Capitalisation of brand values : a trade-off between relevance and reliability

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C

apitalisation

of brand values

A trade-off between relevance and reliability

Date and version:

30-06-2014, final version

Name and student number:

Roos de Haas, 10247629

Supervisor:

Mr. C. Clune MSc

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Abstract

Over the past decades, the debate on brand accounting has escalated greatly. This literature review addresses the issue of whether or not brand values should be recognised on the balance sheet. Several aspects comprising this debate are taken into consideration: brand valuation methodologies, brand value estimates and actually recognised brand values on the balance sheet. The theoretically preferred valuation method appears to provide value relevant brand value estimates. Doubts about the limited reliability of brand value estimates are due to concerns of earnings management. However, it was found that possible earnings management does not have impact on the relevance and reliability of brand values. Consequently, based on this literature review brands should be recognised on the balance sheet.

Dutch summary

In de afgelopen decennia is het debat met betrekking tot het al dan niet opnemen van merknamen op de balans sterk toegenomen. Deze literatuurstudie gaat in op de vraag of merknamen al dan niet op de balans moeten worden opgenomen. Verschillende aspecten omtrent dit vraagstuk worden in aanmerking genomen: waarderingsmethodes, schattingen van waarden van merknamen en daadwerkelijk op de balans opgenomen waarden van merknamen. De waarderingsmethode die in theorie de voorkeur krijgt, blijkt waarde relevante schattingen van de waarden van merknamen te verstrekken. Twijfels over de beperkte betrouwbaarheid van de waarden van merknamen worden veroorzaakt door zorgen over winstmanipulatie. Uit het literatuuronderzoek bleek echter dat mogelijke winstmanipulatie geen invloed heeft op de relevantie en betrouwbaarheid van de waarden van merknamen. Er kan dan ook uit deze literatuurstudie worden geconcludeerd dat het zinvol is om de waarden van merknamen op te nemen op de balans.

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Introduction

"If this business were split up, I would give you the land and bricks and mortar, and I would take the brands and trademarks, and I would fare better than you." — John Stuart, CEO of Quaker Oats (ca. 1900)

This quote illustrates the alleged importance of brands and trademarks as observed already in the 1900s. Yet, it was not until the late 1980s that some companies decided to recognise the value of such intangible assets on their balance sheets. Grand Metropolitan, Guinness and United Biscuits recognised their acquired brands (Barwise, Higson, Likierman, & Marsh, 1989). And most noteworthy, Ranks Hovis MacDougall capitalised both its acquired and internally generated brands (Barwise et al., 1989; Power, 1992; Stolowy, Haller, & Klockhaus, 2001). Especially this move led to controversy and an international debate concerning the accounting treatment of brands.

Traditionally, it was assumed that value was generated through tangible assets, for instance buildings and equipment (Ballow, Burgman, & Molnar, 2004). Nowadays, intangible assets are rather used in differentiation strategies1 in order to generate value. Those intangible assets include goodwill, research and development, brands, human capital, and knowledge. It is said that the driving force of profits and innovation is the development of these intangible assets (Seetharaman, Sooria, Hadi Helmi Bin Zaini, & Saravanan, 2002). Yet, in the current accounting system some of these assets are taken into account and some are ignored (Ballow et al., 2004).

Currently, the International Financial Reporting Standards (IFRS) explicitly state that internally generated brands shall not be recognised as intangible assets on the balance sheet (IFRS Foundation Staff, 2012). In contrast, the marketing field does acknowledge the importance of brands (Keller & Lehmann, 2006). Branding has become a priority for management and academic literature in marketing has covered many different topics. Evidently, a debate on the inclusion or exclusion of brands between the accounting and

1_{Porter (1980) defines two ways in which a company can gain a competitive advantage: cost leadership and}

differentiation. The cost leadership strategy implies offering products at a good price and low costs.

Differentiation is achieved through offering a unique product that customers are willing to pay a higher price for.

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marketing field exists. A plea of the Chartered Institute of Marketing (1993) that is often quoted in marketing literature (El-Tawy & Tollington, 2008; Tollington, 1998b; Tollington, 2001) formulates this debate from a marketing point of view:

It is not the acceptance of brand equity which has been at the heart of the debate; it is whether accounting practices can adapt to a changing business environment in which ‘worth’ is typified by a set of intangible assets. This is an issue which our accounting colleagues show a persistent lack of commitment to resolve. And resolved it should be.

Indeed, the accounting literature expresses concern about the reliability of the brand value estimates. This is considered the major reason for the lack of financial statement recognition (Barth, Clement, Foster, & Kasznik, 1998). Recent literature however points out that brands are reliable enough to be value relevant: the markets seem capable of overseeing differences in reliability (Kallapur & Kwan, 2004). Moreover, empirical results indicate that strong-brand firms have significant abnormal stock returns2 (Fehle, Fournier, Madden, & Shrider, 2008). Disclosure of the brand value estimate would therefore be of interest to the shareholders of the company. Wyatt (2005) argues that management’s choice to record intangible assets will improve the quality of the balance sheet by disclosing information about the underlying economic factors. On the other hand, Jones (2011) finds a strong association between capitalising intangible assets and earnings management3_{, especially}

among failing firms.

Both between the marketing and accounting literature and within the accounting literature contradictions exist with respect to capitalising intangible assets and specifically capitalising brands. This literature review intends to provide an overview of the several aspects comprising this debate: brand valuation methodologies, brand value estimates and brands actually recognised on the balance sheet. Several studies have investigated the recognition criteria for capitalising the value of brands, both within the marketing and accounting field. Furthermore, the relevance of brands and concerns of manipulation have been examined.

