I.1 What are Intangible Assets?

Webster’s International Dictionary defines intangible as: “Not tangible; incapable of being touched or perceived by touch; impalpable; imperceptible.” For the purpose of this report, which deals mainly with the economic attributes and consequences of intangibles, we should narrow the scope of intangibles to intangible assets.

An asset is a claim to future benefits, such as the rents generated by commercial property, interest payments derived from a bond, or cash flows from a production facility. An intangible asset is a claim to future benefits that does not have a physical or financial (a stock or a bond) embodiment. A patent, a brand, or a unique organizational structure (e.g., an Internet-based supply chain) that generates cost savings, are intangible assets.

Throughout this report, I will use the terms intangibles, knowledge assets, and intellectual capital interchangeably. All three are widely used—intangibles in the accounting literature, knowledge assets by economists, and intellectual capital in the management and legal literature—but they refer essentially to the same thing: a non-physical claim to future benefits. When the claim is legally secured (protected), such as in the case of patents, trademarks, or copyrights, the asset is generally referred to as intellectual property.

There are three major nexuses of intangibles, distinguished by their relation to the generator of the assets: innovation, organizational practices, and human resources. The bulk of Merck & Co.’s intangibles were obviously created by Merck’s massive and highly successful innovation (R&D) effort (nearly $2B/yr), conducted internally and in collaboration with other entities.[3] In contrast, Dell’s major value drivers are related to the second nexus, a unique organizational design, implemented through direct customer marketing of built-to-order (BTO) computers, via telephone and the Internet. Cisco’s Internet-based product installation and maintenance system, which generates $1.5B/yr in savings, is another example of an intangible created by a unique organizational design.

Brands, a major form of intangible prevalent particularly in consumer products—electronics (Sony), food and beverages (Coca-Cola), and more recently in Internet companies (AOL, Yahoo!, and Amazon)—are often created by a combination of innovation and organizational structure. Coke’s highly valuable brand is the result of a secret formula and exceptional marketing savvy. The unique products created and acquired by AOL during the 1990s are responsible for its brand, along with massive marketing (customer acquisition) costs.

The third nexus of intangibles, those related to human resources, are generally created by unique personnel and compensation policies, such as investment in training, incentive-based compensation, and collaborations with universities and research centers. Such human resource practices enable employers to reduce employee turnover, provide positive incentives to the workforce, and facilitate the recruitment of highly qualified employees (e.g., scientists). Specific organizational designs, such as Xerox’s Eureka system, which is aimed at sharing information among the company’s 20,000 maintenance personnel, enhance the value of the human resource-related intangibles by increasing employee productivity. Thus, while it is convenient to classify intangibles by their major generator—innovation, organizational design, or human resource practices—the assets are often created by a combination of these sources.

Finally, it should be noted that the demarcation lines between intangible assets and other forms of capital are often blurry. Intangibles are frequently embedded in physical assets (e.g., new technology and knowledge contained in an airplane) and in labor (tacit knowledge of employees), leading to considerable interaction between tangible and intangible assets in the creation of value. These interactions pose serious challenges to the measurement and valuation of intangibles. When such interactions are intense, the valuation of intangibles on a stand-alone basis becomes impossible.

Summarizing, intangible assets are non-physical sources of value (claims to future benefits), generated by innovation (discovery), unique organizational designs, or human resource practices. Intangibles often interact with tangible and financial assets to create corporate value and economic growth.

I.2 Intangibles: Why Now?

In a recent hearing of the Senate Committee on Banking, Housing, and Urban Affairs devoted to “Adapting a 1930s Financial Reporting Model to the 21^st Century,” each of the five testifying experts primarily ascribed the deficiencies of information in corporate financial reports to the growth of intangible assets and the inadequate treatment of these assets by the accounting system.[4] Intangible assets, it was argued, surpass physical assets in most business enterprises, both in value and contribution to growth, yet they are routinely expensed in the financial reports, hence remain absent from corporate balance sheets. This asymmetric treatment of capitalizing (considering as assets) physical and financial investments, while expensing intangibles, leads to biased and deficient reporting of firms’ performance and value.[5] This argument, while perfectly valid, is not new. With a few exceptions, intangible investments have always been expensed in financial reports. What, then, explains the current focus on these assets? Why are intangibles more important now than in the 1960s, 1970s, and 1980s?

The market-to-book (M/B) value (i.e., the ratio of the capital market value of companies to their net asset value, as stated on their balance sheets) is frequently invoked to motivate the focus on intangibles. As indicated by Figure 1, the mean M/B ratio of the S&P 500 companies (the largest 500 companies in the USA) has continuously increased since the early 1980s, reaching the value of 6.3 in March 2000. This suggests that, of every $6 of market value, only $1 appears on the balance sheet, while the remaining $5 represent intangible assets.[6] Hence, some argue, the current focus on intangibles is warranted. However, a longer historical perspective reveals that in the 1950s and 1960s, the mean M/B ratio was also substantially greater than 1 (see Hall, 1999). Morever, as Figure 1 indicates, the market-to-book ratio hovered near unity in the late 1970s and early 1980s. Where were intangible assets then? Surely, firms possessed some intangibles (patents, brands) prior to the mid-1980s. Merck had significant pharmaceutical patents, and Coca-Cola had a precious brand. Are recent intangibles different than previous ones, or more valuable now than in the 1970s? What is unique about current intangibles?

Fundamental Changes Driving Intangibles

Intangibles existed, of course, in the 1970s and much earlier, dating back to the dawn of civilization. Whenever ideas were put to use in households, fields, and workshops, intangibles were created. Breakthrough inventions, such as electricity, internal combustion engines, the telephone, and pharmaceutical products, have created waves of intangibles. Intangibles (intellectual capital or knowledge assets) are surely not a new phenomenon.

What is new, driving the recent (since the mid-1980s) surge in intangibles, is the unique combination of two related economic forces: (a) intensified business competition, brought about by the globalization of trade and deregulation in key economic sectors (e.g., telecommunications, electricity, transportation, financial services), and (b) the advent of information technologies (IT), most recently exemplified by the Internet. These two fundamental developments—one economic/political, the other technological—have dramatically changed the structure of corporations and have catapulted intangibles into the role of the major value driver of businesses in developed economies. The following case of Ford Motor Co. demonstrates both the change in corporate structure and the consequent growth of intangible investments, typical of 21^st-century businesses.[7]

Ford Remaking Itself Into a Cisco

Ford [Motor Co.] announced in April 2000 that it would return $10 billion to shareholders, capital that would not be needed by the new, leaner Ford. It was already in the process of spinning off most of its parts plants into Visteon. Henceforth, it would be just another supplier to Ford…While shedding physical assets, Ford has been investing in intangible assets. In the past few years, it has spent well over $12 billion to acquire prestigious brand names: Jaguar, Aston Martin, Volvo and Land Rover. None of these marquees brought much in the way of plant and equipment, but plant and equipment isn’t what the new business model is about. It’s about brands and brand building and consumer relationships. In the New Economy, quite deliberately, Ford has been selling things you can touch and buying what exists only in the consumer’s minds…The Internet facilitates these changes in two big ways. In a B2B sense, it facilitates the substitution of an outside supply chain for company-owned manufacturing. In a B2C sense, it facilitates a continuous interaction with consumers that offers myriad ways to enhance the brand value…Decapitalized, brand-owning companies can earn huge returns on their capital and grow faster, unencumbered by factories and masses of manual workers. Those are the things that the stock market rewards with high price/earnings ratios. (Forbes, July 17, 2000, pp. 30–34)

Ford is thus restructuring itself, in particular de-integrating vertically (e.g., spinning off the manufacturing of automotive parts), shedding physical assets, investing heavily in intangibles, and facilitating these changes by increased reliance on the Internet. The emergence of intangibles (mainly brands, in Ford’s case) as the major driver of corporate value at Ford is thus the direct result of the two forces mentioned above: competition-induced corporate restructuring facilitated by emerging information technology.[8]

Ford is not an aberration. Driven by severe competitive pressures (globalization), rapid product and service innovation, and deregulation of key industries (telecommunications, financial services, and currently electrical utilities), companies in practically every economic sector started in the early to mid-1980s to restructure themselves in a fundamental and far-reaching manner. Vertically integrated industrial-era companies, intensive in physical assets, were primarily designed to exploit economies of scale.[9] However, these production-centered economies were sooner or later exhausted and could no longer be counted on to provide a sustained competitive advantage in the new environment:

…traditional economies of scale based on manufacturing have generally been exhausted at scales well below total market dominance, at least in the large U.S. market. In other words, positive feedback based on supply-side economies of scale ran into natural limits, at which point negative feedback took over. These limits often arose out of the difficulties of managing enormous organizations. (Shapiro and Varian, 1999, p. 179)

Once economies of scale in production have been essentially exhausted, production activities, intensive in physical assets, became commoditized and failed to provide a sustained competitive advantage. Companies responded to this commoditization of manufacturing by: (a) de-verticalizing themselves, namely outsourcing activities (e.g., Ford’s parts production) that do not confer significant competitive advantages, and (b) strengthening the emphasis on innovation as the major source of sustained competitive advantage. These two fundamental changes in the structure and strategic focus of business enterprises gave rise to the ascendance of intangibles.[10]

Intangible Linkages and Human Resources

While less vertically integrated than its predecessors, the 21^st-century corporation is much more connected than industrial-era enterprises. The vertical integration of traditional companies is increasingly substituted by a web of close collaborations and alliances with suppliers, customers, and employees, all facilitated by information technology, particularly the Internet. Traditional economies of scale are complemented and sometimes substituted by economies of network, where the economic gains are primarily derived from relationships with suppliers, customers, and sometimes even competitors (e.g., Ford and General Motors launching a joint Internet-based supplies exchange).

Whereas the linkages among parties (or corporate divisions) to the industrial era, vertically-integrated companies were mostly physical (e.g., conveyor belts connecting auto parts divisions to assemblers, railway networks, etc.), the current essential linkages between firms and their suppliers and customers are mostly virtual, reliant upon intangibles: Cisco’s web-based system of product installation and maintenance, linking the company to its customers; Merck’s 100 R&D alliances; and Wal-Mart’s computerized supply chain are examples of such intangible linkages. These highly valuable intangibles, often termed organizational capital, where not major assets (value drivers) prior to the 1980s. In the modern corporation, these organizational intangibles are among the most valuable corporate assets.

The 21^st-century corporation is not only more “connected” than its industrial-era predecessor, it is also more dependent on its employees. Economic developments have considerably weakened firms’ control over human resources.

At the very time human capital has become more important, firms grip on it weakened for two reasons. First, the easier access to financing has increased employees’ outside options [going to work for a startup]. Second, the opening up of world trade created the space for many independent suppliers. This generated many alternative employment opportunities, making employees’ human capital less specific to their current employer. (Zingales, 2000, pp. 29–30)

The increasing rate of employee turnover across many economic sectors testifies to the deteriorating bonds between employers and employees.[11] Obviously, firms that are able to maintain a stable labor force and secure (or appropriate) a significant portion of the value created by employees possess valuable employee-related intangibles.

The enormous loss from employee turnover is demonstrated by the finding that 71% of the firms in the “Inc. 500” list (a group of young, fast-growing companies) were established by persons who replicated or modified innovations developed within their former employers (Bhide, 2000). This suggests the magnitude of the loss from failure to retain key employees and secure the value created by them. Specific training programs, compensation practices (e.g., substantial stock-based compensation awarded deep down the corporate hierarchy), and innovative arrangements, such as the establishment of entrepreneurial centers within corporations, were found to be effective in stabilizing the workforce. Like organizational capital, such employee-related intangibles were not prominent in industrial-era enterprises, which exerted significant control over their employees. Human resource intangibles are now prominent in successful corporations.

The Urgency to Innovate

Innovation has always been an important activity of individuals (e.g., Edison, Bell) and business enterprises. The prospects of abnormal profits or monopoly rents, protected for a certain period by patents or “first-mover advantages,” have always provided strong incentives to innovate. The great scientific and industrial inventions of the 19^th and 20^th centuries—electricity, the internal combustion engine, chemical and pharmaceutical discoveries, communications and information technologies—attest to the age-long strong incentives to innovate. Clearly, innovation is not unique to the current economic environment.[12]

What is unique to the modern corporation is the urgency to innovate. Given the decreasing economies of scale (efficiency gains) from production, discussed above, coupled with the ever-increasing competitive pressures, innovation has become a matter of corporate survival in recent decades. This urgency to innovate is reflected in the sharp increase in the number of professional workers engaged in innovation (creative activities). Table 1, reproduced from Nakamura (2000, p. 17), indicates that during the 70 years, 1900–1970, the number of creative workers increased by 2.4 million, while during the last 30 years (1970–1999), this employment sector increased by 5 million individuals. Note also the corresponding increases of creative workers in proportion to all employees—from 3.8% in 1980 to 5.7% in 1999. If one expands Nakamura’s definition of creative workers to include service sectors, such as financial-sector employees engaged in the development of products and services (e.g., derivative/option products, risk management tools), the recent growth in the number of people directly engaged in innovation would be higher still.

TABLE 1 Professional Creative Workers
Year	Professional Creative Workers^† (Millions)	Proportion of all Employment (%)
1999	7.6	5.7
1990	5.6	4.7
1980	3.7	3.8
1970	2.6	3.3
1960	1.6	2.3
1950	1.1	1.9
1900	0.2	0.7

Sources: 1900–1980, Censuses of Population. 1990 and 1999, Employment and Earnings, January 1991 and January 2000.

^†Professional creative workers comprise architects, engineers, mathematical and computer scientists; as well as urban planners, writers, artists, entertainers, and athletes.

While many 19^th- and early 20^th-century innovations were made by individuals (electricity, telephone, and television, to name a few) and were subsequently developed by corporations; by the second half of the 20^th century, innovation became a major corporate activity, with massive resources devoted to it (e.g. U.S. corporate R&D expenditures, one of several forms of investment in innovation, reached the level of $180B in 1999).[13] Success and leadership, even in traditional industries, can now be secured only by continuous innovation. Enron (electricity and gas production), Wal-Mart (retail), and Corning (housewares) are prime examples of companies that leverage major innovations to gain leading positions in their industries, and sometimes even creating new fields (e.g., energy trading, in Enron’s case).

Innovations are created primarily by investment in intangibles. The new products, services, and processes that are generated by the innovation process (e.g., new drugs, ATM machines, or Internet-based distribution channels), are the outcomes of investment in R&D, acquired technology, employee training, customer acquisition costs, etc. When such investments are commercially successful, and are protected by patents or “first mover” advantages, intangible assets become the major source of corporate value and growth.[14]

Summarizing, why the current interest in intangibles? As depicted in Figure 2, the intensified competition in practically all business sectors, brought about by globalization of trade, far-reaching deregulation, and technological changes (e.g., the Internet), forces business enterprises to radically change their business models. Most of these changes revolve around de- verticalization (e.g., outsourcing) and innovation. Intangibles are the natural outgrowth of both: de-verticalization is achieved by a substitution of intangibles for physical assets, and innovation is achieved primarily by investment in intangibles. Hence, the recent growth of and focus on intangible assets.

Figure 2

THE ASCENDENCY OF INTANGIBLES

I.3 So What? (Who Should Care About Intangibles?)

True, intangible capital is large and fast growing, but so too are the physical and financial (stock, bonds) investments of the corporate sector. Why should policy makers, managers, and investors be particularly concerned about intangibles? What justifies a wide public discourse on the issue? Books and treaties on intangibles (intellectual capital) often focus on the deficient accounting and reporting of intangible investments in corporate financial statements and proceed to argue that these information deficiencies call for various remedies. Others argue that the inadequate internal information systems dealing with intangibles adversely affect managerial decisions, and offer remedies.

Generally missing from these claims concerning information deficiencies and the suggested remedies are two important elements: (a) A thorough examination of the reasons for the information deficiencies. Why is it that, despite the growing awareness of the importance of intangible assets, they remain almost universally ignored in accounting and reporting procedures? Obviously, any useful prescriptions concerning intangibles-related information require a thorough understanding of the impediments to change. (b) A careful empirical documentation of the adverse social consequences or failures due to the presumed deficiencies. Shortcomings of a specific information system, in this case accounting for intangibles in internal and external corporate reports, will not result in adverse consequences if decision makers (managers, investors) can obtain the required information from other sources. Investors may, for example, obtain information about intangibles through meetings or conference calls with corporate officers or from research reports issued by analysts.[15] Managers, too, may supplement the deficient internal accounting system with specific information on intangibles (e.g., patents per R&D or employee retention indicators). Accordingly, convincing prescriptions for change in the management and measurement of intangibles should be based on documented deficiencies, or harmful consequences, rather than on ad hoc arguments about information shortcomings.

These two themes—a fundamental understanding of the attributes and socio/political context of intangibles, and an empirical documentation of adverse consequences related to intangibles—are pursued in Parts II and III of this report. The former outlines the “economics of intangibles,” while the latter elaborates on the managerial and capital market impacts of the recent prominence of intangibles in firms’ production functions. This analysis clarifies the relevance of intangibles to wide constituencies, with the following groups standing to gain most from change:

¨ Corporate managers and their shareholders: Evidence indicates that intangible investments are associated with excessive cost of capital (lemons’ discount, in the economic parlance), beyond what is called for by the higher-than-average risk of these investments. Excessive cost of capital, in turn, hinders investment and growth. Managers and investors should, therefore, be interested in mechanisms aimed at alleviating the excess cost of capital.

¨ Investors and capital market regulators: Research documents the existence of above-average information asymmetry (differences in information about firms’ fundamentals between corporate insiders and outsiders) in intangibles-intensive companies. Economic theory suggests that large and persistent information asymmetries between parties to a contract or a social arrangement lead to undesirable consequences, such as systematic losses to the less informed parties and thin volume of trade. Investors and policymakers should, therefore be interested in systematically decreasing the intangibles-related information asymmetries.

¨ Accounting standard setters, corporate boards: Empirical evidence indicates that the deficient accounting for intangibles facilitates the release of biased and even fraudulent financial reports. This should obviously be of concern to regulators of financial information (e.g., SEC, FASB) and corporate board members who rely heavily on accounting-based information to monitor managerial activities.

¨ Policymakers: Financial statement information of the corporate sector is a major input into the national accounts. The various intangibles-related deficiencies in financial information adversely affect public policymaking in key areas, such as the assessment of fiscal policy (e.g., R&D tax incentives) supporting innovation, optimal protection of intellectual property (e.g., scope of patents), and the desirability of “industrial policy.”

