Discussion of Lev, Radhakrishnan and Zhang

It has been suggested that accountants do not resolve issues—that ‘we abandon them. We debate them loud and long . . . until another issue comes along that is more current and more controversial’ (Sterling, 1975).

However, it is also clear that some issues are not entirely abandoned—they are recycled. Those issues are the subject of (seemingly) scholarly articles. They are debated with vigour, but then put to one side—only to re-emerge a generation or two later. For example, discussions about the choice of the ‘correct’ or ‘proper’ depreciation method occupied many pages of technical journals in the 1950s and 1960s (see, e.g., Reynolds, 1961)—and have been periodically revisited ever since (e.g., Burns, 1992; Howe, 2008).

Another example is the debate about whether balance sheets should recognize internally generated goodwill or some other asset items supposedly reflecting the difference between the reported value of net assets and market capitalization. Indeed, it seems likely that concerns about the difference between reported balance sheet values of the shareholders' equity and the market capitalization of shareholders' interests has been the source of ongoing commentary (if not distress) to many observers—and has generated a range of prescriptions about how that supposed anomaly should be dealt with.

For a time, in the U.S. literature, there were debates about whether an organization's human capital should be recognized in financial statements in some way. Paton (1922) noted that ‘the loyalty and efficiency of the labor organization may be a matter of more moment than . . .  merchandise’ (pp. 36–7). Paton did not conclude that ‘human capital’ should attain asset recognition. However. Hermanson (1964) took a contrary position. Noting that ‘the economic factor of production labor has not been given asset recognition by accountants’ (p. 3), he proceeded to advocate a revised definition of the concept of ‘asset’ that encompassed this resource (p. 4), and a process of valuation and reporting on these ‘operational assets’. Hermanson equated ‘human resources’ with ‘operational assets’, and also referred to one method of valuation as involving the calculation of ‘non purchased goodwill’.

A few decades ago in Australia, there were suggestions that many listed companies had so-called ‘unidentified assets’ (such as ‘brand names’) as some major accounting firms actively promoted the service of assisting in the identification of those assets in order to ‘strengthen balance sheets’ and make it more difficult for businesses to be subject to takeover offers. (Fortuitously for those primarily concerned with reported profits, the assets that were to be newly identified were commonly not required by accounting standards to be subject to charges for depreciation or amortization). Australian accounting standards concerned with mergers and acquisitions gave some legitimacy to this process by requiring acquiring companies to assign ‘fair values’ to previously recognizable but unrecognized assets. Currently Australian Accounting Standard AASB 3, Business Combinations (March 2008) alludes to the valuation of ‘identifiable assets’ other that goodwill, and notes that on acquisition there may be certain assets that were not recognized but should have been due to ‘facts and circumstances that existed as of the acquisition date and, if known, would have affected the measurement of the assets recognized as of that date’ (para. 45). A key element in this standard is the definition of the term ‘identifiable’:

In short, just about everything is identifiable. It is hard to identify many items that would be excluded from ‘asset identification’ by this definition—save perhaps, ‘corporate culture’ or ‘organization capital’.

Events of the last decade—particularly the widening applications of information technology and the stellar growth of the market capitalization of many firms in that industry (at least, prior to the recent global financial crisis)—may have triggered renewed interest in unrecognized ‘intangible assets’. Certainly the market capitalization of many firms comfortably exceeded their reported net asset backing.

As has been the case for close to a century, the difference between market capitalization and the reported net assets of a firm continues to be described in various ways. If anything, the volume of contributions has increased. There is now a Journal of Intellectual Capital that since its launch in 2000 has published more than 300 papers discussing such diverse issues as what might constitute intellectual capital in different industries or organizations, how firms might measure or manage human or intellectual or organization capital, or benchmark their activities against competitors, how firms have reported on their intellectual capital, and how indicators of the effectiveness of the management of various intangibles might be compiled and reported.

So what has the Lev, Radhakrishnan and Zhang article (and other recent literature) contributed to the state of knowledge?

