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1 Accounting for Intangible Assets: There is Also an Income Statement Occasional Paper Series

2 Center for Excellence in Ac counting & Security Analysis C olumbia Business School established the Center for Excellence in Accounting and Security Analysis in 2003 under the direction of Professors Trevor Harris and Stephen Penman. The Center (“CEASA”) cal solutions for financia l reporting and security aims to be a leading voice for independent, practi ects economic reality and encouraging investment analysis, promoting financial reporting that refl practices that communicate sound valuations. C EASA’s mission is to develop workable solutions to issues in financial reporting and accounting policy; produce a core set of principles for equity analysis; coll ect and synthesize best thinking and best practices; disseminate ideas to regulators, an alysts, investors, accountants and management; and promote sound research on relevant issues. Drawi ng on the wisdom of leading experts in academia, arch and identifies best industry and government, the Center produces sound rese practices on relevant issues. CEASA's guiding criterion is to serve the public interest by supporting the integrity of financial reporting and the efficiency of capital markets. Located in a leading university with a mandate for independent research, CEASA is positioned to lead a discussion of issues, with an emphasis on s ound conceptual thinking and without obstacles of constituency positions. search is available on our website at More information and access to current re http://www.gsb.columbia.edu/ceasa The Center is supported by our generous sponsors: General Electric, IBM and Morgan Stanley. We gratefully acknowledge the support of these organizations that recognize the need for this center.

3 Accounting for Intangible Assets: There is Also an Income Statement Stephen H. Penman; George O. May Professor, Columbia Business School June 2009 This paper will be published in a forthcoming issue of Abacus . This paper does not necessarily reflect the views of the Center’s Advisory Board or the Center’s sponsors.

4 Table of Contents OVERVIEW ... I ... ... INTRODUCTION ... 1 PRELIMINARY POINTS ... 2 ... 4 MAIN POINT: THERE IS ALSO AN INCOME STATEMENT GATES POOR BALANCE SHEETS ... 6 THE INCOME STATEMENT MITI POOR INCOME STATEMENTS? ... 8 CAN THE BALANCE SHEET MITIGATE HANDLING INTANGIBLE ASSETS WI TH ACCOUNTING INFORMATION ... 12 A. M ICROSOFT C ORPORATION ... ... 12 ... 13 B. D ELL , I NC . ... CONCLUSION ... ... 17 REFERENCES ... ... 19

5 Overview ts from the balance sheet. W Accounting is often criticized for omitting intangible asse ith value in firms of today flowing less from tangibles assets and more from so- called intangibles – brands, distribution systems, supply chains, “knowledge capital,” “organization capital” – with high price-to-book accounting is seen as remiss, ratios as evidence. The remedy often proposed involves book ing these intangible assets to the balance sheet. This paper makes the point that accounting is not n ecessarily deficient in omitting intangible assets from the balance sheet: there is also an income statement, e (and other) assets can be and the value of intangibl ascertained from the income statement. For exampl e, although The Coca-Cola Company does not report its brand asset on its balance sh eet (and trades about five time book valu e), earnings from the brand flows through its income statement. Thus the firm is readily valued from its earnings; the income statement remedies the deficiency in the balance sheet. Accordingly, accounting th at calls for the recognition of “intangible assets” on the balance sheet may be misconceived. ent perfectly corrects for a deficient balance sheet, The paper explores the case where the income statem and the case where it does not. It then , accounting in the balance sheet – by explores whether, in the latter case capitalization and amortization of intangi value – could remedy the deficiency ble assets or carrying them at fair in the income statement (or makes it worse). The investigation involves an analysis and valuat ion of Microsoft Corporation and Dell, Inc., two companies presumed to possess a good deal of “intangibles assets.” The paper is instructive, not only to those con cerned with accounting issues , but also to analysts attempting to value firms with assets missing from the balance sheet. It shows how to handle the accounting information in valuation and how to deal with the perc imagined, with respect to eived deficiencies, real or intangible assets. In the case of Microsoft and Dell, th e reader can observe at how close one comes to their market valuation by using valuation techniques that use accounting information currently provided by GAAP. __________________________________________________________________________________________ Center for Excellence in Accounti ng & Security Analysis i