Thus, a thorough examination of the attributes of intangibles (the “economics of intangibles”), as well as the evidence on specific harmful consequences related to intangibles, points at wide constituencies that should be concerned about the ensuing consequences.

1.4. Takeaway Points

¨ The recent prominence of intangible assets is the result of the confluence of two major forces: substantive changes in the structure of business enterprises and far-reaching information technology and scientific innovations.

¨ Intangibles are inherently different form physical and financial assets. Managerial and regulatory systems are slow to adapt to these differences, resulting in widespread adverse social consequences that should be of concern to managers, investors, and policymakers.

¨ A productive discourse on intangibles should be based on a thorough analysis of the economics of intangibles, an understanding of the incentive and motives (particularly aversion to change) of the major players (executives, financial analysts, accountants); as well as a careful, empirical documentation of the economic consequences of the rise of intangibles.

References

Bhide, A., 2000, The Origin and Evolution of New Businesses, Oxford University Press, New York.

Chandler A., 1990, Scale and Scope, Bellknap Press, Cambridge, MA.

Chandler, A., 1977, The Visible Hand, Bellknap Press, Cambridge, MA.

Gordon, Robert, 2000, Interpreting the “One Big Wave” in U.S. long-term productivity growth, National Bureau of Economic Research, Working Paper 7752.

Hall, Robert, 1999. The stock market and capital accumulation, NBER Working Paper No. 7180.

Hall, Robert, 2000, E-Capital: The link between the stock market and the labor market in the 1990s, Working Paper, Hoover Institution and Stanford University.

Nakamura, Leonard, 2000, Economics and the new economy: The invisible hand meets creative destruction, Federal Reserve Bank of Philadelphia, Business Review (July/August, pp. 15–30).

Romer, Paul, 1990, Endogenous technical change, Journal of Political Economy, 98, S71–S102.

Romer, Paul, 1998, Bank of America Roundtable on the soft revolution, Journal of Applied Corporate Finance, Summer, 9–14.

Shapiro C., and H. Varian, 1999, Information Rules, Harvard Business School Press, Boston, MA.

Zingales, L., 2000, In search of new foundations, National Bureau of Economic Research, Working Paper 7706.

Part II

The Economics of Intangibles

Introduction

The extensive and fast growing literature on intangibles (intellectual capital) generally extols the potential of these assets to create value and generate growth. Scalability, network effects and increasing returns are the major themes (some would say buzzwords) of these writings. Often overlooked in these writings is the fact that intangibles, like physical and financial assets are subject to the fundamental economic laws of costs and benefits. The benefits from scalability, network effects, and other virtues of intangibles come at a price—sometimes a steep one. To enhance the scalability of a software program, for example, it is often required to relinquish control over it (e.g., open source systems).

The fundamental cost–benefit tension underlies the economics of intangibles, as it does the economics of other forms of capital. A thorough understanding of the managerial, valuation, and policy issues related to intangibles, therefore, requires a careful analysis of this tension.

This part of the report is accordingly devoted to outlining the essentials of the economics of intangibles. It opens with a discussion of the two major drivers of benefits from intangibles—nonrivalry (nonscarcity) and network effects—and proceeds with the discussion of the three major cost drivers (value detractors), namely, partial excludability, inherent risk, and non-tradadability. This unified cost–benefit approach to the analysis of intangibles is my definition of the economics of intangible capital.

II.1 Nonrivalry (Nonscarcity)—Scalability

Physical, human, and financial assets are “rival assets” in the sense that alternative uses compete for the services of these assets. In particular, a specific deployment of rival assets precludes them from being used elsewhere. Such rivalry leads to positive opportunity costs for rival assets, where the cost is the “opportunity forgone,” namely the benefit from deploying the asset in the next-best alternative. Thus, for example, when United Airlines assigns a Boeing 747 plane to the San Francisco–London route, that airplane cannot be used at the same time in the San Francisco–Tokyo route. Likewise with the airplane’s crew and the capital used to finance its acquisition. Physical, human, and financial assets are thus rival or scarce assets, where the scarcity is reflected by the cost of using the assets (the opportunity forgone).

In contrast, intangible assets are, in general, nonrival; they can be deployed at the same time in multiple uses, where a given deployment does not detract from the usefulness of the asset in other deployments. Accordingly, many intangible inputs have zero or negligible opportunity costs. Thus, for example, while United’s airplanes and crew can be used during a given time period in one route only, its reservation system (a knowledge-intensive asset) or Frequent Flyer program (organizational capital) can serve at the same time a potentially unlimited number of customers. Stated differently, nothing is given up (no opportunity forgone) when the reservation system fulfills a customer’s order. Once an airline reservation system has been developed, its usefulness is limited only by the potential size of the market, and, of course by competitors’ actions, but not by its own use.[16]

A major contributor to the nonrivalry of intangibles is the fact that these assets are generally characterized by large fixed (sunk) cost and negligible marginal (incremental) cost. The development of a drug or a software program generally requires heavy initial investment, while the cost of producing the pills or software diskettes is negligible.[17] Many such intangible investments are not subject to the diminishing returns characteristic of physical assets.

The nonrivalry (or nonscarcity) attribute of intangibles—the ability to use such assets in simultaneous and repetitive applications without diminishing their usefulness—is a major value driver at the business enterprise as well as the national level. Whereas physical and financial assets can be leveraged to a limited degree only, by exploiting economies of scale or scope in production (e.g., a plant can be used for at most three shifts a day), the leveraging of intangibles to generate benefits—the scalability of these assets—is generally limited only by the size of the market.[18] The usefulness of the ideas, knowledge, and research embedded in a new drug or a computer operating system are not limited by decreasing returns to scale typical of physical assets (e.g., as production is expanded from two to three shifts, returns are decreasing due to wage premium paid for third shift, employee fatigue, etc.). In contrast, intangibles are often characterized by increasing returns to scale. An investment in the development of a drug or a financial instrument (e.g., a risk-hedging mechanism) is often leveraged in the development of successor drugs and financial instruments. Information is cumulative, goes the saying.

The case of Sabre, American Airlines’ reservation and information system, illustrates the unique value creation potential of intangibles in contrast to that of tangible assets.[19] On October 11, 1996, AMR, the parent company of American Airlines, sold (an equity carveout) 18% of its Sabre subsidiary in an initial public offering that valued Sabre at $3.3B. On the previous day, AMR had a total market value (including Sabre) of about $6.5B. Thus, a reservation system generating income from travel agents and other users of its services constituted one half of the market value of the world’s second largest airline, while the remaining half reflected American’s 650 airplanes (in 1996) and all other physical and financial assets, including valuable landing rights. A $40M R&D investment in Sabre during the 1960s and 1970s mushroomed into a market value of $3.3B in the mid-1990s. By October 30, 1999, Sabre’s share in the total market value of AMR increased to 60%, demonstrating the value creation potential (scalability) of intangibles, relative to that of tangible assets.[20]

Intangible capital takes various forms. It can be protected by legal rights (often termed intellectual property), such as patents and trademarks, or be in an unprotected, know-how state. It can be embedded in durable products, such as the software operating machine tools, or exist as a “stand alone,” such as brands. Intangible capital is increasingly present in the form “organizational assets”—unique organizational and managerial designs of business enterprises. Here, too, the ability to leverage organizational capital to achieve efficiencies and create value far exceeds the value creation ability of physical assets. Consider the case of Cisco Systems, as told by The Economist (June 26, 1999, p. 10 of Survey).

The first bottleneck [to fast growth] was in after-sales support. The equipment that Cisco sells, however good, does not just run first time out of the box. Networks have to be carefully configured, and each mix of kit ordered is highly customized. Customers expected continuous support, yet highly trained engineers who could deal with the full range of technical problems were hard to find. Besides, they were being submerged by the daily flood of relatively trial queries.

The answer turned out to be the Web. Cisco decided to put as much of its support as possible online so that customers would be able to resolve most workaday problems on their own, leaving the engineers free to do the heavy lifting. It was an almost instant success, becoming in Mrs. Bostrom’s [head of Cisco’s Internet Solutions Group] words, ‘a self-inflating balloon of knowledge.’ Cisco’s customers did not just go to the website to get information, they started using it to share their own experiences with both Cisco itself and other customers.

Here, then, is a case where a scarce, rival input (Cisco’s engineers and maintenance personnel) was replaced to a large extent by a nonrival intangible asset (online software and instruction programs), which was then leveraged to a “balloon of knowledge” and fortune, estimated by Cisco’s CFO to save $1.5B annually (an amount close to Cisco’s entire 1998 net income).

The benefits of intangibles (knowledge) often exhibit “increasing returns to scale,” as Grossman and Helpman (1994, p. 31) note:

Knowledge is cumulative, with each idea building on the last, whereas machines deteriorate and must be replaced. In that sense, every knowledge-oriented dollar makes a productivity contribution on the margin, while perhaps three-quarters of private investment in machinery and equipment is simply to replace depreciation.

Thus, investment in drug or software development, even if failing the market test, often guides and benefits future drug or software development, which is yet another scalability aspect of intangibles. The scalability of intangibles, emanating from their nonrivalry and increasing-returns properties, is reflected, among other things, in the market dominance of many intangibles-intensive enterprises. Intel Corp. has a 77% market share of PC microprocessors, Cisco Systems has 73% of the router market, while 78% of Internet users access it through America Online, and eBay conducts 70% of on-line auctions.[21] Such market dominance is unheard of in traditional, capital-asset-intensive sectors, where even the most efficient and well-managed enterprises (e.g., Exxon, GE in appliances, or Ford) have market shares of less than 25%.

Summarizing, the nonrivalry attribute of intangibles—the fact that a specific deployment of an intangible asset does not detract from its concurrent usefulness in other deployments (e.g., the use of Amazon.com’s website by customer A does not preclude customer B from using it at the same time)—is a major value driver of intangible assets. This value creation potential, often referred to as the scalability of intangibles, is limited only by the size of the market. In contrast, the rivalry of physical assets—the preclusion of these assets from multiple, concurrent uses—significantly restricts their scalability.

II.2 Network Effects

The economics of networks can be succinctly summarized: One’s benefit from being part of a network increases with the number of other persons or enterprises connected to it. In networks, bigger is better.[22] Networks can be physical, like landline telephone and railroad networks, or virtual like Windows 2000 or the VHS videocassette networks of users. The benefits from a network increase with its size, primarily because there are more people with whom to interact or conduct business. Thus, the benefits from a cellular phone system, whose reach is limited to the Manhattan Borough, are substantially inferior to the GSM cellular system that can reach any place in Europe. Furthermore, the larger the size of the network, the greater the benefits derived from the development of applications (Software programs, CDs, Videocassettes). The payback from Java, for example, is still restricted because some application writers are not convinced that Java will become a sufficiently universal system. Increased network size also enhances the rate of learning and adoption of new technologies, further enhancing the benefits (network externalities) in network markets.[23]

The fact that benefits in network markets increase with the size of the network often creates “positive feedback” in which success begets success. A technology that gains an initial, even small, lead may quickly expand and dominate the market, because users, with their eyes to the future, select technologies that they expect to prevail. Users’ expectations of success are crucial in network markets, enhancing ever more the positive feedback effect (see Economides 1996, for a survey of network effects.).

The Sabre case, discussed above (Section II.1), demonstrates the potency of network effects vs. traditional economies of scale characteristic of physical assets. American Airlines obviously attempts to take advantage of every economy-of-scale opportunity in its airline operations, yet its market share is relatively stable, approximately 16–17% percent.[24] Sabre, on the other hand, exploiting network effects, had a 40–50% market share in the North America market in 1998.[25] The large market share of Sabre is largely due to network effects—it quickly became the preferred reservation system for travel agents. The larger the number of agents using Sabre, the larger was the attraction for airlines, hotels, car rental companies, and other suppliers of travel-related services to join the Sabre network.

Large networks are facilitated by standards.[26] Compatibility with an accepted standard is key to success in network markets.[27] Classic standards are the VHS system for videotapes, the 3½" standard for computer disks, and the Dow Jones Industrial Average (DJIA).

Standards expand network externalities, reduce [consumer] uncertainty, and reduce consumer lock-in. Standards, also shift competition form a winner-take-all battle to a more conventional struggle for market share, from the present to the future, from features to prices, and from systems to components (Shapiro and Varian 1999, p. 258).

Network effects are prevalent in computer, software, telecommunications and consumer electronics markets. Similar, but informationally induced network effects, exist in pharmaceutical markets, when “the use of a drug by others [doctors] influences one’s perceptions about its efficiency, safety, and ‘acceptability,’ and thus affects its valuation and rate of adoption.” (Berndt et al. 1999, pp. 1–2). Thus, demand for a pharmaceutical product by patients and physicians, like demand for a software program or a computer operating system, depends in part on the number of other patients that are using the drug, thereby creating a network effect.

Network markets are sometimes characterized by “tipping,” where even a small real or perceived advantage of a product or system can lead to a very large future advantage, providing the product/system becomes the standard. It is often argued that standards or dominant positions, once established are difficult to change, even with superior technology, since consumers are “locked into the standard” (e.g., Farrell and Shapiro 1989, Katz and Shapiro 1985). The possibility of tipping generally leads to intense competition at the early stages of market evolution, as firms struggle to win a dominant position by such means as moving first, using “penetration pricing” (low or zero prices) to quickly gain customers (e.g., America Online’s early strategy of offering free subscriptions), or merging with providers of complement products (e.g., AOL’s acquisition of Netscape).[28] The “winner-take-all” nature of network markets increases the uncertainty facing producers: The current (year 2000) fierce competition in e-commerce to gain market share and dominant position manifests the characteristics of network markets. In such markets, it is sometimes argued the best product is not always guaranteed to win consumers’ preference. Being locked into an inferior product and reluctant to sustain the cost of switching to an improved one, consumers may stay with the inferior product.[29]

The essence of network effects and positive feedback is demonstrated by the Nintendo example (Shapiro and Varian, 1999, p. 178):

When Nintendo entered the U.S. market for home video games in 1985, the market was considered saturated, and Atari, the dominant firm in the previous generation, had shown little interest in rejuvenating the market. Yet by Christmas 1986, the Nintendo Entertainment System (NES) was the hottest toy on the market. The very popularity of the NES fueled more demand and enticed more game developers to write games to the Nintendo system, making the system yet more attractive. Nintendo managed the most difficult of high-tech tricks: to hop on the positive-feedback curve while retaining strong control over its technology. Every independent game developer paid royalties to Nintendo. They even promised not to make their games available on rival systems for two years following their release!

What does all this have to do with intangibles? Surely, network effects are present in tangibles-intensive industries too. Transportation networks (railroads, trucking, airlines, shipping), fixed-line telephones, car rental companies, and ATM machines are but a few examples of tangible-intensive industries in which network effects can be exploited. In recent years, however, intangibles are at the core of most industries/sectors characterized by network effects. There is the reason.

Network effects arise primarily in situations where consumers/users value large networks. As a Lexus owner, I do not care much about the size of the Lexus owners’ network. However, as an owner of a fax machine, cellular phone, or high-definition television (HDTV), I do care a lot about the size of the network. The usefulness to me of a fax machine, a cellular phone, or a computer operating system increases with the number of other users: more people to communicate/transact with, more applications developed for the network. So, quite simply, network effects exist where there are networks of users. But increasingly, at the core of important networks lies an idea, which was subsequently developed into a product/service, and for which property (ownership) rights are secured by patents, trademarks, or a strong brand.[30] In other words, at the core of network markets lies an intangible, characterized by the triplet: idea–product–control. Examples of such intangibles propelling network markets are the Nintendo Entertainment System mentioned above, Microsoft’s operating systems, Lotus spreadsheets, the wireless application protocol (WAP) for mobile browsers, Intel’s Pentium chips, and Visa cards.

Intangibles are not only present at the core, but also at the periphery of network markets. I refer here to the intangibles formed by alliances that contribute to the network effects:

An alliance formed by a group of companies for the express purpose of promoting a specific technology or standard…an alliance built like a web around a sponsor, a central actor that collects royalties from others [or makes the technology freely available to alliance members but not to others], preserves proprietary rights over key components of the network and or maintains control over the evolution of the technology. (Shapiro and Varian, 1999, pp. 201–202).

An example of a set of alliances aimed at securing a competitive advantage and reaping network effects is provided thus:

In September, Palm announced an agreement with Nokia Corp., the Swedish mobile-phone maker, followed by another licensing deal in October with Japanese consumer electronics giant Sony Corp. The deal provided Palm’s new partners with Palm technology for their phones and other hand-held gadgets.

The two high-profile deals had a domino effect on software developers. Suddenly realizing how serious large consumer-electronics firms were about the hand-held-device market, the developers began flocking to Palm in late 1999, asking to create applications for the gadget. ‘Those licensing deals made it clear to us that Palm was a company with legs,’ says Jason Devitt, chief executive of Vindigo, a New York firm that has since created a local restaurant-and-event-finder for the Palm. Thousands of other software developers flocked to Palm, including Pocket Sensei, which makes user interface software, and Actioneer Inc., which makes a notes-reminder program. (The Wall Street Journal, August 8, 2000, p. A14)

Summarizing, network effects, a hallmark of advanced-technology, information-based industries, are increasingly characterized by product-related intangibles (unique products/services protected by intellectual property) at the core, and alliance-related intangibles at the periphery. Network effects, accordingly, are often predicated on intangibles assets.

II.3 If It’s So Good…?

In the preceding two sections, I have elaborated on the substantial value creation (scalability) potential of intangible assets that result from the nonrivalry (nonscarcity), increasing returns, and positive feedback (network effects) attributes, often characterizing these assets. Such value creation potential is the subject of numerous “new economy” books and articles exhorting the wonders of intellectual capital or knowledge assets. A serious discussion of intangibles, however, must tackle the following “if it’s so good” conundrum:

If intangibles are such potent value creators, what limits the expansion of these assets? Why are not all firms virtual, in the sense of having only, or primarily intangible capital with no or only negligible physical capital? To be sure, a growing number of firms are pretty close to virtual. Microsoft’s net physical and financial assets in June 2000, for example, constituted less than 10% of its market value, and Cisco’s physical and financial assets accounted for 5% of its market value, rendering these companies almost virtual. However, companies in most economic sectors—such as chemicals, transportation, and manufacturers of durable goods—are far from virtual. Such companies have significant investments in physical assets (e.g., property, plant and equipment, inventories), and many are intangibles poor. Among the most notable successes in online (Internet) selling are physical-heavy behemoths like J.C. Penny Co. (“Penny Wise,” Forbes, September 4, 2000, p. 72). Why are these companies not substituting intangibles for physical assets? What limits the growth of intangibles?