Lev et al. refer to what is described as the most important intangible asset (‘organization capital’—others occasionally refer to it as organizational capital). The paper then presents and illustrates a way of measuring the scale of organization capital for a sample of U.S. firms, and finally suggests that measures of organization capital can depict superior organization performance and hence can be used as an aggregate measure of management ability and quality, and that this in turn might be of value to compensation committees.

The following comments do not address the potential usefulness of measures of organization capital as a means of benchmarking management quality. Possibly senior managers may consider use of such data attractive, particularly if it supports a case for higher remuneration. But this obviously deserves to be examined in the context of a wider debate about governance practices within major corporations—and that is beyond the scope of these comments.

Rather, what follows focuses on the implications of claims about the identification and valuation of organization capital to the practice of accounting. After all, the lead author has claimed that there are ‘information deficiencies regarding intangibles’ and that these are the result of accounting shortcomings (expenditures on intangibles are expensed, while those on physical and financial sets are capitalized)’ (Lev, 2001, p. 3). One obvious implication of these comments is that some or all of expenditure on identifiable intangibles should be recognized as assets rather than simply being expensed. An alternative interpretation is that such intangibles should be subject to additional forms of reporting, as suggested by Bloom (2009). Such claims deserve careful if not entirely respectful attention.

WHY IS IT CLAIMED THAT CURRENT TREATMENTS OF INTANGIBLES ARE DEFICIENT?

The Lev et al. paper describes how recent U.S. expenditure on intangibles has been significant relative to total investment by the non-financial sector in property, plant and equipment, and cites studies that suggest that the total value of intangible capital ranges between one and two thirds of the total market value of publicly traded corporations. Plainly investment in intangibles constitutes a big number. But such an observation by itself is unlikely to be of great interest to researchers or practitioners. Big numbers are—just big numbers.

The extended discussion of this phenomenon in Lev et al. carries with it the implication that there is a problem or issue that needs to be addressed within the practice of accounting. Indeed, similar comments about the divergence between market capitalization and reported net asset numbers have a long history (as noted above) and have regularly been recycled in recent literature, particularly in the Journal of Intellectual Capital. For example:

Yet the logic underpinning such observations is not clear. One possible line of reasoning is as follows:

The second proposition—an assumption—is not supported in the technical literature on accounting, or in accounting standards. Nor do many recent contributions of this genre attempt to address this issue in any detail. Indeed, there is not a body of literature that examines the decisions faced by stakeholders and explains how balance sheet information about organization capital can be expected to assist decision making. There are of course several studies that suggest that there is an association between future earnings and stock-market returns, and disclosure of the value of certain intangibles (see, e.g., Aboody and Lev, 1998). Such findings are not entirely surprising, given that the values attributed to intangibles like software in terms of U.S. accounting standards are supposed to not exceed the net present value of future earnings from those assets. Yet such findings have led to the claim that information about capitalized intangibles and amortization rates is ‘value relevant’ to investors. Others studies have also concluded that ‘intangible investments are value relevant and fully reflected in stock prices’—but then conclude (as they might well have done without undertaking an empirical study) that ‘the value relevance of intangibles does not, by itself, imply that intangibles should be measured’ (Kanodia et al., 2004, p. 114).

Those commentators who observe a discrepancy between book values and market capitalization may well agree that the latter reflects investor expectations about future earnings and cash flows. Indeed, some have speculated that increase in the value of (unrecognized) ‘assets’ has been accompanied by a failure to recognize all revenues: ‘It is possible that millions of dollars in revenue are sitting unrecognized in companies’ (Klalia & Hall, 2000).

Apart from casual observations along these lines, many advocates of greater recognition of ‘intellectual property’ do not explore other reasons why the reported net assets of a corporation may differ from its market capitalization. One component of that difference may be that assets and liabilities do not reflect current market values. This possibility is frequently ignored, as writers happily attribute the difference to unrecognized intangibles.

