What exactly do we mean by ‘intangibles’?

1. Introduction

Over the last 15 years or so there have been a num- ber of calls for accounting reforms, with claims that the traditional historical cost approach has outlived its usefulness. 1 One of the claims made in these debates is that the economy has changed in fundamental ways, that business is now funda- mentally ‘knowledge-based’ rather than industrial, and that ‘intangibles’ are the new drivers of eco- nomic activity. Based on these claims, commenta- tors contend that one of the key problems faced by financial reporting is that financial statements fail to recognise many of the most important knowl- edge-based intangibles, such as intellectual capital, and that this has adversely affected investments in intangibles. 2 This has led to calls for accounting standard-setters to re-evaluate how intangibles are accounted for, and to make reforms. My goal in this paper is to synthesise and evalu- ate the current set of policy proposals in this area. My main objective is to provide a critical review of the claims made by the various commentators in this area to justify the need for reform as well as to review the proposals themselves. I argue that the case for reform is surprisingly weak, and does not support claims that large-scale reforms are neces- sary. More specifically, I argue that capital markets actually function rather well in financing compa- nies that engage in innovative, high-technology, and knowledge-based activities. In addition, I argue that an approach to intangibles that involves man- dating more extensive disclosure in this area is likely to be unsuccessful, but that there are market- based incentives for companies to voluntarily pro- vide these disclosures. Moreover, I argue that proposals to modify the current accounting model to recognise intangibles on the balance sheet are flawed for a number of reasons. The paper proceeds as follows. Section 2 dis- cusses the definition of intangibles and so lays out the scope of my discussion. Section 3 then pres- ents and analyses the case for reform, which I find is rather weak. Section 4 then discusses and evalu- ates proposals related to improving disclosure related to intangibles, while Section 5 discusses and evaluates proposals related to recognition. Section 6 concludes. 2. What exactly do we mean by ‘intangibles’? Before evaluating the various policy proposals, it is important to clearly distinguish the different terms used by commentators in this area and arrive at a clear definition of intangibles. My review of the extant literature indicates that the majority of Accounting and Business Research, Vol. 38. No. 3 2008 International Accounting Policy Forum. pp. 191-204 191 Accounting for intangibles – a critical review of policy recommendations Douglas J. Skinner Abstract —I review and critically evaluate the arguments in favour of reforming current accounting and disclosure practices related to intangibles. I argue that the case for reform is actually rather weak. Proponents of reform pro- vide little cogent evidence in support of claims that current practice is having adverse capital market effects. In fact, theory and evidence from corporate finance suggest that capital markets perform well in financing investments in innovative, high-technology activities. I discuss why mandating additional disclosure in this area is unlikely to be successful and that proposals to recognise intangibles are also flawed. Key words: intangibles; accounting reform; accounting standards The author is John P. and Lillian A. Gould Professor of Accounting at the Graduate School of Business, The University of Chicago, 5807 South Woodlawn Avenue, Chicago, Illinois 60637, USA. E-mail: dskinnerchica- gogsb.edu. He received useful comments from professional staff at the ICAEW, from participants at the conference in December 2007, and from the editor and a referee. Support from the ICAEW and the Graduate School of Business, The University of Chicago, is gratefully acknowledged. Eugene Soltes provided useful research assistance. 1 For example, the Jenkins Report, a report from a commit- tee formed by the AICPA in the United States in 1991 and chaired by Edmund Jenkins, provided a number of recom- mendations, such as 1 making financial reporting more for- ward-looking, and 2 reporting business measures outside the conventional financial reporting model, including product re- ject rates, market shares, measures of customer satisfaction, patents, and others. See DiPiazza et al. 2006 for a more re- cent call for change in the financial reporting model. 2 For example, see Cañibano et al. 2000, Lev 2001, Meritum 2001, and Nakamura 1999. Downloaded by [Universitas Dian Nuswantoro], [Ririh Dian Pratiwi SE Msi] at 20:43 29 September 2013 the discussion on intangibles falls into two differ- ent areas. 3 First, the most sweeping proposals take a broad view of intangibles, and include in this cat- egory virtually any resource that is both intangible lacking physical substance and of economic value to the firm. 4 This includes all types of intel- lectual capital, including those items associated with the firm’s human capital the value of em- ployee training, morale, loyalty, knowledge, etc., process-related capital the value of intangibles as- sociated with information technology, production processes, etc., and external relations customer satisfaction, customer loyalty, business relation- ships, other components of brand values, etc.. Second, mindful of the practical difficulties as- sociated with such a wide-reaching definition, ac- counting standard-setters are currently evaluating accounting for a narrower set of items, most no- tably by limiting discussion to those intangibles that are ‘identifiable’ i.e. items that have value on a stand-alone basis and meet conventional defini- tions of assets. 5 It appears that standard-setters are most concerned, at least in the short-run, with achieving better consistency in accounting for in- tangibles. In particular, there are concerns about the different treatment of intangibles acquired in external transactions which are usually recog- nised as assets and those that are internally devel- oped which are not. Accounting standard-setters have also devoted a great deal of attention to accounting for goodwill, which is a topic that I leave aside because it is largely separable from the discussion in many of the proposals on intangibles accounting and be- cause its recognition and measurement is related to accounting for business combinations, which I see as taking the discussion too far afield. I would note though that a loose definition of goodwill – as the excess of a business’ economic value over its book value – is taken by commentators as evidence of the failure of the current accounting model to cor- rectly recognise intangibles, a view that I address specifically below. In this paper, I spend most time on proposals re- lated to the broader definition of intangibles dis- cussed above, although most of the points that I make as part of my discussion are also relevant to the narrower questions currently of interest to stan- dard-setters.

3. The case for reform of accounting for intangibles