Accounting for intangible assets after business combinations under

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University of Groningen

Faculty of Business Administration

Accounting for intangible assets after business combinations under

IFRS:

An industry-specific benchmark

Groningen, September 2006 J.C. van Santen

S1229826

1^st Supervisor: Smeenge, Drs A.

2^nd Supervisor: Eije, Dr J.H. von

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Accounting for intangible assets after business combinations under IFRS:

An industry-specific benchmark

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Preface

This thesis was written in accordance with my graduation at the University of Groningen and is the result of my internship at KPMG Corporate Finance in Amsterdam.

In January of 2006 my interest in the valuation of intangible assets as the subject for my thesis was quickly transformed in a report on recent changes in the accounting for intangible assets. This much debated topic with its current interest seemed very interesting to me and the value it could have for KPMG was a great motivator.

I want to thank my supervisor Romy Marsal from KPMG for her support and contribution to this report and Drs. A. Smeenge from the University of Groningen for his time and insights.

Finally, I want to thank my fellow interns at KPMG, Roel Falke and Merlin de Graaff, and off course all of the colleges at KPMG CF for a pleasant time and for their help in the bringing to an end of this thesis.

Jirin van Santen Groningen, 2006

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Chapter 1 Introduction

1.1 Introduction

The accumulated value of land, plant, and equipment tells little about the market value of a corporation in today’s knowledge economy (Bakker, 2002). Today, a large part of this market value is being produced by intangible assets. Sutton (2004) gives a simple but clear definition of intangible assets: “Intangible assets are long-term assets used in a business which have no physical substance and are not financial in nature”.

The fact that a large part of today’s market value is being produced by intangible assets represents a symptom of a large economic transformation – the transformation from the industrial economy, characterized by seller’s market and industrial mass production, to today’s knowledge economy, where companies have to operate in open global buyer’s markets and where differentiation has become a key success factor (Lev & Daum, 2004).

Under these changing competitive conditions which asked for differentiation and innovation companies have felt a growing need to invest in intangible assets like human resources, IT, R&D and advertising (Lev and Zambon, 2003). These investments have added an increasing amount of knowledge to products, so that the phases of the production process where intangible assets are particularly present (research, organization and marketing) have become essential to managers and investors (Canibano, Garcia-Ayuso Covarsi and Sanchez, 1999).

These investments have become essential for the companies’ competitive position and future viability.

The value of intangible assets in corporations these days is well explained using references of, for example, Ballow, Burgman and Molnar (2004) “the key drivers of value” or Itami (1987)¹ who refers to intangible assets as “key resources and drivers of organizational performance and value creation” ².

However, accounting principles dictated that the investments in intangible assets were expensed in most cases and thus they were not required to be activated on the balance sheet although the future success of the company was based to a large extent on these assets. On the other hand, investors, by the way they priced stock³, implicitly recognized the value that was created over the years by these expenditures as if the expenditures had been capitalized as assets with future benefits beyond the current period (Smith and Parr, 1994).

1 Itami already attributed the difference in Japanese firm performance to the firm’s intangible assets in circa 1980.

2 ‘Estimates converge around an investment of 1 trillion dollar in 2000(Nakamura)– a huge level, almost as much as the corporate industry’s investment in fixed assets and machinery that year’ (Lev, 2003)

3 As a result the market value of Coca Cola was $55 billion against a recorded book value for this equity of $4,6 billion (Smith and Parr, 1994).

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1.2 Relevance

In January 2005 the International Accounting Standards Board (IASB) announced new accounting standards for European listed companies which were enacted in International Financial Reporting Standards (IFRS).

One of the reasons for these new accounting standards was the loss in value relevance of financial statements because of the way in which investors price their stock and in which companies were allowed to account for their investments in or acquisitions of intangible assets (Nearon, 2004).

The decline in value relevance has been evidenced by an increasing gap between the market value and the book value of equity of companies in many countries⁴ since the 1980’s (Amir and Lev, 1997; Lev and Zarowin, 1998). This movement is illustrated in figure 1.1. The difference between market and book value has been regarded as the capital markets view of the value of intangible assets ⁵ (Lev & Daum, 2004).

Figure 1.1: Decreasing relevance of accounting book value in the S&P 500 from 1980 to 2002

Source: Ballow, Burgman and Molnar (2004)

80%

15% 25%

20%

45%

85% 75%

55%

0%

20%

40%

60%

80%

100%

120%

1980 1990 Peak(3/2000) Post-Crash(8/2002)

Time

% of Market

Value

Accounting Book Value Unexplained Value

As a result of this loss in value relevance, creditors and investors were left with incomplete and misguiding information⁶. However, intangible assets not only pose a problem of transparency, but also of management awareness, consensus and procedures (Lev and Zambon, 2003).