6 Introduction Many commentators view the omission of “intangible asse ts” from balance sheets as a glaring deficiency. They like brands, distribution and supply ask: How can accountants report a balan ce sheet that omits important assets chains, knowledge, human capital, and organization capital, particularly wh en value in modern firms comes more from these assets than from the tangible assets on the balance sheet? The complaint reached a crescendo during the 1990s as technology and inte rnet firms identified with these t ypes of “assets” came to the market the balance sheet. While a diminuendo with high price-to-book ratios that we re attributed to missing assets on ssets for many of these firms seem followed as the perceived intangible a ingly evaporated, the accounting for intangible assets continues as a si current trend towards booking more value gnificant research area. Indeed, the to the balance sheet with fair value acc ounting involves many of the same issues. This paper provides a perspec tive that I hope is not only helpful to those grappling with accounting so-called intangible assets. The main issues but also to analysts who use fi nancial statements to value firms with t but also an income not only a balance shee point of the paper simply reminds us that accounting reports statement. The value of assets can be ascertained from the income statement as well as a balance sheet, so the issue of accounting for intangible assets is not nece ssarily a balance sheet problem. Indeed, there is no accounting problem if the income statement informs about the value. If it does so imperfectly, the research question involves asking if and how accounting for intangible assets in the balance sheet can ameliorate the problem. Calls for recognition of intangible assets on balance sheets may be misconceived; they fail to lated income statements and balance sheets work understand the structure of accounting under which articu encies in the other. t can correct for the defici together to indicate firm value, and each statemen Before expanding on this theme, the paper make s a number of preliminary points that bear on how accounting might handle intangible assets. __________________________________________________________________________________________ 1 ting & Security Analysis Center for Excellence in Accoun

7 Preliminary Points “Intangible asset” is a speculative notion ble assets not just because they 1. . Intangible assets differ from tangi they are not identifiable such th at contracts can be written on them lack physical appearance but also because e patents and copyrights, and possibly brands, are exceptions (and these are for delivery. Explicit legal rights lik booked to the balance sheet if purchase d, as with any other asset), but “cust omer relationships,” “organization capital,” “knowledge assets,” “human capital,” and the like, are not specific enough for a market price ever be observed for them. A conjectured value of validated with a market price is a conjectured asset that can never be inherently speculative; value is in the mind of the beholde r. This was so for the “intangible assets” conjectured in the 1990s bubble for which there was no subsequent manifestation. Accounting r uns into trouble when speculative, conjectured values enter the financial statem ents, more so when the asset’s existence itself is conjectural. Indeed, the te rm, “intangible asset” can just be a c over for speculation or even fantasy; the mply by developing attractive language. existence of assets can be promoted si In the speculative 1920s, accountants wrote up asset va lues in balance sheets for perceived value, but woke to the crash of 1929 accused of “putting water in the balance sheet.” The subsequent creation of the led to a 60 year regime where such accounting was a Securities and Exchange Commission in the United States no-no. This outlook was reinforced by f undamental analysts of the time, Be njamin Graham and his adherents. Graham followed a dictum in investing: separate what you know from speculati on and anchor on what you know. To the accountants: Don’t put speculation into the financial statements; tell me what you know – what I can anchor on – but leave the speculation to me, the anal yst. The accountant reports wh at he or she knows from transactions: if an (intangible) a sset is identified in a transaction, book it, but do not book it in response to speculation about its existence. History repeats. In the speculative 1990s, traditio nal accounting – derided as accounting “for the industrial age” where value was said to have come fr nder challenge, accused of om tangible assets – came u failing to adapt to the “information age” (where value is said to come from intangible assets). But this time accounting authorities largely stood fi rm against water in th e balance sheet. With th e bursting of the 1990s bubble and the erosion of market valu e attributed to intangible assets , “industrial age acc ounting” now looks sensible; waiting until a firm makes a sale to add value to the balance sheet is not such a bad idea after all. It’s (The point should be considered by those advocating more fair value what we know, as evidence of value. accounting in the balance sheet.) __________________________________________________________________________________________ Center for Excellence in Accounti ng & Security Analysis 2

8 Those who advocated intangible asset accounting in the 1990s often referred to the high price-to-book nk, would turn in his grave. For the fundamentalist, acc ounting serves to ratios as justification. Graham, I thi independently of prices, not inferred from prices. Only inform about the prices of firms. It should be developed alists’ view, accounting should challenge entrepreneurs, then can accounting challenge prices. In the fundament management, and analysts who claim th at firms possess intangible assets. 2. “Intangible assets” invol ve using assets jointly . Most intangible assets are not stand-alone assets that can be valued on a balance sheet independently of other asse ts; rather, their value comes from producing cash flow streams jointly with other assets. Brands, distribution ne tworks, and customer relationships work together to produce value at the Coca Cola Company, and they cannot wo rk without tangible assets such as delivery trucks and bottling plants. “Knowledge capital” is employed w ith productive processes, marketing, and management, assets to be used and cannot work without tangible assets . “Organization capital” i nvolves the organization of jointly. Indeed, it is the firm that is the asset; the firm is an organization of assets designed to gain competitive advantage, and the entrepreneurial idea that translates to ng the assets is the source a business plan for organizi of value. Listing an intangible asset on a balance sheet as separately identified is suspect, let alone putting a separate dollar number on it. The point, of course, applies to all assets on the ba lance sheet apart from those (like cash and near-cash assets) with separable value (whose liq uidation does not affect the value of the remaining assets). Totaling cannot report joint value. dollar numbers for assets sepa rately listed (“total assets”) The balance sheet is not a 1 Recording intangible assets at historical place to report the value of intangible assets or indeed tangible assets. cost, as with tangible assets, is an open issue to which we will return. 1 The statement implicitly criticizes fair value accounting for non-separable individual assets and liabilities that are used jo intly. But it No. valued. See CEASA’s White Paper also provides an explanation of why separable assets, like market able securities, could be fair 2, Nissim and Penman (2008) for elaboration. __________________________________________________________________________________________ Center for Excellence in Accounti ng & Security Analysis 3

