to the assets in the balance sheet. P&G employed experts to do this work, and they concluded that there was just one intangible: the Gillette brand. The value placed on it was $25.5 billion, or 48% of the price paid. That was interesting information for investors who wanted to know whether this intangible asset, which in accounting terms is a cash-generating unit, would produce the returns they sought. Still today, knowing the value of that asset allows outsiders to track the way P&G manages its Gillette brand.
On the Other Hand…
Another accounting standard (FASB’s ASC 350 and IASB’s IAS 38) deals with existing intangible assets, as opposed to those acquired in a business combination. This standard says something very different. It says quite emphatically that if an intangible was home-grown by the company that owns it, in most cases it may not be identified and measured as an asset. The reason given is that assets must be measured by their historical cost, or what it cost the company to create the asset. That cost is part of the cost of running the enterprise, and it is not thought possible to separate the asset from the rest of the business.
There is a conflict between these two standards: the one related to M&A requires the intangibles that came with the transaction to be valued at a price that willing buyers and sellers in a market would be likely to pay. That is called fair value and is based on a forward-looking estimate of the cash flows the asset will generate. This approach is now well understood in financial circles, and assets such as brands are now routinely valued. In fact, Markables, a Swiss company that maintains a database of global M&A data, claims that 30,000 trademarks/brands are allocated to balance sheets as acquired intangible assets each year.
Over the past decade and a half, standard setters have tried to bring the conflicting standards into line. None of these efforts was completed. Each was halted for stated and unstated reasons.
Many accountants are not fussed about that, because they find the task of identifying and valuing acquired intangibles complex, expensive and time consuming. But the conceptual framework on which all accounting standards are based states that “the objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity.”
When an acquired intangible asset represents nearly half of the purchase consideration, it is hard to argue that its valuation is not useful to creditors. This is where the standards come head to head.
The first standard requires the acquirer, immediately after a business-combination transaction is completed, to conduct an identification of the intangibles and valuations mentioned above. These values are then listed in the notes to the accounts and the aggregate amount is included in the balance sheet under intangible assets. Each year these new assets must be tested for impairment — accounting speak for loss of value. Should the value of the intangible asset fall below the amount at which it is being carried in the balance sheet, the difference is considered to be a loss that is transferred to the income account
But the opposite does not occur. If the firm manages its new asset well, it should increase in value, thus improving the balance-sheet value of the enterprise. But this gain is not shown. It has no part in modern accounting.
Now you see it; now you don’t.
The fact that gains in value are not shown is joined by another confounding outcome of this strange contradiction.
The first standard calls for an acquired asset such as a brand to be identified and valued immediately post-transaction. The acquiring firm then takes control of the asset and uses its marketing skills to improve the brand. It generates new value by keeping existing customers, gaining new ones and introducing improvements and innovations to achieve continuing growth. As the firm brings this about, the nature of the asset passes from the first accounting standard to the second. Instead of being acquired, the asset increasingly is internally generated, and that class of intangible asset is explicitly excluded from being recognized as an intangible asset.
The accounting standard setters are aware of this bizarre anomaly, as their previous actions have proven. But in 2012, when the International Accounting Standards Board called for suggestions as to what their research program should comprise for the next three years and received about 250 responses, this conflict missed the cut and has been put on hold as a long-term project. Topics such as those arising from the financial crisis understandably must take priority, but judged in the light of the accounting profession’s own criteria and the investment community’s needs, this is a conflict that must be fixed.
Roger Sinclair is a specialist in brand valuation and accounting for brands. He is a member of the Advisory Council of the Marketing Accountability Standards Board and serves on the MASB’s Improving Financial Reporting Project team.
Kevin Keller is a professor of marketing at Dartmouth College’s Tuck School of Business. He is also executive director of the Marketing Science Institute, which is a founding member of MASB.