Need Tally
for Clients?

Contact Us! Here

  Tally Auditor

License (Renewal)
  Tally Gold

License Renewal

  Tally Silver

License Renewal
  Tally Silver

New Licence
  Tally Gold

New Licence
Open DEMAT Account with in 24 Hrs and start investing now!
« Top Headlines »
Open DEMAT Account in 24 hrs
 How To File ITR Online - Step by Step Guide to Efile Income Tax Return, FY 2023-24 (AY 2024-25)
 Old or new tax regime for TDS on salary? This post-election 2024 event will impact your tax planning
 What Are 5 Heads Of Income Tax?
 Income Tax Dept releases interim action plan for FY25 on tax collection, refund approvals
  Income Tax Return: 5 lesser-known tax-saving tips from Section 80
 Income Tax Return: 5 lesser-known tax-saving tips from Section 80
 Why you need not rush to file your ITR immediately
 Income tax returns: ITR-1, ITR-2, ITR-4 forms for FY 2023-24 available for e-filing
 Section 80DDB tax benefits for specified illnesses: 5 things to know
 Income tax slabs FY 2024-25: Five tips to help taxpayers decide between old and new income tax regimes
 ITR-1, ITR-2, ITR-4 forms for FY 2023-24 (AY 2024-25) available now on e-filing income tax portal

Need for new paradigm for intangibles?
October, 30th 2006

The ability of a firm to earn profits depends on its control over various kinds of assets. Some of these assets have a physical existence: property, plant and equipment. The profession of accounting has well-understood methods of valuing these assets on a firms balance sheet. Financial assets too have a basis for their valuation in prices set by active financial markets. 
However, as we move away from traditional manufacturing, the success or failure of firms depends increasingly on a kind of asset which has neither a physical existence nor an active market. These the intangible assets exist on a wide spectrum of concreteness. On one end of this spectrum we have intellectual property legally created assets like patents, the ownership of which gives clear-cut claims to the firm. 
On the other end of the spectrum are things like the spirit or ethos of a great corporation which, though crucial to its success, can hardly be quantified or owned. Somewhere in between are things like brands, customer relationships, knowledge embodied in employees or results of R&D which are yet to be turned into patents or products. In todays knowledge economy where tangible and financial assets have been turned into commodities, it is these intangible assets which can earn a firm greater than average returns. 
While the growing importance of intangibles makes it essential to include their value in financial statements, their very nature makes it difficult to do so. There are three reasons for this. First, in most situations there is little relationship between the cost incurred and value of the intangible asset created. Therefore, cost is irrelevant in the measurement of intangibles. Only their fair value can be a relevant measure. 
For example, the value of a brand built up by a firm itself cannot be measured by the cost incurred in product promotion and advertising; it should be measured at the fair value. Yet, it is tough to determine the fair value of intangibles. Prices observed in an active market are the best estimates of fair value. 
However, active market for intangibles is extremely rare and we must fall back on the use of economic models. Valuing intangibles, even by using the most rigorous methodology, calls for subjective judgements. Therefore, the reliability of any estimate of their fair value is questionable. 
Second, analysts and accountants are concerned over the fact that the control of a firm on intangibles is usually inadequate. For example, we cannot say that a firm owns the knowledge embodied in its employees. Therefore, even if we did have a generally acceptable method of measuring human capital, it cannot be recognised as an asset in the balance sheet because the firm does not have adequate control over it. 
Third, it is difficult to measure the amount and duration of benefits from expenditure incurred to develop intangibles. For example, the amount and duration of benefits from the research and development expenditure are surrounded by significant uncertainties. 
Contemporary accounting practices (e.g. Indian GAAP, IFRS, US GAAP) recognise intangible assets only if they have a purchase value attached to them. The measurement of intangibles is based on a transaction system in other words, if there is no transaction, there is no value to be attached to that asset. It can be argued that these accounting rules are not appropriate for the new economy because much of the value creation or destruction precedes transactions, even by years. 
For example, in a pharmaceutical company, sale of a new product occurs much after it has been developed. Therefore, in absence of recognition of intangible assets in the balance sheet, financial statements lack transparency. 
International standard-setters have started taking steps to bridge this gap between current business realities and accounting practices on intangibles. Till recently, IFRS required amortisation of all intangible assets (including goodwill) and established an arbitrary ceiling on the useful life of those assets. Now both IFRS and US GAAP do not require amortisation of goodwill. A company is required to test goodwill for impairment at least annually and the value of goodwill is reduced only if it has been impaired. 
For accounting purposes, IFRS and US GAAP classify intangible assets, other than goodwill, into assets with finite useful life and assets with indefinite useful life. Assets with finite useful life are amortised over their useful life. No arbitrary ceiling is specified on the useful life of those assets. An asset is classified as an asset having indefinite useful life if there is no foreseeable limit to the period over which it will benefit the firm. For example, a brand is an asset with an indefinite useful life. Assets with indefinite useful life are tested for impairment at least annually. 
Indian GAAP is yet to adopt these new accounting rules. Indian GAAP requires amortisation of goodwill over a period not exceeding five years and amortisation of other intangible assets over their useful life. There is a presumption that the useful life of an asset cannot exceed ten years from the date it is available for use and a longer useful life can be assumed only after presenting concrete evidence. 
Therefore, assets for which there is no foreseeable limit to the period over which it will benefit the firm are amortised over a period not exceeding ten years. We hope the Indian GAAP will catch up with IFRS soon. 
The response of standard-setters to the criticism of accounting rules for intangible assets has been cautious, and rightfully so. Accounting for intangible assets should be consistent with fundamental accounting principles that an asset should be recognised in the balance sheet only if its cost or value can be measured reliably. Therefore, although information on internally generated intangible assets is important, those cannot be recognised in balance sheet. 
But, as the information is relevant, there is a case for disclosure of intangible assets in financial statements. The question then is of whether companies should voluntarily disclose this information or whether disclosures should be mandated by standards. 
Since no one knows exactly how to measure intangible assets, it will be difficult for the standards to stipulate quantitative disclosure or to provide guidance on the measurement of different kinds of intangible assets. Standards can stipulate only qualitative disclosure, which should be industry specific. Voluntary disclosures do not benefit the capital market significantly because they lack comparability. 
The principles of accounting are entrenched in managerial decisions. Sometimes the management destroys an organisation by focusing too much on accounting numbers and measuring less and less of what matters. 
Given that we manage what we measure, the board of directors should certainly be concerned about the measurement of intangible assets for internal reporting. The CEO should report the value of each intangible asset to the board of directors at least annually. Companies should prepare financial statements for internal reporting with intangible assets recognised in the balance sheet. 
Accounting ratios calculated based on proforma financial statements measure the financial performance and financial position of the company better than accounting ratios calculated based on published financial statements. 

Asish K Bhattacharyya 
(The author is a professor of finance and control at IIM-C)

Home | About Us | Terms and Conditions | Contact Us
Copyright 2024 CAinINDIA All Right Reserved.
Designed and Developed by Ritz Consulting