Communicating the Risks of Investments in Intellectual Property

Investors examining financial statements in the United States may encounter two primary sets of financial reporting standards. Generally Accepted Accounting Principles (GAAP) are generally used by companies based in the United States. However, firms in much of the rest of the world use International Financial Reporting Standards (IFRS). Recently, the U.S. Securities and Exchange Commission decided that foreign companies may provide U.S. investors with financial statements prepared according to IFRS without having to reconcile them to GAAP. According to research by Kellogg School of Management accounting professor Robert Magee, not only are the statements prepared using the international standards better at communicating certain information to potential investors, the use of these standards promotes better corporate decision-making about how to invest in research and development.

Magee notes that one of the differences between the two accounting methods is the treatment of companies’ investments in intellectual property such as research and development. “In the GAAP system used in the United States, even though we know that research and development costs are intended to produce future benefits, we don’t treat them as assets for accounting purposes,” he explains. “When using IFRS, companies look more closely at projects they are investing in, and if the benefits that they are going to get from the intellectual investment are relatively certain, they recognize an asset rather than simply expensing them as they incur them, as they would have to do under GAAP.”

In effect, the asset recognition decision is used to convey information about uncertainty, Magee further explains. “We don’t recognize investments in intellectual property as assets, not because we don’t think they will create future value, but because the future value is more uncertain than the future value of assets that consist of bricks and mortar.”

Evaluating Investments in Intellectual Property

The ability to analyze the relative riskiness of a company’s intellectual property expenditures is potentially very valuable to outside investors. Therefore, the differences between the two accounting methods have real-world implications for people examining the financial disclosures of a company in which they are considering investing. “If you think back to the Internet boom, companies spent lots of money on investments that were pretty risky—they just threw money at it,” Magee says. “When using the GAAP method of financial reporting, there was no way for investors to use financial statements to evaluate the quality of the firms’ investments in intellectual property.”

The IFRS practice of examining intellectual property expenditures and recognizing some of them as assets is better than the GAAP system at conveying information to potential investorsMagee developed an analytical model to explore whether GAAP or IFRS is more efficient in conveying information to investors about a company’s intellectual property expenditures. If a “reasonably certain estimate” of an asset’s benefits can be made, the model recognizes the asset. The model predicted that IFRS-type asset reporting not only improves communication about investments; it also improves decision-making about investments in research and development and other types of intellectual property.

For example, if an investor receives a disclosure from a U.S. company that uses the GAAP system, the material might say, “We spent $100 million on research and development last year.” The investor does not obtain any information about what portion of that $100 million was spent on short-term, reasonably safe investments in development and what percentage of it was expended on risky investments that could either result in an unusually large profit or a complete loss. In contrast, a company using IFRS would break out the portion of the expenditures that was spent on relatively safe investments.

Magee elaborates, “Suppose that out of $100 million, $35 million was capitalized as development costs. That also provides you with some information about the other $65 million. If $35 million of it was pretty safe, it is likely that the other $65 million was in stuff that was not so predictable. This distinction is valuable, even if it’s imperfectly implemented.”

Magee’s model showed that making these distinctions in financial reports not only conveys information, it also leads to more efficient investment by discouraging the riskiest investments. In a working paper reporting on his research, Magee writes that “when an expenditure intended to create future benefits is expensed, the investor can make an inference about the variance of those future benefits. And, when a firm discloses a future obligation for which it has accrued no liability, the investor can make an inference about the variance of those future costs. This recognition practice conveys information about risk and affects the price that the entrepreneur expects to receive from investors.”

The Recognition Hurdle

Magee calls the threshold of certainty at which an asset or liability is recognized for accounting purposes the “recognition hurdle.” According to the paper, the asset recognition hurdle gives information about the level of uncertainty in payoffs from an investment, and the liability recognition hurdle conveys information about the uncertainty of the future costs. Magee points out, “In effect, the recognition hurdle allows the entrepreneur to communicate to the investor that she is not taking on risky future cash flows when the overall profitability of the project is modest.”

The findings from the model lead to the conclusion that the IFRS practice of examining intellectual property expenditures more closely and recognizing some of them as assets is better than the GAAP system at conveying information to potential investors in the firm. According to Magee, in using GAAP standards, “there just wasn’t any way” to convey information about the relative riskiness of intellectual property investments. Using IFRS, a company can send the message, “We are spending money on research and development in intellectual property, but look, a large portion of what we’re doing is relatively safe.”