Accounting for Intangible Assets: There Is Also an Income Statement

Abstract

Accounting is often criticized for omitting intangible assets from the balance sheet. With 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" -- accounting is seen as remiss, with high price-to-book ratios as evidence. The remedy often proposed involves booking these intangible assets to the balance sheet. This paper makes the point that accounting is not necessarily deficient in omitting intangible assets from the balance sheet: there is also an income statement, and the value of intangible (and other) assets can be ascertained from the income statement. For example, although The Coca-Cola Company does not report its brand asset on its balance sheet (and trades about five time book value), 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 that calls for the recognition of "intangible assets" on the balance sheet may be misconceived. The paper explores the case where the income statement perfectly corrects for a deficient balance sheet, and the case where it does not. It then explores whether, in the latter case, accounting in the balance sheet -- by capitalization and amortization of intangible assets or carrying them at fair value -- could remedy the deficiency in the income statement (or makes it worse). The investigation involves an analysis and valuation 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 concerned 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 perceived deficiencies, real or imagined, with respect to intangible assets. In the case of Microsoft and Dell, the reader can observe at how close one comes to their market valuation by using valuation techniques that use accounting information currently provided by GAAP