In 2006 the first annual reports conform the requirements of IFRS will be presented in Europe. As a consequence of the adoption of IFRS acquiring companies have to account for their acquisitions using the purchase method of accounting. In short, this means that next to the identification of acquired assets and liabilities also certain acquired intangible

4 The gap was biggest in America because of all the enormous amount of newly developed products (for example Gillette Mach3, Microsoft Windows and Pfizer’s Viagra) (Nakamura, 1999)

5 Feltham and Ohlson (1995) also point to conservatism as an asymptotic difference between book and market value. Beaver and Ryan (2000) distinguish between two sources of variation in the book-to-market ratio:

biases and lags. Bias results from joint effects of the accounting process (conservatism and historical cost) and the economic environment (e.g. expected positive present value projects and inflation). By lags, unexpected economic gains that are recognized in book value over time instead of immediately are understood. Finally, market inefficiencies can distort market value (Ross, Westerfield and Jaffe, 2005).

6 Two of the qualitative requirements of financial statements are relevance and reliability. Information is relevant if it assists users in making economic decisions, or assessing past evaluations; information is reliable if it represents faithfully what it purports to represent (Insights to IFRS, 2005).

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assets need to be recognized on the balance sheet against fair value. This and more is primarily embodied in three European standards: IFRS 3 Business Combinations, IAS 38 Intangible assets and IAS 36 Impairment of assets.

A second reason for the IASB to announce new accounting standards for intangible assets was the wish of convergence with United States Generally Accepted Accounting Principles (US GAAP). In 2001 US GAAP was already set in change introducing Statements of Financial Accounting Standard (SFAS) 141 Business Combinations and 142 Goodwill and other intangibles which also require intangible assets to be recognized against fair value on the balance sheet after acquisitions.

The ultimate aim of this convergence is for the US regulator, the Securities and Exchange Commission (SEC), to accept IFRS financial statements from non-US SEC⁷ registrants.

The ultimate benefit of this convergence would be that companies do not need to reconcile their accounts with US GAAP.

However, despite the benefits, the new accounting requirements have been much debated. They are said to be ambiguous and complex, and not only by their first application, as to what intangible assets need to be recognized after acquisitions⁸. In a lot of cases this complexity will lead to higher cost as a result of more professional help or higher audit fees.

Holterman and Roelofsen (2003) point to the fact that industry-specific benchmarks will emerge in process of time on what intangible assets need to be recognized under IFRS.

However, why wait for an industry-specific benchmark to emerge if three years of accounting under the similar standards of US GAAP is available?

1.3 Research statement

As was stated, one of the objectives of the IASB was a high degree of convergence with the accounting standards adopted by its US counterpart. The convergence of IFRS with US GAAP concerning the accounting of intangible assets is of central concern in this research. In the following paragraphs the research goal and research questions are presented.

1.3.1 Research goal

Developing an industry-specific benchmark for the to be recognized intangible assets after acquisitions on the balance sheet of the acquiring company under IFRS by mapping the recognized intangible assets after acquisitions on the balance sheets of acquiring US companies listed in the S&P 500 under US GAAP.

7 Securities and Exchange Commission

8 Also concerning the fair valuation of intangible assets which involves making highly uncertain forecasts and separating the CFs related to the subject intangible asset from the total CFs.

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To meet the objective of this research, the following research questions have been asked.

1.3.1 Research questions

1) ‘Which intangible assets will be recognized after acquisitions by European listed companies in different industries under IFRS?’

2) ‘What part of the purchase price will be allocated to intangible assets after acquisitions by European listed companies in different industries under IFRS?’

The research questions above are expected to constitute the eventual industry-specific benchmark on two dimensions: the type of intangible assets that are recognized per industry and the amount that is allocated to intangible asset as a proportion of the total price paid for a company.

The industry-specific benchmark will be constructed by information on the accounting for intangible assets after acquisitions under similar US GAAP. This benchmark will help different stakeholders of the recent changes in European accounting standards. Three stakeholders can be identified⁹:

Analysts and investors will obtain more possibilities to assess an acquisition by benchmarking them with other acquisitions in the same industry.

Regulators¹⁰ will obtain an additional control instrument, because the way a single company accounted for intangible assets can be benchmarked against an industry average of recognized intangible assets¹¹.

Companies and appraisers will have an indication on what intangible assets should be considered for recognition on the balance sheet before an acquisition.

