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The aim of the study is to analyse the pros and cons attached with reporting the information regarding the intangibles in the financial statements by the business organisations. The research will undertake analysis of three listed UK companies from different industries for the evaluation of the brand and other intangibles recognition in the statement of financial position by these companies.
The data used for research was taken from the annual reports of the companies available at the home pages of respective companies and other internet sources. The practices of the companies were analysed separately to clarify the differences of companies on the treatment and reporting of intangibles by the companies. The information used was from the annual reports of year 2009.
Important findings include use of different techniques for the valuation of intangibles. Although the companies follow the rules and regulations regarding the intangibles, the disclosure is undertaken at minimal level. The differences in the method of valuation and reporting of intangibles make comparison of the companies in the same industry difficult. The disclosure of intangibles involves complex issues and requires high level of understanding from the companies. The complexity increases in the services sector where intangibles form the main source of competitive advantage of companies in the industry. New standardised ways of measurement and reporting of intangibles should be established.
Structure of the Dissertation
Chapter One: The first chapter provides introduction of the focus of this study. It will elaborate the background information and explain the rationale behind this attempt. The aims and objectives expected to be met during the research will also be defined.
Chapter Two: provides the literature review of the academic theories relating to evaluation and presentation of information regarding the intangibles and the effects on market reaction on information announcements and share price fluctuation. The evolution of the accounting regarding the intangibles is discussed. The practices prevalent in the market with the anomalies are also addressed.
Chapter Three discusses the gaps found in the theory and practical application of the accounting standards regarding the intangible assets.
Chapter Four is aimed at the presentation of important findings and the value added by the research. The findings are also analysed and the discussion of results has been presented.
Chapter Five provides an overview of the research findings in relation with the literature review. It will also pinpoint the limitations of the study and will also present recommendations for future research.
Chapter 1: Introduction
The aim of the preparation and presentation of statements of financial position is to cater to the information requirements of the stakeholders. The information helps the decision making process of all the stakeholders. The identification of the user's information requirement is difficult. It is an obligation at the business organisations to annually present a financial statement before the shareholders. Despite the regulatory requirement the "process of reporting has evolved slowly over a long time and invariably lagged behind the current needs of their users". The issue of failure of the financial statements in the presentation of useful information to the users has been debated for a long time. The directors of the companies often reported the undervaluation of the assets hence understating the company's value.
The transformation of the world economy in the knowledge-based economy has increased the importance of knowledge as new production factor. Knowledge creation has always remained an important source of competitive advantage for the business organisations. The importance of knowledge in business has also increased the level of investment in knowledge creation activities.
The changing business environment has triggered the need of business investment in intangibles. These include Research and Development, franchise and brand development and human capital enhancement (Bonfour, 2003; p 398). In many industries they are primary source of earning power of an enterprise. No business enterprise can deny the presence of intangible asset but their presence at statement of financial position is controversial issue. The accounting treats intangible investments as immediate expense. This in turn gives rise to many difficulties including:
Failure of assessment of rate of return on investment in intangibles
Failure of assessment of improved efficiency of firm's investment activity
Failure of recognition of characteristics of intangible investments,
Lack of determination of the value of the intangible capital of firm and the expected lives of these assets.
The above mentioned difficulties hinder the way of internal and external performance evaluation. The lack of information can make monitoring of investment in intangibles vulnerable of wrong assessment. The complexity and lack of understanding regarding the valuation and disclosure issues related to intangibles assets is the basis of motivation of this research study. The research is undertaken as a fact-finding on the various aspects of intangibles and intellectual capital.
Research Aims and Objectives:
The main aim of the present study is to investigate the pros and cons of reporting intangibles in context of the financial performance of the company. In particular, the investigation concentrates on examining the disclosure and reporting practices of intangible assets by different companies and the effects on their market position.
The following objectives are to be met:
The relevant academic literature will be reviewed in order to reveal theories, principles, empirical findings and aspects of financial reporting for intangibles and market reaction on information announcements.
Research in academic literature in order to reveal methods and measures adopted by the companies for the valuation and reporting of information regarding the intangible assets owned by the company.