An important limiting factor is the size of market and growth potential. As was made clear in the preceding sections, the scalability of intangibles is predicated on the size of the market. Sabre’s value and growth potential is substantial because of the huge travel and related services market. Similarly, the potential of many business-to-business (B2B) Internet exchanges derives from the enormous size of the market they plan to service, such as chemicals, auto parts, or aerospace parts. However, in relatively small, low-growth markets—such as gold and other precious metals, certain luxury food products (e.g. wine and liquors), or appliances—the usefulness of intangibles is restricted. Thus, market size and potential growth limit the expansion of intangible assets.

However, the major limitation on the use and growth of intangibles is “managerial diseconomies.” Intangible assets are, in general, substantially more difficult to manage and operate than tangible assets. For one, the well-defined property rights of physical and financial assets, relative to the often-hazy property rights of intangibles, considerably facilitate the management of the former. American Airlines’ executives, for example, do not lose sleep about competitors misappropriating their planes and facilities, but preventing competitors from imitating American’s leading reservation system (Sabre) is a major and continuous challenge. The virtual nature of intangibles further complicates their management. Thus, for example, identifying unused physical capacity (half empty airplanes) and taking corrective actions (e.g., changing price policy) are straightforward tasks, whereas optimizing network effects from a new technology is a harrowing challenge.[31]

Contributing to the difficulties of managing intangibles is the fact that managerial information systems (cost accounting), which provide managers with information on costs, revenues, and deviations from budgets, are almost exclusively geared to industrial-age physical and labor inputs. The costs that are commonly allocated to products, processes, or activities (“Activity-Based Costing”) are raw materials, labor, and overhead (e.g., depreciation). Intangible inputs, such as R&D and customer acquisition costs, are considered period expenses, not allocated to products and processes. Such a tangibles-based managerial information systems are wholly inadequate for the management of knowledge-based enterprises.

Diseconomies resulting from limited capacity to manage intangibles are the major factor restricting the use and growth of these assets. On the positive side, overcoming such diseconomies by improving information systems and the management of intangibles promises enormous rewards. The following three sections elaborate on the unique attributes of intangibles, which create the challenges of managerial diseconomies.

II.4 Partial Excludability and Spillovers

The benefits of tangible and financial assets can be effectively secured (appropriated) by their owners. Thus, for example, investors in securities or commercial real estate enjoy to the fullest the benefits (or sustain the losses) of these investments. The well-defined property rights of physical and financial assets enable owners to effectively exclude others from enjoying the benefits of these assets.

In the case of intangible investments, however, non-owners can rarely be precluded from enjoying some of the benefits of the investments. For example, when a company invests in training its employees (e.g., on-the-job training or tuition payment for an MBA education), other companies (and society at large) will benefit from such investments, when the trained employees switch employers. The investing company cannot effectively exclude others from the benefits of training.[32] Even in the case of patented inventions, where property rights are legally well defined, there are substantial benefits to non-owners, generally termed “spillovers.” Obviously, after patent expiration (20 years from application, in the USA), the invention can be used freely by non-owners, such as in generic drug manufacturing. But even prior to patent expiration, there are often significant spillovers through imitation (product reengineering) by competitors. The large number of patent infringement lawsuits attests to the considerable difficulties and the high cost of appropriating the benefits of patents. Indeed, a recent survey (Cohen et al., 1997) concluded that the effectiveness of patents as a means of appropriating R&D returns has declined since the early 1980s, despite the strengthening of patent protection. U.S. manufacturing firms, the survey reports, rely more on secrecy and lead time (“first to market”) to recoup the R&D investment, rather than on the protection of the legal patent.[33]. Furthermore, significant international spillovers occur primarily because property rights protection is not effectively enforced in many countries, resulting in uninhibited copying and imitation of R&D products (drugs, software). From Amazon.com 1999 10-K report: “Effective trademark, service mark, copyright, patent and trade secret protection may not be available in every country in which our products and services are made available online. The protection of our intellectual property may require the expenditure of significant financial and managerial resources.” Innovation spillovers are thus the consequence of the imperfectly defined and enforced property rights of intangibles.

A striking example of the partial excludability characteristic of intangibles, and the existence of significant spillovers, is provided by the transistor, which was invented at the Bell Laboratories.[34] Bell’s R&D investment in the 1950s and 1960s leading to the transistor’s invention was substantial. It is estimated at approximately $160M.[35] However, Bell’s basic patents in transistors were made available to other enterprises for a paltry payment of $25,000 advance royalty because of an antitrust lawsuit against Bell. Licensing income earned by AT&T on transistors thus amounted to an insignificant fraction of its R&D costs. Obviously, of the huge private and social values created by the transistor for a large number of technology and consumer product companies, AT&T—its inventor—appropriated only a negligible fraction. True to its tradition, AT&T managed more recently to miss on the benefits of another major invention: the cellular (wireless) phone technology. This technology was developed at Bell Labs in the late 1970s, but was deemed by AT&T and its outside consultants commercially useless. Consequently, AT&T abandoned the development of cellular telephony, allowing wireless companies since the mid-1980s a free use of the technology. In 1994, AT&T paid approximately $13B to acquire McCaw Cellular, thereby gaining a foothold in the cellular phone market.

Individuals too rarely appropriate the full benefits of their inventions. For example, Philo Farnsworth, the inventor of the television technology, died destitute and in obscurity, while David Sarnoff and RCA/NBC reaped much of the benefits.[36]

Nowhere is the inability to fully secure the benefits of ideas and developments as serious and consequential as when employees endowed with knowledge and experience leave the enterprise to work for competitors or to form their own companies. The business folklore is replete with examples of key employees leaving a company to form a dominant player in the same industry (e.g., Intel’s founders coming from Fairchild). In fact, a recent study (Bhide, 2000) reports that in excess of 70% of the companies in the Inc. 500 list (young, entrepreneurial enterprises) were founded by people who imitated, often with some modifications, ideas developed by themselves and others in their previous employment. This enormous “spillover” is, of course, due to partial excludability—the inability of owners of intangibles to exclude others from enjoying the benefits of intangibles.

The partial excludability (fuzzy property rights) characteristic of most intangible investments creates unique and considerable managerial challenges. Exploiting the potential of a machine to the fullest is a manageable engineering task. Making full use of the tacit knowledge residing in the brains of employees is considerably more challenging. Only when such knowledge is coded (in manuals or artificial intelligence programs) and systematically shared with other employees, is the value of this knowledge fully exploited to the benefit of the company. Yet, setting up such coding and information-sharing systems is a major challenge.[37] Maximizing revenues from patents and know-how, which are not used to develop products, is challenging as well, requiring taking an “inventory of knowledge” and finding customers (licensees) for these intangible goods.[38] Intangibles’ spillovers create significant opportunities to learn from others through reverse engineering. But this requires special managerial attention and capacity, termed “adaptive capacity” by economists. This is what “knowledge management” is all about. I will elaborate in Part III on the managerial challenges related to the partial excludability attribute of intangibles.

The fuzzy property rights of most intangibles exert significant effects on the public disclosure of firms’ investments in these assets. The “recognition” of an asset for financial reporting purposes, namely the accounting rules for recording and reporting asset values in financial statements require, among other things, that the enterprise has effective control over these assets.[39] Since a business enterprise does not exercise strict legal control over most intangibles—such as human capital, non-patented know-how, and customer acquisition costs—accounting regulators are reluctant to qualify such intangibles as assets, leading to the immediate expensing of corporate investment in most intangibles. This indiscriminate bundling of true expenses (having no future benefits) and intangible investments is a major cause for the deterioration in the usefulness of financial information to managers and investors (Lev and Zarowin, 1999).

The partial excludability and spillovers characteristic of most intangibles, also raise weighty policy issues. Most fundamentally, the gap between the private return (to investors/owners) in intangibles and the social return enjoyed by society should be neither too large nor too small. Too narrow a gap (e.g., by a perfect and infinite protection for patents) will deny society the full benefits of innovations, whereas too wide a gap (no patent protection) will diminish incentives to innovate.[40] Fiscal policies, such as tax incentives and direct subsidies to R&D and employee training, as well as laws establishing and protecting property rights over intangibles (e.g., patent and trademark laws), are aimed at optimizing the social–private return differential. However, effective public policy in this area is seriously hampered by lack of sufficient information on intangible investments and their benefits.

Summarizing, intangibles differ from physical and financial assets in the ability of owners to exclude others from enjoying the full benefits of investments. Non-owners can rarely be perfectly excluded from sharing the benefits of intangibles. Such partial or non-excludability gives rise to spillovers (benefits to non-owners) and absence of control in the strict legal sense over most intangibles. These, in turn, create unique and significant challenges in managing and reporting on intangible assets, leading to a constant tension between the value creation potential of these assets (scalability) and the difficulties of delivering on the promise.

II.5 The Inherent Risk of Intangibles

Intangibles, such as R&D, human capital, and organizational assets are the major inputs into firms’ innovation or creativity processes. While our understanding of the origins, drivers, and circumstances conducive to innovation processes is in infancy, it is widely recognized that innovation is highly risky relative to other corporate activities, such as production, marketing, and finance.[41] Christensen’s (1997, pp. 128–132) in-depth study of the disk drive industry demonstrates the extent of risk associated with innovation. During 1976–1993, the development period of the disk drive industry, a total of 83 companies entered the U.S. disk drive sector. Thirty-five diversified companies, such as 3M and Xerox, engaged in other lines of business; while 48 companies were independent disk drive startups. Of the 48 startups, only ten (21%) generated $100M in disk drive revenues in at least one year since commencing operations—a modest measure of success in an explosive industry with total revenues of $65B during 1976–1994. Of the 35 established companies, only five (14%) reached the $100M annual revenue target. The low overall success rate of diversified and pure-play companies (18%) in this fast-growing industry attests to the high level of risk associated with the innovation process.

Other research corroborates the high risk associated with innovation and intangibles. For example, Scherer et al. (1998) examined a heterogeneous sample consisting of German patents, “bundles” of U.S. patents licensed by seven universities, and the capital market experience of U.S. startup companies. The major conclusion of the study was that “in all cases, a relatively small number of top entities [patents, startups] accounted for the lion’s share of total invention or innovation value.” For example, the top 10% of patents (both in Germany and the USA) accounted for 81–93% of total patent value, clearly implying that the majority of patents are essentially worthless, rendering the investment in those patents a loss. Even for the IPOs examined by Scherer et al., which were backed by venture capitalists and had at the time of going public products on the market and a certain level of revenues, the top 10% of entities accounted for approximately 60% of the total market values of the companies.

These and other empirical studies demonstrate the skewness of the innovation process—a few products/processes are blockbusters, while the rest are duds. Herein lies the inherent riskiness of the innovation/creativity process and of the investment in intangibles underlying this process.

Assuredly, all investments and assets are risky in an uncertain business environment. Yet, the riskiness of intangibles is, in general, substantially higher than that of physical and even financial assets. For one, the prospects of a total loss common to many innovative activities, such as new drug development or an Internet initiative are very rare for physical or financial assets.[42] Even highly risky physical projects, such as commercial property, rarely end up as a total loss. The huge Canary Warf project in London, for example, virtually bankrupt in the mid 1990s, revived later and is considered now a commercial success.

A comparative study of the uncertainty associated with R&D and that of property, plant, and equipment (Kothari et al., 1998) confirms the large risk differentials: The earnings volatility (a measure of risk) associated with R&D is, on average, three times larger than the earnings volatility associated with physical investment.[43] Focusing on volatility of earnings is important in reminding the reader that risk is not limited to potential losses. The concept of risk encompasses both positive and negative outcomes—the possibility of either gaining or losing more than one expected. A total loss is just one possible outcome in the range of future realizations.

What drives the high risk of intangibles? The answer becomes clear when the role and location of intangibles in the innovation process, spanning from discovery to commercialization, is considered:

So the driving process in these increases in value, these increases in GDP and in wealth, is the discovery of new and better formulas, recipes, instructions for rearranging things. Of course, it’s not just the discovery of these formulas and processes that creates value; it’s also the carrying out of those instructions the reworking of that knowledge into physical forms that allow for practical application. (Romer, 1998, p. 10).

It is important to note that along the innovation process, which typically starts with discovery (new ideas, knowledge) and ends up with the commercialization of physical products or services, the level of risk concerning future outcomes (e.g., sales, profits) is continuously decreasing. Basic (radical) research, which often takes place at the very beginning of the innovation process, is of the highest risk regarding technological and commercial success.[44] Next, the prospects of applied research, or product innovation, which generally involves the modification of existing technologies, are obviously less uncertain than those of the preceding basic research. Further along the innovation span and descending in the level of risk, one encounters process innovation—efforts to improve the efficiency of the production process—which is less risky than basic research and product innovation, since there is no commercialization risk associated with process R&D—being aimed, as it is, at internal use. Finally, the production of physical assets, such as computers, machine tools or consumer electronic products, which together embody the implementation stage in the innovation chain, is obviously less risky than earlier innovation stages, since the technological uncertainty of earlier stages has been resolved.[45] The uncertainty associated with a ready-to-market CT scanner, for example, is substantially lower than that associated with the development efforts that preceded the production of the scanner.[46]

The decreasing level of risk along the innovation process clarifies the reason for the inherently high risk of intangible investments. These investments, such as R&D, employee training, acquired technologies, and research alliances, are most intensive at the early, high-risk stages of the innovation process. Much of the investments at later, lower risk stages of the process are in physical assets, such as machine tools and distribution channels.[47]

The inherently high risk associated with intangibles has important managerial, capital markets, and policy consequences, and will be elaborated on in Parts III—V, below. Managerial mechanisms for reducing and sharing the risk of intangibles, such as R&D alliances and diversified portfolios of innovative projects, are at the core of managing the innovation process. Risk assessment of intangibles-intensive firms is (or should be) at the core of investment analysis, particularly given the deficient public information about intangibles. Policymakers are often concerned with the prospects of under-investment in risky, yet socially important, innovations (e.g., genome codification), given that corporate-based risk aversion may prevent an optimal investment in innovation. Risk, of course, plays a major role in the accounting treatment of intangibles. The widely held belief that the prospects of most intangible investments are highly uncertain and not amenable to reliable valuation (e.g., computation of present value of cash flows) underlies the decision of accounting authorities to immediately expense such investment (R&D, employee training, customer acquisition costs, etc.).

Summarizing, investment in intangibles is generally intensive at the early (discovery) stages of the innovation process. It is in these early stages that the risk concerning the technological and commercial success of the innovation is highest. Consequently, the level of risk associated with intangibles is, in general, substantially higher than that associated with most physical and financial assets.

II.6 Markets in Intangibles

The absence of organized and competitive markets in intangibles sets these assets apart from most financial and physical assets. This non-tradability of intangibles has far-reaching consequences for management and investment. Thus, notes Griliches (1995, p. 77):

A piece of equipment is sold and can be resold at a market price. The results of research and development investments are by and large not sold directly…the lack of direct measures of research and development output introduces inescapable layer of inexactitude and randomness into our formulation.

In the policy domain, non-tradability is often invoked to disqualify intangibles from being recognized as assets in corporate financial reports:

It is the same line of reasoning, that a cost can be an asset, that leads some people to suggest that the [Financial Accounting Standards Board] FASB should reconsider FASB Statement No. 2 and allow for recognition of research and development costs as an asset. Note that in none of the cases is the asset [proposed to be] represented on the balance sheet exchangeable. (Schuetze, a former Securities and Exchange Commission (SEC) Chief Accountant, 1993; emphasis mine).

Markets perform numerous vital economic and social functions: They provide producers of goods and services with liquidity, and enable risk sharing and specialization (e.g., inventors could specialize in inventing and then sell the invention to developers). Primarily, market prices provide information about values of goods and services that is vital to optimal resource allocation. Consequently, the absence of organized markets in intangibles has serious consequences.[48] For example, the measurement and valuation of intangibles (e.g., patents, brands) is restricted by the absence of “comparables,” namely prices of assets in similar transactions. In some peoples’ minds, the absence of such comparables disqualifies intangible investments from consideration as assets in both corporate and national accounts. The absence of markets in intangibles also challenges the management of these assets. Illiquidity and restricted risk-sharing opportunities (e.g., the securitization of the firm’s R&D operations) increases the risk of intangible investments and restricts their growth. The absence of markets in intangibles therefore, may create a role for government to improve resource allocation and transparency of intangible investments.

Markets, however, come in different forms and shapes and are constantly evolving. Many companies sell or license their patents (some even donate patents to universities), trades in brands and trademarks are quite frequent, several top performers (e.g., David Bowie) have securitized their song catalogs, and there have been attempts to issue stocks in R&D entities (Lev and Wu, 1999). Most importantly, the advent of the Internet ushered in a host of web-based exchanges in intangibles (intellectual property). The tradability of intangibles is obviously a considerably more complex issue than what appears on the surface—no markets in intangibles. Accordingly, the following discussion examines various key aspects and developments related to the marketability of intangibles.

Are Intangibles Inherently Non-Marketable?

The absence of organized markets in intangibles is, according to some economists, a consequence of the inability to write complete contracts with respect to the outcomes of intangibles. That is, the difficulties in specifying in advance the actions of the parties to the contract (e.g., seller and buyer of an incomplete R&D project) and how these outcomes (research findings) will be shared. As noted by Teece (1998, p. **):

It is inherent in an industry experiencing rapid technological improvement that a new product, incorporating the most advanced technology, cannot be contracted for by detailed specification of the final product. It is precisely the impossibility of specifying final product characteristics in a well-defined way in advance that renders competitive bidding impossible in the industry.

The ability to clearly specify actions and sharing of outcomes between the parties to trade is an essential prerequisite of active markets. Thus, for example, the high volume market in mortgage backed securities (bundles of individual mortgages) is mainly due to the clearly defined property rights (ownership) of mortgages (who assumes the default and pre-payment risks), and the ability to specify in advance how the benefits—streams of interest and principal payments—are to be shared among investors (e.g., some receive the interest, others the principal). It is difficult to conceive, in contrast, similar contracts in bundles of corporate R&D projects, for example, given the considerable difficulties (and cost) of specifying outcomes, as well as allocating rights and responsibilities in advance to investors in bundles of R&D projects. Suppose, for example, that a specific pharmaceutical research idea developed by Merck is included in an R&D bundle sold to investors. Suppose further that the research project is subcontracted by investors to Merck for development, and that the project subsequently fails clinical testing, resulting in terminated development. Nevertheless, the experience and knowledge gained by Merck in the development process of this drug will most probably benefit future developments at Merck or other drug companies. Who then owns those benefits? The investors in the R&D bundle, or Merck? Clearly, writing a contract that will specify all eventualities (“states of the world” in the economic jargon) and the associated rights and responsibilities of the parties involved is prohibitively expensive in the case of R&D and most other intangibles.

