Accounting for Intangibles: From IP to CEO

The capital markets ascribe market value to all assets ' tangible and intangible alike. Because the constraints placed on the accountants that distort book value do not apply to the price discovery aspects of the capital markets, market values may deviate markedly from book value in intangible asset-rich companies. Estimates vary, but the consensus is that among the S&P 500 companies, intangible assets represent anywhere from 60-80% of the market capitalization ' between 1.5x and 4x book value (Professor Baruch Lev of New York University's Leonard N. Stern School of Business estimates the market to book ratio is often as high as six) ' and are therefore largely undervalued or not valued on the books. IntangibleBusiness, an intangible asset valuation specialist, estimated that among the FTSE 100, the difference between the reported value of intangible assets and the market value of intangible assets was nearly '1,000 billion.

As noted recently by the Intangible Asset Finance Society (www.iafinance.org) in a letter to The Economist, much of the difficulty facing accountants in applying the rules to intangible asset value arises from the non-linear relationships amongst investment, value realization, and value loss. For example, Jet Blue airlines (NASDAQ: JBLU) built a reputation for superior customer service with investments in staff training, marketing, advertising, as well as tangible aircraft amenities. It suffered a body blow to its customer service reputation and lost 40% of its market capitalization on an icy weekend in February 2007 when its IT network, in which it had apparently under invested, failed, stranding customers nationwide.

The Problem with Accounting

The problem, then, seems to be with and among the accountants. But rather than revisit the litany of complaints, consider how capital markets are addressing the deficiencies of corporate financial statements and filling the information void.

Data that provide insight into a company's activities that have no formal place on a P&L or balance sheet are known as 'extra financial information' or 'extra financial data.' In 2005, PricewaterhouseCoopers, the global accountancy, reports controlled experiments showing that extra-financial data, and intangible asset value calculation arising, swayed 40% of analysts to change their target valuations of public companies. That same year, Thomson Extel, the publishing group, reported that 6% of buy-side brokerages devoted material resources to extra-financial data to determine intangible asset value. A year later, that figure was updated to 32% of buy-side brokerages.

An increasing number of investment managers also seem to be collecting extra financial information. In 2007, Vigeo group, a provider of extra financial data, reported that it had been retained by ABP Fund, which has '200B in assets under management. Also, in 2007, the Enhanced Analytics Initiative, an international extra-financial investment information cooperative, reported that its membership had a total of US$2.4 trillion of assets under management.

Drivers of Enterprise Value

Extra financial information is not superfluous. In a market where outsourcing allows almost all companies to reduce the costs of goods and services to comparably low levels, competitive advantage ' that which creates above average margins, sets investor's expectations, and contributes materially to enterprise value ' arises primarily from things other than what Marx and Engels deemed to be the means of production. These are assets which cannot be seen, touched, or physically measured and which are created through time and/or effort.

The Intangible Asset Finance Society divides them into four major market-centric groups. The first group comprises intellectual property rights such as trade secrets (e.g., customer lists), copyrights, patents, and trademarks. The other three groups comprise reputations for safety, security & resilience, and quality & integrity.

Redefining the Value of IP Practice

IP practice is a significant part of a critical business process that creates intellectual properties that drive corporate enterprise value by enabling the capture of consumer excess associated with monopoly rights. Moreover, there is the intangible value of innovation ' an asset which Apple, the electronic products company, is exemplary in its exploitation. Increasingly, businesses are recognizing both the tangible and intangible value of IP management and are making IP management a central part of the corporate value proposition.

Robert Sterne and Ron Laurie propose in the Aug./Sep. 2007 issue of Intellectual Asset Management magazine that responsibility for all IP management functions should be lodged in a single individual, the chief intellectual property officer ('CIPO'), whose corporate authority should be co-equal with the other C-level executives within the company. The most compelling argument for this elevation of the IP function to C-level status, according to Sterne and Laurie, is that if IP reports to top management through the chief legal officer ('CLO') or chief technology officer ('CTO'), the IP message will be filtered through the perspectives of the intermediate function ' risk management in the case of the CLO or product development in the case of the CTO.