9 Main Point: There is also an Income Statement If it is impossible to get a summary value number fr om the balance sheet, is accounting information hopeless for inferring the value of intangible a ssets? No; there is also an income st atement. Even though intangible assets ble assets flow through the income statement. Value are missing from the balance sheet, earnings from intangi t also by capitalizing the earnings from the asset. For can be established by measuring the asset value directly bu example, the value of a stand-alone rental building can be ascertained from the market price of the building (a at the business yields (a flow valu ation). When one cannot determine a stock valuation) or from the rents th stock valuation (a balance sheet valuation), one turns to the flow (an income statement valuation). The value of Coca Cola’s brand is not on the income statement, but earnings from the brand are in the income statement. Even with a price-to-book of about 5 because of the missing brand asset in the balance sheet, the Coca-Cola 2 Company is readily valued from its income statement. There is another important point in turning to the income statemen t. While the balance sheet cannot yield a summary number that reports th e value of using assets jointly, the income statement does (at least in ngible assets along with principle): earnings is the accounting measure of va lue added from employing ta entrepreneurship, brands, knowledge, organizational capital, and so on. This is the brilliance of accounting: rendering a performance measure from organizing assets under a business plan. With this summary measure, ask if they exist); one just there is no need to identify intangible assets (or even to observes earnings generated by the business plan. lue of intangible assets is implicitly acknowledg The point that earnings give the va ed in statements of those who claim the existence of intangible assets. Specula tors in the 1990s pointed to price-to-book ratios, but writers on intangible assets often point to earnings performance to infer those assets. A recent paper on “Organization Capital” by Lev, Radhakrishnan, and Zhang (2009) is an example. In the paper, “organization capital” is attributed to Wal-Mart, Microsoft, Southwes t Airlines, Intel, Dell, and others because these firms have had very good earnings performance. Indeed, the pa per estimates the value of “organization capital” from sales and expenses in the income stat ement. One of course seeks to under stand the source of good performance, but attributing earnings performance to “organization capital” is by fiat, w ithout cause and effect demonstrated; one is simply observing firm perfor mance as reported in earnings, whatev er the cause, and calling it something else. 2 See Penman (2010), p. 500 and the Appendix B to CEASA White Paper No. 2, Nissim and Penman (2008) for a demonstration. __________________________________________________________________________________________ Center for Excellence in Accounti ng & Security Analysis 4

10 One thinks usefully of identifying assets with ex ante value, capable of producing future earnings, not ex post performance to a conjectured a sset. One would be reluctant to something after the fact that attributes and so on were start ups or if they had proceeded to claim that intangible assets existed when Wal-Mart, Dell, make losses. Indeed, while commenta tors in the 1990s assaile d “industrial age accoun ting” for ignoring the intangible assets of internet stocks, the derided acc ounting reported serial losses fo r these firms that turned out to predict their demise. These firms failed; negative ear nings were an indication of the absence of intangible assets. The accounting played its ro le of challenging the speculators. Some formality follows to crystallize these ideas. __________________________________________________________________________________________ Center for Excellence in Accounti ng & Security Analysis 5

11 The Income Statement Mitiga tes Poor Balance Sheets In what follows, the analyst is viewed as valuing equity, but the ideas apply to any asset, in particular the firm assets. (Value of the firm = Equity value + Value of Net Debt.) (enterprise) with so-called intangible The balance sheet approach to valuation infe rs value from book value on the balance sheet: = Book Value (1) Value t t Accordingly, balance sheet accounting at tempts to construct balance sheets that are indicative of value. Such accounting and valuation typica business assets and equity value, for lly works for cash equivalents but not for reasons above. However, if one expects no subsequent earnings growth, value can also be inferred by capitalizing forward earnings: Expected Earnings t 1 + = Value t r 3 If current earnings are a sufficient indica Here r is the required return. (because there is tor of forward earnings 4 no expected earnings growth), Earnings t Value = (2) t r e picture: the cancelling error property. Provided that A core accounting concept takes the balance sheet out of th ) earnings, it is always true that earnings are comprehensive (clean-surplus Stock Return = P + d - P = Earnings + (P - B ) – (P – B ) (3) t+1 t+1 t+1 t+1 t t t+1 t t+1 3 Balance sheet valuation and income statement valuation are modeled in Ohlson and Zhang (1998). The Ohlson (1995) valuation model is a weighted average of the two. 4 Retention that adds growth can be accommodated. __________________________________________________________________________________________ Center for Excellence in Accounti ng & Security Analysis 6