The cost structure of many information-related intangibles, which is characterized by large (and often sunk) initial investment and marginal-to-zero production costs, further undermines the operation of a conventional price system for such products. Shapiro and Varian (1999, pp. 19–20) demonstrate this attribute of information-related intangibles with the case of Encyclopedia Britannica:

A few years ago a hardback set of the thirty-two volumes of the Britannica cost $1,600…In 1992 Microsoft decided to get into the encyclopedia business…[creating] a CD with some multimedia bells and whistles and a user friendly front end and sold it to end users for $49.95…Britannica started to see its market erode…The company’s first move was to offer on-line access to libraries at a subscription rate of $2,000 per year…Britannica continued to lose market share…In 1996 the company offered a CD version for $200…Britannica now sells a CD for $89.99 that has the same content as the thirty-two volume print version that recently sold for $1,600.

The negligible marginal costs of producing the outcomes of many intangible investments prevent a stable price system and market in such assets.[49] The often-fuzzy property rights over intangibles also impede the establishment of markets and organized trade. Questions concerning ownership of the human capital resulting from firms’ investment in training, or the distinction between the firms’ ownership of a brand and the part that belongs to its founder (e.g., Microsoft and Bill Gates), complicate trade in intangibles. Even with respect to patents, arguably the intangible with the best defined property rights, the proliferation of infringement lawsuits attests to the fuzziness of such rights. Markets cannot, of course, function without clearly defined property rights of parties to trade.

The impediments to markets in intangibles, as stated above—contracting difficulties, negligible marginal costs, and fuzzy property rights—do not preclude the existence of markets in intangibles. They do, however, indicate that such markets will have to incorporate specific mechanisms and arrangements to alleviate the inherent problems. Indeed, recent web-based exchanges in intellectual property (e.g., pl-x.com) provide valuation and insurance services that are not common in financial or physical-asset markets.[50]

What Does History Tell Us?

Records of active markets in patented technology in the USA exist since the passage of the first patent law in 1790. Lamoreaux and Sokoloff (1999), examining trade patterns in patents during the 19^th and early 20^th century, come to the following conclusion:

We have shown not only that there was a high volume of trade in patented technologies, but also that such commerce and patenting activity were closely associated with each other. Indeed, a broad variety of evidence seems consistent with what theory would suggest, that improvements in the capabilities to trade in technology would stimulate increases in specialization at invention by those with a comparative advantage in that activity, as well as increases in the rate of invention more generally (p. 35).

Lomoreaux and Sokoloff also document that the rise of intermediaries, such as registered patent agents in the late 19^th century facilitated the growth of technology markets. That market, which was characterized in 19^th and early 20^th centuries by a dichotomy between inventors and developers, changed since the early 20^th century:

It was not until the turn of the twentieth century, that the nature of the market for technology began to change again, with a decrease in the proportion of arm’s length transactions and a corresponding increase in the assignments made at issue by patentees who were officers on other principals in the companies specified as assignees (p. 24).

Thus, rather than being developed by inventors and sold at arm’s length to developers, most innovations since the early 20^th century have been invented and developed within corporations or research centers. The market in inventions is currently of marginal importance.

The huge volume and varied nature of intangibles developed and owned by the corporate sector naturally seeks a trading outlet. Since not all ideas and discoveries can be fully developed and operated internally, attempts are made to sell, license or outsource patents and know-how. These incentives to sell/license/outsource intangibles have led to an increasing volume of patent licensing in recent years (Kline and Rivette, 1999), to a large number of mergers and acquisitions where the main asset traded is R&D or technology in the development process (Deng and Lev, 1998),[51] and to the proliferation of alliances and joint ventures aimed at the development and marketing of innovations (Lerner, **). There is clearly substantial trade in intangibles, but it lacks the main characteristic of markets: transparency. Details of licensing deals and alliances are generally not made public, and acquired intangibles are usually bundled with other assets. Consequently, while liquidity and risk-sharing prospects of intangibles have considerably improved, the benefits of observable prices in facilitating measurement and valuation still elude intangibles.

Internet-based markets in intangibles (intellectual capital) may provide the missing transparency, along with liquidity and risk sharing.[52] Not surprisingly, the assets traded in these exchanges are mostly patents—again, the intangibles with the most clearly defined property rights. Such exchanges, however, are in infancy, and the volume of trade is still very low. It is too early to predict whether and when these exchanges will develop into full-fledged markets in intangibles. We have thus gone a long way from the individual inventor market of the 19^th century to Internet exchanges in intellectual capital.

Summarizing, intangibles are inherently difficult to trade. Legal property rights are often hazy, contingent contracts are difficult to draw, and the cost structure of many intangibles (large sunk cost, negligible marginal costs) is not conducive to stable pricing. Accordingly, at present, there are no active, organized markets in intangibles. This can soon change with the advent of Internet-based exchanges, but it will require specific enabling mechanisms, such as valuation and insurance schemes. Private trades in intangibles in the form of licensing and alliances proliferate, but they do not provide information essential for the measurement and valuation of intangibles.

II.7 The Cost–Benefit Tension

The economics of intangibles, like that of other forms of capital, boils down to an analysis of the tension between costs and benefits. In the realm of intangibles, the major benefits are scalability, increasing returns and network effects (externalities). The costs include the usual costs involved in any physical or financial asset/investment (e.g., acquisition, maintenance), as well as the costs unique to intangibles: partial excludability, high risk, and non-tradability. This “economics of intangibles” is depicted in Figure 3.

Decisions concerning the acquisition, management, valuation and reporting of intangibles involve a careful consideration of the benefits expected from these assets against the difficulties to fully secure the benefits. The management of intangibles (knowledge) is aimed at maximizing the benefits and identifying ways to overcome the difficulties. Patenting, cross-licensing, trademarking, moving first, or establishing an industry standard are ways to appropriate most of the benefits of intangibles. R&D and marketing alliances, trading in futures markets (e.g., in energy, bandwidth), and securitization are means of managing the risk of intangibles. Furthermore, the formulation of appropriate “exit strategies,” such as licensing, IPO, or sale on an Internet exchange, is aimed at mitigating the non-tradability restriction.

Figure 3

Economics of Intangibles

Value Drivers Value Detractors

Text Box: PARTIAL
EXCLUDABILITY

¨Spillovers
¨Fuzzy Property Rights
¨Private vs. Social
Returns

Text Box: SCALABILITY

¨Nonrivalry
¨Increasing Returns

Text Box: INHERENT
RISK

¨Sunk Cost
¨Creative Destruction
¨Risk Sharing

vs.

Text Box: NETWORK
EFFECTS

¨Positive Feedback
¨Network
Externalities
¨Industry Standard

Text Box: NON-
TRADABILITY

¨Contracting
Problems
¨Negligible
Marginal Cost
¨Asymmetric
Information

The framework for the economics of intangibles is also useful in analyzing measurement and reporting issues. Thus, for example, to qualify as an asset for financial reporting, it has to be shown that (a) the corporation exercises a considerable degree of control over the asset, namely it is able to appropriate most of the benefits (exclude no owners), (b) the risk concerning commercial success has been considerably reduced (e.g., technological possibility has been established), and (c) market mechanism are available to trade the asset or its consequent cash flows.

In the following parts of the report, I will demonstrate the use of the economics of intangibles in analyzing managerial, investment, and policy issues and advancing recommendations.

Part III

The Record

Part II of this report on intangibles outlined the major economic principles governing intangible investments. To advance knowledge, theoretical principles should be subjected to empirical examination and observation. Accordingly, Part III of the report is devoted to an analysis of the record of intangible investments, that is, the empirical findings concerning the nature of intangible assets and their impact on the operations and growth of business enterprises, as well as on investors in capital markets.

Sections III.1 and III.2 present the evidence surrounding the contribution of research and development (R&D) to corporate growth. This evidence is directly related to the scalability (nonrivalry) and network attributes of intangibles, as discussed in sections II.1 and II.2. I then proceed to examine substantiation of the more recent and fast-growing form of intangible assets: organizational capital (Section III.3). Finally, Section III.4 considers the nascent evidence on the contribution and valuation of human capital.

III.1 The Value Created By Intangibles: A Case Study

On average, investments in intangibles are clearly creating value, namely, yielding a return above the cost of capital; why else would business enterprises invest heavily and consistently in R&D, employee training, brand creation and maintenance, organizational change, and other forms of intangible asset?[53] This is a no-brainer. The questions requiring research are subtler ones: What is the magnitude of the value created by intangibles, relative to other assets? Are there systematic differences in the contribution to value of various types of intangibles (e.g., between the return on basic vs. applied R&D)? Which of the firm’s attributes (e.g., size, diversification) and economic circumstances (a booming economy) primarily affect the productivity of intangibles? And how do investors assess intangibles’ value, particularly given the deficient public reporting about these assets?

The research on these and related issues will be surveyed below, but in order to highlight the relevance of research on intangibles to wide constituencies, I open with a discussion of a specific research project, namely the productivity of chemical R&D.

The Contribution of Chemical R&D

The research on the contribution of R&D in the chemical industry described here was sponsored by the Council for Chemical Research. The chemical industry was one of the earliest sectors to invest substantial resources in R&D. Results were quick to follow, with chemical R&D in the 20^th century generating an impressive array of path-breaking scientific discoveries and innovative products in fertilizers, petrochemicals, synthetic materials, and pharmaceutics.[54] Currently, however, chemical companies are only moderate investors in R&D, and the industry is not considered particularly innovative when compared with computer, biotech, or telecommunications companies, for example.[55] It appears that the productivity of chemical R&D has stagnated in recent years. Moreover, there are widespread concerns about environmental impacts of various chemical products, as well as the safety of others (e.g., genetically engineered crops). This inimical public and investor opinion motivated the Council for Chemical Research to sponsor a series of studies on the contribution of chemical R&D to business enterprises and society at large. In the following, I will briefly report on one aspect of this study—the assessment of the rate of return on corporate investment in R&D (Aboody and Lev, 2000).

A sample of 83 publicly traded chemical companies was used in the analysis, which covered the period 1975–1998. The return on (contribution of) R&D to the investing companies was measured by statistically estimating the contribution of one R&D dollar spent in a given year to the company’s operating income in that year and the subsequent 10 years, controlling for the contribution to income of physical assets (property, plant, and equipment) and of brands (advertising).[56] The focus on the contribution of R&D to current and subsequent income derives from the fact that successful R&D projects have sustained, long-term impact on profitability. This analysis yielded the following conclusions:

¨ A dollar invested in chemical R&D increases, on average, current and future operating income by $2.6.[57] Translated to annual return on investment, the before-tax rate of return on chemical R&D is 25.9%, or ~16.5% after taxes.

¨ A 16.5% after-tax return indicates a very substantial contribution of chemical R&D to corporate value, given that the weighted average (equity and debt) cost of capital of most chemical companies ranges 10–12%. This annual cost–benefit differential of 4–6% indicates that R&D is an important value driver for chemical companies (positive economic value added). Indeed, in stock performance, chemical companies collectively outpaced the S&P 500 companies during the 1985–1998 period (see Aboody and Lev, 2000).

¨ The significant value contribution of chemical R&D is obviously of importance to managers of chemical companies, who are engaged in the allocation of scarce resources to R&D and other corporate activities, as well as to investors in chemical companies and policymakers, given government support for R&D (e.g., tax incentives).

¨ The research project has also indicated the existence of significant economies of scale (size advantages) to chemical R&D: The before-tax return to R&D of large (above industry median) companies is estimated at 27.9%, while the return to R&D of small companies is only 16.4% (after taxes, the latter return barely covers the cost of capital). The implications of these findings for corporate acquisitions and diversification (exploiting R&D synergies), as well as R&D alliances, are straightforward.

¨ In contrast with the abnormal (above-cost-of-capital) return on chemical R&D, the study documented only average return on physical assets (~10% after taxes) and slightly below average return to advertising expenses. Here, too, important implications can be drawn concerning the desirability of additional investment in physical assets—and the benefits from outsourcing manufacturing activities—which decreases reliance on these assets.[58]

¨ With respect to the capital market valuation of chemical R&D, investors were found to fully appreciate (price) the prospects of R&D. This stands in contrast with what is seen in the faster changing technological areas (e.g., telecommunications, computers), where investors appear to systematically underestimate the contribution of R&D (see Section IV.4). This finding about the fair valuation of chemical R&D should alleviate managers’ concerns with negative investor reaction to R&D increases.[59]

I elaborated on the chemical R&D study (Aboody and Lev, 2000) to demonstrate the breadth of issues of concern to managers, investors, and policymakers that can be addressed by systematic research on the contribution of intangibles. In the next section, I summarize the major findings in the economic, finance, and accounting literature regarding the contribution of R&D to corporate performance and growth. The reader will note that much of the research in the field of intangibles deals with R&D, which is just one—albeit important—form of intangibles. The reason for the R&D focus of researchers is simple: R&D is the only intangible that is reported separately (a line item) in corporate financial statements.[60] Expenditures on other forms of intangibles, such as employee training, information technology, or brand creation, are generally aggregated with other expenses in the financial reports. This non-disclosure of most expenditures for intangibles—which constitute, of course, a different and simpler to solve issue than the measurement (expensing vs. capitalization) of intangibles—is a major impediment to the advancement of knowledge about intangibles in particular and corporate performance in general (more on this issue in Parts IV and V).

III.2 R&D and the Growth of Business Enterprises

The contribution of R&D to the performance and growth of business enterprises can be estimated by relating a performance measure (e.g., profits, sales) statistically to R&D expenditures—in the current and previous periods to allow for the delayed effect of R&D on business performance—and by controlling for the effect of other investments (e.g., physical assets) on business performance. This statistical approach to empirically address issues concerning intangibles and their private and social impact was frequently used by economists and researchers in related areas. The empirical work started with extensive historical case studies and proceeded to large sample (cross-sectional) analyses of the impact of R&D on firms’ productivity and growth. This research effort yielded several important findings:[61]

¨ R&D expenditures contribute significantly to the productivity (value added) and output of firms, and the estimated rates of return on R&D investment are quite high—as much as 20–35% annually—with the estimates varying widely across industries and over time.[62]

¨ The contribution of basic research (i.e., work aimed at developing new science and technology) to corporate productivity and growth is substantially larger than the contribution of other types of R&D, such as product development and process R&D (where the latter is aimed at enhancing the efficiency of production processes).[63] The estimated contribution differential of approximately 3-to-1 in favor of basic research is particularly intriguing, given the widespread belief that public companies have been recently curtailing expenditures on basic research, in part as a response to the skepticism of many financial analysts and institutional investors about the commercialization prospects of basic research.[64] Basic research is, of course, more risky than applied R&D (see discussion in II.5, above), but it is inconceivable that risk differentials account for a 3-to-1 productivity superiority of basic research.

¨ The contribution of corporate-financed R&D to productivity growth is larger than that of corporate-based—but government-financed—R&D (granted primarily to government contractors). The fact that most contracts with the government are based on “cost plus” terms may partially explain this finding. This result should not detract from the significant contribution to the industrial and technological infrastructure of publicly funded research conducted by government agencies and in federal laboratories (e.g., the contribution by the National Institutes of Health to pharmaceutical and biotech companies), as well as the substantial contribution of university research to technology.[65]

It should be noted that much of the research summarized above was based on survey data and industry aggregates, due to severe limitations in corporate published data. In fact, most of the examined variables and attributes—such as basic vs. applied research, or company vs. government-sponsored R&D—cannot be directly estimated from information publicly disclosed to investors. Thus, an important implication of these and similar findings is to suggest which kinds of currently unavailable information and data would be useful to managers, investors, and policymakers.

Market Value and Patents

The research effort surveyed above related R&D inputs (intensity, capital) to firms’ productivity, sales, or profit growth, in an attempt to estimate the return on corporate investment in innovation, as well as to examine macroeconomic issues, such as the productivity decline in the United States in the 1970s and 1980s.[66] This methodological approach encounters various problems; in particular, the time lag between the investment in R&D and the realization of benefits (e.g., sales) is often long (particularly for basic research) and generally unknown, increasing the uncertainty about the estimated R&D contribution. Furthermore, biases and distortions in reported profits—arising from firms’ attempts to “manage” investors’ perceptions (see Section IV.4)—might cloud the intrinsic relationship between R&D and its subsequent benefits. These measurement difficulties have prompted a search for alternative and more reliable indicators of R&D output than reported sales and profitability measures. Two output indicators have received considerable attention: capital markets values of corporations and patents.[67] Believers in efficient capital markets argue that stock prices and returns provide reliable signals of enterprise value and performance, hence R&D contribution can be evaluated using market values. Patents, and particularly citations in patent applications, provide an additional indication of the value of R&D.

Concerning capital market studies, the research persuasively indicates that investors regard R&D as a significant value-increasing activity. Thus, for example, a number of “event studies” registered a significantly positive investor reaction (stock price increases) to corporate announcements of new R&D initiatives, particularly of firms operating in high-tech sectors and using cutting-edge technology.[68] When information is available, investors distinguish among different stages of the R&D process—such as program initiation and ultimate commercialization—most significantly rewarding mature R&D projects that are close to commercialization (Pinches et al., 1996). I will return to this important finding in the proposed information system, Part V. Furthermore, econometric studies that relate corporate market values or market-to-book ratios to R&D intensities consistently yield positive and statistically significant association estimates.[69] Further probing of the data suggests that investors value an R&D dollar spent by large firms more highly than R&D of small firms, probably a reflection of economies of scale in R&D.[70]

The evidence thus indicates unequivocally that investors view R&D expenditures as on average enhancing the value of firms and that they also demonstrate some ability to differentiate the contribution of R&D across industries, firm sizes, and stage of R&D maturity. Investors’ ability to fine-tune R&D valuations is obviously hampered by the absence of detailed information on these attributes in corporate financial reports.

Data on R&D expenditures available in financial statements are crude indicators of R&D contribution and value-creation: There is productive R&D and wasteful R&D (e.g., Motorola and partners’ $5B investment in the Iridium satellite communications project, which is currently in bankruptcy, is an example of the latter). The R&D productivity estimates discussed above obviously averaged the good and the bad, missing considerable information in the process. In an attempt to improve the estimation of R&D contribution, researchers experimented with patents, which can be considered an intermediate output measure of R&D (the final output measure is, of course, the benefit (sales, cost savings) generated by the R&D expenditure). Patents are only partial indicators of R&D output, since not every R&D project is patented. Yet, the patent research provided interesting insights.