But a more significant factor is that accounting processes aim to attribute values to individual items of assets or liabilities and do not attempt to value a ‘business’ as a whole. Such a proposition has been extensively recognized in the accounting literature on goodwill at least since when Paton (1922) described goodwill as ‘the residuum, the balance of the legitimate values attached to an enterprise as a totality, over the sum of the legitimate various tangible properties taken individually (p. 310). Later Canning offered similar comments, based on his analysis of accounting practice (Canning, 1929, pp. 38–44). Others have repeated or paraphrased these comments. The following summary comes from popular text on accounting theory published in the 1960s:

Further, the distinction between valuations of individual assets and valuations of a business has been afforded some formal recognition in Australia—for example, in 1985 Australia's Accounting Standards Review Board explained that it had adopted the following assumption when deliberating about the measurement of assets and liabilities:

Looking beyond the accounting literature it can be noted that regulatory arrangements in Australia provide for the targets of takeover offers to furnish shareholders with experts' reports on the merits of a bid (see Corporations Act 2001, ss 638–40) and these reports commonly include valuation of a corporation's businesses—producing estimates that differ substantially from reported net asset values. For that matter, regulatory arrangements governing takeovers are commonly premised on the observation that bidders may be prepared to pay a ‘premium for control’ of a business—a premium in excess of market values for those securities. But those who describe the significance of ‘intellectual capital’ (or internally generated goodwill) do not follow through with an explanation of why balance sheet values should be aligned with market capitalization (or other estimates of the ‘value of a business’, such as those provided in response to takeover bids).

Possibly a case could be made on the ground that some enterprises routinely trade in ‘businesses’. It could be argued that some ‘tangible’ assets (such as agricultural properties in remote regions) would usually only have a market value when considered and sold ‘as a business’. Underpinning these claims would be suggestions that stakeholders are routinely misled by the absence of information about the value of a firm's various businesses (regulatory arrangements attempt to ensure that shareholders are informed about these matters in the context of mergers or takeovers). But that case does not appear to have been made.

The alternative argument is that companies with valuable intangibles (however they are described) that have previously been expensed or are otherwise not recognized as assets in their balance sheets will have that ‘value’ reflected in high earnings and rates of return. In turn, those high earnings and rates of return may be reflected in the market price of securities.

From this perspective, a gap between market capitalization and reported net asset value is not a problem—it is simply a phenomenon.

On the other hand, it can readily be argued that capitalization of so-called intangibles (such as marketing expenditure or moneys spent on software development) can provide a misleading representation of a firm's financial position and performance. It is well recognized that potential lenders often disregard the balance sheet values attributed to ‘goodwill’ or other intangibles. There have been many instances in which companies that reported major investments in software or other intangibles have failed and those ‘assets’ were subsequently seen as being worthless—Enron and Worldcom are prominent examples.¹ Supporters of the capitalization of software development expenses (e.g., Aboody and Lev, 1998) make no mention of the possibility that in many instances such expenditure is incurred in modifying vendor's software that is being used under licence—so that it may never be possible to recover that investment through sale, and continuation of the licence arrangements may not be automatic if there is a change in control of the licencee.

Investment banks that a few years ago might well have been regarded as enjoying superior financial returns (because of their intellectual property) have recently failed or distressed when they were unable to refinance borrowings during the global financial crisis. Arguably, placing a valuation on their intellectual property would not have ensured that markets were better informed. Rather, it may have reinforced media-fostered perceptions that these business were run by superior managers.

WHY BOTHER IDENTIFYING DIFFERENT CLASSES OF INTANGIBLES?

One of the most bemusing features of the burgeoning literature on intangibles is the way various authors use different terms as synonyms, and present different classifications of intangibles.

Lev (2001) explains that he uses terms ‘intangibles’, ‘knowledge assets’ and ‘intellectual capital’ interchangeably (p. 5), but then alludes to a four-way classification of intangibles—those arising from research and development, information technology, employee training, and customer acquisition (p. 2). The current paper by Lev et al. refers to organization capital as the ‘major’ category of intangibles, defined as follows: ‘Organization capital—the agglomeration of business process and systems, as well as a unique corporate culture, that enables them [sic] to convert factors of production into output more efficiently than competitors’. This description appears to encompass all four of Lev's previous listing. But since organization capital is described as a ‘major’ item then there must be other ‘minor’ items as well.

Indeed, other authors have referred to different categories of intangibles, or different components of intellectual capital. For example it has variously been suggested that intellectual capital comprises:

But classification is a purposive activity. Things may be classified in order to better understand aspects of their behaviour, or because there are differences in their features that suggest different treatments.