12 For an equity investment, P is equity price, B is th e book value of equity, and d is dividends, but the equation 5 applies to the return, earnings , and book value for any asset. e from the balance sheet does not nings says that omission of valu This equation relating returns to ear nce sheet, P – B, at the e nd of an accounting period is the same as that in the matter if the error on the bala beginning; the errors cancel. In this case, the return equals earnings and, as valu e is always equal to the r expected stock return cap italized at the rate, (under the no-arbitrage condition), value is also equal to tolerates accounting e rror in the balance sheet if that error is constant. capitalized expected earnings. Valuation We teach the cancelling error property in introduc tory accounting courses by pointing out that it does not matter whether one capitalizes R&D expenditure (and subsequently amorti zes it) or expenses it 6 Even though it is perceived to be “wrong” to immediately, provided there is no growth in R&D expenditure. leave R&D investment off the balance sheet, the balan ce sheet errors from expe nsing immediately cancel, leaving earnings unaffected. More generally, the omission of assets from the balance sheet is mitigated by the 7 income statement and cancelling errors. 5 This equation first appears in Easton, Harris, and Ohlson (1992 ), but textbooks of old used to discuss the cancelling error pro perty. ends: The equation is derived as follows. The “clean-surplus” equation forces the articulation of earnings, book value, and net divid B – d + Earnings = B t+1 t+1 t+1 t – (B Substituting d - B , ) into the stock return , P + d - P = Earnings t+1 t+1 t+1 t+1 t t t+1 Stock Return = Earnings + (P - B ) – (P – B ). t+1 t+1 t t+1 t t+1 6 The reader can demonstrate this by work ing through the accounting from investing $100 in R&D each y ear that generates sales of $150 in each of the subsequent three years (say), with the R& D amortized over three years un der the capitalization regime. Once steady state is reached in the balance sheet (constant sales and book values), earnings are the same for both regimes. Penman ( 2010), Chapter 16 provides an example, and extends the example to the case where there is growth. 7 The perspective here implicitly criticizes a balance sheet emphasis for financial reporting that is proposed in the FASB and I ASB atement focus here lies in sharp contrast. For a more detailed discussion documents on a new conceptual framework. The income st discussion on the balance sheet focus, see CEASA’s Occasional Paper, Dichev (2007). __________________________________________________________________________________________ Center for Excellence in Accounti ng & Security Analysis 7

13 Can the Balance Sheet Mitigate Poor Income Statements? lance sheet adds nothing when there is no growth in Having understood that putting an intangible asset on the ba an intangible asset on the balance sh eet can only be helpful if there is that asset, it follows that recognizing ng that, while expensing R& D does not affect earnings growth. Again we know from our introductory accounti th in R&D expenditures, growth in R&D depresses relative to R&D capitalization when there is no grow earnings if the R&D expenditure is expensed. The stock re turn-earnings equation (3) says that this introduces a change in premium; that is, errors in the balance sheet do not cancel (the premium over book value widens). The accounting produces error in both book value and earnings; the task of correc ting these errors is left to the analyst. If intangible asset research is to focus on the balance sheet, the question is whether correction of the balance sheet error (by booking intangible assets) mitigates the error in earnings as a basis for valuation. Can accounting resolve the problem, or must it be left to th e analyst to add value for intangibles? Below are some issues to consider in pursu ing this research question: 1. For the reasons in the preamble, booking the va lue of intangible assets on the balance sheet is quite doubtful if value comes from using assets jointly. Even if id entifiable, any valuation is likely to be speculative. 2. Reporting speculative, fuzzy numbers on the balance sheet can damage ear nings as an indicator of value rather than ameliorating the error in earnings. By the clean-surplus relation, ea rnings is the difference in so errors in measurement of book va lue (net assets) is magnified in book value (adjusted for net dividends), 8 errors in both the beginning and ending book value. is affected by the random earnings; the error in earnings e, by adding error to beginning and ending book values (One would strictly be worse off in the no-growth cas that would otherwise cancel.) 3. If one rules out intangible assets on the balan ce sheet at estimated (speculative) value, one is left with the question of whether they should be booked at historical cost and then amortized. This is more familiar ground to the accountant and well worth further research. As capitalization makes no difference in the no- ether earnings in the growth case is more informative with capitalization. Here are growth case, the issue is wh some considerations: a. Isolating the cost of intangible assets that are hard to identify (like orga nizational capital, knowledge capital, and the like) is likely to be difficult. Not onl y are current earnings affe cted by any imprecision (as expenses capitalized would otherwise be in earnings), but future earnings will be affected by the amortization of 8 ect to fair value accounting. point with resp Peasnell (2006) makes this __________________________________________________________________________________________ Center for Excellence in Accounti ng & Security Analysis 8