The Patents Research

Various attributes of patents, such as the number of patents registered by a company (patent counts), patent renewal and fee data, and citations of and to patents were examined by researchers. Both patent counts and the number of innovations emerging from a company’s R&D program were found to be associated with the level of corporate investment in R&D (the higher the R&D expenditures the larger, on average, the number of consequent patents and innovations), as well as with firms’ market values (the larger the number of patents and innovations, the higher the market value, on average). Patents are thus related to both inputs (R&D) and outputs (market values) of the innovation process, and therefore are meaningful intermediate measures.

It is clear, however, that patents and innovations are noisy measures of R&D contribution, due to the “skewness” of their value distributions—that is, the tendency of a few patents or innovations to generate substantial returns (blockbusters), while the majority turn out to be virtually worthless.[71] Citations (references) to a firm’s patents included in subsequent patent applications (“forward citations”) offer a more reliable measure of R&D value, since such citations are an objective indicator of the firm’s research capabilities and the impact of its innovation and activities on the subsequent development of science and technology.[72]

Various studies have shown that patent citations capture important aspects of R&D value. For example, Trajtenberg (1990) reports a positive association between citation counts and consumer welfare measures for CAT scanners; Shane (1993) finds that patent counts weighted by citations (i.e., the firm’s number of registered patents divided by the number of citations by others to these patents) contribute to the explanation of differences in Tobin’s q measures (market value over replacement cost of assets) across semiconductor companies; and Hall et al. (2000) report that citation-weighted patent counts are positively associated with firms’ market values (after controlling for R&D capital).[73] Patents and their attributes thus reflect technological elements used by investors to value companies.

In a direct test of the usefulness of patent citation measures as indicators of value, Deng et al. (1999) and Hirschey et al. (1998) examine the ability of various citation-based measures to predict subsequent stock returns and market-to-book (M/B) values of public companies. The following three measures were found to possess such predictive ability: (a) the number of patents granted to the firm in a given year; (b) the intensity of citations to a firm’s patent portfolio by subsequent patents; and (c) a measure based on the number of citations in a firm’s patents (“backward citations”) to scientific papers (in contrast with citations to previous patents). This latter measure reflects the “scientific intensity” of a patent and may provide a proxy for the extent of basic research conducted by the company. The fact that patent indicators are associated with subsequent stock prices and returns suggests that investors are not fully aware of the ability of these measures to convey useful information about firms’ innovation processes. This, of course, is not surprising, given the novelty of patent-related measures as indicators of enterprise value.

Patents are the intangible assets most actively traded in markets (Section II.6 above), in the form of licensing and sale of patents. An examination of firms’ royalties from the licensing of patents indicates that (a) the volume of royalty income is swiftly increasing (Kline and Rivette, 2000), and (b) investors value a dollar of patent royalties (i.e., the implicit market multiplier of royalty income) 2–3 times higher than a dollar of regular income. The reason for the high valuation of patent royalties probably lies in the stability of this income source (patents are usually licensed for several years), relative to other more transitory components of income. Patent royalties also impact investors’ valuation of R&D, namely the market value they assign to a dollar of R&D expenditures. The valuation of the R&D of firms with royalty income is higher than the valuation of R&D of firms that do not license patents, probably due to investors’ belief that the quality and prospects of R&D of firms able to license patents is relatively high.[74]

Summarizing, R&D, a major form of corporate intangible investment was found to be an important contributor to firms’ productivity, growth, and capital market value. The magnitude of this contribution—return on R&D investment—varies considerably across industries and overtime, but is, by and large, considerably higher than firms’ cost of capital; hence the value creation attribute of R&D. The research record, therefore, strongly supports the assertions made in Section II.2 concerning the scalability of intangibles due to their nonrivalry and increasing returns properties, as well as the existence of positive network effects (externalities) of many intangibles.

In addition to the general findings about the positive contribution of R&D to corporate value and growth, the empirical record indicates the following:

(a) The return on basic (fundamental) research is substantially higher than that of applied or process R&D.

(b) Despite the expensing of R&D outlays in financial reports, investors consider R&D an important asset.

(c) Even for Internet companies, where the uncertainty regarding future benefits is currently considerable, investors value much of the R&D (product development) as an investment (asset) rather than an expense.[75]

(d) Patents and their attributes (e.g., citations) constitute useful intermediate output measures of R&D value.

(e) In recent years, internal R&D is complemented by acquired R&D and technology under development, where the latter often surpasses the former in volume of expenditure.[76]

(f) Royalties from patent licensing are a potent (in terms of creating market value) source of corporate income.

III.3 Organizational Capital

The extensive research effort focusing on R&D provided important insights about the organization of R&D (e.g., economies of scale), the private and social returns on R&D, the appropriation of R&D benefits (e.g., the effectiveness of patent protection), and investors’ valuation of innovation activities. R&D, however, is but one component of firms’ intangible capital (knowledge assets), which is, of course, particularly pronounced in the technology and science-based sectors. Other components of intangibles—human and organizational capital—have received substantially less research attention than R&D. Consequently, our knowledge concerning these important intangibles is rudimentary, at best.[77]

While no reliable data on firms’ investment in organizational capital are available, it stands to reason that the size of these investments—and their contribution to growth—was very substantial over the last two decades. One indication is the relatively small size and slow growth of R&D expenditures, when compared with the explosive growth in the market value of corporations during the last two decades. For example, R&D (as a proportion of nonfinancial corporate gross domestic product) increased from a mean value of 2.3% in 1980–1989 to 2.9% during 1990–1997, which represents a modest increase indeed. Fixed tangible investment (as a percentage of corporate GDP) in fact decreased from 14.1% in 1980–1989 to 12.6% in 1990–1997.[78] In contrast to these relatively small changes in R&D and tangible investment, the S&P 500 index, reflecting the market value of the major U.S. corporations, surged during the last two decades from 135.76 at end of 1980 to 1,517.68 on August 31, 2000—a greater than 10-fold increase.[79] This imbalance suggests that other investments, besides R&D and tangible assets, have created the bulk of the growth in corporate value over the past two decades. Organizational and human capital are prominent among those value creators.[80] Indeed, since the mid-1980s, corporate restructuring—which is a prime creator of organizational capital—became a major managerial activity. So, what do we know about organizational capital?

Computer-Related Organizational Capital

Brynjolfsson and Yang (1999) statistically associated the market values of 1,000 large companies to their tangible assets, R&D expenditures, and investment in computers.[81] Estimation results were striking: while a dollar of physical investment (property, plant, equipment) is valued in the capital market at approximately one dollar, on average (yet more evidence of the “commoditization” of tangible assets, as discussed earlier in this report); each dollar of computer capital was found to be associated with close to $10 of market value! If this were literally true—one dollar invested in IT creates $10 of market value—computer purchases would have been manifold larger than they actually are. The explanation to the high valuation associated with computers is that they reflect the value (contribution) of organizational capital, not just of computers. Stated differently, computers are a proxy for the extensive corporate investment in organizational change. Brynjolfsson and Yang (1999, pp. 26–27) explain as follows:

Our deduction is that the main portion of the computer-related intangible assets comes from the new business processes, new organizational structure and new market strategies, which each complement the computer technology…More recent studies provide direct evidence that computer use is complementary to new workplace organizations…As IT [information technology] is a new technology still being developed rapidly, IT investment may accompany considerable changes in the structure and behavior of organizations…Wal-Mart’s main assets are not the computer software and hardware, but the intangible business process they have build around those computer systems…Amazon’s website and the computer hardware infrastructure are only a small portion of their total assets, but the accompanying business model and business process that support the model are quite valuable…the value of the business data about customer information, supplier information and business knowledge is several times as large as the cost of disk storage itself.

This is the strongest evidence I am aware of concerning the substantial contribution of organizational capital to corporate value.[82] Relatedly, Morck and Yeung (1999) provide evidence that corporate diversification, both across industries and countries, enhances the value of an enterprise in the presence of intangibles. This is intriguing evidence, since diversification (conglomeration) has fallen out of favor since the early 1980s. The management mantra since then has been, “Focus on core operations, and spin-off unrelated activities.” Empirical research indeed supported the virtues of corporate focus by documenting the existence of a 15–20% “diversification discount,” namely the market values of diversified companies are lower on average than those of similar, “pure-play” (single-industry) companies (e.g., Berger and Ofek, 1995; Daley et al., 1997).

Thus, Morck and Yeung’s evidence on the positive contribution of diversification to corporate value seems inconsistent with both corporate practice (focus on core operations) and empirical evidence. In fact, however, there is no inconsistency. Morck and Yeung’s findings about the contribution of diversification relate only to companies that posses substantial intangibles. Here is the explanation (pp.6–8):

Consider a company like 3M, which possesses a wealth of knowledge in adhesive material. It profitably branches into businesses that can tap into its technological know-how, like stationery (e.g., stick up notes and adhesive tapes) and cassette tapes (attaching electromagnetic particles to plastic tapes)…firms diversify into businesses, some appear to be unrelated, which use some common information-based assets…[such as] production knowledge and skills, marketing capabilities and brand name, and superior management capabilities. Information-based assets, once developed, can be applied repeatedly and simultaneously to multiple businesses and locations in a non-rivalry manner to generate extra returns.

Thus, while diversification across unrelated operations often detracts from enterprise value, when the diversification is aimed at scaling intangibles, it results in considerable value added. Such leveraging of intangibles across industries and countries obviously requires considerable organizational capital, such as the Intranet systems of pharmaceutical and chemical companies aimed at sharing information among R&D personnel, the capacity to value patents and identify potential buyers/licensees—such as the system used by IBM in its Internet-based technology exchange (www.patents.ibm.com)—or the development of exchanges in new goods and services, such as Enron’s energy and bandwidth trading activities. These forms of organizational capital are potent value creators and benefit from diversification.

Available research clearly indicates that the contribution of organizational capital to the enterprise is very substantial.[83] This, however, is only the tip of the iceberg. Questions abound: What exactly are those organizational assets? Under what circumstances do they contribute to value? How can such contribution be enhanced? While anecdotal stories in the managerial/new economy literature proliferate (Dell’s innovative distribution system, Federal Express’s efficient package-tracking system, Gap’s exploitation of brand portfolio, and Williams Cos.’s installation of fiber-optic lines in gas transmission pipelines, to name a few), systematic research on specific types of organizational capital is scarce. In the following section, I analyze the relevant evidence that is available on customer-related intangibles.

III.4 Brands, Franchises, and Customer-Related Capital

The “value chain” of knowledge-based enterprises generally starts with discovery (ideas, inventions), proceeds through the technological development phase of the new products/services under development, and ends up with the commercialization of the innovation outputs (e.g., the value-chain phases of drug development are basic research, drug testing and FDA approval, and finally marketing and sales). Considering the research available on the various phases of the value-chain, we have seen that there is substantial research on discovery-related intangibles (e.g., R&D, acquired technology, adaptive capacity), summarized in III.1 and III.2; some research on technological feasibility (e.g., patents, investor reaction to FDA approvals), summarized in III.2; and only scant systemic research about commercialization- and consumer-related intangibles. I will survey in this section the major research findings concerning the final phase of the value chain—customer-related intangibles.[84]

Customer Acquisition Costs

We have seen earlier (Section III.2) that discovery-related intangibles can be measured by input indicators, such as R&D expenditures, acquired technology, or investment in IT; as well as by output indicators, such as number of patents and their attributes (e.g., citations), or the number of innovations generated by the R&D process. In a similar vein, the measurement of customer-related intangibles can be based on input data, or on outcome (output) measures. Following are several examples.

Practically all business enterprises have customers and spend considerable resources on increasing the customer base, stabilizing it (i.e., reducing customer turnover, or churn), and extracting maximum value from customers. Internet companies, spend on customer acquisition more than most other enterprises. Network effects (Section II) are paramount in the various Internet sectors (business-to-business [B2B], business-to-consumer [B2C], etc.), rendering first-mover advantages often decisive. A widely known case of quick and effective penetration is AOL’s drive during 1994–1996 to acquire new customers by massive advertising, providing free service and other incentives.

Are such customer acquisition costs an intangible—that is, an asset expected to generate future benefits—or just a regular marketing expense? Acquisition costs are an intangible asset if, based on past experience of the industry and the specific company and current outlook, customers can be expected to stay with the company well beyond the current year. A case in point is the cellular (wireless) phone industry. Cellular phone operators are paying substantial commissions (ranging $250–300 per customer) to retailers for linking them with customers. For large companies, adding hundreds of thousands or even millions of customers a year, these commissions are the major administrative expense item, amounting to hundreds of million dollars annually. During the early to mid-1990s, the U.S. cellular industry stabilized, and industry statistics indicated that customers stay, on average, about 3.5 years with a cellular operator (see, Amir and Lev, 1996). A case could thus be made that the commissions paid for cellular customer acquisitions are indeed an investment in an intangible asset, since the payoffs of this investment stretch considerably longer than one year (a single year is a common accounting cut off between an expense and an asset).

Indeed, an empirical study (Amir and Lev, 1996), associating returns on stocks of cellular companies with commissions paid, earnings before these commissions, and other control variables, indicates that these commissions are considered an investment by shareholders. Specifically, despite being expensed in the financial report, these commissions were found to be positively and significantly associated with stock returns (changes in stock prices).[85] Thus, when it can be established, based on past experience and industry trends, that the acquired customers will, on average, stay with the company over a multiyear period, the cost of acquiring these customers is indeed an intangible asset.[86] This is also the case for commissions paid by lenders for acquiring loans, and commissions for life insurance contracts.

The Acquisition of Internet Customers

As noted above, Internet companies, particularly e-tailers (B2C) and portals, spent substantial resources on customer acquisition (advertising, free service, other freebees) during the nascent period of these sectors (late 1990s). Getting first to the market and quickly capturing a large market share were (and, in many cases, still are) an essential component of the Internet company business model. Applying, the asset recognition criteria established in the preceding section—a reasonable expectation of multiyear stream of benefits from customers and a history demonstrating some stability of the customer base—the customer acquisition costs of most Internet companies would not qualify as an asset (AOL, Yahoo!, and perhaps Amazon are the exceptions).

Hope (some will say delusion) nevertheless ruled the day, and investors indeed considered customer acquisition costs as an investment, rather than a regular business expense. Several empirical studies (Hand, 1999, 2000; Demers and Lev, 2000) indicated that in 1998 and 1999 these costs were positively related to market values of Internet companies.[87] Investors thus perceived customer acquisition costs to be an asset.

The situation concerning customer acquisitions costs, however, changed dramatically in the first half of 2000. Investors’ euphoric perceptions of the potential of e-tailers turned to pessimism, resulting in a collapse (particularly during March–April 2000) of stock prices of most Internet companies. Empirical studies focusing on this “shakeout” period (Demers and Lev, 2000) clearly indicate that investors no longer consider customer acquisition costs an asset. The positive and significant association between market values and customer acquisition costs, present during 1998–1999, vanished in the first half of 2000.[88] This confirms the validity of the asset recognition criteria outlined above: customer acquisition costs qualify as an asset if experience and current industry outlook provide a solid basis for an expectation of a stable, multiyear customer base. This is clearly not currently (mid-2000) the case in for B2C Internet companies.

Customer-related Output Measures

Customer acquisition costs and related indicators (e.g., advertising expenses, commissions) are input—or cost—measures. They, like R&D expenditures, are generally “situated” at the early phase of the valuation chain, where uncertainty about economic success (commercialization) is relatively high.[89] For management and investment purposes, as well as for accounting recognition of assets in financial reports, it is useful to expand the scope of customer indicators to include output measures, capturing the value of intangibles in advanced phases of the value chain, where uncertainty about commercial success is substantially reduced. In analogy to the previously discussed discovery intangibles, one might consider R&D expenditures (input) vs. patents and “innovation sales” (output measures).[90] Brands and trademarks are examples of customer-related output indicators. Similarly, customer satisfaction measures also indicate intangibles’ values at an advanced phase of the value chain.

Brand valuation and management is “big business,” which is practiced by many corporations and consultants, and researched extensively by marketing and management academics.[91] The current discussion is restricted to empirical work on the value-creation potential of brands, and their property rights “protectors,” which are manifest as trademarks.

Customer satisfaction is, of course, a driver of brand value. Ittner and Larcker (1998) report that various measures of customer satisfaction—some developed internally by firms, others by an independent polling institute—are associated with firms’ market values. The usefulness of customer satisfaction measures for management and investing, where benchmarking against competitors is essential, is limited, however, since these indicators are not yet standardized and publicly reported, and therefore cannot be compared across firms. Relatedly, Barth et al. (1999) found that estimates of corporate brand values published by Financial World are associated with market values. These and similar studies thus establish that various methodologies aimed at quantifying brand values and other aspects of customers’ intangibles (e.g., satisfaction) possess some empirical validity in terms of being associated with market values.[92]

Seethamraju (2000) extended available research on customer-related intangibles by considering trademarks. In contrast with patents, which drew considerable research attention (Section III.2), trademarks still suffer from research neglect. A trademark includes any word, name, symbol, device, or any combination thereof, which a person has a bonafide intention to use in commerce to identify and distinguish goods or products from those manufactured by others.

Trademarks lack the citations record present in patents, which allow the measurement of various patent attributes. Nevertheless, Seethamraju provides useful findings: (a) For a sample of companies that acquired trademarks from other companies, he finds a positive and statistically significant investor reaction to the acquisition announcement, indicating that investors expect, on average, value-added from the trademarks beyond the price paid (e.g., from synergies, or increased market control).[93] (b) More importantly, for internally developed trademarks, Seethamraju develops a model to value trademarks, based on their contribution to future sales. He then estimates the mean value of trademarks in his sample to be $580M. Further tests established a positive association between the estimated values of firms’ trademarks and their capital market values, lending support to the valuation methodology. This preliminary research into the valuation of customer-related intangibles suggests that useful output measures of these assets can be defined and estimated.

Internet Traffic Measures

The advent of the Internet provides a rich set of new indicators reflecting various important aspects of customer-related intangibles. I refer here to what is generally known as “traffic measures” of Internet companies. These measures, generally collected by specialized companies, such as Media Metrix and Nielsen/Netrating, indicate important attributes of customers of Internet companies.

