It will not take much to persuade most readers of IAM articles that intangibles are a vital driver of value for many companies. Over the past several years, a growing body of evidence has shown that firms invest more in these assets than in physical goods, especially in their growth phase; that their product or service differentiators (and therefore their profits) are more reliant on the underlying technology, branding, styling or content than on anything tangible; and that, when it comes to share pricing or exit, it is the intangible assets that justify exceptional returns for scalable businesses. Where value used to be associated with producing more, it is now dependent on knowing more.
That much is clear, but quantifying the impact of intangibles in the absence of a transaction that crystallises their value remains more challenging. The value that assets such as IP deliver is always context dependent; also, by definition, IP is unique, meaning that even if historical precedents suggestive of value are present, there will always be question marks about how relevant they are to any given business and its assets.
Various initiatives have sought to address this visibility issue. As examples, intellectual capital statements and integrated reporting have for some time provided companies with accountancy-based approaches that can express intangible value. However, these frameworks offer a lot of room for interpretation, so they may end up telling investors and stakeholders little that is truly comparable across companies, which is perhaps why they have not taken root. By contrast, while statutory accounting rules offer comparability, they are grounded in conventions that made perfect sense in the industrial age but are regarded by many as being much less satisfactory for the knowledge economy.
Given these factors, how can a business articulate the value its non-physical assets contribute? This article considers the options for making value visible to others through the lens of a company investing in patent-protectable technological advances.
Accounting regulations
For those less familiar with the mechanics, it may be most helpful to start with a layperson’s explanation of how accountancy currently views intangibles, starting with International Accounting Standard (IAS) 38, issued in 1998.
It is important to balance any discussion on such matters by saying that national implementation of the rules discussed below vary and may take precedence – for example, US Generally Accepted Accounting Practice has some differences. Different rules can also apply to similar types of transactions, depending on firm type and size.
Fundamentally, IAS 38 has to deal with the fact that intangibles are often internally generated, firm specific and not regularly traded on transparent markets. In all these respects, intangibles are different from the tangible commodities that have traditionally been recognised on company balance sheets.
These differences make revaluation of intangible assets over time difficult, and IAS 38 allows for this to happen only under very limited circumstances. Accordingly, even if a patent family proves to be exceptionally valuable (based on associated revenues from product sales, licensing or enforcement), its recognised value will still be shown at cost.
This, in turn, raises the question of which costs are eligible. The view IAS 38 takes is that only certain types of intangible investment can be recognised (capitalised) – marketing-related costs are excluded, for example – and only when:
- it is probable that the expected future economic benefits that are attributable to the asset will flow to the entity; and
- the cost of the asset can be measured reliably.
Clearly, allowing companies to capitalise whatever internal investment they deemed may have future value could be problematic and misleading. However, the rules mean that research activity has to be expensed through a company’s profit and loss account; only development cost is eligible. Drawing a line between the ‘R’ and the ‘D’ of R&D is not something all management accounting systems (or management accountants) find easy, and technology companies may well feel that the experimental research that has informed their patenting strategy does in fact deliver long-term value.
Once this type of internal expenditure is capitalised (where permitted), it also has to be written down or amortised over its useful life. This gives the impression that the assets are declining in value over time, when the opposite may well be true; also, each year, the profit and loss will take a hit due to the associated amortisation charges.
This brief explanation may help to explain why some companies elect to capitalise very little of their intangible investment. However, this is not ideal either, as it leaves businesses that are mainly intangibles driven looking good at spending money and somewhat lacking in substance.
The rules that govern business combinations (chiefly M&A activity) are different. International Financial Reporting Standard (IFRS) 3, issued in 2003 and revised in 2008, sets out how to account for intangibles under these circumstances. Broadly, this requires the price paid for tangibles, identifiable intangibles and goodwill to be identified and represented appropriately on the acquirer’s balance sheet.
While IFRS 3 builds on the conventions set out in IAS 38 (e.g., the need for assets to be identifiable and separable), it deals with a context where an external transaction has allocated a value to a business that needs to be apportioned. This is very different from accounting for internal investment. It also recognises that under such circumstances, a broader set of assets (including marketing-related ones) can meet asset recognition criteria.
Since the price paid may bear no relation to the costs the purchased business was able to capitalise when creating or obtaining the IP and intangibles, this process can justifiably come up with a figure that is vastly different from any asset value shown historically in the seller’s accounts.
Expressing off-balance sheet value
This places technology companies in something of a quandary. It implies that for an accountant, the only way to determine how much intangibles are really worth is to sell them. While this is logical (the ultimate value of any asset gets determined by the market), it is not terribly helpful.
Companies generally do not want to sell intangibles and IP rights, because if they do, there may be little (if anything) left of value in their business. However, they often need to leverage the value of their assets in other ways. For a technology company, this may be by:
- licensing them;
- enforcing them (or using them to counter an accusation of infringement);
- moving them between entities;
- using them in collaborations or joint ventures; or
- harnessing them to raise equity or debt finance.
These transactions require value to be expressed in ways that do not rely on statutory accounts; rather, they need to represent what the assets are worth regardless of the accounting treatment that has been applied. They are also less likely to be based around the principle of cost, especially where patents are involved – a point that may require further explanation.