14 fuzzy numbers. The specter of earnings management – sh ifting expenses to the balance sheet from the income observable expenditures through adve rtising is statement – arises. Capitalization of on R&D and brand building more straightforward. Resolving when and how expenditures on non-tangible assets might be capitalized is a promising area of research. b. Even if historical cost can be identified with integrity, establishing an amortization schedule would typically be quite speculative. Unlike purchased patent s and copyrights that have definite lives and tangible assets with estimable lives, the life of more sublime intangible assets is very uncertain, as is the pattern of economic benefits for matching costs against revenue over time. Fuzzy amortization expense may well destroy earnings as a basis for valuation and about value. The experience with thus make accounting less informative amortizing purchased goodwill (before the new accounting that requires impairment) speaks to the issue. Analysts routinely added back amortization expense, seen as arbitrary, implicit ly rejecting accountants’ attempts to deal with intangible valuation in this way. Th e analysts said: leave the speculation to us. Solving the amortization issue with impairment testing (as with the new requirements for goodwill), is fraught with difficulties. Ascertaining the impaired va lue of an intangible is problematic , though one could look to triggering events like failure to get government approval for a drug. In general, the experience with one-time charges has t to abuse with earnings been unsatisfactory; they are seen as obscuring the pr ofitability picture and subjec management. It is an open research ques ity of earnings to indicate value. tion as to whether they improve the abil These points aside, the issues ng are the most encouraging for around capitalization and amortizi accounting research. It is on this point that the Lev, Ra dhakrishnan, and Zhang (2009) pa per is most interesting: and amortizing selling, administrativ e and general expenses (SG&A) and their analysis involves capitalizing 9 For identifiable expenditures, re search might focus on developing also an abnormal profit measure. amortization schedules (for R&D, for ex ample) that captures the economics. That might be feasible in the case of an established firm with a long history of payoffs to R&D. However, the established firm is likely to report earnings that are quite informative (with canceling errors ) under an immediate expens ing rule, so changing the where earnings are less informative, the specification accounting may not be effective. For a start-up R&D firm, of an amortization schedule (and even the assessment of any future bene fits at all) is much trickier. As benefits to intangible assets are so speculative, the accountant might well fall back on the advice of the fundamentalist: Don’t put specula tion in the financial statements; te ll me what you know, but leave the speculation to me, the analyst. The advice says that the accountant has no comparative advantage in handling of the business and speculation. That division of labor is assigned to the analyst with his or her deep knowledge the industry. 9 Kovacs (2004) also finds that treating SG&A as an asset indicates future benefits. __________________________________________________________________________________________ Center for Excellence in Accounti ng & Security Analysis 9

15 Accounting is utilitarian, so the accounting resear ch question is one of developing accounting that handles intangible assets in a way that helps rather than hinders the analyst who wishes to value the firm. The standard residual earnings model, expr essed in its short form here, explains how an analyst estimates value from 10 Earnings , forecast by Earnings book value and earnings. With t+1 t Book r Earnings . ) Value − ( t t Value + = Book Value (4) t t r g − The growth rate here, , is the expected growth rate for residual earnings (in the numerator) which, in turn, g comes from the growth in the book valu e (net assets) and the earnings they generate. Penman (1997) shows that the growth rate, g , is determined (solely) by the errors in the book value an d earnings relative to their benchmarks in equations (1) and (2). That is, growth in residual earnings is actually an accounting phenomenon produced by earnings and book value that differ from those which directly indi cate value. If the accounting has balance sheet errors (such that value ≠ book value) but those errors cancel, as in the stock return equation (3), 11 g = 0, and the valuation is based solely on earnings. If in addition to balance sheet errors there are errors in the is determined by the size on the two earnings such that equa tion (2) does not hold, g ≠ 0 and the amount of g 12 errors. Significantly, we observe that analysts in practice forecast earnings and earnings growth. Forecasting is in to add speculative gr owth to the accounting when the accounting is incomplete. speculation and analysts step The picture is quite consistent with in Graham saw expected growth as the view of the fundamentalists. Benjam 10 Retention can be accommodated such that Earnings plus further earnings expected from retention. equals Earnings t t+1 11 In this case, equation (4) is equivalent to equation (2). Restating equation (4) for g = 0, − ) [] × ( Book r Earnings Value t t + = Value Value Book t t r × Value Book r Earnings t t + = − Book Value t r r Earnings t = r in equation (4) is due to errors g As this valuation holds in the case of balance sheet errors that cancel, one sees that the introduction of in earnings as well as errors in the balance sheet. 12 Feltham and Ohlson (1995) show how conservative accounting (that keeps assets off the balance sheet) induces growth in residua l earnings. Penman (2010), Chapter 16, has examples showing how growth in investment produces growth in residual earnings when assets are not booked to the balance sheet. __________________________________________________________________________________________ Center for Excellence in Accounting & Security Analysis 10

16 he was most careful in handling growth, but he saw it as the most speculative part of a valuation. As an investor 13 something to be handled by th e analyst, not the accountant. This picture focuses the research question: can accounting be utilized or modified to supply the g ncial statement analysis) or is the determination of (perhaps through reporting line items that aid additional fina the growth rate for residual earn ings best left to the analyst? yst handles the valuation of firms with intangible What follows are two cases which show how an anal assets. The first is Microsoft Corporation, to which comme ntators attribute intangible assets in large doses. The ation capital” asset is often second is Dell Inc., a firm to which a significant “organiz attributed because of its unique “direct-to-customer” di versified supply chain. 13 See Graham (1973), pp. 315-316 and Penman (2006). __________________________________________________________________________________________ Center for Excellence in Accounting & Security Analysis 11