2_{Abnormal stock returns exceed expected stock returns, in this case both statistically and economically.} 3_{A widely accepted definition of earnings management is provided by Healy and Wahlen (1999): “earnings}

management occurs when managers use judgement in financial reporting and in structuring transactions to

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However, there appears to be a lack of connection between the different studies. This study contributes to the literature by connecting the separate aspects of the primary question whether or not the value of brands should be recognised on the balance sheet. The findings might also be relevant to policymakers and users of accounting information.

The results show that both brand value estimates and recognised brand assets are unquestionably relevant. Also, a minimum level of reliability seems to be guaranteed when brands are valued on the balance sheet. Concerns about managerial manipulation were partly justified. However, the analysis of the literature showed that the potential manipulation did not impact the relevance and reliability of the brand values. Consequently, it is preferable to recognise brand values on the balance sheet.

This study is organised as follows. Section two provides some useful definitions and outlines the financial reporting standards regarding brands. In section three the capitalisation of brands is considered by analysing three aspects: valuation methodologies, brand value estimates and actually recognised brand values. Section four discusses the results and the final section offers concluding remarks.

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Foundation of debate

In order to study the matter of brand recognition, definitions regarding intangible assets and brands in particular will first be described. Next, criteria for recognising intangible assets on the balance sheet are outlined. These current criteria are established by the two main regulatory bodies in the world, the International Accounting Standards Board (hereinafter referred to as the IASB) and the Financial Accounting Standards Board (hereinafter referred to as the FASB). Also former criteria will be discussed, as these differ from the current criteria and thereby enabled researchers to empirically test the brand values actually recognised on the balance sheet.

Definitions

In marketing literature, a brand is commonly defined as a name or symbol intended to uniquely identify the goods or services of a seller from those of its competitors (Seetharaman, Zainal Azlan Bin, & Gunalan, 2001; Tollington, 1998a). Legal recognition secures the brand’s unique personality and prevents competitors from using the same brand name to sell goods or services. Several functions of brands can be identified (Keller & Lehmann, 2006). They can assist customers in opting for a particular product and they can imply a certain quality level. Also, the effectiveness of marketing efforts can be determined by evaluating the strength of a brand.

Considering this study’s focus on financial statement recognition, it is important to critically evaluate whether brands can be classified as assets. The terms brand value and brand asset are often used interchangeably, whereas the context is somewhat different. In order to classify the brand value as an asset, the definition of intangible assets should be considered. Also the recognition criteria, which will be outlined in the next section, should be satisfied. Not one definition of intangible assets has gained general acceptance in the accounting literature, but the definitions provided by the main regulatory bodies in the world are quite similar (Cañibano, Garcia-Ayuso, & Sánchez, 2000). The IASB, which succeeded the International Accounting Standards Committee (IASC) in 2001, specifies an intangible asset

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2012). Identifiable means that the asset can be separated and sold from the entity or that the asset arises from contractual or other legal rights. The FASB, which is the rule-making body in the United States, defines intangible assets as “assets (not including financial assets) that lack physical substance” (FASB, 2001).

Before assessing whether brands comply to the aforementioned definitions, an essential distinction must be made. A company can acquire brands in three ways. First, through marketing efforts and advertising costs, a company can create a brand internally (Austin, 2007). Second, a brand can be acquired separately (Otonkue, Edu, & Ezak, 2010). Finally, brands can be acquired in business combinations, e.g. mergers or acquisitions. In the latter situation, a brand value can be recognised as part of goodwill, which is the difference between the amount paid for the acquisition and the net assets of the acquired company (Seetharaman et al., 2001). The distinction is important, because the IASB and the FASB impose different accounting treatments for the different types of brands.

The IASB explicitly states that internally generated brands should not be recognised as intangible assets (IFRS Foundation Staff, 2012), regardless of whether they meet the definition and recognition criteria (El-Tawy & Tollington, 2008). The reason for this prohibition is that internally generated brands are unique and they cannot be distinguished from the cost of developing the business as a whole. Brands that are acquired in a business combination meet the definition of intangible assets. Their admission into the balance sheet will therefore depend solely on the recognition criteria. Although not stated explicitly, the FASB expresses the same point of view regarding internally generated brands: “the costs of internally developing, maintaining or restoring intangible assets that have indeterminate lives, are inherent in a continuing business and related to an entity as a whole, shall be recognised as an expense when incurred” (FASB, 2001). Accordingly, in the United States it is not allowed to capitalise and disclose internally generated brands in the external financial statements (Cravens & Guilding, 2001). Brands that are acquired should be recognised separately (FASB, 2001; Kallapur & Kwan, 2004).

Besides the difference in accounting treatment between internally generated and acquired brands, the impact of recognising them also highlights the validity of the debate. Suppose the costs of internally creating a brand should be expensed as incurred. These expenses are then charged against the revenues and thereby reduce the profits. Now suppose the new

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accounting treatment allows for the brand value to be capitalised on the balance sheet. Then, the costs of creating the brand are not charged against revenues, so the company’s profits will be higher. As a result, the company’s equity will be higher if the brand value is capitalised on the balance sheet. The consequence of not recognising an acquired brand, is that it is classified as goodwill instead, for which different accounting standards apply (FASB, 2001; IFRS Foundation Staff, 2012; Seetharaman et al., 2001).

Accounting Standards

In spite of the prohibitions from the IASB and the FASB regarding the recognition of internally generated brands as intangible assets, accounting studies have scrutinised this possibility. Therefore, it is necessary to outline the recognition criteria of intangible assets as if the prohibition does not exist. Firstly, the criteria as established by the IASB will be discussed. Countries that are now reporting according to the standards from the IASB, were previously imposing somewhat different criteria. Therefore secondly, these abandoned criteria will shortly be reviewed. Thirdly, the criteria specified by the FASB will be described.