It must be acknowledged that some contributions to the literature have based their analysis upon efforts to ‘give managerial guidance in the field of managing intangible assets’ (Andriessen, 2001) and have avoided linking their discussion to proposed changes in accounting practice. But, as noted above, others (including Lev, 2003) have openly claimed that the gap between market capitalization and book value indicates that their accounting practice is defective.

In accounting, assets are classified to assist readers of financial statements to understand the underlying phenomena. On the face of it, the classification of assets into classes (such as current and non-current) is intended to assist readers of financial reports to assess a firm's liquidity and solvency. History suggests that asset classification has also been employed as a means of prescribing different measurement methods (e.g., current assets were to be valued at no more than cost, non-current assets could be retained at cost regardless of movements in market prices) (see Walker, 1974).

Why, then, do so many authors allude to different classes of intangibles? What is the objective of that classification? If organization capital is only one component of a set of intangibles, then the reader might well ponder what is different about organization capital, vis-à-vis other intangibles? Why single out organization capital?

Perhaps a clue lies in Lev's advocacy of extended reporting of intangibles, as he argues the optimal use of intangibles requires ‘quality and timely information about these assets’ (2001, p. 1). Evidently organizational capital is the outlier—it is implied that organization capital is not only the most significant intangible, it is the only one that is not recognized for accounting purposes. Other intangibles (such as research and development expenditure, or expenditure on software development, or goodwill on acquisition) can be capitalized in terms of accounting standards. Of course, extant accounting standards do not necessarily require capitalization.

The current Lev et al. paper does not explore this issue (beyond suggesting that valuations of this item could support claims for higher executive remuneration). Nor has it been explored in any depth in several papers that have presented classifications of categories of organization capital.

The following list may summarize several reasons why so much attention is given to describing classes of intangibles. It may be suggested:

To be fair, some papers of this genre do not claim there is a need for one or other class of intangible to be recognized on the balance sheet or to be reported in other ways—and several authors have been critical of efforts ‘to treat intangibles the same way tangible assets are treated, by trying to force them into the double-entry bookkeeping system’ (e.g., Andriessen, 2001). Some emphasize that they regard intangibles like intellectual capital as important to the ‘field of management’ (e.g., Kaufman and Schneider, 2004). Note: to management, not to management accounting.

The three items in the above list will be briefly reviewed.

EXTENDING THE CONCEPT OF ‘ASSET’

As already noted, a feature of much of the recent literature on intangibles is that it incorporates claims that contemporary financial reports do not reflect all of a firm's value (as evidenced by market capitalization if companies whose securities are publicly traded). Yet many other papers that promote the recognition of organization capital or related intangibles for reporting purposes do not bother to explore how the definition of asset should be redrafted to encompass those intangibles that the authors contend should be recorded on balance sheet.

Which elements should be encompassed by a revised definition? The antecedents of current definitions (as they have been embodied in the conceptual framework documents) can be traced to Canning's analysis of the accountant's implied definition of the concept of ‘asset’, based on a survey of published accounts. That implied definition was intended to encompass the full range of items recognized as assets in practice. Recent advocacy—in suggesting that contemporary practice is inadequate because of the non-recognition of intangibles—presumably seeks to go even further.

Paradoxically, some contributions have suggested that intangibles must both be subject to legal rights, and saleable, to warrant recognition as assets (see, e.g., Caddy, 2000)—an observation that echoes Chambers' definition of assets (‘severable means legally in possession’; Chambers, 1966) and which is significantly narrower than the concepts outlined in profession-sponsored ‘conceptual frameworks’ (and is inconsistent with the practice of regarding goodwill on acquisition as anything other than a balancing item arising from the application of consolidation techniques).

But as has long been observed, all assets are, in one sense, ‘intangible’. Even objects that have a physical existence and which are generally recognized as ‘assets’ (such as buildings or equipment) are the subject of legal rights, and it is these rights that mean that future benefits accrue to the owner or others who have rights of possession. Many financial assets, such as accounts receivable or interest-bearing securities, are specific forms of legal rights and have no physical or ‘tangible’ existence.

