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The Intangible Asset Enigma Variation

In the first quarter of 2002, 59 public companies wrote down $210 billion in compliance with SFAS 141 and 142. Many investors are now asking how could these companies have been so impaired or their purchase price so wrong? Arguably, improper identification and valuation of intangible assets may have been in part to blame for the write-down.

SFAS 141, Paragraph 39 provides that an intangible asset shall be recognized as an asset apart from goodwill if it arises from contractual or other legal rights or it is separable from the acquired entity and sold, transferred, licensed, rented, or exchanged with a related contract, asset, or liability. The issue is whether this paragraph or the supplemental guidance provided in Appendix A10-28 of SFAS 141 is sufficient to enable financial executives to identify correctly all intangible assets; I would submit that it is not for the reasons stated below:

First and foremost, paragraph 39 inserts a jurisprudential and not an accounting framework for determining what is an intangible asset, and as a rule, financial executives are not intellectual property or commercial lawyers, therefore they should not be expected to competently identify for example what is a trade secret or an arms length agreement. Second, by utilizing traditional notions of what constitutes intangible assets they may include items explicitly precluded by the FASB. Case in point is the issue of an assembled workforce. Almost all annual reports declare proudly “our people are our greatest asset.” But the FASB has explicitly declared in paragraph 39 a prohibition from including an assembled workforce as an intangible asset. Thus, a major “intangible” is required to be re-classified as goodwill and be subject to impairment testing. Third, an IP lawyer may deem as an intangible asset something that the FASB does not want to include for policy reasons. Thus, the majority of what constitutes the value of an assembled workforce could be deemed a trade secret and therefore be classified as an intangible asset under A14 because it comprises methods, techniques, and know-how learnt exclusively on the job.

It should be evident that without a true appreciation of the nature, character, and attributes of the asset it is very difficult to properly identify it. So what’s in a legal definition? In the case of intellectual property everything is in the definition, because the legal provision or case law defines not only the legal right, but also its application and scope of protection. For example, The Economic Espionage Act of 1996 makes it a federal crime to steal trade secrets punishable by up to 15 years imprisonment or a $10 million fine. The statute defines a trade secret as “all forms and types of financial, business, scientific, technical, economic, or engineering information, including patterns, plans, compilations, program devices, formulas, designs, prototypes, methods, techniques, processes, procedures, programs, or codes, whether tangible or intangible, and whether or how stored, compiled, or memorialized physically, electronically, graphically, photographically, or in writing.” The application of the statute is limited to companies that take reasonable measures to keep such information secret. The scope of the information covered is limited to that which derives independent economic value, actual or potential, from not been generally known.

The challenge with intangible assets does not end with the issue of being able to correctly identify them, but extends to being able to correctly value them. FASB in its discussion of fair value both in the statements and interpretation bulletin places great stead on the market approach with respect to the valuation of intangible assets. If we look beyond the formidable obstacles of the paucity of markets and data with respect to intangibles, even one of the fundamental valuation methods used in the market approach, namely the royalty method, is flawed through its failure to take into account many basic contractual law considerations with respect to royalty agreements:

Although rightfully much importance is placed on use, this should be considered in terms of not only use per se, but whether such use is exclusive or non-exclusive; and where it is non-exclusive, how may other third-parties may use the intangible asset and upon what terms. With respect to the royalty rate, it is a question not only of the rate for the period of the agreement, but also a consideration of the variation in terms and conditions with respect to its renewal. In relation to payment, consideration should be given to the ease by which the royalty is capable of calculation, the form of the royalty payment, and the period over which it may be paid. It is imperative to make a determination as to the strength of the intellectual property, because this will have a direct impact on the relative value. For example, a licensor would most probably be able to garner a higher royalty rate after a successful infringement lawsuit than before. Conversely, a pending patent subject to either an office action or opposition is in a far weaker position and would probably have to accept a lower royalty rate than that being realized in a comparable marketplace. It is also important to consider the indemnification provisions. Litigation is an expensive business, and the extent to which a party can insulate itself from its impact is a significant factor with respect to for example a patent license. On average, patent litigation costs a litigating party $1 million. Last but not least should be consideration of not only the provisions with respect to termination, but also any penalties associated with termination. The ease by which either party may be able to extricate itself from a license is an important factor. If a party can simply walk away upon the realization that the royalty rate was too high, the high royalty rate becomes a meaningless benefit to the licensor.

Alfred King predicts $1 trillion in goodwill will be written down in 2002. Bears Stearns believes that 500 public companies are candidates for write-downs in 2002. Question: Will your company be one of them?