IASB criteria

Next to the requirements underlying the definition of intangible assets, the IASB has proposed two recognition criteria in International Accounting Standard 38 Intangible Assets (hereinafter referred to as IAS 38) (IFRS Foundation Staff, 2012). First, the intangible asset will be recognised on the balance sheet if it is probable that future economic benefits, attributable to that particular asset, will flow to the company. Second, it must be possible to make a reliable measurement of the cost of the asset. Additionally, the IASB mentions that the first criterion is deemed to be satisfied for intangible assets that are acquired separately or in a business combination. Given the two categories of brands, it can be concluded that the reliability criterion should be critically assessed in both cases; the first criterion however only concerns internally generated brands. The IASB however does not clarify “reliability” in detail. According to Austin (2007), reliability involves information that is free from error and bias and faithfully represents the company’s transactions and events. Furthermore, reliability can be impaired by intentional or unintentional errors arising from personal

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incentives, lack of information, knowledge or data necessary to appropriately classify or measure accounting elements (Maines & Wahlen, 2006).

Former criteria

From 2005 onwards all listed European Union (hereinafter referred to as the EU) companies are required to prepare their financial statements in accordance with the International Accounting Standards established by the IASB (Stolowy & Jeny-Cazavan, 2001). Before 2005, there was a considerable lack of harmonisation among the EU countries with respect to the accounting treatment of intangible assets and brands in particular. Both the United Kingdom (hereinafter referred to as the UK) and France for instance were not opposed to the recognition of internally generated brand assets on the balance sheet (Stolowy et al., 2001; Tollington, 1998b). In the UK, companies actually capitalised self-generated brands as this was permitted through the Statement of Standard Accounting Practice (SSAP) No. 14 (Kallapur & Kwan, 2004). Despite the legal possibility, French companies chose not to recognise internally generated brands, because of the high degree of uncertainty (Stolowy et al., 2001). Germany on the other hand believed that reliability with regard to internally generated brands was impossible and therefore considered their recognition illegal (Stolowy et al., 2001).

Though not a member of the EU, Australia adopted a standard very similar to IAS 38 from 2005 onwards, i.e. the Australian Accounting Standards Board (AASB) 138 Intangible Assets (Jones, 2011). Previously, Australian companies voluntarily recognised and disclosed identifiable intangible assets, including brands (Ritter & Wells, 2006). The same situation applied to New Zealand, where disclosure of internally-generated and acquired brands used to be allowed and put into practice (Cravens & Guilding, 2001) before adopting the international standards from 2005-2007 onwards (Austin, 2007).

FASB criteria

In general, the FASB has defined three criteria to define an asset (Seetharaman et al., 2001). First, probable future benefits that contribute to future cash inflows should be present. Second, a particular entity should be able to obtain the benefit and control others’ access to the asset. Third, the transaction or event that gives the company the right to the benefit should have already occurred. Regarding internally generated intangible assets, the

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requirements are somewhat more specific. The asset should be specifically identifiable, have a determinate life and be unrelated to the company as a whole. In its Conceptual Framework, the FASB furthermore stresses the relevance and reliability as the two benchmarks for choosing among accounting alternatives, like the issue of whether you should or should not allow capitalisation (Barth, Beaver, & Landsman, 2001). Information is considered relevant when it influences the decisions of users of financial statements (Austin, 2007). According to the FASB, components of reliability are verifiability, representational faithfulness and neutrality (Kallapur & Kwan, 2004).

In summary, the IASB and the FASB both prohibit the recognition of internally generated brands. Overall, the focus point of brand accounting is the conflicting relationship between relevance and reliability (Stolowy et al., 2001). The FASB emphasises the importance of these concepts. The IASB focuses more on the importance of reliability than on relevance. Empirical studies have tested for the relevance and reliability of brand value estimates in an attempt to support or object the prohibition of the IASB and the FASB. Recognition of internally generated brands has not always been prohibited, as was outlined in the section on former criteria. This enabled researchers to study the values of brands recognised in financial statements, which will be discussed in subsequent sections.

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Examination of brand values

According to Power (1992), three levels of analysis can be distinguished when it comes to the issue of asset recognition. First, the identification of an asset in general should be evaluated. Second, criteria for recognition of the asset in the financial statements should be satisfied. Third, a valuation method must be used for measuring the value of the asset. In this section, those elements will indeed be critically examined. Yet, the order of the examination will be slightly different. In the first subsection the various brand valuation methodologies will be outlined and commented on as brands are already often valued for internal purposes. With the methodologies in mind, the next section critically evaluates whether the brand value estimates comply with the recognition criteria. Finally, the brand values actually recognised on the balance sheet will be evaluated. This is possible, because in several countries capitalisation has been allowed, as was outlined in the previous section. The results of these three analyses should provide a judgement regarding the question whether brands should be recognised on the balance sheet.

Brand valuation

Accounting for brand valuation is regarded as a relatively new aspect of financial accounting (Seetharaman et al., 2001). According to Salinas & Ambler (2009), this development occurred due to at least four factors. First of all, brand values were used to measure marketing performance in financial terms. Secondly, the valuation of brands emerged as an attempt to explain the deviation between companies’ share prices and their tangible assets. In this respect, the debate on whether or not brands should be capitalised on the balance sheet arose. As third factor, the trading of brands from one company to another has called for valuation methodologies in order to reach a proper price. Last of all, fiscal and legal reasons can encourage the need to value brands. For a company it can be beneficial for instance to arrange the ownership of brands in such a way that the tax expense is minimised. Especially when fiscal and legal conflicts end up in court, the need for brand valuation is urgent.

Salinas & Ambler (2009) distinguish 23 brand valuation methodologies, of which 17 are actually used in practice. Yet it is outside the scope of this study to outline all these

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methodologies. Therefore, a concise overview of general approaches to value brands will be provided. Generally, four approaches are distinguished (Cravens & Guilding, 1999; Salinas & Ambler, 2009; Seetharaman et al., 2001). These approaches are cost-based, market-based, income-based and formulary. In the following subsections, these approaches will briefly be outlined and then criticised upon. Subsequently, an overall judgement concerning brand valuation will be given.