17 Handling Intangible Assets with Accounting Information A. Microsoft Corporation ed at $25 per share or After publishing its annual report for fiscal-year endi ng June, 2008, Microsoft trad market saw considerable value, $192,489 million, $228,775 million. With book value of $36,286 million, the missing from the balance sheet (the price-to-book ratio is 6.3). The book value of $36,286 million was made up of $12,624 million of net operating assets (enterpris e book value) and $23,662 million of cash and near-cash et, and are typically considered to investments (and no financing debt). The latter are separable, marked to mark r 2008 reported interest income on the cash and near-cash be carried at their value. The income statement fo assets of $846 million (after an allocation of tax) and after-tax income from the business of $16,835 million, for total net income of $17,681 million. These accounting numbers are summa statements and presumably one ry numbers from the financial would gather more information with a full financial statement analysis. But how far can we go towards a ers? Applying residual earnings valua valuation with just these few numb tion as if there were no expected growth (no errors in earni ngs), Value of equity = Enterprise value + Value of cash = sidual e Income Enterprise Expected R 2009 Value Book Enterprise Cash + + 2008 2008 r nance web sites were giving Microsoft a beta of about The risk-free rate at the time was about 4 percent and fi beta of 1.0 of 5 percent, a reasonab 1.0. With a typical risk premium for a le required return for the enterprise (the weighted-average cost of capital, WACC) is 9 pe rcent. The equity value, calculated from the summary income statement and balance sheet numbers is (in millions of dollars), 16 , 835 ( 0 . 09 ) 624 , 12 × − Value of Equity = = 210,718 or $23.03 per share. 12 624 23 + , 662 , + . 0 09 Note that the valuation forecasts 20 09 enterprise income as being the same as that reported for 2008 and the capitalization at 9 percent forecasts a perpetuity at th at level. Thus we are only using information in the financial statements, strictly. One can quibble about the a ppropriate required return, but the point is clear: While __________________________________________________________________________________________ Center for Excellence in Accounting & Security Analysis 12

18 considerable value is missing in the balance sheet, the acco unting that includes earnings explains almost all the dismiss the research question: can accounting be designed to value that the market sees. Of course, this is not to do an even better job? But is does serv e to say that accounting, as practi ced, does not do as poor a job as those who insist on intangible asset accounting imply. so the validation is not emphatic. But history would Of course, the market price could be a misprice, ould have provided a strong challenge to mispricing: In the bubble years suggest that the accounting numbers w when Microsoft was trading at up to $60 (on a post- split basis) and very high multiples, the accounting valuation was much lower than the market price. Rather than the market price suggesting that the accounting was ignoring intangible assets, the a d the value of intangibl e assets through earnings) ccounting (which reflecte would have suggested that the mark et was mispricing those assets. While after-the-fact observations are dangerous, subsequent experience s uggests that investors who shunned in tangible asset stocks such as Microsoft, Cisco Systems, Intel, Dell, and the like in the late 1990s fared considerably better than those who purchased the stocks because they had “intangible assets”. The valuation above can be critici zed because it does not incorporat e the expected growth rate in or whether it is best left to the equation (4). But the core question is wh ether better accounting can supply this analyst. It is a fascinating questi on, because (as noted) growth is an accounting phenomenon due to errors in earnings and book value. Note, however, th just earnings and book values; they at financial reports do not report also report more detailed financial information in line it ems and, over time, historical sales, earnings, and book 14 For a market price of value growth rates. This information can be exploited with financial statement analysis. $25 for Microsoft, the growth rate implied (that reverse en gineers the residual earnings model) is 0.84 percent. The analyst challenges this implied growth rate using further financial statement analysis and other information. B. Dell, Inc. le “organization capital”. Ar Dell, the computer manufacturer, is said to have valuab e its financial statements deficient because this nominated asset is not on the bala ce sheet for Dell for fiscal nce sheet? Below is the balan year 2008, reformulated to se parate assets in the busines s from the net financial as sets consistin g of cash and near-cash assets less financing debt. 14 tes for valuation. An example there (and in See Penman (2010), Chapter 14 for financia l statement analysis that elicits growth ra Appendix B of Nissim and Penman 2008) shows how the historical sales growth rate for Coca-Cola Company yields a valuation close to the market price. __________________________________________________________________________________________ Center for Excellence in Accounting & Security Analysis 13

19 DELL, INC. Comparative Balance Sheet, 2008, Reformulated (in millions of dollars) 2007 2008 Enterprise Book Value: Enterprise Assets Working cash 40 40 5,961 4,622 Accounts receivables Financing receivables 1,853 2,139 660 Inventories 1,180 2,668 Property, Plant and 2,409 Equipment Goodwill 1,648 110 Intangible assets 780 45 Other assets 3,653 3,491 18,069 13,230 Enterprise Liabilities 10,430 Accounts payable 11,492 Accrued liabilities 4,323 5,141 4,221 Deferred service 5,260 revenue Other liabilities 23,145 647 20,439 2,070 Net Enterprise -7,209 -5,076 Assets Net Financial Assets Cash Equivalents 7,724 9,506 208 Short-term 752 investments Long-term investments 2,147 1,560 9,492 12,405 -225 Short-term borrowing -188 Long-term debt -362 -569 Redeemable stock -94 8,811 -111 11,537 3,735 4,328 Common Shareholders’ Equity __________________________________________________________________________________________ Center for Excellence in Accounting & Security Analysis 14