Common traffic measures reflect three attributes of web users:[94] (a) “Reach” indicates the percentage of the “unique visitors” (i.e., not counting repeat visits by the same person) to the company site during a given period (generally a week or a month) relative to all web users. For example, during April 2000, Amazon.com had close to 11M unique visitors (according to Nielsen/Netrating), which constituted 13.68% (Reach) of all U.S. web users. (b) “Stickiness” specifies the extent or depth of the firms’ web use. This important aspect of customers is often indicated by the average number of web pages viewed by a person and the average time a person spent in the company site. Stickiness measures are particularly important to advertisers, since advertising on a site is obviously more valuable when site visits are of an extended duration. For Amazon, in April 2000, visitors to the site viewed a total of 254M pages, which amounts to 23 pages, on average, per person (Amazon ranked 13 among all sites covered by Nielsen, according to this measure). Time wise, the mean Amazon visit lasted 11.6 minutes. (c) “Loyalty” is a measure of propensity for repeat visits. In April 2000, Amazon had just over two visits per person, on average. This measure reflects an important characteristic of the firms’ brand value: the higher the number of repeat visits, the higher the brand value, in general.

Several empirical studies on the valuation of Internet companies (e.g., Trueman et al., 1999; Hand, 2000; and Demers and Lev, 2000) report the following: (a) All three traffic indicators outlined above are positively associated with market values of Internet companies (price-to-sales, market-to-book value), suggesting that these measures reflect important attributes (profit potential, growth) of Internet companies. (b) Traffic measures can be used to improve the prediction of future revenues of Internet companies.

On the basis of this research, it can be concluded that for Internet companies, where users access is recorded, various useful output measures of customer-related intangibles are publicly available. The usefulness of such measures will be improved when they reflect actual purchase behavior of customers, rather than just visits and time spent in the site. Such value measures, however, are not yet publicly available.

Summarizing, research into customer-related intangibles is in infancy, relative to work on discovery intangibles (Sections III.2 and III.3). Nevertheless, the available evidence reveals the existence and usefulness of both input (e.g., customer acquisition costs) and output (trademarks, Internet traffic measures) indicators, reflecting various aspects of these intangibles.

III.5 And, What About Human Resources?

Amazon.com’s 1999 annual report provided the following information about its employees.[95]

As of December 31, 1999, the Company employed approximately 7,600 full-time and part-time employees. The Company also employs independent contractors and temporary personnel. None of the Company’s employees is represented by a labor union, and the Company considers its employee relations to be good. Competition for qualified personnel in the Company’s industry is intense, particularly for software development and other technical staff. The Company believes that its future success will depend in part on its continued ability to attract, hire and retain qualified personnel.

This is essentially the full extent of employee-related information provided by Amazon to its shareholders and other constituents.[96] In this arena, Amazon is not an aberration, but exemplifies the rule. Indeed, an examination of the financial reports of 40 large public companies (Bassi et al., 1999) indicated that, without exception, there were no disclosures of relevant, quantitative information concerning human resources, except for the following platitude: “our employees are our most important asset.” No wonder then that, in contrast with the two intangibles nexuses discussed above—discovery and organizational assets—systematic research on the measurement and valuation of human resource intangibles is extremely lean.

What are Human Resource Intangibles?

Clearly, business enterprises do not own their employees. Nevertheless, such enterprises invest considerable resources in their labor force. On- and off-the-job trainings, specific compensation plans (e.g., granting employees stock options) aimed at increasing work incentives and reducing employee turnover, systems aimed at sharing information among employees (e.g., Intranet systems), and coding tacit knowledge and experience residing in employees’ brains, are examples of corporate expenditures on human resources.[97] Expenditures, however, do not necessarily create assets. Only when the benefits from such expenditures—in the form of increased productivity—exceed costs, is an asset created.

Herein lies the major difficulty in estimating the value of human resource intangibles—identification and quantification of the benefits from expenditures on human resources. Consider, for example, firms’ expenditures on reimbursing employees’ graduate school (e.g., MBA) tuition. Determining the cost of reimbursement is a technical no-brainer. But what are the benefits? Presumably, the productivity and quality of decisions made by employees with graduate degrees is higher than by those without the degree. Morale and loyalty to the organization may also be enhanced by education. But how can these benefits be measured? How can they be separated from total revenue and cost data? I am not aware of operational ways of quantifying the benefits of expenditures on the labor force, at the enterprise level.

The benefits of some intangibles (e.g., new products and services, some unique organizational designs) are separable, and can be attributed to cost (investment) data in an effort to estimate return on investment and the value of intangibles. Given the strong interactions between labor and other productive inputs, however, the quantification of benefits from investment in human resources is a very challenging task. This is an important issue for the accounting recognition of human resource intangibles as assets. Such recognition requires, in general, the identification and estimation of expected benefits, as well as having a certain degree of control over these assets.[98]

Some Research Findings

While the separation and quantification of the benefits of investment in human resources at the enterprise level is very difficult, cross-sectional (multi-firm) statistical analysis focusing on such investments and controlling for other factors (e.g., firm size, industry factors, risk) is possible. For example, various studies have examined the effect of specific work practices and human resource policies on employee productivity and firm value. Human resource policies and practices, such as the implementation of Total Quality Management (TQM) programs, teamwork training, pay-for-skill and profit-sharing systems, can create intangible assets, providing that they generate sustained benefits that exceed the costs of such programs. A recent study (Cappelli and Neumark, 1999, pp. 39–40) yields tentative results concerning such benefits.

The results of our analysis suggest that the effects of these work practices on productivity appear to be positive, consistent with other recent research, although in our data little or none of this evidence is statistically significant. At the same time, there are benefits to employees from innovative work practices based on employee involvement in the form of higher labor cost/higher compensation…there is no evidence of net benefits to employers associated with these practices, as labor cost increases tend to offset any productivity increases…Indeed, it is possible that “high performance” work practices have other beneficial consequences (higher morale, greater adaptability, lower waste, etc.) that either do not affect firm performance measurably or do so in ways not captured by our performance measures (emphasis mine).

Thus, in contrast with discovery and organizational intangibles (Sections III.1—III.4), for which systematic evidence indicates the existence of significant links between investment and value created, the research on human resource expenditures and programs has thus far come short of substantiating strong and sustainable links between expenditures and enterprise value.[99] It should be noted, however, that this research is, at best, in its infancy and is seriously hampered by the absence of publicly disclosed corporate data on human resources. The consequent reliance of researchers on survey data adds noise and uncertainty to their findings. I conclude, therefore, that the jury is still out concerning the existence and value of human resource intangibles.

In closing this empirically oriented section, I would like to briefly mention two research strands related to the valuation aspects of human resources. Several attempts have been made to measure the quality of scientific and R&D personnel of companies by the number of their scientific publications and the status of their co-authors, and to relate such quality measures to firm value. Thus, for example, Darby et al. (1999) measure biotech firms’ intellectual human capital by counting the number of scientific articles the firms’ employees co-authored with “star scientists” (e.g., Nobel laureates), including of course, cases where the firms’ scientists were themselves stars. The authors report that these human resource measures are associated with biotech companies’ future economic success and market values.

Finally, Rosett (2000) constructs a measure of firm-specific human capital based on the present value of expected costs of compensating employees. This is an implementation of a methodology proposed by Lev and Schwartz (1971) for the estimation of firm’s human capital value.[100] Rosett reports that the estimated human capital values are positively associated with enterprise risk, as perceived by the capital market. The reason being that the human capital asset, which is missing from the assets section of the balance sheet, has an associated liability in the form of an obligation for future employee compensation, which is also missing from the balance sheet. This off-balance-sheet liability, argues Rosett, increases the firm’s financial leverage (debt/equity ratio), relative to that reported on the balance sheet, hence the finding that the inherent risk of the enterprise increases with the value of its human capital.

Summarizing, of the various intangible assets considered above, we have the least systematic information on human resources. It is not even clear, at this stage, which expenditures on human resources (training? incentive-based compensation?) indeed create assets. It appears that research on human resource intangibles will significantly advance only with the disclosure of meaningful data by the corporate sector.

III.6 Takeaway Thoughts

¨ Extensive empirical research, particularly on discovery (R&D, patents, innovations) and organizational (IT, brands, customer acquisition costs) intangibles, has established the existence of strong links between these investments and corporate value and performance. This record corroborates the value creation potential of intangibles, resulting from their nonrivalry, increasing returns, and network effects characteristics (Part II of this report).

¨ The research regarding intangibles has provided the foundation for the measurement and management of these all-important productive inputs. Various quantifiable input and output measures of specific intangible assets—such as renewal investment (R&D, technology, IT), patent and trademark values, customer acquisition costs, Internet companies’ traffic measures, network effects (e.g., alliances), and scientific human capital values—can be used by both managers and investors to assess corporate performance and value. Quantitative indicators of intangibles will also be useful to policymakers in forming and evaluating public policy.

¨ The reliance of research on corporate-disclosed data is crucial. Occasionally, surveys and interviews provide some useful information. Yet, by and large, significant research advances are predicated on systematic and credible (e.g., audited) information disclosed by business enterprises or public agencies (e.g., the patent office). The wealth of information gained from research on R&D and patents, relative to human resources, attests to the centrality of corporate information on intangibles to the advancement of knowledge and policymaking. This highlights the importance of enriching the information environment concerning intangible investments, which will be taken up in the following two parts of this report.

Part IV

Intangibles in the dark

Most who write and comment about intangible (intellectual) assets, as well as many New Economy pundits, elaborate on the sharp distinction between the accounting treatment of physical and intangible investments: While the former are considered assets and reported (along with financial investments—stocks, bonds) on firms’ balance sheets, the latter are by and large written off in the income statement, along with regular expenses, such as wages, rents, and interest.[101] This difference between the accounting treatment of tangible and intangible assets, it is generally argued, has dire consequences for managers, investors, and policymakers relying on financial information (e.g., corporate financial reports or prospectuses). Proposed remedies range from encouraging firms to voluntarily disclose more information about intangibles (the majority of commentators) to suggesting changes in the regulated accounting and reporting system (a minority view).

On the whole, while agreeing with some of the recommendations for improved disclosure, I find the arguments about information deficiencies—and particularly the proposed remedies—unconvincing and lacking solid foundation. Particularly missing from the debate are the following elements:

¨ A thorough analysis of the economic reasons for the differences in the accounting treatment of physical and intangible investments. It is not just the result of accountants’ conservatism, or resistance to change.

¨ Awareness of the “politics of intangibles,” namely the motives and incentives of managers, public accountants, and financial analysts concerning the disclosure of meaningful information about intangibles. More information about intangibles will not fall like manna from heaven, just because book writers or committees call for it. The incentives of the major players in the information arena will have to be changed substantively to improve the information environment concerning intangibles.

¨ Examination of the empirical evidence concerning the current state of information availability and the social harms caused by the information deficiencies concerning intangibles. Substantive improvements in the disclosure of information about intangibles can be brought about, in my opinion, by policy changes only (otherwise, the information would have been voluntarily disclosed by now), which can be triggered only in the face of documented, significant social and private harms.

¨ A realization that many of the information challenges facing corporate outsiders (investors and policymakers) also beset insiders (managers and board members). The belief that managers have sophisticated internal systems to measure and value intangibles is a myth. Certainly, managers often use some nonfinancial measures internally—such as customer satisfaction, employee turnover, or a fine partition of R&D by projects. Nevertheless, the managerial usefulness of such measures is restricted, due to lack of standardization and public availability; hence, they cannot be used for benchmarking. Furthermore, beyond simple indicators, such as employee turnover, most companies do not have the capacity to conduct an in-depth analysis, such as an evaluation of the return on investment in intangibles, which is essential for optimal resource allocation.

¨ Missing mostly from the debate on intangibles are the following: (a) A comprehensive plan for improvement in the measurement and disclosure of intangibles. The suggestions generally advanced, such as “more nonfinancial measures,” are haphazard, and lack consistency. In particular, they do not address the underlying reasons for the current deficiencies. (b) Similarly missing is a clear proposal for a change in the current incentives of mangers and accountants to elicit the disclosure of the proposed information. The general calls for “a period of experimentation” are, in my opinion, vacuous. If there is insufficient experimentation now, what will motivate more of it in the future?

The following discussion is organized according to the five themes outlined above: Reasons for current information deficiencies, the politics of intangibles, social harms, managerial information needs, and the proposed information system, including incentives for changes in information disclosure. The first three themes will be discussed in Part IV, while the latter two appear in Part V.

IV.1 The Tangibles–Intangibles Accounting Asymmetry

“To know the past, one must first know the future.” This counterintuitive, yet profound statement by the mathematician Raymond Smullyan, though not referring to accounting, reflects the essence of accounting measurements, their objectives, and limitations better than any textbook discussion that I have encountered.[102] A simple, accounting-based example will clarify Smullyan’s statement.

Despite widely held beliefs that corporate financial statements convey historical, objective facts, practically every material item on the balance sheet and income statement, with the exception of cash, is based on subjective estimates about future events. A few examples are as follows: the net value of accounts receivable (or loans of banks) depends on managers’ estimates concerning future customers’ defaults; the stated value of fixed-income securities (bonds) “held to maturity” depends on managers’ intent and ability to hold the securities until maturity, irrespective of future economic conditions and financial needs; the net value of property, plant, and equipment depends on managers’ depreciation estimates; obligations for pensions and post-retirement benefits rely on heroic, long-term assumptions concerning future wage increases and the rate of return on pension assets; and the firm’s contingent liabilities for product warranties or insurance claims are based on estimates of future payments to fulfill these obligations, often stretching over several years.[103]

Obviously, “to know the past,” namely report accurately on last quarter/year’s earnings and assets/liabilities values, one must have a pretty good knowledge of the future (e.g., assets’ useful life, customers’ rate of default, or future wage increases). Stated differently, a financial statement for, say, fiscal 2000 prepared in 2010, when much of the uncertainty concerning the firm’s activities and economic condition in the post-2000 period is resolved (e.g., the actual default record of credit sales in 2000 will be known by 2010), will be much more accurate (though less relevant) than a fiscal 2000 financial statement prepared in February 2001, when considerable uncertainty concerning events beyond 2000 still prevails. Thus, the quality and relevance of accounting-based information depends crucially on the extent of uncertainty surrounding future outcomes and the ability to pierce this uncertainty (“to know the future”).

Herein lies the crux of the accounting problems with intangibles: To know the past—evaluate the performance and assess the value of intangible assets—one must know the future, namely the outcomes of these investments (e.g., the commercial success of a drug or software program under development). But as the discussion in Part II (the economics of intangibles) made clear, the future of intangibles is in general murky. The uncertainty associated with most intangible assets is inherently higher than that of physical and financial assets. Motorola (and partners’) $5B investment in the Iridium project (telecommunication satellites) is currently in Chapter 11; Monsanto’s far reaching transition from a chemical to an agribusiness company, which was initially hailed as a great success, recently hit a wall of consumer resistance to genetically modified products, and led a battered Monsanto to be acquired by Pharmacia; and the massive investments of many Internet e-tailers during the late 1990s in intangibles (product development and customer acquisition costs) are essentially lost as the business models of many of these companies were found in 2000 to be unsustainable. On the positive end of the risk spectrum—risk entails both unexpected losses and unexpected successes—is Cisco Systems, creating an empire worth approximately $400B in the market (as of September 2000) from smart investments in technology, and AOL with its dominant Internet position gained by shrewd investment in customer acquisition and product development.[104]

Tangible and intangible assets receive differing accounting treatments, primarily because of the high uncertainty regarding future outcomes of intangible investments; the former are considered assets, while the latter are expensed. Further motivation for the expensing of intangibles rests on the unique characteristics of this type of asset: partial excludability (lack of control) and non-tradability (Part II). What is not controlled by the enterprise (inability to exclude nonowners from enjoying some benefits), goes the argument, cannot be considered an asset, and the value of what cannot be compared with similar assets (due to absence of markets) is inherently subjective and unreliable.

Any serious proposal for improvement in the measurement and reporting of intangibles has, therefore, to deal with the root causes of high uncertainty, partial excludability and non-tradability attributes of intangibles. I will demonstrate briefly here (and at greater length in Part V) how an appreciation of the attributes of intangibles and the foundations of accounting measurements can guide useful proposals for change.

The high uncertainty of intangibles highlights the importance of information on risk reduction of these assets as they move along the value chain, from ideas, through technological feasibility, to commercialization. For example, systematic information on the results of clinical tests of drugs under development, or beta tests for software programs, falls into this category of important risk-related information.[105] Obviously, the commercialization prospects of technologically feasible products are substantially better than pre-feasibility products/services.

The high uncertainty of intangibles also highlights the importance of information concerning risk sharing. R&D alliances and joint ventures, securitization of intangibles, and cross-licensing of patents are among the primary means used by firms to manage the risk of intangibles. Therefore, detailed information on these risk management activities and their consequences possess high relevance to both investors and managers (including board members).

The partial excludability and non-tradability attributes of intangibles point at the importance of information on the firm’s ability and success in appropriating maximum benefits from intangible investments. The extent of patenting and trademarking of discoveries, the volume of revenues from licensing patents and know-how, and the success of the firm in litigating patent infringements are important indicators of the firm’s ability to exclude others from reaping the benefits of its innovations. Similarly, information about trading knowledge assets in the traditional and virtual (Internet) markets for intellectual capital is relevant to both managers and investors. These indicators will also have important accounting implications. Effective exclusion of outsiders implies control over assets, an important condition for asset recognition in financial statements.

An appreciation of the nature of accounting as it relates to intangibles also allows for a critical assessment of current proposals for information disclosure. Consider, for example, the suggestions for continuous financial reporting instead of the current quarterly and annual financial reports. It is generally taken for granted that investors and other financial statement users prefer access to updated information more than once a quarter (“in Internet time, three months is a lifetime”). The discussion of proposals for continuous reporting generally revolves around technical issues of providing users with direct access to company data bases.

Lost in the discussion is the crucial factor of reliability of the estimates underlying financial reports. In general, the shorter the reporting period (a quarter, say, compared with a year), the less reliable are the estimates underlying the computation of earnings and asset values. Consider, for example, the estimate of the provision for customers’ defaults (loan loss reserve). A default estimate based on past experience with annual sales, may provide a reasonable estimate of future default, since many transitory events and factors are smoothed out over the course of a year. In contrast, an estimate of customers’ default related to last week’s or yesterday’s sales (continuous reporting) will be subject to enormous random errors, and hence be highly unreliable, adversely impacting the quality of reported earnings and asset values. Indeed, empirical studies (Lev **, Ohlson **) show that the longer the accounting period (a quarter, a year, five years), the more reliable earnings are as measures of corporate performance. Thus, given that “to know the past, one must first know the future,” one must view proposals for continuous reporting with great care, particularly when intangibles with their high uncertainty are at issue.