Cost-based approach

In this method, all the costs involved in developing the brand are considered (Cravens & Guilding, 1999; Seetharaman et al., 2001). This is the most conservative way of valuing brands, as it is historically based and excludes a focus on the future. According to Cravens & Guilding (1999), accountants consider this the most acceptable way to value brands. The primary problem with this approach however is that all costs that were previously expensed must now be included in the brand value. Brands can be very old, for instance Moët, Evian, The Times and Walt Disney (Stolowy et al., 2001), but it seems peculiar to capitalise costs from many years ago (Barwise et al., 1989). Therefore, only the costs over a relevant, specified period should be considered. It is also challenging to properly separate between the costs that were directly attributable to the brand and those that were supportive or indirect (Cravens & Guilding, 1999). After determining the historical costs related to the brand, it should be considered what discount rates are used to arrive at the brand’s present value (Seetharaman et al., 2001). A pitfall of this method is that weak brands that are accompanied by high advertisement costs are overvalued and successful brands that required limited advertising expenditure are valued lowly (Barwise et al., 1989). Another disadvantage of the cost-based approach is that it is not a good future indicator (Salinas & Ambler, 2009). In their extensive study on brand valuation methodologies, Salinas & Ambler (2009) find evidence that the cost-based approach is not being used in practice.

Market-based approach

This method is based on the estimated amount at which a brand can be sold, the market value (Cravens & Guilding, 1999). Future benefits associated with the brand are taken into consideration and should be discounted to obtain the present value. According to Salinas & Ambler (2009), this is the most reliable method as it is based on actual sales of brand names.

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However, the fundamental problem in this method is that an actual market for most brands does not exist (Cravens & Guilding, 1999). Even if brand sales occur, the necessary information often remains private (Salinas & Ambler, 2009). Also, when these transactions take place, the price typically fails to reflect the brand’s value at the existing business, because the brand will be much more valuable to its new owner as otherwise the sale is off (Barwise et al., 1989). Two ways solutions exist to circumvent these issues associated with brand sales (Cravens & Guilding, 1999). First, proxies can be created based on how the financial markets estimate the brand value. Second, the performance of a substitute brand can be assessed and compared to the performance of the brand being valued. Accordingly, the market-based approach can be satisfactory if the brand is not unique and there are enough similar transactions in the market (Salinas & Ambler, 2009).

Income-based approach

This valuation method is the exact opposite of the cost-based method. Instead of considering the costs associated with developing the brand, the income-based approach focuses on the future potential of the brand (Cravens & Guilding, 1999). Therefore, future net income resulting from the brand should be determined and discounted to the present value. Problems of subjectivity are however involved in selecting this net income cash flow and the appropriate discount rate (Tollington, 1999). The income-based approach is the most popular approach: Salinas & Ambler (2009) identify 12 methods to determine the net income attributable to the brand. Three methods will now be discussed as these are most frequently used in practice and are studied often (Cravens & Guilding, 1999; Salinas & Ambler, 2009; Seetharaman et al., 2001; Tollington, 1999). One way is to compare the brand’s price premium to an unbranded product, called the price premium method (Cravens & Guilding, 1999; Tollington, 1999). This method does contain some problems. For example, a comparable unbranded product might not exist (Seetharaman et al., 2001; Tollington, 1999). Also, costs and economies of scale are ignored, which could lead to the undervaluation of high-volume brands and the overvaluation of smaller brands (Cravens & Guilding, 1999; Tollington, 1999). A second method is the royalty relief or royalty payments method, in which the annual royalties associated with the brand are estimated (Cravens & Guilding, 1999). These royalties are based on the licensing fee the company would have to pay if it did not own the brand (Salinas & Ambler, 2009). Or vice versa, the royalty income

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the company would generate from licensing out its brand (Tollington, 1999). This involves estimating future sales and applying an appropriate royalty rate. The royalty relief method has been accepted by fiscal authorities as a reasonable model (Salinas & Ambler, 2009). Nevertheless, the fact that brands are unique by nature and therefore not really comparable, remains a problem in this method. The third method that is often used and studied, analyses supply and demand effects to estimate the strength of the brand name (Seetharaman et al., 2001). This method considers the key demand drivers to determine the influence of the brand name in the consumer’s decision making process (Salinas & Ambler, 2009). An advantage is the independence of comparable transactions or comparable unbranded products. This method does tend to be highly subjective and considerable deviations emerge among the companies that are implementing this method. Irrespective of the method chosen, the income-based approach requires that any brand extensions from the core brand are included and that the brand is strategically assessed (Cravens & Guilding, 1999).

Formulary approach

Multiple criteria are considered in arriving at a brand’s value in this approach (Cravens & Guilding, 1999). The most well-known source of brand values, consulting company Interbrand, uses this method, based on the income-based approach (Cravens & Guilding, 1999; Fehle et al., 2008). The Interbrand methodology, as it is often labelled, is recognised worldwide by auditors, tax authorities and stock exchanges (Cravens & Guilding, 1999; Madden, Fehle, & Fournier, 2006). Though developed for external reporting purposes, the approach can also be used perfectly in the context of internal management (Cravens & Guilding, 1999). Interbrand uses publicly available data to estimate the operating profits that are likely to be earned over the next five years by products carrying the brand name (Fehle et al., 2008). In estimating the brand profitability, only factors that relate directly to the brand’s identity are considered (Cravens & Guilding, 1999). Next, Interbrand evaluates the brand strength based on seven factors to create a multiplier that is attached to the calculation of brand profitability:

1. Leadership: to what extent the brand functions as a market leader holding a dominant market share.

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2. Stability: ability of the brand to retain its image and consumer loyalty over a prolonged period of time.

3. Market: the product market the brand operates in, as the ability to generate many sales varies by market.

4. Internationality: potential to expand the brand globally.

5. Trend: ability of the brand to remain modern in the consumer’s opinion. 6. Support: the extent to which the brand consistently receives full support

within the organisation.

