Friday, 16 May 2008

Reporting Intellectual Property - Mapping What Drives Value: 1st Part

by Roya Ghafele, Ph.D.
ghafele@haas.berkeley.edu

Reporting systems that lie outside traditional accounting statements are needed so to overcome existing information gaps on intellectual property. IP can be a key driver of an innovative or creative firm, yet information necessary to understand and track what gets business going in markets for ideas is -due to current financial reporting standards- scarce and unsystematic.

The double entry accounting system that is used world wide underpins the notion that all business transactions constitute a unique and identifiable exchange of assets, which results in equal credits and debits.[1] This architecture may however impede borrowers and investors to fully grasp the relevance intellectual property has to a business.

Internally generated intellectual property can be of major relevance to a firm, even if it is not involved directly in a business transaction. This has led Guo and Lev argue that transaction based accounting may give a distorted picture of a creative or innovative company since their driving factors are not necessarily based on an arm’s length transaction between a willing buyer and seller.[2]

Therefore, the transaction-based value reported by accounting may have little to do with the economic value of a company in cases where internally generated IP is the main driver of a business.

Take the following three examples, where immaterial assets, such as patents, trademarks or trade secrets were a main driver of business:

· Texas Instruments leverages its patents through licenses and collected some 800 million USD in royalties between 1986 and 1992.
· The Austrian SME Tinnitronics built its business around the internally developed device Ti-Ex ™ that seeks to fight tinnitus. The firm’s business model is to rent and sell the IP (patents and trademark) protected device to patients. Without IP, Tinnitronics would not be in business.
· Coca Cola keeps its trade secret over its syrup since 1891. Paired with successful trademark management the company’s trade secret makes up for most of its success since the 19th century.

Current accounting regulations allow only to fully understand how the IP relates to business in the context of Texas Instruments, since revenue streams can be directly related to a discernible, seperately identifiable asset (key criteria for an intangible asset under International Accounting Standards - IAS 38). The worth of the patent and trade secret in the latter two cases can/need not be made explicit, which does not allow to understand the value IP has to the company. Thus, both the earnings and the book value of equity may be distorted.


... to be continued

This article was first released in "Know IP – The Stockholm Network’s Monthly IPR Journal
Volume 3: Issue 4. May 2007". The Stockholm Network has given its kind permission to reproduce this article on the website.

[1] Rodov I./Leliaert P. FIMIAM: Financial method of intangible assets measurement. Journal of Intellectual Capital. 2002. 3/3: 323-336.
[2] Guo R.J/Lev B./Zhou N. The Valuation of Biotech IPOs. Journal of Accounting, Auditing & Finance. 2005. 20/4: 423-459.

2 comments:

Michael said...

100% in agreement! You've nailed it on the head.

The deeper problem is that our entire accounting system is predicated on a notion that the transaction price at a moment in time is an accurate reflection of intrinsic economic value of the good. This is true when the positive and negative externalities of the transaction are small relative to the price agreed upon by the parties to the transaction. Price instabilities (i.e., bubbles) will form when buyers do not pay enough for the negative externalities generated by a transaction.

Supply and demand are dynamic cycles, not static curves frozen in time. Economists, accountants, and lawyers need to learn from scientists and engineers how to better model the systems that they're messing around with.

See more at brokensymmetry.typepad.com

Michael F. Martin said...

Roya,

I am totally on your wavelength.
The accounting system is redicated on a static picture of supply and demand. Markets are dynamic. Accounting should be too.

IP simply pushes these problems to the foreground because the cycles of innovation are so much longer (and hence more subject to instability) than other supply and demand cycles.

Do you know of any economist who has tried modelling supply and demand as coupled damped, driven, harmonic oscillators?

http://brokensymmetry.typepad.com/broken_symmetry/2008/05/beyond-econ-101.html

Michael

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Michael F. Martin
Venetian Capital Management
Palo Alto, CA 94301