The process of Accounting for Intangible Assets

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Accounting is considered as a language of business. Even language has its own grammar providing certain set of rules, which are required to be followed. Likewise, accounting has certain norms to be observed by the accountants in recording of transactions and preparation of financial statements. These norms become accounting standards when a professional body codifies and makes them mandatory for recording and reporting purposes. These rules reduce the vagueness and chances of misunderstandings by harmonizing the varied applications and practices.

Similarly, accounting also requires adherence to certain set of rules, and guidelines, which reduces the flexibility in preparation of financial statements. In 1941, the American Institute of Certified Public Accountants (AICPA) defined accounting as the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part, at least, of a financial character, and interpreting the results thereof. With greater economic development, the meaning of the terms accounting gradually became broader.

In 1966, the American Accounting Association (AAA) defined Accounting as the process if identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information. Further, in 1970 the Accounting Principles Board of AICPA states the function of accounting is to provide quantitative information, primarily financial in nature, about economic entities, that is intended to be useful in making economic decisions.

To be useful, the accounting information must possess the characteristic of reliability, relevance, understandability and comparability. Information is said to be reliable if it is free from error and bias and faithfully represents what it seeks to represent. Information must be believed and depended upon by the users for a given purpose. To ensure that information is reliable, it must be verifiable, neutral and faithful in representing the economic condition. Information is said to be relevant if it influences the decisions.

To be relevant, information must be available in time, must help in prediction, and help in feedback. Understandability is another important dimension wherein the accounting information must possess the quality of economic significance to the user i.e. to understand the content and significance of financial statements and reports. The qualities that distinguish between good and bad communication in a message are fundamental to the understandability of the message.

A message is said to be communicated when it is interpreted by the receiver of the message in the same sense in which the sender has sent. The comparability aspect of information refers to the quality of information that enables users to identify changes in the economic phenomena over a period of time, between two or more entities. Accounting reports should be comparable across the firms to identify similarities and differences. To be comparable, accounting reports must belong to a period, use common unit of measurement and common format of reporting.

The Securities & Exchange Commission (SEC) in 1972 established the Financial Accounting Standards Board (FASB), giving away the private sector the responsibility to establish and maintain financial accounting and reporting standards on behalf of the SEC. The FASB creates accounting standards through the issuance of Statements of Financial Accounting Standards or SFAS. These statements make up the Generally Accepted Accounting Principles (GAAP), which are defined as the set of rules and practices that are followed while recording transactions and preparing the financial statements.

It is believed that United States plays major roles as a source of capital around the world because of which even the foreign companies familiarize themselves with US GAAP so as to raise capital in the US. GAAP also has a major impact on several aspects of decision-making in the conduct of business around the world.

Nature of Intangible Assets

Assets are the economic resources of an enterprise that can be usefully expressed in monetary terms and, are capitalized in the balance sheet. Assets are things of value used by the business in its operations. An intangible asset is an identifiable non-monetary asset, without physical substance, held for use in the production or supply of goods and services, for rentals to others, or for administrative purposes. Examples of intangible assets include goodwill, patents, copyrights, research and development costs, franchises, brands, intellectual properties and royalties. Pfizer's patents on the best selling drug Celebrex, and the Coca Cola's brand name are examples of highly valuable intangible assets that enable their owners to generate substantial revenues and profits over extended periods.

Classification of Intangible Assets

Products/Services - A large and constantly growing share of the gross national product of developed economies is in intangible form; this includes software products, financial and health services, and leisure and entertainment, to name a few intangible products. Furthermore, for many tangible products, such as drugs, computers, or machine tools, the physical component are overshadowed by the intangible ingredient i.e. knowledge embedded in them. Intangible and intangible intensive products and services generally emanate from the discovery and learning processes of companies.

Customer Relations - When the loyalty of customers to a product or company enables a business enterprise to charge higher prices than its competitors charge or to secure a large market share, customer-related intangibles are present. Such intangibles are known as brand names, and are secured and enhanced by unique and continuously improved product/services, coupled with extensive promotion, advertising campaigns, and cultivation of customers. According to the Business Week, world's most valuable brands of 2005 include Coca Cola, Mercedes, McDonald's, Marlboro, Microsoft, Intel, Nokia, Disney, IBM and General Electric.

Human Resources - Unique human resources policies and practices, such as employee incentives and compensation systems, or on-the-job training programs, which consistently enhance labor productivity and reduce employee turnover, create intangible assets. An example of a human resource practice generating substantial benefits is provided by Edward Lazear, A Stanford economist, who has studied the consequences of the transition from a flat hourly rate to a piece-rate compensation of employees in the Safelight Glass Corp., the nation's largest installer of automobile glass. The findings were surprising: a 41% employee productivity jump, enabled in part by a 61% drop n paid sick hours. Such profit generating practices are intangible assets.

Organizational Capital - Intangible assets uniquely come in the form of unique corporate organizational designs and business processes that allow companies to outperform competitors in generating revenues or by economizing on production costs. Dell's built-to-order computers Wall Mart's supply chains, and Citibank's online banking facilities are examples of organizationally related intangibles that have created sustained and considerable value for their owners.

Significance of Intangible Assets

Intangible assets differ from physical and financial assets in two important aspects that have considerable implications for the management, valuation, and the financial reporting of intangibles:

a. Partial Excludability -

According to the IRG Datex 2005 Database (Table 1) of New Zealand companies, it is evident that most of the companies spend an enormous amount of money to purchase intangible assets such as mastheads, goodwill, brands, licenses etc. However, only a small 10.9 % of the sample companies disclosed their intangible assets. Hence, it can be concluded that intangible assets still make up a large portion of assets for many companies.

Looking at the historical figures from United States, the annual investment of the US corporate sector in intangible assets during 2000 amounted to $1 trillion. To put this staggering amount into perspective, the same year investment of US manufacturing sector in physical assets was $1.1 trillion. Thus corporate investment in intangibles almost matched the investment in tangible assets, and given the substantially higher rate of growth of the former, relative to the latter, the rate of investment in intangibles will soon surpass that of physical investments.

Viewed from another perspective, in October 2003, the market value of US publicly traded companies was five times larger than their balance sheet value, which reflects primarily the net worth of physical and financial assets. Thus, about three quarters of the value of public companies, as perceived by investors, reflects non-physical and non-financial assets. Much of this huge value constitutes intangible assets, which are absent from corporate balance sheets. Even if the capital markets will slide, it would take a monumental collapse to erase a 5:1 gap between market and balance sheet equity values.