7. Protection: whether the organisation has a legal right to protect its brand, through registration and patents.

Assessment of each of these factors helps companies consider the functions that are either specifically attributable to their brands or are separate functions (Seetharaman et al., 2001). This is a requisite to ensure the effectiveness of the formulary approach.

Lindemann (2003), former global director of brand valuation at Interbrand, provides a detailed description of the five-step Interbrand approach, which is often reproduced in literature (see e.g. Fehle et al., 2008; Madden et al., 2006).

Overall judgement on brand valuation

As of the late nineties, no general agreement was present when it comes to the appropriate valuation methodology (Barwise et al., 1989; Tollington, 1999). Nowadays, many different brand valuation methodologies still appear in the literature and in practice. However, several studies attempted to designate one method as the best. Seetharaman et al. (2001) recommend the formulary approach to all organisations that wish to measure the brand value, because the disadvantages of this method are the least. Moreover, Cravens & Guilding (1999) label the formulary approach superior compared to the other approaches, due to its comprehensive nature. According to Lindemann (2003), the Interbrand method is the most widely recognised and accepted methodology. In general, however, all valuation methods require subjective judgements in the brand valuation process (Barwise et al., 1989). Furthermore, the precision of any brand valuation is hard to tell, because the true underlying economic value of the brand is unobservable. Power (1992) acknowledges that the problem for opponents of brand valuation is that arguments about unreliability cannot be completely

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settled. But, he argues that the judgements involved in determining the brand strength are similar to the process of estimating useful lives. Also, he states that reliability is a question of what is socially accepted as reliable. More than that, reliability depends on ‘who’ is engaged in valuing brands. Indeed, concerns are expressed regarding who is a ‘fit and proper’ brand valuer, except perhaps the auditors (Barwise et al., 1989). Whereas it is said that the Interbrand methodology cannot be trusted because of Interbrand’s lack of independency, auditors are criticised for the exact same matter (Power, 1992). Barwise et al. (1989) do believe that the highly structured Interbrand method would provide similar valuations for the same brand when executed by different valuers, thereby securing consistency.

Overall, brand valuation is considered as inevitably subjective. Though one cannot reasonably deny that brands have value, the question is posed whether brand valuation should occur for external financial reporting purposes or solely for internal management purposes (Barwise et al., 1989). This issue will be further examined in subsequent sections on brand value estimates and actually capitalised brands on the balance sheet. Even if the brand value does not appear on the balance sheet, the process of brand valuation can be extremely useful (Cravens & Guilding, 1999). Although the market-based approach is regarded the most reliable methodology, the formulary approach, if any, must be recommended by regulatory bodies should the capitalisation of brands be enacted.

Brand value estimates

Annually, Interbrand publishes a list of the 100 companies that have the strongest brands in the world, including its estimates of these brands (Interbrand, 2014). The three ‘Best Global Brands’ in 2013 were Apple, Google and Coca-Cola, with an estimated brand value of $98,316 million, $93,291 million and $79,213 million, respectively. In both the accounting and marketing literature, the Interbrand estimates are often used to investigate statistical associations between the brand value and measures of equity. In this section the findings of such studies will be outlined, compared and critically analysed from an accounting point of view.

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(Stolowy et al., 2001). However, as the regulatory bodies do not specify the degree of relevance and reliability necessary for capitalisation, it is hard to conclude from empirical studies whether or not the brand value should indeed be recognised on the balance sheet. Also, it is difficult to test separately the relevance and reliability of the estimates (Barth et al., 2001). The two criteria together can be operationalised empirically by testing for the value relevance of information. According to Barth et al. (2001), value relevance implies that the value of a brand has a predicted significant relation with share prices, which is only possible if the brand value reflects relevant information and is measured reliably enough to be reflected in share prices.

Barth et al. (1998) used the estimated brand values provided by Financial World, which uses the Interbrand methodology, to test for the value relevance. Their sample showed an average book value of equity of $3,682 million and an average market value of equity of $13,673 million. This corresponds to the idea that the sample firms have considerable unrecognised assets, probably such as brand names. Moreover, the ratio of the estimated brand value to the book value of equity was on average 209%. Therefore, including the brand values on the balance sheet would have a substantial effect. Before actually conducting research, the authors state the purpose of their research. They will assess whether the brand value estimates are related to share prices and returns. If they are, this is regarded as evidence that brands are relevant for investors and that the Financial World’s brand value estimates are reliable enough to be reflected in share prices. Also, the timeliness of changes in the estimates is considered. The findings prove significantly that the brand value estimates are sufficiently reliable and contain value relevant information, even after controlling for simultaneity bias. Additional analyses show that the brand value estimates reflect value relevant information that was not yet reflected in published financial statements. Moreover, the brand value estimates contain value relevant information even beyond the information reflected in analysts’ earnings forecasts. This contrasts with the judgement of Barwise et al. (1989) that companies that recognised brand values have disclosed little new information about their brands. Regarding the reliability aspect, Barth et al. (1998) found weak evidence that brand value estimates are not significantly less reliable than other components of book value of equity, opposed to investors’ perceptions. However, they refrain from recommending the recognition of brand values on the balance

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sheet, as the reliability threshold should be determined by standard setters. Yet, implicitly it can be concluded that Barth et al. (1998) advocate financial statement recognition (Ohlson, 1998). Although Barth et al. (1998) do not indicate any limitations to their study, some criticism is expressed in the accounting literature. Wyatt (2008) questions the generalizability of their findings as their sample is not random. The Financial World brand value estimates mainly concern large, profitable companies in manufacturing industries and lack financial services companies. So, it is unclear whether in general brands can be valued as reliably using the Financial World or Interbrand methodology. Ohlson (1998) criticises the claim that brands are value relevant if significant statistical relations are proven. He advocates that researchers need to amplify the conceptual foundation upon which interpretations of statistical relations can be made. Also, he questions whether the main regulatory bodies should adjust their reporting standards based on value relevance findings. Holthausen and Watts (2001) share this opinion. They point out that value relevance findings might have limited implications for standard setting. Only if the underlying theories in the studies are descriptive the conclusions are useful to standard setters. Descriptive theories explain and predict accounting, standard setting and valuation. Barth et al. (2001) contradict the view of Holthausen and Watts (2001). They conclude that value relevance research actually provides useful insights for standard setting. Hence, Barth et al. (1998), have laid the foundations of the debate about the recognition of brand value estimates.