A common theme in recent literature on intangibles is the claim that there is an anomaly in contemporary practice since goodwill arising from acquisitions is recognized as an ‘asset’, while so-called ‘internally generated goodwill’ is not so recognized.

It might equally be argued that it is anomalous to regard goodwill (usually, an item that arises as a by-product of consolidation accounting) as an ‘asset’. That anomaly is compounded by the requirements of accounting standards for goodwill on consolidation to be amortized via charges to operating profit. Those requirements produce items of expense that cannot be validated by observation of evidence (e.g., movements in market prices). They are only the product of accountants' calculations.

However, some advocacy of the recognition of organization capital has been based on an assertion that recognition of more intangibles would bring accounting concepts of wealth and income closer to ‘economic’ or ‘business concepts’ (e.g., Hermanson, 1964).

While there are still those who advocate that accounting should be re-designed to more closely accord with economic concepts of income, the accounting profession's standard setting process has moved on. Current conceptual frameworks reflect the objective of accounting as being to assist stakeholders to make decisions. While claims may be made that treating certain intangibles (like organization capital) as an asset in balance sheets would enhance decision making by stakeholders, a body of evidence to support those claims has yet to be presented.

VALUING ORGANIZATION CAPITAL OR OTHER INTANGIBLES

Lev (2003) has previously argued that intangibles should be subject to additional financial disclosures, incorporated in balance sheets and (presumably) be regularly revalued. Such a proposal may well be music to the ears of professional valuers, whose business is derived from assigning dollar values to many things. (Indeed, Wayne Lonergan's paper in this issue provides enthusiastic support for such proposals.)

The Lev et al. paper is a demonstration of one sophisticated method of assigning a value to organization capital. If there was a market for such techniques, one might expect others to come forward with competing alternatives.

But a sceptical accountant might well ask, would such numbers produced by a hired valuer be relevant and reliable?

The issue of relevance can be explored in a number of ways: by modelling decisions, by examining factors that influence the judgments made by key external stakeholders external to the firm, or by laboratory or field experiments in which participants are asked to make judgments based on financial reports or other information which may be modified by the inclusion (or not) of data about selected intangibles. Plainly a body of work that indicates the relevance of intangible reporting in different forms has yet to emerge. The Lev et al. paper provides some evidence derived from investment returns in the securities market to indicate that some firms enjoy superior market returns. That may suggest that intangible reporting would be regarded as relevant to market participants—but it is hardly conclusive.

While Lev et al. provide some examples of firms that have demonstrated sustained superior financial performance, others have provided examples of the ephemeral nature of market perceptions (e.g., Caddy, 2000).

Indeed, it would appear that organization capital can be ephemeral. If it represents the aggregate efforts of the knowledge and skills of individual employees of a firm, it could evaporate overnight if competitors engage in aggressive recruitment. Even if intellectual capital is the integration of individual knowledge and skills together with organizational structures and processes (Swart, 2006, p. 138) the same would hold. If the information technology revolution has led to a ‘knowledge economy’, it has also facilitated information theft: descriptions of technical processes, manuals of procedures, and accumulated market intelligence can be copied in digitized form and be taken out the front door of a firm by an employee who has chosen to accept an offer of employment with a competitor.

There are also grounds for concern about whether any valuations—ephemeral or not—will really convey relevant and reliable information if the range of values that might be ascribed to them is extensive and subject to manipulation. For example, while some (e.g., Aboody and Lev, 1998) argue that internally developed software should be capitalized, close inspection of the elements of expenditure incurred in developing software suggests that application of accounting standards could produce more than 30 million options for capitalizing some or all of that expenditure (see Walker and Oliver, 2005). Admittedly, this is another big number—but this big number indicates the flexibility of this area of accounting, and how the income numbers that emerge after a capitalization policy have been applied may not be comparable between firms.

EXTENDED (FINANCIAL OR NON-FINANCIAL) REPORTING

Technological change has been fast and pervasive, and one does not need to bandy about phrases like the ‘knowledge economy’ or a ‘knowledge intensive workforce’ to recognize that investment in research and development of various kinds, and a commitment to staff development and training, and the fostering of a corporate culture that fosters employee engagement and celebrates innovation, can not only make life more enjoyable for staff but also enhance productivity and provide firms with a competitive advantage.

