Problems in Recognising Intangible Assets

Existing accounting frameworks such as that of the AASB only allow intangible expenditures to be recorded in the accounting system as assets if the items meet both the asset definition and the recognition criteria (AASB 138, para. 18). The asset

definition criteria for intangible assets comprise three primary attributes which are identifiability, control and future economic benefits. These attributes are defined in AASB 138 (para. 10) as follows (AASB, 2007).

1. Identifiability – it (a) is separable, that is capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability; or (b) arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights or obligations. 2. Control – if the entity has the power to obtain the future economic benefits

flowing from the underlying resource and to restrict the access of others to the benefits.

3. Future economic benefits – the benefits flowing from intangible assets may include revenue from the sale of products or services, cost savings or other benefits resulting from the use of the asset by the entity.

Meanwhile the asset recognition criteria for intangible assets as outlined in AASB 138 (para. 21) comprise two attributes (AASB, 2007).

(a) it is probable that the expected future economic benefits that are attributable to the asset will flow to the entity; and

(b) the cost of the asset can be measured reliably.

However, many intangible assets tend to have different economic characteristics to those defined and recognised under the current financial accounting framework. Hence, they often fail to be included in the balance sheet. There are three distinguishing economic characteristics of intangible assets: inherent uncertainty, partial excludability and non-separability, which render these assets, in many cases outside the definition and recognition criteria.

2.4.1.1 Inherent Uncertainty

Although expected future economic benefits are emphasised both in the definition of an asset and in its recognition criteria, intangible investments are often described as having highly uncertain and ambiguous future benefits (Lev, 2001; Abernethy et al., 2003; Hunter, Webster and Wyatt, 2005; Skinner, 2008). There is a certain degree of risk associated with any type of investment and assets in any uncertain business environment. However, the degree of risk for intangible assets is significantly greater than that of other tangible or even financial assets (Lev, 2001). The substantially higher levels of risk associated with intangible assets is closely related to the link between these assets and the nature of innovation activities (Wyatt, 2001).

As discussed earlier, innovation activities are driven mostly by investment in intangible assets. Innovation activities, in turn, involve the solution of problems and, normally, the problems are ill structured (Dosi, 1988), which means that available information does not automatically generate a solution to the problem. This is because what is searched for is basically unknown before the search, discovery and creation activities take place. As a result, it is most likely that there will be significant time lags between the expenditures and efforts undertaken by the firm to begin the innovation activity and the time for the arrival of a commercially viable innovation. Take, for example, the patent on the drug Fluoxetine (commercially known as Prozac). The expenditures made to develop the drug took place over many years during which period the possible therapeutic and commercial success of the drug were virtually unknown. Thus, the ill structured nature of innovation activities leads to the uncertain nature of the discovery process and the inability to predict the arrival of innovation. Consequently, the investment outcomes of innovation efforts can hardly be known with certainty ex ante (Dosi, 1988). Therefore, because of the ambiguity in determining the future economic benefits, many investments incurred to generate intangible assets are not recognised in the financial statements.

In addition, intangible expenditures such as R&D, market research and work-force training are concentrated at the early, higher risk phase of the innovation activity. In contrast, much of the investments at the later, lower risk phase of the activity are in the form of tangible assets. Thus, Lev (2001) argues that the decreasing level of risk along the phase of innovation activities leads to the inherent uncertainty associated with intangible assets. By referring to Figure 2.1, it can be seen that an innovation activity usually starts with the search and discovery process and ends with the commercialisation of final outputs of products or services. For example, basic research, which often takes place at the very beginning of the innovation process (the invention phase), has the highest level of risk in relation to technological and commercial success. This type of research concerns the original investigation without a specific aim or application in which a relationship between costs and future benefits is not evident (Wyatt et al., 2001). According to Berk, Green and Naik (1999), research at this phase is subject to four types of risk: (1) technical risks pertaining to the successful completion of the invention; (2) the risk associated with the likelihood of technological obsolescence once the invention is complete due to competitive threat; (3) uncertainty associated with the potential cash flows the invention will generate once completed; and (4) uncertainty associated with the duration and costs of the invention process itself. In contrast, the production of tangible assets in the innovation activity is exposed to a lower level of risk mainly because the technological uncertainties embodied in the earlier innovation phase have been largely resolved.

Therefore, in comparison to tangible assets, investments in intangible assets are subject to higher degrees of risk, resulting in greater uncertainty of future economic benefits. In fact, this uncertainty has been provided as a major justification by accounting standard setters in their decision to expense most intangible investments (Kabir, 2008). This is mostly because including uncertain investment estimates potentially increases the errors in current and forecasted measures of future performance. The uncertain estimates of future benefits also complicate the process of formulating a reliable measurement in valuing these assets. Consequently, this

particular economic characteristic prevents a significant portion of intangible expenditures from being recognised under current accounting model due to failure to comply with asset definition and recognition criteria.

2.4.1.2 Partial Excludability

Another equally important asset definition criterion is the firm’s complete control over the asset and its ability to restrict the access of others to the benefits. Property rights provide a firm with information about the availability of control rights and the probability that the firm can effectively secure or appropriate the expected investment benefits of the asset. Tangible and financial assets have well defined property rights in which the ownership and benefits of these assets can be legally appropriated by their owners. For example, the owner of a particular piece of land or property can enjoy the full benefits (or bear losses) of the investment while non- owners will have no share or rights over such investment. However, unlike tangible and financial assets, intangible assets are often characterised by partial excludability or fuzzy property rights. This refers to the inability of owners of these assets fully to exclude non-owners from enjoying some of the benefits of the investment (Wyatt, 2001; Skinner, 2008), a phenomenon known as spillovers (Arrow, 1962; Jaffe, 1986; Geroski, 1995; Takalo, 1998). For instance, a firm’s investment in developing skilled and experienced employees does not necessarily preclude others from the benefits of those investments. The investment benefits will eventually flow through to other non-owners such as other firms and society at large when the employees leave the firm either to work with other firms or to start their own. This is largely due to intangible investments’ dominance by people compared with machinery and the ease of copying non-embodied forms of intellectual capital (Hunter et al., 2005).

