N. 8, April - May 2003 
IP & RTD: Articles 

Revision of the definition of "Intangible Asset"

Should the EU continue to follow US

IPR accounting standards?


© Eusebi Nomen, 2003
Associated Professor on Intangible Assets Valuation
ESADE Business School, Universitat Ramon Llull, Barcelona
nomen@esade.edu
 
Any Intellectual Property Right (IPR) from which future earnings are expected qualifies as an intangible asset.

What is an intangible asset? Although there is no consensus on the definition of an intangible asset, according to accounting standards, the main characteristic for identifying an asset as intangible is the absence of any physical substance.

How should we treat an asset that incorporates both tangible and intangible elements?

The International Accounting Standard IAS 38 sets out a test whereby the different elements are assessed to judge which is more significant.

Let me present one of the many cases that proves the IAS 38 theory on intangible assets to be misleading. A vacant building lot has elements with material substance: the land; and elements without material substance: the building rights or the zoning. Let us assess the situation: since the land is used for building purposes, the building rights or zoning are more significant than the physical components of the land.

Hence, following the IAS 38 test, a building lot should be accounted for as an intangible asset. Obviously, this doesn't make any sense. We therefore need a new theory, a new test, a new definition of an intangible asset.

In our research we have identified a new demarcation principle: the distinctive characteristic of an intangible asset is the absence of physical properties or legal provisions quantitatively limiting its perceived benefits or potential use.

The physical properties of a piece of land, and zoning regulations, limit the amount of properties one can build on it. They limit its use.

The physical properties of a truck, and traffic regulations, limit the load a truck may carry. They also limit its use.

Meanwhile, an IPR has no physical properties, and there are no regulations limiting the number of times you may use a given IPR. That is, a trademark may be applied to one unit of a given product or to a million units. Copyright may be used to produce one copy or a million copies of a work. The marginal cost for using an IPR is zero. This zero marginal cost of an IPR is widely recognised in economics.

Thus, I propose a new definition of an intangible asset: An intangible asset is an asset that lacks physical properties or legal provisions quantitatively limiting its perceived benefits.

"So what?", you might ask. Well, thanks to this new understanding of an intangible asset, in the case of intangible assets with unique perceived benefits (well known marks, breakthrough patents etc. - the type of IPR that usually triggers mergers or acquisitions), it will not be possible to comply with the obligation to estimate the Fair Value of an intangible asset as required under the new Financial Accounting Standards (FAS) of June 2001: FAS 141 on Business Combinations and FAS 142 on Goodwill and other Intangible Assets.

According to the International Valuation Standards, in order to estimate the Fair Value or Market Value of any asset, the valuer must first determine the highest and best use. Since benefits perceived on an intangible asset are not quantitatively limited by any intrinsic factor such as its physical properties or applicable legal provisions, it is not possible to determine the highest and best use of an intangible asset with unique perceived benefits. Its use will only depend on the capacity and will of its owner and its maximum use will depend on market saturation levels. Consequently, a valuer may only determine a given use for a given user, not the highest and best use. So the valuer may only estimate a Value in Use, not a Fair Value.

"So what?", you may ask again. While a value in use is subjective, a fair value is socially objective. If we allow subjective valuation when recognising an asset, or at the time of an annual impairment test, then the Enron or Vivendi scandals will seem just child's play.

Considering this, should we be worried in the EU? The question may arise, although the EU is not currently subject to FASs. Only the US and firms traded on US markets are subject to FASs. The problem is that the EU is presently subject to the International Accounting Standards (IAS) and the FASs and IASs are expected to converge by the year 2005. Furthermore, from the latest information, all chances are that provisions on FAS 141 and 142 will prevail over provisions on IAS 38.

"So what?", you may still ask.

Well, FAS 141 and 142 introduce the obligation to identify each intangible asset at the time of any business combination (merger, acquisition, etc.) or at the time of acquiring intangible assets or bundles of intangible assets, and they also recognise each intangible asset at its fair value; in addition to the obligation to conduct annual impairment tests for intangible assets with indefinite economic lives and for goodwill. An impairment test implies an impairment loss if the new estimation of fair value is lower that the carrying amount.

Therefore, it is necessary to estimate the Fair Value of an intangible asset with unique perceived benefits at the time of its recognition, and, if its economic life is indefinite, then it's necessary to estimate its Fair Value annually in order to conduct the impairment test. The problem is that the valuer will only be able to estimate its Value in use (subjective value) and not its Fair Value.

Furthermore, the new accounting rules open the door to financial engineering based on IPRs. For example, a given company may either decide to merge related firms, in order to include an itemized list of intangible assets on its balance sheet and have the manoeuvring capabilities derived from impairment tests based on non-objective valuations, or not to merge, so as to prevent such events in the future. But, more importantly, we must take into account how tax regulations will treat impairment losses in different territories.

Moreover, financial engineering opportunities may influence decisions on the location of entities resulting from business combinations. Can you imagine the macroeconomic impacts of such a situation?

Even more importantly, reformulating strategies and structures may disrupt culture and knowledge production or management centres as these will seek the most appropriate business locations. For this reason we are investigating the consequences of submitting UE companies to the EE.UU. provisions on FAS 141 and 142.