What's worth more: the machines that make Intel Corp.'s Pentium chips or the intellectual property behind them, backed by the Intel brand? For most successful companies, patents, copyrights, brands, and other intangible assets trump physical assets, such as factories, offices, and even product inventory, hands down. These intangibles get little scrutiny under today's accounting methods. But managers are paying closer attention to them than ever before, and so are regulators. Earlier this year, a report by the U.S. Financial Accounting Standards Board highlighted the need for companies to measure intangible assets. In May, a task force set up by former Securities & Exchange Commission Chairman Arthur Levitt recommended that the SEC encourage supplemental reporting by corporations on such assets.
Baruch Lev, an accounting and finance professor at NYU's Stern School of Business, sat on that committee. He shared his thoughts withBusinessWeek Senior Editor Neil Gross.
Q: How did intangible assets come to play such a central role at so many companies?
A: It began to happen--and not so gradually--about 15 or 20 years ago. The reasons include a significant increase in competition brought on by globalization and deregulation of major industries. Innovation became a matter of life and death, and you get innovation by investment in R&D, people, and processes.
Physical assets generally don't create value. Just compare the physical assets at two pharmaceutical companies, such as Merck & Co. (MRK ) and Pfizer Inc. (PFE ) When it comes to lab equipment or buildings, there's really no difference between the two. All companies buy the best there is. Value is the ability, say, to get a drug through the Food & Drug Administration process more quickly than others [can]. This is a huge intangible, which creates additional yields.
Q: How does accounting enter this discussion?
A: Accounting hasn't kept pace with the rise of intangibles. The reason is that accounting is based on transactions--purchases, sales, and capital expenditures--which were mainly what created value up until about 20 years ago. In the new environment, value is created or destroyed long before the transaction takes place, for example, when a drug passes clinical tests or when it fails.
The markets react immediately. But accounting reacts two to four years later, when there are sales. There's a significant disconnect between what happens in capital markets and what our accounting systems reflect. The bottom line--the income number, the most important item in a financial report--is less and less informative.
Q: What is your remedy for this situation?
A: What's required is new accounting, a new measurement system, which should be instituted internally within organizations. And we need a change in mentality. Today, practically all intangibles are expensed: investments in R&D, enhancement of brands, employee training, customer acquisitions. These are not yet considered assets and generally are not accounted for, meaning managers don't compute the rate of return or take inventory of those assets. Because of this, you get misallocations. Before seeking to change accounting rules, companies should institute an asset mentality, one that recognizes that intangibles are assets just like inventory and machines.
Q: Can you tell us how this relates specifically to patents and other intangibles?
A: Many companies have thousands of patents. In most cases, they are not treated as carefully as capital equipment or inventory. Most companies are developing only a small percentage of the patents they have. But good management means estimating the value of patents and doing something with the ones you decide not to develop. When Lou Gerstner came to IBM (IBM ), he saw that thousands of patents weren't being developed. He declared that they should either be sold or licensed. First, that caused antagonism. Now, close to 15% of IBM's pretax income comes from patent licensing. This is an asset mentality.
Q: Isn't it difficult to value something like a patent, whose true worth may only become obvious in the course of litigation?
A: Yes, all intangibles are difficult to value. Some are outright impossible. Risks are extremely high, there are no markets for intangibles, and you don't have any comparables. But I'm not talking about valuation of everything you have. It may just be a matter of figuring out what patents you have, which ones have a ready market, and whether there are potential licensing clients. And you wouldn't need to go through this drill every year. Maybe only once every three to four years.
It's the same with brands. Companies like Procter & Gamble Co. (PG ) have hundreds of them. They should take an inventory every three to four years and determine which brands are still producing and which ones are dead. But the fact that accounting doesn't consider these things as assets casts a long shadow on what managers are doing.
Q: You recently concluded a large report on R&D investment in the chemical industry. How does that study link to this topic?
A: We found a very significant return on investment in R&D in the chemicals industry, in the range of 17% after tax. A large part of research is process R&D. It's not aimed at new products or services but rather at making manufacturing processes more productive. A good accounting system, in my mind, would link investment in process R&D to operating efficiencies, meaning you would figure out what cost efficiencies resulted from specific processes. Once you make these linkages, you can compute what is missing from intangibles. I'm talking about return on investment. Companies do this with stocks and bonds but not with intangibles. So they can't make decisions about how to invest.
Q: Does brand enhancement also come into play in this sector?
A: Yes. I work with a large chemical company that has many brands to support and enhance, as well as R&D. They have to balance these investments, which is a typical question of resource allocation. Brands such as nylon and Lycra take heavy investment to keep people constantly aware of them. And the investment must be linked with consequences. That's the part that's missing. The consequence of brand is a price premium over competitors. If you cannot manage to sell your product at a higher price, then you have a name, not a brand.
Q: What about human resources?
A: It's the same story in HR practices such as employee training. You make specific types of investments in your employees that cost money. What are the benefits? As with patents and brands, you need an asset mentality and a good measurement system. But you also need the right incentives for people to enhance intangibles. That doesn't happen naturally.
Take the example of info tech. One of the problems here is that for most companies, if a particular division has a problem, it goes to a vendor such as Oracle or IBM, which solves it locally. So you get lots of local information systems and little infrastructure.
I know one large pharmaceutical company that has 650 portals. This became such a huge, unmanageable thing. You need some incentives in place so that people who create technology think about the enterprise as a whole. We're talking about a new system of resource allocation that brings intangibles on par with the financial assets of the company.
Q: When it comes to accounting, could a change in the regulatory environment help?
A: There's huge controversy about accounting. At one level, all of this is about regulation. That's how you get changes. But the current environment is very anti-regulation. I don't see any significant changes in laws on the horizon. But I see a groundswell of concern.
Q: Sometimes it takes a catastrophic event to galvanize an industry. This has been the case for some types of environmental regulations. Do you foresee such an event in this arena?
A: We are in such a situation right now. How else can you explain the complete meltdown of the dot-coms? People speak about a bubble, but financial reports never provided any warning of this. And yet people have not used the meltdown as a lever for reform. Maybe it's because many managers and auditors are comfortable with the status quo. Still, I see change coming from two directions: Managers will become increasingly comfortable with measures of intangibles. And demand from investors will motivate managers to disclose more of this information.