Industry report - Financial reporting for intangibles: the case of the invisible assets 26 Feb 14
Foresight Valuation Group LLC - IP valuations
Google’s recently announced sale of Motorola Mobility’s mobile phone business to Lenovo for $2.9 billion reignited some of the discussion around the valuation of Motorola’s IP assets at the time of the original $12.4 billion acquisition in 2012. Financial markets and IP experts were embroiled in speculation about what exactly Google paid for when buying Motorola, and how central the intellectual property – primarily Motorola’s massive patent portfolio – was in driving the acquisition price. Looking at Motorola’s balance sheet on the eve of the acquisition offered no clues to untangling the acquisition price: according to US Generally Accepted Accounting Principles (GAAP), internally grown 'intangible assets' (the accounting terminology used when referring to intellectual property) are not reported as assets on the balance sheet of the company that created them.
The Google-Motorola acquisition highlighted the tension between the value of intangible assets held by operating companies and the way in which such assets are reported in financial statements. Google’s post-acquisition allocation of $5.5 billion to “patents and developed technology” may have come as a surprise to many observers who attributed a higher portion of the acquisition price to the IP assets. However, as there was no disclosure of the fair value of these assets in Motorola Mobility’s books before the acquisition, there was no way of assessing the fair value of the assets – hence the wide gap between the price speculations and the actual price reported by Google.
Reporting gap or value opportunity?
Despite some far-reaching changes in recent years, including global harmonisation of financial reporting and the move towards fair value reporting, accounting standards worldwide are still largely blamed for failing to measure and report intangible assets. Is there really a serious gap in asset reporting, as many companies claim, or does this actually represent an opportunity for companies to control and manipulate the reporting of their intangibles?
Financial reporting is the main channel of communication between companies, shareholders and capital markets. In general, companies disclose financial information not only to report performance, but also as a way to manage investors’ expectations and affect the return on stock prices. There are two types of disclosure: mandatory and voluntary. Generally speaking, mandatory disclosures are any information disclosures required and regulated by the US Securities and Exchange Commission (SEC) and other regulators. Financial statements fall under this category, and the US GAAP define the scope and content of such statements. Voluntary disclosures, as the name implies, are not regulated and are not mandatory – they are anything else that companies choose to share with the market, whenever they want to share it. The annual reporting of the value of internally developed intangible assets falls under that second category. Intangible assets must be fully disclosed only when they are acquired and paid for, either in a business combination (M&A deal) or in an asset purchase, when the purchased intangibles are valued and reported on the balance sheet of the buyer at their fair value.
In that regard, companies are free to report the value of their internally grown intangible assets any time. They are just not required to do so on their balance sheets as part of the SEC-regulated financial reporting. Yet companies do not voluntarily report the fair value of their intangible assets. So the lack of mandatory reporting seems to be causing a gap in information on some of the most valuable assets held by technology companies today.
Silence is golden: are companies better off not reporting their intangibles?
It is unclear whether companies would readily switch to a system that required them to disclose fully the fair value of their intangibles, as they do with almost any other type of asset. There could be several reasons for that.
There is generally no dispute as to the high value of intangible assets. The more interesting question is whether the stock markets are efficient enough to reflect the full value of intangible assets in equity prices, despite the lack of value disclosure in the books of reporting companies.
Results from academic research conducted at the Stanford Graduate School of Business show that the markets rely on signalling, such as R&D expenses, to value intangibles, although it is more costly for companies and analysts to signal or interpret that value. Below are some of the findings' highlights:
- Equity values appear to reflect information on the value and productivity of R&D investments.
- Stock prices reflect value estimates of unrecognised brands and trademarks.
- Firms with unrecognised intangibles spend more free cash flows on signalling activities (eg, share buybacks), suggesting greater concern about equity undervaluation.
- Greater analyst coverage and greater analyst effort are required for firms with unrecognised intangible assets.
It is well documented in academic studies that managers thrive in situations of information asymmetry, as they can leverage that to their benefit. The fact that managers have better information than the market on the value of their IP assets gives them an advantage, as they can control the extent and timing of that information disclosure. For example, one academic study shows that 'insider' stock gains in R&D-intensive firms are substantially larger than insider gains in firms without R&D. This suggests that R&D is a major contributor to information asymmetry, and that insiders take advantage of this.
Markets do not do well with wide fluctuations in financial reporting. In order to smooth out these fluctuations, accounting rules create intermediary assets and liabilities that act as a buffer to absorb the annual changes so that they do not fully hit the income statement as they occur. This usually requires setting up an elaborate accounting system to smooth out the volatility, as is done in accounting for pensions, for example. Intangible assets will fluctuate in value if valued annually, as they are subject to high risk and uncertainty (litigation challenging validity, uncertain royalty flows). Companies may not happily embrace this type of onerous disclosure, as IP assets may just be too volatile for the accounting system to handle.
While the financial reporting system is far from perfect, one could argue that it actually works to the benefit of corporations as they have greater control on how and when they report their intangible assets. Whether markets as a whole are better off is a different question, which I would leave to IAM readers.
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