The answer to the second research question contributes to constructing the benchmark by adding an amount to the type of intangible asset identified in the first question.

However, it will further hopefully expose differences in the importance of intangible assets between industries. The industry-specific benchmark will identify industries that have recognized more intangible assets than other industries indicating a difference in dependence on intangible assets between industries. This can help managers to understand and proactively manage the intangible assets in their value creating system.

9 Holterman and Roelofsen, 2003

10 Institutions that regulate the financial capital markets and set the financial disclosure norms to protect the interest of the creditors and investors(www.sec.gov)

11 The recognition of intangible assets that are more quickly amortized may be a motive for companies to influence their total recognized intangible assets.

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1.3.3 Sub questions

To come to well-founded answers on the central research questions, the following sub questions have been formulated:

1. What are intangible assets and what is meant with intangible assets in this research?

The objective of this sub question is to give the definition and the classification of intangible assets that will be used in the course of this research by a discussion on the concept of intangible assets.

2. How are intangible assets accounted for under recent IFRS and current US GAAP?

In order to put this research into context, an analysis of the most important accounting issues for intangible assets after acquisitions under IFRS and present day US GAAP has been made.

3. What are the differences between accounting for acquired intangible assets and goodwill under US GAAP and IFRS?

Although IFRS has converged to large extent with US GAAP accounting for intangible assets, there are differences. Taking into account of these differences is essential when looking at the industry-specific benchmark.

4. How is the purchase price allocated to the acquired assets and liabilities?

In order to understand more about the accounting for intangible assets this chapter focuses on the total process in which acquired assets and liabilities are recognized and allocated in an acquiring company. However, the focus will be on intangible assets.

5. Which intangible assets are recognized after acquisitions under US GAAP in different industries?

The focus in this question is on the identification of intangible assets types that are specific or relatively often recognized in a certain industry.

6. What part of the purchase price is allocated to intangible assets after acquisitions under US GAAP in different industries?

As opposed to the previous question, this question focuses on the total amount allocated to the recognized intangible assets as a proportion of the total price paid for the acquired target.

7. How is the amount allocated to intangible assets distributed over the different kinds of intangible assets recognized after acquisitions under US GAAP in different industries?

The answer to this last question allows the industry-specific benchmark to be specified on type of intangible asset and the amount allocated to that specific type as proportion of the total purchase price. The last three questions thus serve as input to the benchmark.

8. What are the differences between the recognition of total intangible assets and intangible asset types after acquisitions across industries under US GAAP?

This question has the objective to analyze the data that was collected with the previous three questions. Therefore, the differences are analyzed with the help of some statistical methods.

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1.4 Research layout

In order to achieve the goal of developing an industry-specific benchmark for the recognized intangible assets, the public filings of acquiring US corporations have been analyzed on the recognition of and the amount allocated to intangible assets after acquisitions. The results of this research are presented in Chapter 7.

First, the concept of intangible assets is thoroughly discussed in Chapter 2. In this chapter sub question 1 will be answered. It is important to further examine the concept of intangible assets, in order to understand what is meant with the concept used in this research. Next to definitions and classifications, the value that intangible assets can constitute for companies is treated.

Chapter 3 clarifies the accounting standards relevant in this research on the accounting for intangible assets. European IFRS and US GAAP will be discussed separately to answer the second sub question.

In Chapter 4 the process of Purchase Price Allocation (‘PPA’) will be scrutinized primarily on the basis of valuation reports provided by KPMG CF. This chapter intends to explain the separate steps in after acquisition accounting under IFRS emphasizing the case of intangible assets.

Chapter 5 analysis and explains the relevant differences between US GAAP and IFRS concerning the accounting for intangible assets after acquisitions.

Chapter 6 explains the research methods used for this research and presents data and descriptive statistics. Consecutively, the research objective, the objects of measurement, and the data collection are discussed after which the data is presented and some descriptive statistics are displayed. Finally, the used method for data analysis is treated.

Thereupon, the results of the data analysis will be presented in Chapter 7.

This report ends with Chapter 8 in which all the chapters are summarized and a final conclusion is drawn.

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Chapter 2 Intangible Assets

In the previous chapter the ground for new standards on the accounting for intangible assets was addressed. This chapter discusses the concept of intangible assets by answering the following question: What are intangible assets and what is meant with intangible assets in this research?

This chapter is build up as follows. In the paragraph 2.2 various definitions of intangible assets are given, followed by a specific paragraph on how intangible assets are defined in accounting. In paragraph 2.3 some classifications of intangible assets are discussed which will introduce different kinds of intangible assets that companies can posses.