To investigate the effects of disclosure of information regarding the intangible assets on the share price movements and market reaction
Chapter 2: Theoretical Overview
Every investment by a business entity is aimed at the provision of future economic benefit. The investment in the intangibles is undertaken by the organisations for obtaining the probable future economic benefits. All the intangible assets are difficult although not impossible to control. The valuation of intangible assets is undertaken on the basis of past transactions or events to be happened in future. That's the reason the intangible assets do not fulfil the criteria of being regarded as asset as defined by the FASB. For undertaking the analysis of the current practices of companies for the valuation and reporting of the intangible assets, it is important to wholly understand the objectives of financial reporting. The FASB and other accounting bodies have stated that the financial reporting should provide information:
"that is useful to potential investors and creditors and other users in making rational investment, credit, and similar decisions;
that helps current and potential investors, creditors, and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts and net cash inflows to the enterprise; and
that describes the economic resources of an enterprise, the claims to those resources, and the effect of transactions, events, and circumstances that change its resources, and claims to those resources" (Nearon, 2003).
The undertaking of investment and credit decisions is also dependent upon the information regarding the entity's investment and return on innovation in different business aspects. Consistent information about intangible assets, claims on intangible assets and causes of change in these assets help investors and creditors in undertaking choice of investments. On the other hand, it is also argued that the consistency over time regarding the information about intangible assets cannot assure consistent cash flow for the company.
With the increasing technological advancement all over the world the intangibles are considered very important for the economic success of corporation (Gregory, 1996; p 105). Intangibles are regarded as important contributor to the progress and the value of companies. An array of corporate intangibles is available for the organisation to increase their economic benefit; "brand" is one of them.
Brands take form of anything, which is associated with a product. It can be a word, tone, symbol or design, which provides a product with a distinguished identification among other products. Brands are much more than what they are regarded as. They are the unique images associated with product or service attributable to the quality and distinguishing characteristic of a product or service in a customer's mind (Keller, 2003; p 598)
Brands provide the companies with the competitive edge in the industry. In consumer industry, brands have the power to influence the customer preferences. In consumer product industry they are regarded as a key competitive factor which influences the consumer preferences for a product and therefore the sales of the company. Because of the importance of brands for the economic development of certain businesses, the accounting treatment of brands has been a moot issue which has raised controversies in many countries, such as Australia and the United Kingdom. For instance, companies such as Grand Metropolitan and Rank Hovis McDougall, decided in 1988 to include the value of brand names, either purchased or internally developed, in their consolidated balance sheets were highly criticised (Power 1992).
With the increasing awareness regarding the importance of investments in intangible assets, the usefulness of financial statements in explaining the financial position of an enterprise has also become controversial. This is because they fail to provide information regarding the enterprise's revenues and investments in intangible assets. Â
The need for the development of regulations regarding the issue was felt in July 1998. The first step was taken in the direction after debate of almost 10 years. ISAC, the International Accounting Standards Committee (IASC) approved a new International Accounting Standard, IAS 38, which regulated the treatment and reporting of Intangible Assets. Further development in the regulations was undertaken with the introduction of two Exposure Drafts (E50, Intangible Assets, E60, and Intangible Assets) in 1996 and 1997. The presentation of Draft Statement of Principles in 1994 raised controversies. The draft was mainly aimed at two issues of recognising the intangible asset generated through internal efforts of reorganisation and the determination of payback period of these assets.Â
a) Scope of IAS 38:
All the intangible assets not covered under other accounting standards are in the scope of IAS 38. With other things the IAS 38 addresses the accounting treatment of the expenses undertaken by an organisation in research and development, knowledge creation, training of employees start-up, and research and development (R&D) activities (Brooking, 1996).
The current IAS regarding the intangible assets practised by the organisations globally is the combination of IAS 9, (aimed at addressing the accounting treatment of Research and Development Costs) and IAS 38.
The accounting standards treat all the assets created by the research and development activities as an intangible asset since the primary aim of these activities is knowledge creation. It is also obligatory to use same accounting principles for the treatment of all intangible assets. So both the standards were merged together in order to form one principle for the treatment of all intangible assets. The inclusion of IAS 38 with IAS 9 does not affect the requirements.Â
b) Recognition in financial statementsÂ
According to the IAS 38, an intangible asset is defined asÂ 'an identifiable non-monetary asset without physical substance held for use in the production or supply of goods or services, for rental to others, or for administrative purposes' (InsideKnowledge, 1998).