20 Trading at $20 per share or an equity market ca pitalization of $41,200 million at the time, the market lue of $3,735 million (a price- to-book of 11). The missing attributed considerable value to Dell over the book va balance sheet value could readily be attributed to th e enterprising way Dell organizes its business (direct-to- ory, outsourcing of production, and innovative supply chains). But putting customer delivery, just-in-time invent balance sheet could be redundant: the ba lance sheet, presented in the form an “organization capital” asset on the here, actually highlights thes e features. Relative to $61.1 billion in sa les, accounts receivable is low (direct-to- customers yields cash in advance), inventory is low (just-in-time), and property, plant and equipment is low (outsourcing). The low enterprise asset values mean that to get value. But the big shareholders need invest less feature of the balance sheet is the negative net enterpri se assets, - $5,076 million in 2008. This negative number is due not only to the low investment in assets, but to the large enterprise liabili ties. In managing its supply chain, Dell is able to get suppliers to accept deferred payment (so that accounts payable and accrued expenses are high), and attracts customers to pay in advance (producing deferred revenues). there is even more value (from the business) missing The negative net enterprise assets means that from the balance sheet than the 11 pr ice-to-book ratio would suggest; the sh areholders equity is positive only because Dell holds $8,811 million in net financial assets. Does this make the accounting even more deficient? No; because there is also an income statement. That st atement reports enterprise income (after tax) of $2,618 million. Calculating residual income from the enterprise (value added over book value at the beginning of the year) using a required re turn of 10 percent, Residual Income = 2,618 – (0.10 × -7 ,209) = 3,338.9 (in millions of dollars). Dell’s residual income is actually larger than its inco me. This is because Dell adds value with earnings of $2,618 million, but also from organizing its business with negative net enterprise assets. The value of the Dell effectively runs a float and accounting. That organization means that organization asset is reflected in the ting in the business, can withdraw from the business and that float means that shareholders, rather than inves invest elsewhere: rather than invest ment being charged at th e required return to reduce residual income, the component of the residual income calculation, $720.9 = – (0.10 × -7,209) million, is the value that shareholders part the flow to add from investing the float at 10 percent. (Dell’s large, yearly st ock repurchases are in shareholders out of this float.) Incorporating the residual income into a valuation with no growth, Value of Equity = 8,811 – 5,076 + = 37,124 million or $18.02 per share. __________________________________________________________________________________________ Center for Excellence in Accounting & Security Analysis 15

21 This is lower than the market price of $20, but the point is that much of the value of “organization capital” in from expected growth, the market price is in the accounting. The missing valu e in the accounting must come and that growth (in residual income) must come from grow th in enterprise income or growth in the float from the way the business is organized. The challenge for re search into the accounting for intangibles is to ask should be left to the analysts to whether the extra $2 in value can be e licited by better accounting of whether it speculate about. __________________________________________________________________________________________ Center for Excellence in Accounting & Security Analysis 16

22 Conclusion This paper challenges both the per lue of intangible assets and the ception that accounting ignores the va prescribed remedy of booking intangible assets to the balance sheet. The paper explains how rich accounting the balance sheet. The reason is that there is also an can be, even with the omission of intangible assets from ciencies in the balance sheet. The ex amples with Microsoft and Dell, two income statement that remedies defi companies to whom “intangible assets” are often attribut ed, demonstrate that accoun ting, handled appropriately, is not backward looking, but repor ts forward looking information from which value can be estimated. Of course, income statements may for seasoned firms like Microsoft and not always be as rich as those Dell. Indeed, for a start-up reporting losses, the accounting can be quite uninformative. But one has to ask whether there is an accounting solution that solves the problem. A start-up is the most speculative of firms, possibly with no product developed yet from its R&D, no government approval for its drug, and no sales. Guessing the likely outcome for these firms and puttin g it into the balance sheet (or even capitalizing expenditures) would be very speculativ e accounting. I tell my students who as k how to value a start-up biotech: Go and get a PhD in biochemistry; it is not an issue that accounting can solve. The paper aims not to discourage research into accounting for intangible assets, but to put it in perspective. As with any accounting research, the rese archer needs to start with an understanding of how lance sheet alone is misc accounting works to indicate value, and focus on the ba onceived. The issue of capitalization and amortization of e xpenditures on intangible assets is ve ry much alive, but developing than damage earnings is a challenge. amortization schedules that improve rather ysis – the analysis of balance sheet and income Research might also focus on financial statement anal statement line items – and combining that analysis wi th other non-accounting informa tion to forecast earnings growth. In so doing, research helps th e analyst to whom the task of specul ation falls. The Lev, Radhakrishnan, and Zhang (2009) paper is really a financial statement anal es, and property, plant, and ysis utilizing sales, expens equipment, along with other information on employees and peer performance to forecast future sales and operating income growth. The financial statement an alysis looks promising. However, placing a label “organization capital” on the financia l statement analysis measure extracte d adds little, for no cause and effect is documented. Intriguingly, though, the Lev, Ra dhakrishnan, and Zhang (2009) m easure involves some capitalization and amortization (of SG&A expense). Capitalizing and amor not an analysis issue. tizing is an accounting issue, __________________________________________________________________________________________ Center for Excellence in Accounting & Security Analysis 17