Finally, a paragraph is devoted to what intangible assets make so valuable in today’s companies.

2.2 Definition of intangible assets

According to Smith and Parr (1994) intangible assets can only be fully understood within the context of a business company¹². Every business company compromises three basic elements: monetary, tangible and intangible assets.

Monetary assets or working capital primarily compromise of cash, accounts receivable and inventories. Plant, property, equipment and all the rest of companies’ assets that are tangible logically compromise the tangible assets of the company (Smith and Parr, 1994). Probably for the sake of convenience, intangible assets are defined by Smith and Parr (1994) as “All the elements of a business enterprise that exist in addition to monetary and tangible assets.”

In the context of acquisitions, intangible assets are also often defined (with goodwill) as the excess of the cost of an acquired company over the value of its tangible net assets.

However, these definitions of intangibles as a residual of do not embody the fact that intangible assets have become very valuable assets for companies these days.

Intangible assets are first of all assets. A careful definition of assets begins by describing them as ‘resources under the ownership of a business that expects to derive economic benefit from the exploitation of that resource’. Further, an asset may have a physical existence or not in case of a debtor or a bank balance.

12 This is typically so because within that context intangible assets attain their highest value (Ibid).

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According to Sutton (2003) an accounting asset usually has the following three characteristics:

1 It is expected to provide future economic benefits to the company;

2 It is owned or controlled by the company; and

3 The company acquired it as result of a past transaction or event

Brockington (1996) believes that intangible assets differ on one point with tangible assets. Given the definition of Brockington “a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow “ the point of difference is that intangible assets have no physical substance.

Krens (1996) uses this definition “An intangible asset is a capital asset having no physical existence, its value being limited by the rights and anticipative benefits that possession confers upon the owner” ¹³. Here the emphasis is not only on the non-physical character of intangible assets but also on a figurative meaning of possession.

In line with the definition of Krens (1996) is the definition from an economic perspective outlined by Reilly and Schweihs (1999). For an intangible asset to exist, it typically should possess a number of characteristics or attributes including the following:

It should be subject to specific identification and recognizable description;

It should be subject to legal existence and protection;

It should be subject to the right of private ownership, and the private ownership should be legally transferable;

There should be some tangible evidence of manifestation of the existence of the intangible asset(e.g. as contract, license or some kind of registration);

It should have been created or have come into existence at an identifiable time or as the result of an identifiable event; and

It should be subject to being destroyed or to a determination of existence at an identifiable time or as a result of an identifiable event.

The definition from an economic or a valuation perspective emphasizes on the fact that a bundle of legal property rights should exist with the existence of any intangible asset¹⁴

15.

From a strategic management perspective the value and the strategic role of intangible assets for the organization as ‘a source of competitive advantage’ is the point of focus in definitions (Hall, 1992, Barney, 1991, Hitt, 2001, Dierickx and Cool, 1989).

2.2.1 Accounting

In this paragraph the different definitions of intangible assets encountered in accounting standards are considered. This paragraph is based on research by Stolowy and Jeny (2000) on how accounting standards approach intangible assets, both in terms of definition and treatment. This approach is illustrated in figure 2.1 which is clarified below.

13 Krens (1996) derived this definition from Kohler (1970).

14 Economic phenomena, like market share, high profitability and a monopoly position do not qualify as intangible assets (Reilly and Schweihs, 1999).

15 Smith and Parr (1994) specially refer to intellectual property when an intangible asset is protected by law.

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The approaches to definitions used by accounting standard setters can be divided in conceptual approaches and list-based approaches. Conceptual definitions refer to actual definitions and the list-based approach refers to a list of intangibles as a kind of inventory.

Following on from the above, the conceptual approach can be divided into three categories¹⁶:

Tautological definitions, for example an intangible asset is characterized by the lack of physical substance.

Definitions by opposition, for example fixed assets other than tangible or financial.

Real definitions are definitions which make a genuine conceptual effort to determine what an intangible is.

Conceptual approaches

List based approaches

Tautological By opposition Real

DEFINITIONS

Figure 2.1: How intangible assets are defined Source: Stolowy & Jeny, 1999

The International Accounting Standards Board (IASB) uses the ‘real’ definition¹⁷ of intangible assets “Intangible assets are identifiable, non-monetary assets without physical substance” (IAS 38.8)¹⁸.

The definition of an intangible asset contains criteria that should be met by the item to be considered for recognition as an intangible asset¹⁹.