The tool which provides explanation of the difference in the book value and market value of a company is the accounting of intangible assets (Green, 2006; p. 31). Investors keep futuristic approach regarding the financial data while undertaking investment decisions. The data regarding continuous growth and development and intangible assets motivates the investors to undertake investment in a company (Andriessen & Tissen, 2000, p. 477). The inclusion of information regarding intangible assets provides awareness to all stakeholders about the future growth expectations regarding a business organisation (Green, 2006; p. 31). It is important for organisations to understand the role played by intangible assets in achieving competitive advantage (Green & Ryan, 2005; p. 52). Business managers use different valuation methods for intangible assets. The most appropriate method is one which not only meets the legal obligations but also caters the information needs of all stakeholders. Despite the presentation of several valuation methods, still need is felt for the time-tested standard.
For an asset to be treated as an intangible it is important that the enterprise has full control over it and it can be separated from the goodwill of enterprise (Jennings, 1996; p.515). The recognition of an intangible asset in the financial statement is related to the probability of achieving future flow of benefits to the enterprise attributing to the asset and reliability of cost measurement of that asset. The standard for both the externally acquired or internally generated assets is same. However, there is an additional requirement of recognition for intangible asset generated internally.
In case of inability of an item to satisfy any of the requirements, the obligation is to treat that item under the heading of expenditure. IAS 38 changes the recognition of item in expenditure as soon as it is incurred. The inclusion of this expenditure at any later date in the cost of asset is also prohibited by the IAS 38.
c) Internally generated intangible assetsÂ
The treatment of internally created intangible assets in a similar course as purchased intangible assets has remained a debatable issue. There are proponents and opponents of similar accounting treatment of assets purchased and internally generated assets in an organisation. These opponents include the users of financial statements. The recognition of the internally generated asset is often regarded as suspicious. According to users the true value determination of an internally generated asset is not possible. The recoverable amount from the intangible assets should be determined according to the active market basis rather than on the basis of past experience or future transaction (Low, 2002). The intangible assets having no active market should be valued as zero for the provision of true information to the users. The requirement of IAS 38 for the management of the enterprise and the auditors to undertake judgment regarding the definition of an item as an intangible asset is very subjective, which can affect fair comparison of financial statements.
The IAS 38 fails to provide future predictions for the internally generated intangible asset. The companies do not often recognize the expenses undertaken on internally generated intangible assets.
There are also opposing views regarding the generally accepted accounting principles (GAAP) for the treatment of intangible assets. Book value is regarded as a better measure of valuation of a company's position. According to the authors, the GAAP principle regarding the treatment of intangibles has reduced the value and relevance of financial statements. Bruch Lev and Margaret Blair in their books pointed out the same fact.
The authors provide evidence of the decline in the relevance of reporting by evaluating the equities' market-to-book-value ratios. In the era of 70s the average share prices were approximately same as valued in the books. In 1990s the increase in the ratio with a constant rate was observed making the prices of shares three times more than the book values. With the advent of internet the access to information of masses facilitated. The analysts began to preach the idea that the basis of the wealth creation has been transformed to the business models and executive teams of the organisation and previously conceived foundations of wealth creation- are now outdated stuff. The share prices increased to a level of 7 times of the actual book values. The theory was successful and welcomed by all the sophisticated institutional investors and naive consumer investors. According to a report in New York times of 2nd September 2002 the average price-to-book ratio for Merrill Lynch's 20 most widely held stocks on 2nd September 2002, was 4.28 (New York Times, September 2, 2002), which was far less than the values reported.
The current intangible asset accounting policy is also damaging to the small companies as investors tend to discount the value of intangibles hence increasing the cost of capital for the company. This leads to the conclusion that despite introduction of many rules and regulations, a large part of enterprise value remains unexplained by the GAAP book values.
Chapter 3: Practical Application of Theory:
Preparation of financial report is an important exercise for the business organisations. The following section is aimed at the description of the practical application of theory by the organisations in their financial statements.
Treatment of Intangible assets at British Airways:
In case of business combination exceeding the fair values at which the net assets are acquired, the company capitalises the resulting goodwill and tests it for the impairment at annual basis.
The practice has been changed due to the implementation of IFRS 3 in 1999. The recognition of the goodwill is undertaken on the acquisition and the goodwill is amortised for the period of 20 years. Before the adoption of IFRS 3 the goodwill acquired at the acquisition was used to set off against reserves. The implementation of IFRS 3 has changed the treatment and the goodwill is not anymore recognised. The goodwill on acquisition is included within the cost of those entities. Impairment testing is undertaken through the allocation of good will to the cash-generating units.