It can be concluded that Barth et al. (1998) provided evidence that the Interbrand valuation methodology is relevant and sufficiently reliable for financial reporting purposes. Fehle et al. (2008) and Madden et al. (2006) have taken the research on brand value estimates even one step further. They investigated the relationship between brand values and shareholder value. As Madden et al. (2006) outline, shareholder value is created if a company’s stock returns are higher than any returns the shareholders might receive from investing in other companies at the same level of risk. Based on the brand value estimates provided by Interbrand, they composed a portfolio of companies with strong brands, e.g. Apple, Ford Motor, McDonalds, Reebok and Walt Disney. The returns of this portfolio are then compared to two benchmark portfolios: one full-market portfolio and one portfolio containing all the

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firms of the database4 except the firms in the strong brand portfolio. Madden et al. (2006) use the Fama-French method5_{to adjust returns for risk, which is a very common method in}

the finance literature. The outcome of the empirical study shows that the strong brand portfolio significantly outperformed the two benchmark portfolios. So, strong brand firms yield higher monthly returns and thereby create shareholder value. More importantly, they do so with less risk than a relevant market benchmark. Although Madden et al. (2006) extend previous research by providing empirical evidence for the relationship between brand value and shareholder value creation, the generalizability of their findings is questionable. That is, Interbrand does not at all seek to value all brands. So, the authors have not been able to absolutely compare both strong and weak brands. Also, it is possible that unmeasured but strong brands were left out of the strong brand portfolio, as that was solely based on Interbrand brand value estimates.

Fehle et al. (2008) continued on the work of Madden et al. (2006). They discovered that firms on Interbrand’s strong brand list statistically outperform the rest of the market, thus have remarkably higher risk-adjusted performance. Because the strong brand firms are significantly larger than the average firm in the market, Fehle et al. (2008) conduct an additional analysis to check for the influence of the firm size. The results show that the findings for strong brand firms are not due to their firm size, thereby strengthening the initial findings. Also, market share characteristics do not significantly influence the performance of the strong brand firms. Fehle et al. (2008) conclude with the recommendation of disclosing brand values in financial statements as this would be of interest to shareholders. Generally, the limitations concerning the work of Madden et al. (2006) also apply to the study of Fehle et al. (2008). The importance of their work would increase substantially if they would be able to compare firms that have valuable brands with firms that have low brand value but similar size and industry characteristics.

4_{Madden et al. (2006) use the University of Chicago’s Center for Research in Security Prices (CRSP) database,}

which measures stock returns monthly.

5_{The Fama-French method assumes a relationship between the expected return of a security and its risk, which}

is influenced by four factors: overall market return, return difference between small and large firms, return difference between high book-to-market ratio firms and low book-to-market ratio firm and momentum (Madden et al., 2006). If a security’s actual return is higher than the expected return derived from the Fama-French equation, the security outperforms other securities that have similar risk. The model can be used both for analysing individual stocks and stock portfolios.

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Recognised brand assets

Whereas the previous section discussed research on the relevance and reliability of brand value estimates, this section enlarges the debate on financial statement recognition. First, the reasons for managers to capitalise brand values on the balance sheet will be discussed. Second, the relevance and reliability of the recognised brand values is examined. Also, the impact of managerial incentives on the relevance and reliability of brand values is tested, thereby combining the first two aspects.

Managerial discretion

Guilding and Pike (1994) conducted interviews with senior managers in strong brand firms to examine the managerial implications resulting from brand accounting. It appeared that the primary reason for valuing brands was the desire of managers to capitalise the brand values on the balance sheet. However, if this would be prohibited, beneficial managerial implications were still expected to result from brand valuation. Nevertheless, finance directors seem to perceive less benefits arising from brand valuation than marketing directors. With this in mind, empirical evidence will be examined critically in this section. As outlined in section two, internally generated brands are not allowed to be capitalised on the balance sheet under the current recognition criteria. The major concern about loosening the recognition criteria on reliability, is that it might trigger earnings management or manipulation (Skinner, 2008). Wyatt (2005) addresses these concerns of manipulation of the balance sheet and earnings. A sample of Australian firms is used to test what factors are related to management’s choices to record identifiable intangible assets6_{on the balance}

sheet. The identifiable intangible assets investigated comprise copyrights, licenses and mainly brands. In the study period, 1993-1997, managers of Australian firms had the choice to recognise internally generated and acquired identifiable intangible assets. This accounting discretion turned out to be used by managers in a positive way. The recorded identifiable intangible assets are highly correlated with the underlying economics of the firm. The underlying economics provide information about potentially profitable investment

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opportunities and the rights to control the expected benefits from these investments. So, apparently managers choose to capitalise intangible assets to better report to shareholders the value of investments. The identifiable intangible assets appear to be typically value relevant to investors. Therefore, Wyatt (2005) concludes that permitting management’s choices to record intangible assets on the balance sheet will improve, rather than reduce, the quality of the balance sheet. Hence, the concerns of manipulation appear to be overstated according to Wyatt (2005). Although Wyatt (2005) finds significant evidence of the relevance of intangible assets, the limited sample period is criticised (Ritter & Wells, 2006). Also, criticism is expressed by Ritter and Wells (2006) regarding the absence of tests on the relation between intangible assets and future earnings.