Discussion

The fact that there are three accounting approaches to definitions of intangible assets which illustrates that no definition is generally accepted. This lack of overall homogeneity in the accounting definitions of intangible assets is evidence that no overall conceptual framework exists leaving the concept of intangible assets unnecessarily complex in the global economy (Stolowy and Jeny, 1999).

16 These types of definitions are not mutually exclusive.

17 IASB does not really give a list of intangibles, but IAS 38 includes a list of intangible assets excluded from the definition(Stolowy and Jeny, 1999)

18 It must also meet the definition of an asset: Controlled by the entity and expected to generate future economic benefits for the entity (IAS 38)

19 When the approach applied in defining intangible assets turns out to be weak in a conceptual way, the recognition criteria compensate for gaps left behind (Stolowy and jenny, 2000).

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2.3 Goodwill

A very special case of an intangible asset is goodwill. Generally, a company records goodwill when it buys part or all of the net assets of another company and the purchase price it paid exceeds the fair value of those net assets. The premium is described as

‘purchased goodwill’. However, companies can also generate goodwill internally as a result of successful business operations.

Whether acquired or internally generated, goodwill represents the present value of future above-normal returns which the assets in combination are expected to generate (Sutton, 2003).

Goodwill is also described by Smith and Parr (1994) as the ‘most intangible of intangibles’ indicating that the true nature of goodwill is intangible. However, IFRS states: ‘goodwill represents future economic benefits that are not capable of being recognized separately as assets’.

Thus, all of the positive attributes and characteristics as evidence of a goodwill asset are really attributes and characteristics of intangible assets.

So, in the case of regarding goodwill as an intangible asset one could say that if valuation experts were skilled enough in the identification and quantification of the intangible assets in the company portfolio, valuation practitioners would not need to resort to the catch-all term goodwill. However, there is at times no economic justification for the analysis necessary to do this, and in those cases, the term is useful, as long as valuation practitioners recognize that it represents an aggregation of intangible assets and intellectual property (Smith and Parr, 1994). Some examples of goodwill are resources such as employee skills, product reputation, and customer loyalty.

2.4 Classification of intangibles

A lot of intangible assets can be part of a companies’ asset base. To clearly structure all these possible intangible assets a division in classes is often used. In the next section three of these classifications are discussed to further enlarge the understanding of the intangible assets concept.

2.4.1 Classification according to Smith & Parr

Smith and Parr (1994) divide intangible assets in four categories:

Rights;

Relationships;

Grouped Intangibles; and

Intellectual Property.

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Rights

Every business enterprise acquires rights through establishing contractual agreements with other businesses, individuals and governmental bodies²⁰. Smith and Parr (1994) further divide rights into receiving contracts, franchises and providing contracts.

Receiving contracts enable the business to receive goods or services at better-than- market rates or assure the receipt of goods or services in short supply (for example insurance coverage at better-than-market rates or employment contracts that act to retain key personnel).

Franchises are connected with the rights of a franchisee or franchisor. In a franchise, an asset, developed by the franchisor, is rented by a franchisee. A franchise can be ‘weak’

or ‘strong’ to depict the degree of control exerted by the franchisor²¹.

Providing rights afford the business the opportunity to provide goods or services to others at a profit (for example licenses granted to another for the use of intellectual property in return for royalty payments or Mortgage servicing rights to collect, process and manage insurance matters on a portfolio of mortgages for a fee).

Relationships

Every business has established relationships with outside agencies, other companies, and other individuals. Relationships can be divided into three groups: employee-, customer- and distributor relationships.

One of the most obvious relationships of an enterprise is that with its employees.

Employee relationships secure the services of a business companies’ employees for a longer period in time avoiding the very costly activities of locating, hiring and training employees. The more specialized the workforce, the greater the cost of its assemblage, and the larger its value to the enterprise.

Customer relationships depend upon two characteristics of a company: inertia and information.

The term inertia is used to describe the degree of ease with which a customer is able migrate to another source of a particular good or service. The harder this is the more valuable the customer relationship.

Information refers to the existence of some customer identifying record and/or some obligation or advantage on the part of either the business or the customer to continue the relationship as criterion for a customer relationship to exist. The more information is available, the more valuable is the customer relationship.

20 At a minimum, a business establishes its right to carry on operations by obtaining a license or by registration at the local government level. A large enterprise may have a bundle of rights compromising thousands of elements.

21 A ‘weak’ franchise provides only an umbrella business concept and trademark whereas a ‘strong’ franchise might be a franchise in which every element of the business company is specified and controlled (Ibid).

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Finally, a business that depends on others to distribute and/or sell products may have established distribution relationships of considerable value. For a company without retail stores, the relationship with representatives can be extremely important²².