IV.2 The Politics of Intangibles

Why are task forces (e.g., the Financial Accounting Standards Board (FASB) 2000) calling for the disclosure of more information about intangibles and policymakers (U.S. Senate, the SEC) scheduling hearings about the presumed inadequacy of information on intangibles? Are market forces not supposed to assure that a demand for information on intangibles will be met by adequate supply? Is there a “market failure” for information on intangibles, and why?

The Information Revelation Principle

Economic theory and sheer common sense suggest that, when there is demand for certain information items, there will generally be sufficient incentives to supply the information. Consider a simple, hypothetical scenario of a capital market in which investors have no information about the companies traded in that market. In such a state of “complete ignorance,” the market value of all the traded companies will be identical, since investors will assign the same probabilities of success and failure to all the traded companies. A uniform valuation of all securities will prevail.

Most likely, there will be at least one company in the market whose executives strongly believe that its intrinsic (true) value is higher than the uniform value prevailing in the market. At least one company must have above average worth. The executives of this above average company obviously have an incentive to provide information to investors about the “true worth” of their company (e.g., sales growth, earnings, asset values). Upon disclosure of such information, investors will increase demand for the stocks and upgrade the prices of the disclosing companies (if the information is credible, of course), and downgrade the prices of those who keep silent. The reason: investors are getting increasingly suspicious (concerned) about the companies that keep silent in face of others who disclose information. In capital markets, no news is bad news.

As market values of silent companies continue to fall below the initial uniform value, even those that initially had good reasons to keep silent, namely companies with intrinsic value below the average market price, now have incentives to disclose information, since the recently reduced prices are now below their intrinsic value. This information revelation process will evolve until all companies disclose their information—the “full revelation” principle, in the economic parlance.[106]

The Failure of Full Revelation for Intangibles

Why does the full revelation principle fail to operate in the intangibles context? Why did a recent extensive study by the FASB of voluntary information disclosure by public corporations conclude the following:

The Steering Committee was pleasantly surprised to discover that companies presently are voluntarily disclosing an extensive amount of useful business information…The results of the over-all study included some disappointments. One was the general lack of meaningful and useful disclosures about intangible assets.[107]

The FASB’s findings of “extensive amount of useful business information” currently disclosed voluntarily are consistent with the “full revelation” scenario, outlined above. But why the information failure when it comes to intangibles? Clearly, prescriptions concerning improved information disclosure have to address this question.

The main reason for the intangibles’ information failure lies, in my opinion, in the complex web of motives of the major players in the information arena—managers, auditors, and well-connected financial analysts. I refer to this web of motives as the “politics of intangibles’ disclosure.” A specific example will highlight my argument.

The term “in-process R&D” (IPR&D) refers to research and technology projects in the development process that are acquired by business enterprises, often with other tangible and intangible assets. The data in Table 2, which were derived from IBM’s third quarter (September 30) 1995 report, provide an example of the IPR&D included in the acquisition of the Lotus Development Corp. by IBM.

TABLE 2 In-process R&D Data for IBM’s Acquisition of Lotus Development Corp., 1995
Asset/Liability	Value (cost) (millions of dollars)
Tangible net assets	305
Identifiable intangible assets	542
Current software products	290
Software technology under development	1,840
Goodwill	564
Deferred tax liabilities	(305)
Total acquisition price	3,236

Source: IBM’s third quarter (September 30) 1995 report.

Thus, IBM estimated $1.84B as the value of IPR&D (essentially software programs and products under development) included in the Lotus acquisition, i.e., 57% of the total acquisition price ($3.24 billion).

United States’ accounting regulations (generally accepting accounting principles; GAAP) prescribe that IPR&D, once identified and valued, should be immediately and fully expensed in the acquiring company’s financial report. This expensing caused IBM to report a whopping loss of $538M in the third quarter of 1995, compared with a profit of $710M in the same quarter a year earlier. IBM is not an aberration. The acquisition of R&D and technology has been mushrooming in recent years as companies attempt to shore up their technological capabilities, with many companies having multiple acquisitions per year and staggering IPR&D write-offs.[108] For example, during 1997–1999, Cisco Systems conducted 14 acquisitions that were accounted for by the “purchase method.”[109] The total price paid for those acquisitions was $1.77B, of which $1.36B (77%) were expensed as IPR&D.[110]

One would expect corporate executives to rebel against an accounting rule that forces them to declare a major part of the value of corporate acquisitions a current expense (akin to sunk costs), in the process depressing reported earnings and asset values. In fact, however, when the FASB announced in 1999 its intention to change the IPR&D expensing rule, it encountered such strong opposition by managers that it backtracked from the change. Why the opposition to a change of clearly inappropriate procedure? Enter the “politics” of intangibles’ disclosure.

The massive expensing of practically all investments in intangibles—both internally developed (e.g., R&D, customer acquisition costs) and acquired from others—as mandated by GAAP, is a recipe for inflating future reported profitability and growth, as well as serving to protect managers against embarrassments. When Cisco expenses 77% of its acquisitions’ value, it guarantees that future revenues and earnings derived from these acquisitions will be reported unencumbered by the major expense item—the amortization of the acquisition costs.[111] Hence the inflation in future profitability and growth. The expensing of intangibles also causes commonly used profitability measures, such as the return on equity (ROE) or return on asset (ROA)—often among the drivers of management compensation—to be inflated, since the denominators of these ratios (equity and total assets, respectively) are missing the expensed part of the acquisitions. Even when the acquisitions fail to yield the expected return, the low (after IPR&D expensing) equity base will obscure the failure from outsiders.

And what about the depressed earnings due to the expensing of IPR&D? Not to worry. Investors generally consider these write-offs as “one-time items,” of no consequence for valuation.[112] Thus, companies get the best of all worlds from the IPR&D expensing: no price hit at the time of expensing, and a significant boost to future reported profitability.

This is not the end of the IPR&D story. Given the high risk of intangibles, the probability of acquired R&D or technology under development to result in failure is not insignificant. If the acquisitions were considered assets, such failure would have required a public write-off of the investment in the financial report, triggering questions about the reasonableness of the acquisition, and possibly lawsuits. An immediate expensing obviates the need to provide explanations in case of failure.

The in-process R&D case generalizes to other intangible investments. The immediate expensing of these investments and virtually no information disclosure about the progress of products under development, or return on investments, suit managers well, particularly given the generally high level of uncertainty associated with intangibles. Failures generally draw attention more than does success, and immediate expensing upon acquisition or investment, as well as minimal information disclosure about project development, obscures most failures.[113]

What about the benefits from disclosure that drive the full revelation principle discussed above? Economic theory postulates that the disclosure of relevant information will be rewarded by a lower cost of capital (relative to no disclosure). In reality, there is only scant evidence of a link between improved disclosure and cost of capital, and the estimated reduction in cost of capital is very modest.[114] In my opinion, this evidence is too fragile to counter the strong incentives to inflate future profitability and avoid embarrassments.

What about public accountants and financial analysts? The former, mainly concerned with shareholder lawsuits, are comfortable with accounting rules that eliminate risky assets from the balance sheet that, in the occurrence of failure, may draw lawsuits by irate shareholders. The latter (analysts), particularly well-contacted ones, believe that they obtain from managers (via conference calls, background briefings, etc.) sufficient information about firms’ innovation activities. In fact, public disclosure in financial reports of such information strips them of privileged information.

The “politics” of intangibles’ disclosure, conjectured above, is not a diabolical scheme to obscure relevant information. Rather, it reflects expected attitudes, given the economic characteristics of intangible investments—high risk and difficulties to fully secure benefits. What is important is not to place the blame for the scarcity of information, but rather to understand the motives (crucial for the design of effective remedies) and particularly the consequences. I, therefore, turn next to an empirical analysis of the consequences of information deficiencies concerning intangibles.

IV.3 Intangibles Darkly: The Consequences

So what if the accounting system fails to reflect important attributes of intangibles? Perhaps, managers, investors, and policymakers obtain the missing information from other sources (e.g., conference calls with executives)? Are there really serious social and private harms caused by the scarcity of information on intangible investments? Here is the evidence.

The Current Disclosure Environment

With but one important exception—software development costs—practically all intangible investments are expensed as incurred in financial reports.[115] The costs of developing software products beyond the stage of technological feasibility (usually determined by the existence of a working model, i.e., successful alpha or beta tests), have to be capitalized—namely considered an asset—and amortized according to the expected useful life of the software products.[116] In 1995, the American Institute of Certified Public Accountants (AICPA) issued a Statement of Position (SOP) extending the capitalization of software development costs (beyond technological feasibility) to products intended for internal use (AICPA, 1995). The justification for the software exception to the general rule of expensing intangibles appears to be that software projects are generally well defined (separable), of relatively short duration (compared, say, with drug development), and their benefits can in most cases be directly attributed to the investments. Such separability of projects and identifiability of benefits is missing, argue accountants, from most other intangibles.

In reality, however, even this limited requirement to capitalize software development cost is ignored by many software companies, including the industry leaders, Microsoft and Oracle. These and other firms routinely expense all software development costs.[117] Undoubtedly, financial analysts’ skepticism of the capitalization of intangibles strongly drives the expensing decision of many software companies.[118] The drag on future earnings due to the amortization of capitalized software—and, in extreme cases, the need to write-off software capital that is no longer commercially viable—is an additional deterrent to following the FASB’s software capitalization requirement.

Whether capitalized (infrequently) or expensed (the general rule), R&D expenditures are at least reported separately (a line item) in companies’ financial statement.[119]’[120] This is not the case for most other intangible investments. In general, no information is provided in financial reports on firms’ expenditures regarding employee training, brand enhancement, information technology investment, or other intangibles. Thus, while companies provide detailed information on investment in tangible and financial assets, no information on intangible investment (except for R&D) is provided to the general public. This results in an almost complete lack of transparency concerning intangibles. With but few exceptions, this situation prevails worldwide, as seen in Appendix A.

The distinction between the measurement issues concerning intangibles (e.g., should they be recognized as assets in financial reports or expensed) and the disclosure of substantive information about intangibles is often lost in the public debate. Too often one hears the following argument: “It’s impossible to value intangibles and, therefore, no change should made in current corporate disclosures.” This reflects the confusion of the measurement and disclosure issues. The difficulties in valuing intangibles—a measurement issue—should not preclude the disclosure in footnotes to financial reports or by other means of factual, important information, such as on investment in IT, employee training, customer acquisitions costs, etc. I will return to this issue in Part V, below; but will first ask what economic theory says about the consequences of information deficiencies.

The Consequences of Information Asymmetry

Economic theory postulates that information asymmetry—namely differences in the information available to parties to a contract or to a social arrangement (e.g., a stock exchange)—leads to adverse private and social consequences. Such consequences were thoroughly investigated in the capital markets context, where some participants (e.g., managers, well-connected financial analysts) are better informed than others about firms’ activities and future prospects. Here are some salient conclusions, of particular relevance to intangibles, of the voluminous economic literature on information asymmetry.

¨ Abnormal gains to informed investors.

Kyle (1985, 1989), among others, established that informed persons (e.g., managers having information about the success of a drug under development in human clinical tests) would gainfully trade to exploit their private information.[121] Given human nature, this, of course, if far frsom surprising, but Kyle also established that active information search by investors (e.g., financial analysts) will not eliminate the edge of insiders. Thus, contrary to widespread beliefs, the extensive information gathering and analysis by financial analysts and institutional investors, aided by the Internet, will not “level the playing field.” Ways will have to be found to motivate insiders to disclose at least some of their information.

¨ Intangibles and information asymmetry.

Particularly relevant to our analysis is the conclusion from Kyle’s model that the gains of informed investors will be a function of the variability of the value of the firms. We know (e.g., Kothari, **) that intangibles increase the variability (volatility) of firms’ values, and we can, therefore, expect the extent of information asymmetry and insiders’ gains to increase with the intensity of intangibles. This theoretical prediction is strongly corroborated by Aboody and Lev (2000) (discussed in Section IV.4). The adverse social consequences of substantial gains to informed investors are the corresponding losses to other investors and the deterioration in investors’ confidence in the integrity of capital markets.

¨ Increasing bid–ask spreads of securities.

Glosten and Milgrom (1985) established that information asymmetry is the major determinant of securities’ bid–ask spreads (namely the price differential that traders or market makers quote for buying or selling a security). Bid–ask spreads widen, for example, when the market maker faces better informed investors, as a self-protecting mechanism against excessive losses to these investors. An important implication of the Glosten–Milgrom model is as follows:

There can be occasions on which the market shuts down. Indeed, if the insiders are too numerous or their information is too good relative to the elasticity of liquidity of trader’s [uninformed investors] supplies and demands, there will be no bid and ask prices at which trading can occur and the specialist can break even…a market, once closed, will stay closed, until the insiders go away or their information is at least partly disseminated to market participants from some other information source…The problem of matching buyers with sellers is most acute in trading shares of small companies. (Glosten and Milgrom, 1985, pp. 71,74; emphasis mine).

Thus, severe information asymmetries will lead to decreases in volume of trade and in the social gains from trade.[122]

¨ Spreads and cost of capital.

Amihud and Mendelson (**) established the important linkages between information asymmetry, bid–ask spreads, and firms’ cost of capital. Large spreads imply high transaction costs to investors (the spread is the cost of a “round trip”—buying and then selling the security). Investors will demand a compensation for the high transaction costs in terms of a higher return, which in turn implies a higher cost of capital to the company. A high cost of capital impedes investment and growth. Hence, the adverse private and social consequences of information asymmetry.

Economic theory thus establishes the fundamental cycle of business enterprises and capital markets (depicted in Figure 4), which can have virtuous or vicious implications for firms and their employees. Serious information deficiencies (upper link in Figure 4) will lead to excessive cost of capital, low employee compensation (e.g., “out of the money” stock options), and in extreme cases takeover of the entire enterprise, triggered by low market values (lower link in Figure 4). This scenario is particularly relevant to intangibles-intensive enterprises, given the deficient information about these assets, which are, as theory postulates, mostly serious for small, early-stage enterprises. Are these theoretical predictions borne out by the evidence?

Figure 4

The Virtuous–Vicious Cycle

Text Box: Business
Enterprises Text Box: Capital
Markets

IV.4 Evidence of Harms

High Cost of Capital

Boone and Raman (1999) examine the impact of changes in R&D expenditures on the bid–ask spread of stocks. Relating R&D changes to bid–ask spreads is an effective way to examine the consequences of the information asymmetries created by R&D (and, by implication, by other intangibles), since the bid–ask spread reflects investors’ transaction costs, which in turn affect companies’ cost of capital. Boone and Raman report a statistically significant association between increases in R&D expenditures and the widening of securities’ spreads.[123] R&D changes were also found to be negatively associated with the “depth” of trade, namely the quantity of securities the market maker is willing to commit for a given quoted spread.

Evidence on the impact of R&D changes on firms’ cost of debt is provided by Shi (1999), reporting that increases in R&D expenditures are associated with increases in the cost of debt of public companies. In addition to these issues, consider the studies reporting a positive link between the quality of financial reporting (not necessarily on intangibles) and firms’ cost of capital (e.g., Botosan, 1997, Sengupta, 1998), and the conclusion is clear: deficiencies in information disclosure to capital markets, particularly pronounced for intangibles-intensive companies, result in excessive cost of capital, which in turn hinders business investment and growth.

Systematic Undervaluation of Intangibles.

Attempts to empirically identify systematic mispricing of securities or anomalous behavior of investors (e.g., overreaction to certain types of information) follow a widely accepted research methodology: portfolios of securities are formed on the basis of the hypothesized trigger of mispricing (e.g., a negative earnings surprise), followed by an examination of the pattern of risk-adjusted returns on these portfolios subsequent to their formation. If the examined securities are properly priced, subsequent risk-adjusted returns should randomly wander around a zero mean. If, on the other hand, the examined securities are systematically mispriced and if investors recognize the mispricing over time, then the portfolio returns will systematically drift upward or downward, as investors correct the mispricing.[124]

Lev et al. (1999) examined more than 1,500 R&D intensive companies, paying particular attention to financial reporting biases related to R&D. They find that companies with a high growth rate of R&D expenditures—but relatively low growth rate of earnings, typical to young, intangibles-intensive enterprises—are systematically undervalued by investors. This is indicated by the high positive risk-adjusted returns such portfolios generate during the five years after formation. This finding makes sense, since companies with high growth of R&D, but low earnings growth, portray the worst performance to capital markets, due to the full expensing of R&D. Given the low reported profitability of these companies, investors apparently heavily discount the prospects of their R&D, hence the undervaluation. When the R&D ultimately bears fruit, investors correct the undervaluation.

Chan et al. (2000) provide corroborating evidence: the returns on portfolios of companies with high R&D expenditures relative to their market values are systematically positive and large, consistent with undervaluation of such companies. This evidence is closely related to that discussed above (information deficiencies leading to high cost of capital); undervaluation implies an excessively high cost of capital. The harmful social consequences are obvious: companies that invest consistently in intangibles (technology, knowledge), yet are still not stellar performers, tend to have a high cost of capital imposed on them by capital markets, impeding investment and growth.[125]

A Level Playing Field?

The most direct evidence on the existence of a unique, intangibles-related information asymmetry, between managers and investors, and the exploitation of such asymmetry by some executives comes from a study of insider gains in R&D companies (Aboody and Lev, 2000). Corporate executives’ compensation packages are heavily weighted with stocks and stock options, particularly in technology and science-based companies (e.g., biotech). These executives are, of course, allowed to trade in the shares of their companies, but they are prohibited from trading on material “inside information,” loosely defined as information that would have affected investors’ decisions, once disclosed. Corporate executives, along with other insiders, are required to report their trades to the SEC no later than the 10^th day of the month following the trade. This publicly available information about insider trades allows researchers to examine important issues, such as the extent of insiders’ profits, the relevance of inside information to investors and the adequacy of regulation concerning insiders’ gains.[126]

Aboody and Lev (2000) examine all trades by corporate officers in the stocks of their companies, over the 1985–1998 period, and conclude the following: (a) Gains to insiders in companies with R&D activities are, on average, 3–4 times larger than insiders’ gains in companies without R&D.[127] (b) When insiders’ trades in R&D companies are publicly disclosed through the SEC filings—on average, one month after the trades were executed—investors react to the information by buying shares when insiders’ purchases are reported, and selling upon being informed that insiders unloaded shares (approximately one month previously). This evidence thus indicates that intangibles create significant information asymmetries (e.g., managers knowing about a drug failing clinical tests, a software program successfully passing a beta test, or an acquired technology that failed to live up to expectations, well before investors), and that much of this information is kept from investors until the disclosure of insiders’ trade (hence investors’ reaction to such disclosure).