Similarly, Jones (2011) conducted research on the association between earnings management and the capitalisation of intangible assets. In contrast to Wyatt (2005), the findings of Jones’ study demand a rather critical attitude towards financial statement recognition. Jones considers the incentives for managers to capitalise intangible assets from a bankruptcy perspective. An extensive sample of failing and non-failed Australian firms between 1989 and 2004 was collected. Again, at that time Australian firms experienced a high degree of flexibility in reporting intangible assets. This was before adopting the more conservative standard similar to IAS 38 in 2005, as was described in section two. Over one third of the identifiable intangible assets reported in the financial statements consisted of brands. Jones identified three remarkable conclusions. First, the rate of voluntary capitalisation among failing firms appeared to be higher than among non-failed firms. Particularly in the years prior to failure, the rate increases significantly. However, this conclusion does not apply to the media, diversified industrials and food and household industry groups. Second, management’s tendency to capitalise identifiable intangible assets has a strong relation to earnings management incentives, especially among failing firms. Third, voluntary capitalisation has a strong statistical impact on the probability of failure. These findings are clearly inconsistent with Wyatt’s conclusion that managers’ motivation for capitalising identifiable intangible assets is to better communicate the economic value of investments to shareholders.

An important study by Muller (1999) also considered the factors influencing the decision to capitalise brands on the balance sheet. This study specifically investigated the contracting

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cost incentives for capitalising estimates of acquired brand names in the UK. These contracting costs result from shareholder approval rules opposed by the London Stock Exchange (hereinafter referred to as the LSE). If a firm considers an acquisition or disposal, in some cases the approval of shareholders is required. This depends on the size of the acquisitions and disposals, relative to the firm’s net assets. As was shortly explained in section two, the impact of capitalising acquired brand names is then important. The UK firms investigated by Muller (1999) had two options regarding acquisitions. First, consider the entire acquisition amount as goodwill and write this goodwill off to equity, thereby reducing the net assets. Second, separate the value of the acquired brand names from the goodwill. The acquired brand name is then capitalised on the balance sheet and the goodwill is again written-off to equity. Compared to the first option, the net assets are higher in this situation. Muller (1999) tested for the relation between the capitalisation of acquired brand names and the costs resulting from shareholder approval as mandated by the LSE. The results indicate that firms indeed capitalised acquired brands in order to avoid shareholder approval. Although this findings provide important insights on the incentives for management to capitalise brands, Wyatt (2005) believes the question of which fundamental economic factors influence the decision remains unanswered. Also, Kallapur and Kwan (2004) criticise the fact that Muller (1999) has not examined the effects of the contracting cost incentives on the value relevance and reliability of the recognised brand values.

Value relevance of recognised brands

The value relevance of recognised identifiable intangible assets is tested in a similar way as the value relevance of brand value estimates. Ritter and Wells (2006) find a positive association between stock prices and voluntarily recognised identifiable intangible assets. Again, the sample comprised Australian firms that experienced discretion regarding the recognition of identifiable intangible assets. In addition, Ritter and Wells find a positive association between the value of identifiable intangible assets and realised future period income. This suggests that the recognition of identifiable intangible assets provides information about future period income, beyond current period earnings. This might result from the idea that it takes time for investments in intangible assets to influence earnings. Especially valuable is the study by Kallapur and Kwan (2004), which attempts to combine the

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value relevance of brand value estimates, Kallapur and Kwan (2004) examined more extensively the value relevance and reliability of actually recognised brands. Also, the effects of contracting incentives were investigated, thereby elaborating the work of Muller (1999). Like in Muller’s (1999) study, the sample consisted of UK firms that experienced flexibility in recognising intangible assets. The value relevance was tested in a similar way as by Barth et al. (2001). The findings imply that the recognised brand values are value relevant even though managers had incentives to overvalue them. As the recognised brand values appear to be value relevant, they cannot be totally unreliable. However, Kallapur and Kwan (2004) enhanced their study by testing thoroughly the reliability. They investigated differences in brand capitalisation rates among firms with high and low contracting incentives. If management incentives to introduce bias are present, lack of verifiability likely affects the reliability and value relevance of the brand values (Holthausen & Watts, 2001). Kallapur and Kwan (2004) followed the concept of Muller (1999) regarding the mandatory LSE shareholder approval for large acquisitions or disposals. Their findings suggest that capitalised brand assets might lack reliability for firms with high contracting incentives. However, the authors particularly note that this lack of reliability does not imply that markets are misled. In contrast, the markets seem capable of seeing through the differences in reliability. Yet, these findings do not disclose whether markets are misled by the non-recognition of brands. That would occur when strong-brand firms are undervalued, due to not disclosing or recognising the value of their brand assets. Kallapur and Kwan (2004) do find evidence that announcements of brand capitalisation result in positive abnormal returns. This might suggest that strong-brand firms are undervalued prior to capitalising their brand asset values. Like Barth et al. (1998), Kallapur and Kwan (2004) do not draw any policy conclusions, because their evidence shows that brands might be relevant, but might also lack reliability. As the exact trade-off between relevance and reliability is not disclosed by the main regulatory bodies (Barth et al., 2001), this difficulty remains present in any value relevance study.

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Discussion

The central issue examined in this literature review concerns the recognition of brands on the balance sheet. From an accounting point of view, the focus of the debate is on the relevance and reliability of brand values. Critical assessment of important studies that addressed this matter, results in the overall conclusion that capitalisation of brand values should be allowed. Studies have proven the value relevance of brand value estimates (see e.g. Barth et al., 1998; Fehle et al., 2008; Kallapur & Kwan, 2004; Madden et al., 2006; Ritter & Wells, 2006; Wyatt, 2005). This implies that a minimum level of reliability is present, because otherwise the estimates cannot be value relevant. Furthermore, the brand value estimates reflect information beyond information reflected in financial statements and in analysts’ earnings forecasts (Barth et al., 1998). Also, evidence was found that strong brand firms yield significantly higher returns than other firms in the market (Fehle et al., 2008; Madden et al., 2006). Therefore, capitalising the brand values on the balance sheet would be highly interesting to shareholders. Although a minimum level of reliability exists, the main problem evidently in all empirical studies regards the degree of reliability that is required for recognition on the balance sheet.