As a result, the firm cannot be certain of effectively appropriating the investment benefits because property rights remain with the individual employee. Firms have responded to the problems of defending property rights through both formal systems and informal systems. Formal systems for obtaining property rights over intangible

assets include the legal system, contract law and registration systems for patent, trademark and design rights. Informal systems include complex knowledge structures and factors affecting the firm’s information environment and stock of intangible assets such as trade secrecy, superior internal competencies and employees, alliances, brand name and market share (Wyatt, 2005).

Nonetheless, even in the case where property rights are legally well defined such as patented inventions, there will still be significant spillovers. This is because, first, the invention can be used freely by non-owners after expiry of the patent. For example, generic drugs can be legally produced once the patent protections afforded to the original pharmaceutical company that developed the drugs have expired, which is up to 25 years from application in Australia. Further, generic drug firms may benefit from the previous marketing efforts of the brand-name drug. Second, even before expiration of the patent there are often enormous spillovers through imitation by rival firms (Takalo, 1998; Lev, 2001). Some of the most innovative industries such as software, computers and semi-conductors have historically weak patent protection and experienced rapid imitation of their products (Bessen and Maskin, 2000).

However, the risk of imitation is inherent in the patent system itself. This is because under the system, patent-holders are required to disclose their protected inventions to the public in exchange for exclusive rights over inventions for the purpose of increasing the diffusion of technological knowledge and reducing wasteful duplication of innovative efforts (Magazzini, Pammolli, Riccaboni and Rossi, 2009). For example, in Australia, IP Australia publishes the contents of an innovation patent once granted and again at certification and the contents of a standard patent application 18 months after its priority date and again after acceptance. This information is disclosed in the Australian Official Journal of Patents (AOJP) which is made available to the public through its website. Such publication means that the contents of the patent are no longer confidential so that the invention becomes part of public knowledge.

IP Australia outlines two reasons for such disclosure: to assist in advancing industry and technology and to enable patent-holders to take legal action for any future infringements. Thus, acquiring legal protection such as a patent does not necessarily prevent imitation because the imitator always has an opportunity to try to invent around the patent by producing a non-infringing substitute (Takalo, 1998). Finally, it is also possible for spillovers to occur at the international level due to various reasons including ineffective enforcement of property rights protection for intangible assets such as patents and copyrights in many countries. This results in the copying and imitation of various R&D products, most noticeably software and other intellectual works such as music, movies and literature. Moreover, spillovers can also be brought about by intangible assets embedded in the activities of multi- national corporations to local firms in host countries which can be in various forms of technologies and skills that the host countries do not possess (Blomström and Kokko, 2001).

The inference from the above discussion is that securing and defending property rights is a common problem for intangible investments. This is because the value may be tied up in people who cannot be owned or else attributable to rents that are easily copied and dissipated by rival firms (Webster, 1999). As a result, this particular characteristic of partial excludability or fuzzy property rights exposes intangible assets to spillovers and imitation risks that enable others to share the firm’s investment benefits over the assets. This means that unlike tangible or financial assets, the firm does not have absolute control over intangible assets and such absence of control creates significant challenges in the managing and reporting of intangible assets under current financial reporting systems. In addition, the lack of control also affects the firm’s ability to capture the expected investment benefits (Dosi, 1988; Geroski, 1995; Wyatt, 2005; Kabir, 2008). This, in turn, leads to another problem related to the recognition of asset, that is to formulate a reliable estimate in measuring intangible assets, supporting the arguments against the recognition of these assets in the balance sheet.

2.4.1.3 Non-separability

Upton (2001) states that although few would argue that information about intangible assets is not relevant, many would question whether these items are measurable. Those that argue against the recognition of intangible assets, particularly the internally generated ones, emphasise that the problem is, first, cost is not a reliable measure of the underlying value of the assets and second, measures other than cost including fair value lack sufficient reliability (Upton, 2001). The main reason for these problems relates to the tendency of intangible assets to be non-separable. The non-separability of intangible assets means that they are not capable of being separated and divided from the firm without any loss of value (Lev, 2001; Hunter et al., 2005; Skinner, 2008). This is essentially because the value of intangible assets such as brand names, employee skills and organisational capabilities is the result of many different and interrelated activities and expenditures. For example, the value of a brand may depend on the patent to a particular technology, aggressive advertising efforts and other reputation enhancing activities.

The creation of intangible assets involves ideas that build on other ideas to generate complementarities and synergies (Basu and Waymire, 2008), many of which, as discussed earlier, have different owners and are not owned by any given firm. These complementarities and synergies mean that the value of a specific intangible asset is intrinsically connected to the residual value of the firm within which it will be employed. This embodiment of intangible assets in the value of the firm renders the definition criterion of identifiability unlikely. Another accounting implication is that, without being able to identify separately the costs or value attributable to each of these intangible assets, it is not possible reliably to measure them as independent assets at either their cost or fair value (Upton, 2001; Kabir, 2008; Skinner, 2008), which is one of the important recognition criteria.

Thus, from the standpoint of current financial accounting frameworks, the mismatch between economic characteristics of intangible assets and accounting principles

results in the under-recognition of these assets in the balance sheet. The difficulties in measuring and reporting these assets are reflected in the decision of most accounting frameworks to write-off most intangible expenditures as operating expenses in the income statement.