Then there are the accounting concerns. Expenses associated with the process of IP management under any divisional arrangement create an accounting conflict. Income from products sold whose excess margins are due to prevailing patent rights accrues to the business unit; the intangible value arising from a reputation for innovation accrues to the enterprise; and the costs accrue to the corporate division. Historically, larger companies addressed the first conflict by assigning IP ownership to the business units. Today, because of emerging IP strategies and centralized IP control is once again the prevailing trend, operational costs and revenues are in better alignment. The reputational value and risks to that value, however, do not necessarily have a stable home in the existing corporate structure.

Beyond IP Rights

IP rights are important drivers of a company's competitive advantage, but they work cooperatively with the other intangibles to build and sustain enterprise value. Think of these intangibles as stones in a Roman arch ' collectively, they support enterprise value; material impairment of any one stone could bring the entire enterprise crashing down.

Which brings us to the corporate board. Morally, and explicitly under Sarbanes Oxley, a corporate board is charged with selecting and incentivizing a CEO to create enterprise value and then, for the balance of the time, for protecting enterprise value. If the IP function needs a champion at the C-level, then so do the other intangible assets that create and sustain enterprise value. And if those intangibles collectively speak to 60-80% of a traded company's value, then does that responsibility not best reside between and among the CEO and the board?

IP Track to CEO

The track to the CEO's office has changed as the key determinants of competitive advantage have changed. Over the past few years, sales, marketing, engineering, and most recently, finance have serially been the corporate lines through which proto-CEOs have risen through the ranks. With intangibles now providing the competitive advantage, perhaps the next trend in CEO-spotting will take place in the IP suite accompanied by a burning fuse?

Nir Kossovsky, M.D., is CEO of Steel City Re, an enterprise value assurance company. He may be contacted at [email protected]. Dr. Kossovsky also serves as the Executive Secretary of the Intangible Asset Finance Society.

'Jazz isn't music because you can't read it or write it,' declared Buenos Aires concert master Luis Schifrin to his son. A master of what his father deemed intangible, Lalo ' as he called himself ' went on to become a great jazz pianist, write more than 100 scores for films, television, and video games, and become most famous for composing the 'burning-fuse' theme tune from the Mission: Impossible television series.

By modern accounting standards, like those of Schifrin p're, most things of value are intangible. International Accounting Standard 38, promulgated in March 2004, requires an enterprise to recognize an intangible asset, whether purchased or self-created (at cost) if, and only if:

• It is probable that the future economic benefits that are attributable to the asset will flow to the enterprise; and
• The cost of the asset can be measured reliably.

It is unlikely that accountants would have recorded the 'burning fuse' theme tune as an asset on a corporate balance sheet. But that shouldn't limit a CEO from managing the asset for maximum value, communicating its value to stakeholders, or protecting that asset's value from risk.

Intangible Asset Finance

The capital markets ascribe market value to all assets ' tangible and intangible alike. Because the constraints placed on the accountants that distort book value do not apply to the price discovery aspects of the capital markets, market values may deviate markedly from book value in intangible asset-rich companies. Estimates vary, but the consensus is that among the S&P 500 companies, intangible assets represent anywhere from 60-80% of the market capitalization ' between 1.5x and 4x book value (Professor Baruch Lev of New York University's Leonard N. Stern School of Business estimates the market to book ratio is often as high as six) ' and are therefore largely undervalued or not valued on the books. IntangibleBusiness, an intangible asset valuation specialist, estimated that among the FTSE 100, the difference between the reported value of intangible assets and the market value of intangible assets was nearly '1,000 billion.

As noted recently by the Intangible Asset Finance Society (www.iafinance.org) in a letter to The Economist, much of the difficulty facing accountants in applying the rules to intangible asset value arises from the non-linear relationships amongst investment, value realization, and value loss. For example, Jet Blue airlines (NASDAQ: JBLU) built a reputation for superior customer service with investments in staff training, marketing, advertising, as well as tangible aircraft amenities. It suffered a body blow to its customer service reputation and lost 40% of its market capitalization on an icy weekend in February 2007 when its IT network, in which it had apparently under invested, failed, stranding customers nationwide.

The Problem with Accounting

The problem, then, seems to be with and among the accountants. But rather than revisit the litany of complaints, consider how capital markets are addressing the deficiencies of corporate financial statements and filling the information void.