23 Isolating the contribution of this accounting to the forecast of grow th (from financial statement analysis hose involved in research in to accounting for intangibles. components of the measure) would be very helpful to t As most of the research on intangibles focuses on th e valuation of intangible assets, this paper takes a valuation approach for evaluating the accounting issues. There may well be othe r issues (stewardship of assets, e accounting for intangibles should be approached differently. control, and planning) where th __________________________________________________________________________________________ Center for Excellence in Accounting & Security Analysis 18

24 References of Financial Reporting. CEASA Center for Excellence Dichev, I. D. 2007. On the Balance Sheet-Based Model Occasional Paper Series (September), ysis, Columbia Business School, in Accounting and Security Anal available at https://www4.gsb.columbia.edu/null?exclusive=filemgr.download&file_id=10 . Easton, P., T. Harris, and J. Ohlson. 1992. Accounting earni ngs can explain most of s ecurity returns: The case of long-event windows. Journal of Accounting and Economics 15: 119-142. Feltham, G., and J. Ohlson. 2005. Valuation and clean su rplus accounting for operating and financial activities. Contemporary Accounting Research 12: 689-731. Graham, B. 1973. The Intelligent Investor , 4th rev. edition. New York: Harper and Row. Kovacs, E. 2004. The future benefits in selling, general and administrative expenses. Unpublished Ph.D. dissertation, Columbia University. Lev, B., S. Radhakrishnan, and W. Zhang. 2009. Organization capital. Abacus , forthcoming. ounting. CEASA Center for Nissim, D. and S. Penman. 2008. Principles for the Appl ication of Fair Value Acc Excellence in Accounting and Security Analysis, Columbia Business School, White Paper No. 2 (April), available at http://www4.gsb.columbia.edu/null?&ex clusive=filemgr.download&file_id=3822 . Ohlson, J. 1995. Earnings, book values a nd dividends in equity valuation. Contemporary Accounting Research 11 (Spring): 661-687. Ohlson, J., and X. Zhang. 1998. Accrual accounting and equity valuation. Journal of Accounting Research 36 (Supplement): 85-111. tion-specific value. BIS Peasnell, K. 2006. Institu Working Paper No. 210. es and the terminal value calculation for the dividend Penman, S. 1997. A synthesis of equity valuation techniqu discount model. Review of Accounting St udies Accounting Research 2: 303-323. Penman, S. 2006. Handling valuation models. Journal of Applied Corporate Finance 18: 48-55. Penman, S. 2010. Financial Statement Analys is and Security Valuation , 4th edition. New York: The McGraw- Hill Companies. __________________________________________________________________________________________ Center for Excellence in Accounting & Security Analysis 19

25 People at the Center The Arthur J. Samberg Professor of Professional Practice , Columbia Business School; Former Vice Trevor Harris , , Morgan Stanley; Co-Director, CEASA Chairman George O. May Professor of Accounting , Columbia Business School; Co-Director, CEASA , Stephen Penman Svetlana Juster Associate Director of Research, Columbia Business School, CEASA , Advisory Board Chair Arthur Levitt, Jr. Senior , 25th Chairman of the United States Securities and Exchange Commission (1993-2001), Advisor , The Carlyle Group Board Members Philip D. Ameen Former Vice President and Comptroller , General Electric Company , Mark J.P. Anson , President and Executive Director of Investment Services , Nuveen Investments John H. Biggs , Former Chairman and Chief Executive Officer , TIAA-CREF Richard Carroll Chief Accountant , IBM , J. Michael Cook Retired Chairman and CEO , Deloitte & Touche LLP , , Director , London School of Economics and Political Science; Sir Howard J. Davies , Financial Former Chair Services Authority, United Kingdom Peter Fisher , Managing Director , BlackRock Sallie Krawcheck Former Chairman and CEO of Citi Global Wealth Management , Citigroup , David F. Larcker , Professor of Accounting , Stanford University, Graduate School of Business Carol J. Loomis , Senior Editor-at-Large , FORTUNE Magazine Robert J. Swieringa , Anne and Elmer Lindseth Dean Emeritus and Professor of Accounting , S.C. Johnson Graduate School of Management, Cornell University; Former Member , Financial Accounting Standards Board

26 © 2009 Center for Excellence in Accounting and Security Analysis

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