Grouped intangibles

Grouped intangibles refer to the going concern value and/or goodwill²³ that often remains as a residual after intangible assets have been analyzed, identified and valued.

Going concern value has been defined as ‘the additional elements of value which attaches to property by reason of its existence as part of a going concern’ or as ‘having the elements of a going concern in place’. Thus, a going concern is distinct from an insolvent one and therefore represents value. Their value is a measure of the cost incurred for all acquiring and organizing that are needed to build up the company from scratch plus the profits lost during the process.

Next to the already treated residual²⁴, goodwill represents patronage and excess earnings. Patronage is the proclivity of customers to return to a business and recommend it to others whereas excess earnings refers to the fact that a business that possesses significant goodwill is likely to have earnings that are greater than those required to provide a fair rate of return on the other assets of the business.

Intellectual property

Intellectual property usually refers to patents, trademarks, copyrights and trade secrets²⁵. This is a special classification of intangible assets because the owner of intellectual property is protected by law from unauthorized exploitation of it by others.

A business that owns intellectual property can internally utilize its benefits or transfer interests in the property to others who will exploit it.

2.4.2 Classification according to Teece

Instead of intangible assets, Teece (1997) refers to intellectual capital. According to Teece, intellectual capital embraces all the intangible assets.

Intellectual capital (and thus also the intangible assets it embraces) are classified in 2 groups²⁶:

Structural capital

Human capital

22 The relationship between representative and customer may be stronger than the relationship between company and customer (Ibid).

23 Smith and Parr (1994) believe them to be separate where others combine them (also see paragraph 2.3).

24 This is really a permutation of the excess earnings concept because the value of the enterprise will only exceed the value of identifiable assets if there are excess earnings(Smith and Parr, 1994)

25 Also known as know how

26 Most classifications for (Sveiby, 1997; Bontis, 1997, and St. Onge, 1996) assume a three-way distinction between external structure, internal structure and employees (Teece, 1997)

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Structural capital results from relationships and organizational value reflecting the external and internal foci of the company, plus renewal and development that is potential value for the future. Value can be generated by all (good) relations with other participants in the environment external to the company, such as its customers, suppliers and alliance partners.

Human capital results from the fact that people generate capital for the company through their competences, their attitudes and their intellectual agility. Competences include skills and education, while attitudes cover the behavioral component of the employees’ work.

Intellectual agility is the ability to innovate and change practices, to think laterally about problems and come up with new and innovative solutions. The distinction from intellectual agility from competence and behavior is justified by the fact that it is neither a skill nor a behavior, but a mix of both.

2.4.3 Classification according to IFRS

Next to a real definition of intangible assets, the IASB also defines intangible assets using the list-based approach. As was explained, the list based approach refers to a list of intangible assets as a kind of inventory. The intangible assets in the list used by the IASB are divided over 5 classes:

Marketing-related intangible assets

Customer-related intangible assets

Technology-based intangible assets

Contract-based intangible assets

Artistic-related intangible assets

Table 2.1 shows the list-based approach of the IASB towards intangible assets. Some intangible assets from the table are explained below.

Marketing-related intangibles consist primarily of intangible assets used in the marketing or promotion of products or services.

Trademarks include any word, name, symbol or device or any combination thereof, adopted and used by a company to identify his goods and distinguish them from those provided by other companies. Trademarks are registered for by government authorities.

A trade name refers to a single name of a company used to identify it.

Service marks are the same as trademarks except they are used to identify services rather than products.

Certification marks identify products that have specific characteristics such as those which are union made.

A trade dress of a product describes its total image and includes its size, shape, color or texture. Trade dresses are used to describe the appearance of the product itself²⁷.

27 It may be important to note that it is possible to infringe on a competitors’ trade dress, even though trademarks differ.

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A non competition agreement is an agreement between a buyer and a seller of a business in which the seller is refrained from competing with the purchaser of a business.

The non competition agreement thus restricts the seller from continuing in the same line of business for a certain period of time, often within a defined geographic area (Reilly and Schweihs, 1999).

