Management And Accounting Web

Lev, B. 2004. Sharpening the intangibles edge. Harvard Business Review (June): 109-116.

Summary by Alberto Gonzalez
Master of Accountancy Program
University of South Florida, Fall 2004

Financial Reporting Main Page | Capital Markets Main Page | Value/Valuation Main Page

Traditional approaches in assessing company value involve the use of accounting information derived from tangible items such as plant investments, debt, sales and costs. However, these methods do not take into consideration the multitude of intangible assets held by companies. Patents, R&D, trademarks, software, a well trained labor force, unique processes, and customer relationships are just a few examples of intangible assets not fully recognized by the current financial accounting system. According to Lev, the lack of information on intangible assets (especially research and development) is detrimental to companies heavily invested in intangible assets. The solution to this information gap is to change the way certain intangibles are reported on financial statements.

Investor Undervaluation

Investors undervalue companies with significant R&D investments since financial statements contain very little meaningful information pertaining to intangible assets. The author supports this assertion with market valuation research on companies with large R&D investments. The study indicated that on average R&D intensive companies had positive risk-adjusted stock returns when compared to the overall market. The positive return suggests, “That investors are slow to realize the full value of the R&D investments.” Undervaluation establishes barriers to raising affordable capital required in R&D investments.

Management Misallocation

Investor undervaluation due to lack of pertinent R&D information results in management misallocating finite resources away from basic research to current technology improvements. Even though basic research can, in the long run, result in higher returns on investment than incremental product improvements; managers are hesitant to commit sufficient capital to such endeavors since they will be punished by investors for doing so.

Information "GAAP" in Financial Reporting

Insufficient accounting information causes investors to undervalue companies, which in turn causes insufficient R&D investment by managers. What makes current financial reporting cause such self-destructive behavior? A major problem with GAAP is that it forces investors and managers alike to think of R&D as strictly expenditures. Current accounting standards require in-house R&D to be expensed immediately, rather than capitalized and amortized over the estimated useful life of the asset. The author suggests that mangers should establish an “asset mentality” for R&D since it would allow them to “structure the intangible investments for maximum productivity and longevity.” What this means is that management will no longer consider R&D as an expense with no value past the fiscal year, but rather as a long-term investment with future rewards. In addition, GAAP does not require detailed disclosure on R&D investments that might give investors a better understanding and thus reduce undervaluation. The solution to these problems would be to require or encourage companies to provide sufficient R&D information.

Finding a solution to this problem is difficult because most companies do not record detailed information concerning intangibles using conventional accounting methods. The author states “Efforts need to be aimed at producing two vital streams of information, one involving productivity, the other asset values.” Productivity for intangibles could be measured by using ROI calculations. This may be easier for R&D than for other intangibles since R&D investments and results are measurable. Productivity measurements allow management to see if their investments in intangibles affect other areas. For example, a company may decide, after evaluating ROI, that more R&D resources should be spent on a particular product line. In addition, as stated earlier, the other solution is to change the view of intangibles from an "expense mentality" to an “asset mentality.” To support this idea, Lev provides a sidebar discussion and illustration related to a methodology for calculating the value of "intangible capital" and a company's "comprehensive value (p. 114).

Briefly stated, the value of intangible capital is determined by subtracting the average earnings from physical and financial assets in the relevant industry from the company's overall earnings. This residual represents an estimate of what Lev refers to as the company's "intangibles-driven earnings". Then, the present value of this forecasted stream of earnings represents the value of the company's intangible capital. With this information the company's "comprehensive value" can be estimated, i.e., the value derived from the physical assets on the balance sheet plus the value of their intangible capital. Finally, a market-to-comprehensive-value ratio can be calculated to provide a more useful indicator of value than the flawed market-to-book value ratio. Calculations for ten well known companies are reported in the sidebar. According to Lev's calculations, General Electric, Altria Group, IBM, Merck, Verizon and SBC Communications are undervalued, while Pfizer, Exxon Mobil, Microsoft and Intel are overvalued.

Company Estimated Intangible
Capital in $ billions
Ratio of Market value
to Comprehensive Value
General Electric 324 0.79
Pfizer 200 1.29
Exxon Mobil 164 1.04
Altria Group 143 0.55
IBM 134 0.93
Merck 124 0.99
Microsoft 123 1.59
Verizon 105 0.80
Intel 95 1.09
SBC Communications 62 0.90

The recommended solutions mentioned above create two concerns. One is related to competitors' access to proprietary information and the other concern relates to the reporting company's exposure to litigation. The author indicates that these are not insoluble problems. Obviously care needs to be taken in reporting sensitive information, but completely ignoring the value of intangibles is rarely the best approach. Companies need not reveal all their proprietary information to improve reporting. However, providing some information is clearly better than no information. In terms of the litigation issue, Lev recommends reporting only factual information about investments and benefits related to intangibles, not forecasts. The author cites numerous examples of industries (pharmaceuticals) where R&D information is readably available to the public with no apparent harm to individual companies. In addition, he notes that GAAP already includes a requirement to report certain acquired intangibles and that intangibles developed in-house are not fundamentally different from those acquired from other companies.

Conclusion

Intangible assets such as R&D have become essential for company survival in today’s knowledge-based global market. However, in order to unleash the full potential of intangibles, the current accounting system must keep up with the changing economy. If not, these intangible related problems will result in tangible failures.

___________________________________________

For a recent book on this topic see Lev, B. and F. Gu. 2016. The End of Accounting and the Path Forward for Investors and Managers. Wiley.

Related summaries:

Clinton, B. D. and S. Chen. 1998. Do new performance measures measure up? Management Accounting (October): 38, 40-43. (Summary).

Collingwood, H. 2001. The earnings game: Everyone plays, nobody wins. Harvard Business Review (June): 65-74. (Summary).

Dechow, P. M. and D. J. Skinner. 2000. Earnings management: Reconciling the views of accounting academics, practitioners, and regulators. Accounting Horizons (June): 235-250. (Summary).

Grojer, J. 2001. Intangibles and accounting classifications: In search of a classification strategy. Accounting, Organizations and Society 26(7-8): 695-713. (Summary).

Ittner, C. D. and D. F. Larcker. 1998. Innovations in performance measurement: Trends and research implications. Journal of Management Accounting Research (10): 205-238. (Summary).

Jalbert, T. and S. P. Landry. 2003. Which performance measurement is best for your company? Management Accounting Quarterly (Spring): 32-41.(Discussion of EVA, tracking stock and balanced scorecard). (Summary).

Johanson, U., M. Martensson and M. Skoog. 2001. Mobilizing change through the management control of intangibles. Accounting, Organizations and Society 26(7-8): 715-733. (Note).

Kaplan, R. S. and D. P. Norton. 2004. Measuring the strategic readiness of intangible assets. Harvard Business Review (February): 52-63. (Summary).

Martin, J. R. Not dated. What is a business valuation? Management And Accounting Web. http://maaw.info/BusinessValuation.htm

Schilit, H. 2002. Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. 2nd edition. McGraw Hill. (Summary).

Ulrich, D. and N. Smallwood. 2004. Capitalizing on capabilities. Harvard Business Review (June): 119-127. (Summary).