Data that provide insight into a company's activities that have no formal place on a P&L or balance sheet are known as 'extra financial information' or 'extra financial data.' In 2005, PricewaterhouseCoopers, the global accountancy, reports controlled experiments showing that extra-financial data, and intangible asset value calculation arising, swayed 40% of analysts to change their target valuations of public companies. That same year, Thomson Extel, the publishing group, reported that 6% of buy-side brokerages devoted material resources to extra-financial data to determine intangible asset value. A year later, that figure was updated to 32% of buy-side brokerages.

An increasing number of investment managers also seem to be collecting extra financial information. In 2007, Vigeo group, a provider of extra financial data, reported that it had been retained by ABP Fund, which has '200B in assets under management. Also, in 2007, the Enhanced Analytics Initiative, an international extra-financial investment information cooperative, reported that its membership had a total of US$2.4 trillion of assets under management.

Drivers of Enterprise Value

Extra financial information is not superfluous. In a market where outsourcing allows almost all companies to reduce the costs of goods and services to comparably low levels, competitive advantage ' that which creates above average margins, sets investor's expectations, and contributes materially to enterprise value ' arises primarily from things other than what Marx and Engels deemed to be the means of production. These are assets which cannot be seen, touched, or physically measured and which are created through time and/or effort.

The Intangible Asset Finance Society divides them into four major market-centric groups. The first group comprises intellectual property rights such as trade secrets (e.g., customer lists), copyrights, patents, and trademarks. The other three groups comprise reputations for safety, security & resilience, and quality & integrity.

Redefining the Value of IP Practice

IP practice is a significant part of a critical business process that creates intellectual properties that drive corporate enterprise value by enabling the capture of consumer excess associated with monopoly rights. Moreover, there is the intangible value of innovation ' an asset which Apple, the electronic products company, is exemplary in its exploitation. Increasingly, businesses are recognizing both the tangible and intangible value of IP management and are making IP management a central part of the corporate value proposition.

Robert Sterne and Ron Laurie propose in the Aug./Sep. 2007 issue of Intellectual Asset Management magazine that responsibility for all IP management functions should be lodged in a single individual, the chief intellectual property officer ('CIPO'), whose corporate authority should be co-equal with the other C-level executives within the company. The most compelling argument for this elevation of the IP function to C-level status, according to Sterne and Laurie, is that if IP reports to top management through the chief legal officer ('CLO') or chief technology officer ('CTO'), the IP message will be filtered through the perspectives of the intermediate function ' risk management in the case of the CLO or product development in the case of the CTO.

Then there are the accounting concerns. Expenses associated with the process of IP management under any divisional arrangement create an accounting conflict. Income from products sold whose excess margins are due to prevailing patent rights accrues to the business unit; the intangible value arising from a reputation for innovation accrues to the enterprise; and the costs accrue to the corporate division. Historically, larger companies addressed the first conflict by assigning IP ownership to the business units. Today, because of emerging IP strategies and centralized IP control is once again the prevailing trend, operational costs and revenues are in better alignment. The reputational value and risks to that value, however, do not necessarily have a stable home in the existing corporate structure.

Beyond IP Rights

IP rights are important drivers of a company's competitive advantage, but they work cooperatively with the other intangibles to build and sustain enterprise value. Think of these intangibles as stones in a Roman arch ' collectively, they support enterprise value; material impairment of any one stone could bring the entire enterprise crashing down.

Which brings us to the corporate board. Morally, and explicitly under Sarbanes Oxley, a corporate board is charged with selecting and incentivizing a CEO to create enterprise value and then, for the balance of the time, for protecting enterprise value. If the IP function needs a champion at the C-level, then so do the other intangible assets that create and sustain enterprise value. And if those intangibles collectively speak to 60-80% of a traded company's value, then does that responsibility not best reside between and among the CEO and the board?

IP Track to CEO

The track to the CEO's office has changed as the key determinants of competitive advantage have changed. Over the past few years, sales, marketing, engineering, and most recently, finance have serially been the corporate lines through which proto-CEOs have risen through the ranks. With intangibles now providing the competitive advantage, perhaps the next trend in CEO-spotting will take place in the IP suite accompanied by a burning fuse?

Nir Kossovsky, M.D., is CEO of Steel City Re, an enterprise value assurance company. He may be contacted at [email protected]. Dr. Kossovsky also serves as the Executive Secretary of the Intangible Asset Finance Society.