Marketing-related Contract-based Technology-based

Trademarks and trade names Licenses Patented technology

Service marks, collective marks,

certification marks Royalty, standstill agreements Software and mask works Trade dress(unique color, shape or package

design)

Advertising, construction, management, service or supply contracts

Trade secrets including secret formulas, processes, recipes

Non-competition agreements Lease agreements Unpatented technology

Newspaper mastheads Construction permits Databases

Franchise agreements Internet domain names

Artistic-related Operating and broadcast rights In Process Research & Development

Plays, operas and ballets Use rights Customer-related

Books, magazines, newspapers and other literary works

Servicing contracts( mortgage

servicing contracts) Customer contracts Musical works such as compositions, song

lyrics, and advertising jingles Use rights(drilling, water) Customer lists

Pictures and photographs Employment contracts Order or production backlog

Video and audiovisual material Non-contractual customer relationship

Table 2.1 Illustrative list of intangible assets per intangible class²⁸ Source: IFRS

Customer-related intangibles occur as a result of interactions with outside parties.

A customer list is seen as documentation on the historical customer relationship. The documentation is typically more than a simple listing. For example customer or patient records and credit files (Reilly and Schweihs, 1999).

An order or production backlog arises from contracts such as purchases or sales orders.

Contract-based intangibles generally represent value attributable to that broad category of rights accruing to an individual or to a company as a result of written, legally enforceable contractual agreement. A change in general industry or economic conditions may exert a positive or negative impact on the current value of an existing contract (Reilly and Schweihs, 1999).

28 The intangible assets on this list are not limitative and not mutually exclusive.

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Technology-based intangibles represent value attributable to proprietary knowledge and processes that have been developed or purchased by a company and are recognized as actually providing or having the potential to provide, significant competitive advantages or product differentiation²⁹.

A patent is the legal process whereby technology is turned into controllable property with defined rights associated with its ownership.

Computer software is defined as ‘everything that is not hardware’. Software falls in two categories.

1) product software (or software intended for sale or license);

2) operational software (or software intended for internal use).

Databases are organized collections of related data. They include customer information, inventory records and open order files. There are many specialized proprietary databases that have broad commercialization potential, like mailing lists, credit information and scientific data.

Databases can also be used to generate income either directly, through the sale or license in their entirety, including the associated property rights, to customers or indirectly, through the internal use of the data to perform a service to customers (Reilly and Schweihs, 1999).

A trade secret is information, including a formula, pattern, compilation, program, device, method, technique, or process, that (1) derives independent economic value, actual or potential, from not being generally known and (2) is the subject of efforts that are reasonable under the circumstances to maintain a secret (Reilly and Schweihs, 1999) In process research and development is defined as costs incurred in incomplete R&D projects by a company being acquired by another company (Lev & Daum, 2004).

Artistic-related intangibles refer to rights to plays, literary works, music, paintings, photos, and video and audiovisual material.

Discussion

In this paragraph three classifications of intangibles were discussed. However, just as with the definition of intangible assets, a generally accepted classification is missing. The business literature clearly operates under different classifications than the accounting standards which is not conducive for the understanding of intangible assets.

However, the more basic classification of the IASB requires, in the contrary of other classification used in business literature, that the classification is understandable and practicable for its users.

29 Often, and inappropriately, only participants in the high-tech industries are recognized as controlling technology-based intangibles of any significant value. However, any proprietary technology that confers to its owner is generally recognized as a technology-based intangible asset (Reilly and Schweihs, 1999).

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2.5 The value of intangible assets

In the first chapter some references on the value of intangible assets have been quoted, but the reality behind the value of intangible assets in companies has not been discussed. This paragraph tries to explain why intangible assets are such important assets for today’s companies.

Successful companies no longer rely on traditional factors of production for their survival because this possession of industrial capacity alone is not enough anymore to ensure continued growth and profitability.

One of the reasons for this change in reliance is the constantly changing competitive conditions that were already stated in paragraph 1.1 which have induced a need to define new strategies, which focused on differentiation and innovation.

In this rapidly changing environment the most important and sustainable sources of competitive advantage have become intangible but the question remains on what makes those intangible assets so valuable in this scenario?

One way to look at the role of intangible assets in today’s organizations is represented by the Resource Based View (´RBV´) of the company.

According to this model, differences in company’s’ performances across time are driven primarily by the possession of unique resources (Hitt, 2001). Many intangible assets have characteristics that indicate a degree of uniqueness. For example a patent that is based on exclusive rights to the owner or a trademark which has the power to distinguish a product or service from others.

The fact that resources are unique forms the relation between intangible assets and their value. For unique resources to have potential of sustainable competitive advantage³⁰ a resource must posses four attributes: (1) it must be valuable, in the sense that it exploit opportunities and neutralizes threats in a companies environment, (2) it must be rare among a companies current and potential competition, (3) it must be imperfectly imitable and (4) no strategically equivalent substitutes for this resource must exist that are valuable but neither rare or imperfectly imitable (Barney, 1991).

