Intangible assets in the consolidated financial statements
The impetus is an accounting change that fundamentally alters the way listed companies in Europe account for acquisitions. Its impact will become apparent next year [2005] when these companies report results.
The new regime, which resembles one already implemented in the US, would require public companies to record the value of intangible assets - such as brands - on their balance sheets when they are acquired. When these assets are judged to have an indefinite life - which is often the case with a brand - they will be subject to annual review for impairment. The same test will be conducted on goodwill - the difference between the value of the assets acquired and the price paid.
The resulting writedowns which would follow any impairment are ‘only' paper losses, as they do not affect a company's cashflow statement. But the US experience suggests that such exercises can produce stomach-churning moments for managements that have overpaid for intangible assets or managed them badly. In 2002, the company then known as AOL Time Warner took a staggering Dollars 54bn charge for the value lost when AOL acquired Time Warner during the waning days of the bull market in 2000. As a demonstration of management failure it could hardly have been more dramatic.
While all European companies will be required to comply with the new rules, the policies for unlisted companies vary by country. UK private companies have the option of adopting the new rules. Those in countries such as Spain or France are barred from the new regime.
The new rules, which are being implemented by the International Accounting Standards Board, seek to address one of the most glaring deficiencies in accounting - its lack of relevance to the way business is conducted in today's economy.
The concept of an asset dates back to the time when most assets were tangible. Things such as plant and equipment were assigned a market value and expected to wear out over time. In today's service economies, most assets would be intangible - such as the group accountants refer to as the ‘assembled work force', the assets that famously ride up and down in the elevators every day.
‘The accounting model is based on the economy of 120 years ago,' says Robert Willens, tax and accounting analyst at Lehman Brothers in New York. ‘The model is geared to an economy that isn't in existence anymore.'
The new standards focus on the confusion that resulted as more and more acquisition activity involved companies that consisted largely of intangible assets - such as AOL. Under the old rules, the value of tangible assets was calculated and the difference between that amount and the purchase price was recorded as goodwill and written off over decades.
The deficiencies were obvious. Attributing massive amounts of value to goodwill raised more questions than it answered for investors in public companies. What specific assets accounted for the goodwill? How were managements valuing these assets? How were companies managing these assets over time?
Moreover, the practice of slowly writing off goodwill - as a charge against earnings - also had problems. Some brands, for example, increase in value over time and these values can be maintained for long periods. Consider Coca-Cola, IBM, Rolls-Royce or, to pick a more classical example, Stradivarius.
Under the new rules, companies will have to calculate values for a long list of assets. Determining such values is tricky. The methods suggested by the regulators typically involve making use of estimates of future cashflows and economic conditions - never an easy task. A further option would involve comparing the prices fetched by recent sales of comparable assets.
Regardless of the method used, one complication will be figuring out which assets have definite lives - meaning their values will be written off over time - and which do not. In some cases, such as those involving contracts, the answers will be obvious. Other assets might give companies more wiggle room, which raises the possibility of abuses, Willens says.
The new accounting rules represent only a partial response to the question of how to better inform investors because they only govern intangible assets that are acquired. Companies are not being required to value intangible assets they create and build themselves. There is also no provision for giving intangible assets a higher value over time . . .
‘Branding - the bean counters get into creative accounting', Gary Silverman, Financial Times, 31 August 2004.
Discuss the implications of the new IAS/IFRS rules on the financial statements and share prices. Illustrate your comments based on actual examples of listed companies.