The Elusiveness of Intellectual Assets

By General Patent Corporation

Today’s modern accounting systems are truly wondrous. They seem to account for everything…well, almost everything.

When raw materials or finished goods are purchased, the double-entry basis of modern accounting creates an asset called inventory. When an invoice is issued, another asset – accounts receivables – is created. When an order is shipped out the door, the inventory decreases to reflect that. And when an invoice is paid, the accounts receivables balance reflects the payment.

Capital assets – like land, buildings, vehicles and equipment – are amortized over time to reflect the fact that – unlike inventory that is consumed and used up – their use and benefit extend over several years.

There are operating expenses, financial expenses and capital expenses. And if all transactions have been faithfully and accurately recorded throughout the year, all the numbers balance when the auditors show up.

The one notable exception to this is intellectual assets – patents, trademarks and service marks, copyrights, trade secrets and know-how. These are considered “intangible assets” because they do not come into the organization the way other assets do. You cannot walk through the warehouse and see them on the shelves, they do not show up as cash on bank statements, and they do not appear on the receivables aging report.

A company invests in R&D, and it writes off its R&D expenditures as operating expenses in the year in which the R&D occurs and the money to fund it is spent. As new technologies are developed, the company files for patents on those new technologies, probably engaging a patent attorney to prosecute the patent application(s), and writing off the patent attorney’s fees in the year in which the patent application(s) were filed.

The company is issued a U.S. Patent – an item that surely must have some value – but it is an asset that does not appear on any balance sheet since the cost of securing that intangible asset was written off as an operating expense. As recent patent sales have shown – the Nortel patent auction and the recent sale of AOL’s patents to Microsoft are two excellent examples – patents are no longer sleepy assets that companies keep locked in a file cabinet someplace.

Prior to 1975, U.S. businesses could capitalize their R&D expenses. They could treat them as they would a capital expenditure (like a building or equipment), and create an asset that is amortized over a period of years. U.S. businesses must follow “Generally Accepted Accounting Principles” (GAAP) that are established – and regularly updated and amended – by the Federal Accounting Standards Board (FASB). Accounting rule SFAS 2 has required since 1975 that all R&D expenses be expensed and not capitalized.

The effect of this is to increase expenses and reduce profits: Good for privately held companies since it reduces their tax liability, but not favored by publicly held companies that would prefer to capitalize the expense and show greater profits for their stockholders and market analysts.

Companies in Canada and the UK are governed in this regard by IAS 9 that requires that they expense “research” expenditures, but they may amortize “development” costs such as the cost of prosecuting a patent application.

Accounting does have a mechanism for the difference between a company’s “book value” (the value of the company’s assets as reported on its latest balance sheet) and the fair market value of the company that may be established, for example, when a company is sold or put up for sale. The difference is called “Goodwill.” So, in many cases, the value of a company’s intellectual assets fall into this catch-all category.

Imagine a company hiring a young artist to paint a mural for its lobby. Years later, that artist’s work becomes popular, critically acclaimed and in demand. Suddenly this mural – the cost of which was expensed many years ago when the mural was painted – is worth tens of thousands or hundreds of thousands of dollars – yet it does not show up anywhere on the company’s balance sheet. So it is not just patents and other intellectual property that fall into this category. Except that it is far more likely for a business to end up owning a valuable patent than a priceless mural.

There are no proposals currently under consideration in the accounting community to address this issue, so companies (as well as universities, hospitals, foundations and other not-for-profit groups) will continue to invest in R&D, create new technologies, and receive patents for their inventions. And these assets – some of which will be valued into the thousands or even millions of dollars – will not appear on the organization’s balance sheets.

And thus the source of the old line that “accountants are those who show up after the battle is lost to shoot the wounded.” It’s true: No matter what we do or where we work, or what our specialty or field of expertise is, we cannot avoid taxes, lawyers and accountants.

[This post originally appeared at the General Patent Corporation website.]