Put simply, intangible assets are just more likely to be valuable, rare, and hard-to- imitate and this is what makes such company-specific assets under the RBV such potential sources of sustainable, competitive advantage (Arikan, 2002).

However, some authors believe that the value of intangible assets cannot be addressed on a stand-alone basis. In their view, intangible assets should build on the capabilities created by other intangible and tangible assets, rather than create independent capabilities with no synergies among them³¹. Intangible assets only compromise value in the context of a strategy, what they are expected to help the organization accomplish (Kaplan and Norton, 2004).

30 “... a value-creating strategy which other companies are unable to duplicate the benefits or find it too costly to imitate.” (Hitt, 2001)

31 Hall (1993) proposes a framework for linking intangible resources to the companies’ capabilities, which provide a sound basis for the identification of the contribution that intangibles make to the objectives of the organization and the accomplishment of competitive advantage.

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Lev and Daum (2004) add that intangibles are inert commodities since they cannot create value nor generate growth by themselves and most business companies have equal access to them.

The potential for competitive advantage in the future depends on the characteristics of the intangible assets, but the management and integration of these assets in a company are essential to represent all the intangible assets value to the customer. The

‘organizational infrastructure’ has become a critical ‘production factor’.

2.6 Conclusion

In this chapter the sub question: What are intangible assets and what is meant with intangible assets in this research? was paramount.

Intangible assets differ in two ways from tangible assets. First, they are non-physical and second legal rights confer upon the owner of the intangible asset.

The definitions used in accounting standards are all about the recognition of intangible assets after acquisitions on the balance sheet. They compromise of characteristics of intangible assets that are used a recognition criteria.

The relevance and the content of this research are heavily based on the adoption of the new accounting standards in Europe concerning intangible assets and their convergence with the accounting standards for intangible assets under US GAAP.

For that reason it is logical to define intangible assets in the same way as in the accounting practice. The definition that is used in this research is therefore the real accounting definition of intangible assets stated by the IASB: “Intangible assets are identifiable, non-monetary assets without physical substance”.

This means that in this research intangible assets only exist in an accounting sense or in other words, if they meet the criteria for recognition and appear on the balance sheet of the acquirer. In this sense, goodwill is not an intangible asset.

Further, three classifications have been discussed of which the classification used by IFRS will be used in the continuation of this report. Intangible assets in this research are thus classified in five different classes: marketing, customer, technology, contract and artistic.

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Chapter 3 Accounting Legislation

In this chapter the question How are intangible assets accounted for under recent IFRS and current US GAAP? is of central concern.

In this chapter first the European standards for annual reporting will be discussed followed by a paragraph on the already stated convergence efforts of the IASB and FASB.

After that, the current American legislation concerning intangible assets will be addressed ending this chapter with a discussion on the effects of the new standards.

3.2 European legislation

The history of International Accounting Standards (IAS) began when in 1973 the International Accounting Standard Committee (IASC) was founded by several national organizations of accountants³². At that time, international investors and financial institutions were concerned about the variation in the quality of financial accounting and reporting across countries. Therefore, their objective was to produce global accounting rules.

Although the IASC made little impact in the first two decades of its existence, a breakthrough came when in 1995, the IOSCO, the origination representing international securities’ regulators, agreed to accept IAS-based financial statements submitted by companies seeking cross boarder listing of their securities. This was followed in 2000 when the European Commission decided to require all listed EU-companies to file consolidated accounts according to IAS from 2005.

Despite the achievements of the IASC, which issued 41 standards in 28 years³³, it was replaced by the International Accounting Standards Board (IASB) in 2001 because of considerable criticism on having poor governance and ineffective standards. Since then, the IASB has amended some IAS, has proposed to replace some IAS with new IFRS, and has adopted or proposed some new topics where there was no previous IAS. The new standards were issued under the name International Financial Accounting Standards (IFRS).

The term IFRS has both a broad and a narrow meaning. Narrowly, IFRS refers to the new numbered series of pronouncements that the IASB has issued and is issuing, as distinct from the IAS-series issued by its predecessor. IAS as specification maintained for standards issued before 1 April 2001.

32 under which the Royal Nivra (The Dutch institute for certified accountants)

33 34 standards -or IAS- were in force in mid-2002

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Accounting for intangible assets after business combinations under

Accounting for intangible assets after business combinations under

IFRS:

An industry-specific benchmark

Accounting for intangible assets after business combinations under IFRS:

An industry-specific benchmark

Preface

Contents

Chapter 1 Introduction

Chapter 2 Intangible Assets

Chapter 3 Accounting Legislation