With regard to the proper brand valuation method, the formulary approach is found to be superior. The formulary approach as implemented by Interbrand is widely recognised. Because it is highly structured, different valuers would compute the same brand value, thereby securing the consistency of brand valuation. Moreover, the brand value estimates provided by Interbrand turned out to be value relevant. Therefore, this would be the recommended method for valuing brands.

The major concern with regard to the aforementioned reliability criteria relates to managerial incentives to manipulate brand values. No consensus was reached in the literature with regard to this issue. On the one hand, managers seem willing to communicate better information to shareholders about potentially profitable investment opportunities (Wyatt, 2005). On the other hand, it was found that the decision to voluntary capitalise brand values on the balance sheet is strongly related to earnings management (Jones, 2011; Muller, 1999). In this case, earnings management plays an important role in the capitalisation decision. Despite these drawbacks, capitalisation of brand values is still

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potentially beneficial. The key justification underlying this belief regards the implications of a lack of reliability. It was found that the markets seem capable of seeing through differences in reliability (Kallapur & Kwan, 2004). So, possible deficiencies with regard to reliability appear to be not misleading to the markets. This major finding takes some heat off the anxiety concerning unreliable brand value measures.

The implications of this finding concern the modification of the accounting standards. Currently, brands acquired separately or in a business combination can already be capitalised on the balance sheet. These brands are measured initially at cost, which equals the purchase price (IFRS Foundation Staff, 2012). No guidelines regarding the measurement of internally generated brands are disclosed, as this is prohibited under the current criteria. As mentioned before, the formulary approach or the Interbrand methodology should be recommended by the accounting standards. However, mandating this approach causes some problems for smaller firms. They might lack the expertise to value their brands themselves according to the Interbrand methodology. Also, hiring brand consultants to measure their brand value can be expensive. A solution to this problem could be to distinguish between certain categories of companies. For example, recognition of brands could be mandatory for publicly trading companies. On the contrary, small and medium enterprises (SMEs) could voluntarily capitalise their brands. In all cases, disclosure of the steps involved in the valuation of brands should be provided in the financial statements to ensure comparability. In addition to the initial measurement of brand values, the measurement of brand values after recognition should be considered. In this regard, three issues exist (Stolowy et al., 2001). First, whether brands have a definite useful life and should therefore be subject to amortisation. Second, whether revaluation of brands should be allowed. Third, whether unexpected declines in brand values should be written-off. These issues should be critically assessed, as both arguments for and against the matters exist. However, this is beyond the scope of this literature review, because this is a separate topic in itself.

For the sake of considering the broader debate, alternatives to capitalising brands on the balance sheet will briefly be discussed. If a company wishes to communicate to shareholders the value of its brands, this can be disclosed in the narrative section to their financial statements if not on the balance sheet (Salinas & Ambler, 2009). However, it is believed that

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sections other than the financial statements themselves (Skinner, 2008). Moreover, recognition in the financial statements appears to be more reliable than disclosure in the notes (Wyatt, 2008). This results for instance from the notion that external auditors appear to permit more misstatements in footnotes than in the financial statements. Finally, Penman (2009) offers yet another alternative. The income statement could capture deficiencies in the balance sheet. The value of intangible assets, like brands, can be calculated from the income statement. Penman supports this argument with an analysis and valuation of companies like Microsoft, Dell and Coca-Cola, whose brand values are omitted from the balance sheets (Penman, 2009; Penman, 2010). Although this analysis looks promising, it is not without any disadvantages. An essential prerequisite to this valuation method is the availability of comprehensive financial statements. As Penman (2009) indicates, this is not the case for every company. Furthermore, from shareholders’ perspective, this valuation method is less convenient as it requires expertise and time.

In this literature review, studies relevant to the issue of whether brands should be recognised on the balance sheet were analysed and discussed. Further research is necessary with regard to how recognition of brands should be included in accounting standards. As mentioned before, this requires critically assessing methods for measuring brand values after the valuation of brands for initial recognition. Furthermore, empirical evidence should be gathered with regard to weak brands. This is necessary to ensure the generalizability of the Interbrand valuation method and the value relevance of the brand value estimates.

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Conclusion

This literature review aimed to investigate from an accounting point of view whether brands should be recognised on the balance sheet. Although recognition is currently prohibited by the main regulatory bodies, both accounting and marketing researchers advocate capitalisation. Because the size of the brand values can be substantial relative to the total assets on the balance sheet, the impact of recognition could have major consequences for strong brand firms. This both supports the importance of recognition for shareholders and calls for reliable measures with regard to estimating brand values. Therefore, the crucial trade-off in this debate concerns the balance between reliability and relevance. Through three subsections, an overall assessment of the reliability and relevance of brand values was established. In the first place, the valuation methodologies were examined. This resulted in recommending the formulary approach, also known as the Interbrand methodology. Next, the brand value estimates provided by Interbrand were tested on their value relevance. This showed that the brand value estimates were value relevant, although some concerns about reliability were present. Last, the brand values actually recognised on the balance sheet were critically investigated. Special attention was paid to the reliability concerns. Again, the value relevance of the brand values was proven. However, some evidence of managerial manipulation was found. Yet, the impact of this low reliability on the value relevance turned out to be reverse. Markets seemed capable of seeing through the differences in reliability. Despite the limitations of conducting a literature review, the findings offer interesting insights into the possibility of recognising brand values on the balance sheet.

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