In the aviation industry landing rights are also treated as intangible assets.
British airways uses the fair value basis for the capitalization of Landing Rights and the amortization is undertaken on a straight-line basis. The life of the intangible asset is regarded as 20 years.
The capitalisation of purchasing or the development cost of software which can be used in isolation from the hardware, is undertaken separately. The amortization is undertaken on straight-line basis for the period of 4 years. The changes in the carrying value of an intangible asset is undertaken in case of an event or circumstances affecting the recoverable carrying value (British Airways, 2008).
Goodwill and intangible assets:
The company provides the information regarding the impairment processes undertaken at annual basis on general basis. The company undertakes additional reviews in case of the incidences of affecting the values of the intangible assets takes place.
Impairment reviews are performed by comparing the carrying value of the asset concerned to that asset's recoverable amount (being the higher of value in use and fair value less costs to sell).
Treatment of Intangible assets at Unilever:
The company derives the value in use by undertaking the discounting of cash flow
Importance is given to growth rates and discount rates in long-term for undertaking correct valuation of value in use of intangible assets. The impairment process is undertaken at annual basis and is assumed to be appropriate.
The company considers the life of brands is forever continuing as long as it is supported by the successful advertising and marketing practices.
"Indefinite-lived intangible assets principally comprise those trademarks for which there is no foreseeable limit to the period over which they are expected to generate net cash inflows. These are considered to have an indefinite life, given the strength and durability of our brands and the level of marketing support" (Unilever, 2008).
The company owns many brands which are successful in market since many years, and due to the nature of the industry, the chances of their obsolescence are very low. The company facilitates the process of demand creation for its brands by suitable advertising and marketing campaigns.
There are also assets on company's statement of financial position which have finite life. These include patented and non-patented technology, knowledge, and software. The method adopted for amortisation is straight-line basis for the period of ten years. The capitalisation and amortisation is undertaken in operating profit. The company uses the assumption that there is no change in the level of amortisation for finite lived intangible assets over the next five years (Unilever, 2008)
Both the companies practice different treatment of intangible assets. The methods of capitalisation and amortisation also differ.
There have been evidences of increase in the share price with the increase in the transparency of the reported information. The degree of clarity was also found related to the decrease in the cost of capital. The companies do have concerns regarding the efficiency of financial markets. It is often stated that the financial analysts often only analyze the effects of market conditions rather than analyzing the business-specific information.
However, the businesses have the awareness of the influence of transparency of information regarding the intangible assets on the share price development. The provision of information having high degree of transparency improves the validity of share prices rather than increasing them. The level of confidence of staff and other important stakeholders also increases through provision of insight in the information regarding the intangible assets.
The analysis of the financial statements also point out different drawbacks of the financial reporting of intangible assets. These included the difference in defining the different business ratios according to the discretion of management of the organisation hence moulding the information in the favour of business organisation. The difference in use of the ratios is depicted in the financial statements of all the three organisations. For example many businesses overhead charges are transformed in sales charges so that they can be included as an investment. The development of new regulations is required to be undertaken so that the independent consultancies can be enlisted for the evaluating the performance of the company with regards to market share, customer satisfaction and process quality.
The information regarded as the trade secret is an important contributor of the competitive position of the company. Most companies avoid providing the information to the public.
Another implication of the implementation of IAS for the disclosure of information related to intangible assets will lead to an increase in the operating charges. The implementation of new system of regulations related to intangible assets will require high level of time and money investment from the organisations. It will also lead to undertaking of increased levels of business procedures undertaken for the compilation of information.
Different tools for the support for the company are available in market including Enterprise Resource Planning (ERP) and other data mining software packages which can facilitate the companies in reducing the process cost of information preparation. The increased level of information dissemination will increase the level of control of the organisation on intangible assets. Despite the fact that the distribution of information will lead to increased level of control of entity on intangible assets most business entities do not tend to actively participate in the process of information provision.
The high level of transparency also leads to the drawback of providing continuous information regarding the handling of intangible assets, which in turn could affect and impinge the flexibility of the management by making the provision of information compulsory.
The information provision regarding the intangible assets can also lead to the arousal of false expectations. This includes the information regarding the new development projects and other development activities.
Most listed companies are often not convinced of the benefits attached with the provision of transparent information to the financial markets. There can be several pros and cons attached with the systematic reporting on intangible assets of an organisation. Very often the businesses are reluctant to provide negative information and try to present a balanced picture to boost the level of confidence of potential stakeholders. It is also assumed that the high rating of business by the financial analysts is directly related to the high degree of clarity and openness in the communication with the stakeholders.