A market participant might approach a deal thinking that there is no reason to pay more for a set of assets than it would cost to build them for itself. If all the intangibles reside in software that automates a well-known process and can be replicated or replaced easily, there may be some justification for this view.
However, in practice, time is often of the essence (e.g., if the software uses extensive data resources, algorithms or AI that cannot be easily replicated), and this reduces the relevance of cost. Also, where patents are in place, legal rights exist that can stop unauthorised reproduction.
If cost is not the answer, then what approaches can work?
The answer is unlikely to lie in market comparison. Despite being the favoured method for determining the value of most other categories of asset, this approach is generally unusable as anything other than a sense check. It is seldom possible to find authoritative information on sufficiently recent past sale transactions involving assets that are similar enough to those being valued (the whole point of IP being that its value lies in its uniqueness).
The main exception is licensing data, as collated by specialist providers. While the nature of the available sources means that the available data sets represent only the visible tip of a substantial iceberg, these do provide a means of isolating intangible value and published precedents that licensor and licensee can use to arrive at an agreed price.
The go-to approach for most applications is to consider the contribution the assets make to income (or to other measures of economic benefit such as cost savings). This is particularly relevant where a company has a patent-protected innovative technology offer, because the motivator for anyone adopting it will normally be to produce future financial benefits.
Income approaches are generally better aligned with the way another market participant would view the position, but they need to be executed with care. This is where valuation standards setting out how these approaches should be applied become important.
Valuation standards and popular methods
Depending on the context and the question that needs to be answered, different sets of valuation standards or regulations may be relevant. IFRS 13, for example, issued in 2011, sets out how ‘fair value’ should be measured and may be applied as a standard (this might be required if, for example, a price needed to be established for assets being transferred from a corporate entity into a spin-out company in exchange for an equity stake).
Conversely, if assets are to be transferred between corporate entities, the detailed rules created as part of the base erosion and profit shifting work led by the Organisation for Economic Co-operation and Development will be the key point of reference.
Many valuers reference the standards produced by the International Valuation Standards Council (IVSC) in their work. As well as a series of general standards that document good practice, IVSC has a specific standard (IVS 210) for intangible asset valuation, which describes the approaches that are generally regarded as suitable. It goes into some detail about applicable methods.
Only one market approach is considered applicable to intangibles, which is the comparable transactions method (and, as explained above, this is generally very difficult to apply). By contrast, a number of income methods are referenced in the standard – of which the two most popular, judging by past surveys of valuer practices, are excess earnings and relief from royalty.
Each of these methods provides a way to separate out the returns that are reasonably attributable to intangibles from other assets owned by the business, which can then be expressed as a present value using discounted cash flow. The first, excess earnings, works by determining the overall ROI that the company’s assets are expected to deliver (typically over multiple future periods) and then deducting the proportion attributable to tangible items (and any intangibles that are not within scope for valuation). The ‘excess’ is the intangible contribution. This method is particularly popular in purchase price allocation exercises.
The second, relief from royalty, calculates how much another party would pay to license the target assets (thus giving the current owner the benefit of ‘relief’ from not having to pay royalties). This method is in widespread use in China, Europe, Korea, south-east Asia and the United States for supporting transactions involving IP in isolation.
Discussion on different methods may prompt the question of why there is not a single accepted way of valuing intangibles as there is with tangible assets. This is sometimes seen as a barrier to more effectively transacting business with the asset class. However, the fact that different methods may be preferred reflects the fact that the valuation questions being considered are not the same. In purchase price allocation, it is important to derive an appropriate split of value already given between the different asset categories. When a transaction is yet to happen, the focus is on establishing what value might reasonably be attributable.
This does not mean that greater standardisation is not possible. In some contexts, it may well be essential. For example, a commercial bank engaging with patents and other intangibles as collateral requires a consistent valuation method that can be delivered at a cost that does not make the loan terms uneconomic. It will also be seeking the answer to a different question, which is how much enduring value there may be in a set of intangible assets if the business does not achieve its plan (as this is the only circumstance under which it would call in its security).
Income approaches have their flaws: principally that, in any given transaction, the forward-looking revenues or cost savings are generally more important than the historical actuals, and, by definition, these are not certain. In practice, this risk and uncertainty are dealt with either by modifying the financial inputs to produce a wider range of projections, adjusting the discount factor (over and above the applicable cost of capital) or both.
The way forward
Industry standards do not change often, but they are not static. The IVSC, for example, recently introduced a revised set of standards, which came into force in January 2025.
Also, the latest programme of work by the International Accounting Standards Board is considering whether IAS 38’s existing rules on intangibles should be modified. This work acknowledges that users need better information and the board is reviewing whether: there are too many prohibitions on asset recognition; revaluation rules are too restrictive; and the differences between the rules governing internally generated and acquired assets cause a lack of comparability.
Some governments are taking independent steps to address the shortage of information, notably the IP Office of Singapore, which has led an initiative to introduce a national intangibles disclosure framework.
For the present, however, technology companies wishing to leverage the value of their patents and other intangible assets will need to find a way to express it separately from any statutory obligations.
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