It has always been open to firms to disclose to their shareholders and other stakeholders what they are doing about R&D or product development or marketing. International accounting standards now permit income statements to report on items in terms of their nature (‘line items’ such as salaries and wages or advertising) or in terms of their function.

Similarly, company annual reports may include ‘management discussion and analysis’ which can outline what firms have been doing via investment in various forms of intangibles.

Advocates of greater reporting about intangibles must consider that these reporting regimes have been inadequate—and so wish to see greater attention paid to these items in financial reports or elsewhere. But reporting rules already require the identification of recognized intangible assets in the balance sheet or accompanying notes, and also disclosure of information about amortization or impairment write-downs. What else should be reported?

Again, it has always been open for statements of cash flows to separately identify expenditure on items like R&D—even if they are expensed.

Presumably advocates would like to see even greater disclosure and description of intangibles. Much could be achieved within the current framework of financial reporting and the inclusion of a management discussion and analysis.

While some may wish to see new forms of reporting, it seems likely that different considerations would arise in different industries. For example, patent expiry dates may be relevant to potential investors in pharmaceutical suppliers or herbicide manufacturers. Marketing expenditure may be relevant to investors in manufacturers of cosmetics. The scale of R&D may be relevant to potential customers of software suppliers. It seems likely that any regime of extended reporting about the value of intangibles would require the exercise of professional judgment—including consideration of the extent to which any disclosures may alert competitors and reduce a firm's competitive advantage.

FINAL NOTE

There are many ways in which accounting, with its focus on the financial aspects of affairs, does not provide all the information that every stakeholder might wish to have when formulating judgments about the performance and prospects of firms. Much of that information can be—and is—provided outside the accounting system.

One notable omission from the debate about intangibles appears to be a considered analysis of why certain items (such as ‘organization capital’) should be afforded priority for extended disclosure over other topics. After all, there are competing claims.

Some advocate greater disclosure of the investment needed to upgrade or remediate physical assets—particularly in the public sector, where governments have a responsibility to manage legacy infrastructure (see Walker et al., 2000) but the same concerns may also arise in certain industries which operate railways or pipelines or tollroads or engage in electricity generation and distribution. Similarly, existing disclosure rules do not provide comprehensive information about financial commitments that are not recognized as liabilities (see Walker, 2008). And arguably, more could be disclosed about the extent to which some firms are dependent on major customers or suppliers. Some stakeholders would like to see corporations disclose more about their employment policies and the extent to which they provide opportunities to different elements of the population. A growing number of stakeholders would welcome greater disclosure about a firm's policies in the reduction of greenhouse emissions and in efforts towards sustainability of operations.

This leads to the question of how much disclosure in annual reports would satisfy the expectations of all stakeholders.

It seems those who advocate extended reporting need to put forward a case as to why their particular proposals warrant priority over others.

And if advocates of more disclosure really want to promote change, then perhaps they need to devote more attention to how items might get on to the agenda of regulatory agencies. History suggests that items are only recognized as ‘problems’ after some crisis or anomaly.

What really is the ‘problem’ about non-recognition of intangibles in accounting? Has non-disclosure of the supposed value of intangibles led to investors or other stakeholders being misled? Or have claims about the value of intangibles by Worldcom in the U.S.A., or the value of licences by held by Australia's ABC Learning, actually misled investors?

After all, the very evidence that has led commentators to suggest there are unrecognized intangibles (i.e., the gap between market capitalization and book value) can also be interpreted as indicating that current reporting arrangements are more or less working. Shareholders are already able to look beyond book values to assess the capacity of a firm to generate profits and cash flows in the future. Possibly accounting reports could be improved if they provided a more meaningful record of the past achievements of firms in generating cash flows and accumulating cash or cash equivalents. Possibly more information could be provided about the circumstances of individual firms within their respective industries. But arguably such improvements will not come from importing into balance sheets a series of items that are not subject to legal rights and are not saleable.