6. Chapter 4: Value Added
The transparency of information regarding the intangibles of a business organisation facilitates the greater insight to the business cash flow. The financial reports of the companies should be prepared while keeping in consideration a fixed reporting framework consisting of the systematic arrangement of indicators of intangible assets (Green, 2005; p.29).
The evaluation of the financial statements of the companies being studied depicted that the statements were prepared according to the reporting framework prepared by the discretion of management of the companies. This framework is often considered as the most valuable structure of reporting which the company uses for the provision of information regarding the intangible assets owned by the companies. The companies are reluctant to provide information regarding the procedures followed by them in the preparation of financial reports intended to the external users and other stakeholders. There is lack of availability of information in this context as increased disclosure of the information is regarded as the disclosure of exclusive information contributing to the competitive advantage of a company. There is also evidence of preparation of internal level reports before catering to the requirements of external users. The importance of the framework of reporting can be judged by the fact that the reporting framework is regarded as an important source of attracting funds.
A lot of research has been undertaken at international level regarding the reporting on intangible assets. Further research is required in the direction of increasing objectiveness and consistency of information. The ways of improvement should be researched in the area of indicators comparison to improve the reliability of information. The research helped the researcher in reaching the conclusion that intangible assets are major contributors of the process of value creation of business for the shareholders.
7. Chapter 5: Recommendations:
The most important issues facing the intangible accounting are the "recognition" and "disclosure" of information in the statements of financial position. The recognition means the effect of the intangible asset on the statements of financial position. The provision of information regarding the asset in the statement of financial position is regarded as disclosure. The issues facing the accounting for intangibles can be solved by increasing the level of recognition and disclosure of intangible assets.
The accounting history is full of evidence regarding the gaps in the recognition and disclosure of intangible assets.
To increase the clarity and transparency of information the inclusion of intangible assets attributable to the benefit streams is suggested. Although it is obligatory for comprehensive statement of financial position under the Generally Accepted Accounting Principles to add information in the financial statements still gaps are found in the provided information. The provision of information in the comprehensive statement of financial position will lead to the provision of clear information about the company, both with and without the capitalization of intangible assets. Previous research regarding the disclosure of information regarding the intangible assets provides the evidence of the benefits attached. According to Lev,
"Disclosure of plans from the companies regarding the acquired trademark has prospects of benefits from a significant market reaction, even after accounting for other variables. Similarly, disclosure of information about the success of R&D-such as citations to the company's patents, licensing royalties, and the success of clinical tests would allow investors to value R&D differentially across companies and time periods, based upon the presence or absence of these signals" (Lev, 2010).
It is also recommended that the disclosure should be facilitated with the creation of common valuation techniques through the accounting regulation. The introduction of common valuation techniques will facilitate the process of comparison by adding meaning to the comparison. Customer satisfaction is also regarded as an important asset. However the companies may calculate the satisfaction rate as 100% and hence will report biased information
The development of common valuation techniques is imperative for the development of asymmetry in the information regarding the intangible assets. The imposition of regulations regarding the adoption will not create disturbances in the reporting mechanism but will reduce information asymmetry.
A value chain system should be developed which can bring all of these concepts together into a system. This will enable the more clear presentation of value-creation activities undertaken by a company. The introduction of the Value Chain Blueprint will facilitate the process of measurement of the success of value-creation projects from the early stages of development through commercialization (Lev, 2010).
Brands are intangibles which should be accounted in the statement of financial position of a company. The brand becomes a market asset for the company and changes the conventional valuation techniques adopted by the creditors and the potential investors for undertaking the evaluation of a company. Companies like Unilever in the consumer product business treat their brands as the primary assets. Although there is enough awareness in investors and creditors regarding the importance of brands, the risk involved in the valuation obstructs the full recognition of the brand as an asset. The companies include intangible assets in the statement of financial position all over the world at international level so the accounting treatment should also be changed. As consumers all over the world relate to different brand names and the brands have major influence on their preferences, their inclusion in the statement of financial position as a major asset is highly justified. However, there are some important reservations which should be addressed to increase the effectiveness and usefulness of information provided regarding the intangible assets. It is the usefulness and the income stream attached which encourage the companies to establish and nurture brand family. True valuation of brands can make brand properties out of them.