The private and social harms of such information deficiencies are obvious: insiders’ gains come at the expense of outside investors. Furthermore, excessive insider gains erode investors’ confidence in the integrity of capital markets, leading to thin trades and a decrease in the social benefits from large, transparent capital markets (e.g., in optimally allocating investors’ capital). The prospects of gains from inside information may also distort the incentives of some managers, leading to decisions and actions that are not in the best interest of shareholders and society.

The Deteriorating Usefulness of Financial Reports

The strength of correlation between a message (e.g., an earnings report) and receivers’ reaction to the message (e.g., stock price changes around the earnings release) is an effective measure of the information content or usefulness of the message. Low correlation, indicating that the message did not trigger significant action by receivers, suggests that the message was not very informative; whereas high correlation—strong receivers’ action—indicates informative messages. Figure 5 (from data in Lev and Zarowin, 1999) portrays the pattern of the association between corporate earnings (of approximately 5000 U.S. enterprises) and stock price changes (returns). The message is unmistakable: reported earnings are playing a decreasing role in the total information affecting investors’ decisions.

What about other information items? Lev and Zarowin (1999), Brown et al. (1999), and Chang (1999) document a decreasing pattern of association between stock returns and various key financial variables, such as earnings, cash flows and book (equity) values. And what about nonaccounting information? Amir et al. (2000) added to the set of financial (accounting) variables the present value of five-year forecasts of earnings made by financial analysts. Presumably, analysts are privy to considerable information beyond the financial reports, and they reflect this information in their earnings forecasts. Hence, combining the information in financial reports with that in analysts’ forecasts, and correlating the combined information with stock returns (reflecting the consequences of investors’ decisions), will indicate the usefulness of all the information available to investors (from financial reports and other sources). Estimates by Amir et al. (2000) clearly indicate that the decreasing pattern of usefulness, portrayed in Figure 4, holds also for the wide information set, combining financial and other information. Interestingly, where financial information fails the most—intangibles-intensive enterprises—the contribution of financial analysts is the largest. Yet, even with this differential contribution of analysts, the decreasing trend of usefulness of publicly available information over the past two decades is unmistakable.

Why the deterioration in the usefulness of information available to investors? The following surface as “culprits”: (a) the fast increase in the proportion and importance of knowledge-based, intangibles-intensive companies in capital markets, and (b) the deficiency of information concerning the assets and activities of these companies. Herein lies the main social harm: the current economic environment is characterized by a fast pace of change and high uncertainty. In such an environment, relevant and reliable information is a crucial guide to mangers’, investors’, and policymakers’ decisions. Failure of the major information system—corporate financial reports—in this economic environment is particularly damaging.

Manipulation Through Intangibles

Since R&D and other intangible investments are immediately expensed in financial reports, changes in these expenditures affect the bottom line—earnings—dollar for dollar. The temptation to change the level of investment in intangibles in order to “manage” reported earnings is, therefore, large.[128] Indeed Darrough and Rangan (1999) document that, in the year of initial public offering (IPO), firms tend to have decreased R&D levels, and consequently higher reported earnings, apparently in an attempt to improve investors’ perceptions about the company’s prospects. Similar evidence on the use of R&D to “manage” earnings is also provided by Bushee (1998).

Surprisingly, some companies even publicly announce the use of R&D as an “earnings booster.” For example, in a report on Eastman Kodak’s warning to investors of weak sales and earnings, The Wall Street Journal (September 27, 2000, p. B8) quotes Kodak’s chief financial officer (CFO) saying that Kodak is considering “belt-tightening measures, including a cut in digital [cameras] research and development.” The broader concern, of course, is that some managers may harm the long-term prospects of their companies to meet short-term earnings targets.

Summarizing, economic theory attributes seriously harmful private and social consequences to information asymmetry: decreased social gains from trade, high cost of capital—and the consequent impediments to corporate growth—and abnormally large gains to insiders at the expense of outside investors.

Dated accounting and reporting rules concerning intangibles contribute to information asymmetry. Empirical evidence indeed indicates that this information asymmetry leads to the predicted undesirable consequences, namely, systematic mispricing of securities, high cost of capital, and excessive gains from insider trading.

IV.5 Takeaway Thoughts

¨ The distinction between the accounting treatment of tangible and intangible assets originates from substantive differences between the two types of assets: the partial excludability, high uncertainty, and non-tradability attributes of intangibles. While these attributes may provide some justification for applying specific accounting measurement rules (e.g., the expensing of employee training costs), they do not provide any justification for denying investors fundamental information about intangibles (e.g., the disclosure of employee training costs in footnotes). Measurement and valuation difficulties concerning intangibles should not provide an excuse for nondisclosure of relevant information about intangibles.

¨ The major players in the information arena—managers, auditors, financial analysts—are generally comfortable with the current disclosure (rather nondisclosure) environment concerning intangibles. The immediate expensing of internal and acquired R&D, for example, is a recipe for boosting future growth of reported earnings. It also decreases embarrassment and litigation exposure. In such a “comfortable” arrangement, it will take more than the frequently heard calls for “voluntary information disclosure” and a “period of experimentation” to generate a significant change in the information environment.

¨ Hard evidence regarding the harmful private and social consequences of the disclosure environment of intangibles (both within business organizations and in capital markets) is fast accumulating. From excessive cost of capital through manipulation of financial information, to abnormally high insider gains, the evidence indicates that significant information asymmetries lead to serious private and social harms. There is, thus, a scientific base for substantial improvement in information disclosure concerning intangibles.

The value chain of businesses generally starts (left column in Figure 6) with the discovery of new ideas for products, services or processes (consider Cisco’s online product installation and maintenance system as an example of a business process). Such ideas can emanate from the firm’s internal R&D process (top box) or from employees’ networks, such as Xerox’s Eureka system—which shares information and experience among 20,000 technicians—or Bristol Myers Squibb’s R&D intranet system. Increasingly, knowledge and ideas are obtained from the outside (middle box, left column), embedded in acquired assets. In many companies the acquisition of technology and R&D-in-process now surpasses internal R&D (Cisco Systems, for example).

Knowledge is also “acquired” by learning from and imitation (reverse engineering) of others. This process—termed by economists “R&D spillovers”—refers to the benefits to organizations (or nations) from the innovative activities of others. Effective and systematic organizational learning requires specific capacity to learn (“adaptive capacity”), as indicated by a specially designated and staffed corporate function with qualified personnel, who are actively engaged in learning (e.g., scientists liaising with universities and research institutes).

The third major source of new ideas and knowledge, particularly prominent in the modern corporation, is active and formal networking (bottom box, left panel in Figure 6). Research alliances and joint ventures, and the integration of suppliers/customers into the firm’s operations (e.g., Dell’s BTO computers) provide valuable information for the design of new products/services/processes, and their improvement.

These internal, external, and networking sources of information and ideas initiate the value chain. They generally require significant and consistent allocation of resources, while constituting the most knowledge-intensive phase of the value-chain.

The next phase of the value chain (middle column in Figure 6) marks the crucial stage of achieving technological feasibility of the products/services/processes under development. In a sense, this marks the transformation of ideas into working products. Given the large variety of products and services developed by business enterprises, technological feasibility is marked by numerous milestones. In some cases, patents and trademarks signal a feasible product (although quite often patents are issued at a very early stage of the development phase). In other cases, the successful passing of formal feasibility tests, such as clinical test for drugs, or beta test for software programs, is the mark of feasibility (second box in the middle column).

Increasingly, Internet and intranet technologies offer quantitative measures indicating technological feasibility. Thus, for example, online operations that gained a reasonable number of visitors (indicated by such frequently used traffic measures as “Reach,” see Demers and Lev, 2000)—and even more importantly, repeat visitors (indicated by “loyalty” traffic measures)—clearly exhibit a certain degree of technological feasibility of network operations. J.C. Penney, for example, recently had 1.3M unique visitors a month (repeat visitors are counted only once) to its web site—more than any other retailer of apparel and home furnishings.[130] This is clearly an indication of a successful web site.[131] Technological feasibility marks a particularly important phase of the value chain, bringing with it a substantial reduction in the risk associated with new products and services (recall the discussion of the risk of intangibles in Part II). Thus, information on technological feasibility provides investors and managers important risk gauges.

The final phase of the value chain, commercialization (right column in Figure 6), signifies the successful realization of the innovation process. Ideas, transformed into workable products and services, are in turn brought expeditiously to the market to generate earnings exceeding the cost of capital. That’s what a business enterprise is all about.

The proposed information system is aimed at portraying the enterprise’s success in carrying out the value chain process. Note that this information is factual; it does not contain forecasts of future plans and strategies.[132] Accordingly, managerial concerns with shareholder litigation, which generally allege reckless or manipulative forward-looking managerial statements, do not apply here.[133] To operationalize the information system, we of course need specific metrics. These will be outlined below, but first a word about the relationship between the proposed system and accounting.

And What About Accounting?

It is widely recognized that current accounting systems do not convey relevant and timely information about the value chain (business model). Investment in discovery/learning, both internal and acquired, is expensed immediately in financial reports, by and large, with most expenditures (e.g., on employee training, software acquisitions, investment in Web-based distribution systems) not even separately disclosed to investors. The transaction-based accounting system all but ignores the implementation stage of the value chain (e.g., a Food and Drug Administration (FDA) drug approval, a patent granted, or a successful beta test of a software product), although considerable value creation generally occurs during this stage. And even the commercialization stage, which generates recordable costs and revenues, is reported in a highly aggregated manner, defying attempts to evaluate the efficiency of the firm’s innovation process, such as the assessment of return on R&D or technology acquisition, the success of collaborative efforts, or the firm’s ability to expeditiously “bring products to the market.”

These limitations of accounting-based information are rooted in the structure of accounting, which essentially reflects legally bounding transactions with third parties (e.g., sales, purchases, borrowing funds, stock issues). In the industrial and agricultural economies, most of the value of business enterprises was created by transactions—the legal transfer of property rights. In the current, knowledge-based economy, much of the value creation or destruction precedes, sometime by years, the occurrence of transactions. The successful development of a drug, for example, creates considerable value, but actual transactions (sales) may take years to materialize. This is, by the way, the major reason for the growing disconnect between market values and financial information.

Viewed from this perspective, the prosposed information system, which focuses on the fundamental phases of the value chain, precedes and complements accounting-based information. Accounting, in a sense, provides a final “reality check” on the proposed system of value creation/destruction as products/services/processes move along the value chain.

It should also be noted that two important aspects of intangible assets, and the modern corporation in general—scalability through networking and high risk—are all but ignored by the traditional accounting system, but portrayed in detail by the proposed system. As Figure 6 demonstrates, the three phases of the value chain highlighting the scalability efforts of the organization capture both the investment and outcome of various networking activities (e.g., employee communities of practice, R&D alliances, customer/supplier integration, online sales). Concerning risk, the progress of products and services along the value chain marks a continuous reduction in the associated risk. Furthermore, the value chain portrays various risk-hedging activities of firms (such as conducting R&D with partners), along with associated outcomes. The proposed information system thus complements and substantially expands on the traditional accounting system.

V.5 The Scoreboard

Figure 6 provides an outline of the value chain (innovation) process of a modern company. For disclosure purposes, both within the enterprise and to outsiders, the value chain configuration has to be transformed into a parsimonious set of measures: a scoreboard. What should be the nature of these measures?

I propose the following three criteria for the choice of measures comprising the value chain scoreboard:

1. All measures are quantitative. Qualitative aspects of the value chain (e.g., employee work practices, patent cross-licensing) will be discussed in an annex to the scoreboard.

2. The measures are standardized (or easily standardizable), meaning that they can be compared across firms for valuation and benchmarking purposes. Nonstandardized measures, such as employee satisfaction indicators, are of limited usefulness.

3. Most important, research has shown that the measures are relevant to users, generally by establishing a significant statistical association between the measures and indicators of value (e.g., stock return, productivity improvement).

There are 10 fundamental links in the value chain scoreboard (boxes in Figure 6). I will consider each of these 10 links, outlining the specific measures proposed for disclosure. Note: the large number of measures mentioned below is due to the large variety of business enterprises. For a given organization, typically no more than 10–12 indicators will suffice.

1. Internal renewal.

Voluminous evidence (surveyed in Part III) indicates that, on average, investment in R&D, IT, and customers pays off in terms of increased productivity and capital market values of companies. Therefore, I propose the disclosure of periodic R&D expenditures, meaningfully classified; for example, R&D aimed at new products, improvement, or maintenance of existing products, and cost containment R&D (process R&D). Expenditures on the internal development of information technology should also be disclosed and classified meaningfully. Data relating to customer acquisition costs (particularly relevant for Internet companies) should be disclosed, and these should be reported separately from advertising and marketing expenses. Expenditures for employee training enable the assessment of companies’ human resource practices, and should therefore prove useful to decision makers. These are the major components of the internal investment in renewal.

2. Acquired knowledge.

Data disclosing the acquisition of technology and R&D-in-process, as well as information supporting IT acquisition—classified to software and hardware—are useful to decision makers. If the company has a formal “adaptive capacity” function, aimed at the systematic learning from others, data on the periodic expenditures on this function will also augment decision-making capabilities.

3. Networking.

This category of the discovery phase of the value chain calls for information on the number of R&D alliances the company is engaged in, the total investment in such alliances, and the investment in the integration of customer/supplier systems (e.g., involvement in business-to-business (B2B) exchanges). In the qualitative annex to the disclosure system, information elucidating the stage of alliance development (initial stage, product development stage, or dormant) will prove useful. For Internet enterprises, the presence/absence of alliances with “top players” (e.g., AOL, Yahoo!) reveals much.

The above-mentioned measures, which portray the discovery/learning phase of the value chain, are essentially factual cost data, easily available to all corporations. It is often stated that, when it comes to intangibles, cost (investment) data are irrelevant because “cost is unrelated to value.” This statement is both empirically wrong an informationally irrelevant. The extensive survey of empirical evidence provided in Part III of this report makes it abundantly clear that the cost of intangibles is, on average, highly correlated with (closely related to) value. On average, the more the enterprise spends on R&D, IT, or customer acquisition; the higher the value added in terms of productivity, earnings, and market values.

The statement about the irrelevance intangibles’ of cost data also ignores the importance of such data for any return on investment analysis. The original price one has paid for a stock may not be the best indicator of its current or future value, but it is an indispensable component of the return-on-investment calculation. Cost (investment) data of intangible capital are, therefore, an essential piece of the value chain puzzle. Information on various aspects of the value of intangibles provides the missing pieces. Such value-related information is outlined thus.

4. Intellectual property.

This first link in the implementation phase (middle column in Figure 6) refers to data on intangibles secured by legal rights. The number of patents, trademarks, and copyrights registered during the period, as well as patent renewals, provide the rudimentary information. Empirical research (e.g., Deng et al., 1999; Hall et al., 2000) indicates that various attributes of patents, such as the number of citations to the firm’s patent portfolio contained in subsequent patents (“forward citations”), are important indicators of the quality of the firm’s science and technology. A variety of information pertaining to patent attributes may be obtained from specialized vendors. The qualitative annex can include a brief discussion of the firm’s efforts to appropriate the benefits of its legal property, such as the state of litigation of patent infringement.

Of particular importance are data on royalties received from the licensing of patents and know-how. Gu and Lev (2000) report that investors place higher value on such royalties than on most other components of income, probably due to the long-term nature of license agreements. Furthermore, royalties assist investors in valuing the prospects of R&D expenditures of companies. The R&D expenditures of firms with substantial royalty income are accorded higher market valuations than R&D of companies lacking royalties, probably because the existence of customers for the firm’s patents attests to the superior value of its R&D. Surprisingly, some companies known to have significant royalty income (e.g., IBM, Texas Instruments) do not disclose this information. Thus, data on the intellectual properties of companies (legally protected intangibles) provide the first intimation of the value of intangibles.

5. Technological feasibility.

This marks a crucial stage in the value chain and an important indicator of risk reduction (Part II). Resulting information from clinical and feasibility tests (e.g., beta test for software), can be most effectively communicated in a qualitative manner. For on line (Internet) operations, the state of technological feasibility can be communicated by “traffic (eyeball) measures,” such as unique visitors to the site, or “Reach” (percentage of unique visitors of total web users). Such measures—collected by specialized companies (e.g., Nielsen/Netrating, Media Metrix)—can be used for benchmarking and were shown (e.g., Demers and Lev, 2000) to be statistically associated with market values. The company can provide this information to investors at substantially lower cost, compared with its purchase by individual investors.

6. Customers.

Relevant customer information includes the number of marketing alliances and investment therein. For Internet companies, quantitative information on customers’ “stickiness”—that is the extent of web usage (e.g., time spent, on average, in the firm’s site, number of pages read, etc.)—as well as information on customer “loyalty” (e.g., repeat buyers), provide important indicators of the quality of the customer base. The size of the customer base (e.g., number of E*trade subscribers) completes the proposed customer-related section.

7. Employees.

This is arguably the most neglected disclosure area. This is surprising, because in the current, tight labor markets, policies aimed at securing qualified employees and retaining them are of the utmost importance. Accordingly, information on workplace practices (e.g., incentive-based compensation, training) should be provided in the qualitative annex, along with quantitative information illuminating employee retention rates and the structure of the work force. The latter can be conveyed, for example, in the form of the ratio of scientific/technical employees (e.g., scientists, IT personnel, etc.) to total employees—hot skills-to-total workforce.

The data in links 4–7 thus provide information on the intermediate, implementation stage of the value chain. I turn now to the final stage: commercialization.

8. Top line.

Information in this link is aimed at highlighting the impact of the firm’s innovation activities on the top line: revenues of the enterprise. Revenue growth (by product/service segments) and market share data are essential top line information items. Of particular relevance is an indication of the firm’s ability to quickly “bring products to the market.” This may be conveyed by the measure of “innovation revenues,” indicating the percentage of revenues coming from recently introduced products (e.g., those introduced during the last 3–5 years). For example, the stated policy of the highly successful medical-device company Medtronic (total market value $63B in September 2000) is to have “70% of revenue coming from products launched in the previous two years.”[134] The 3M Corporation was among the first to include innovation revenue data in its financial reports.[135]

Finally, highlighting the growing importance of Internet activities, data that documents the share of revenues coming from online activities will prove useful. Similarly for information on the share of revenues generated from networking activities (alliances and joint ventures). Of particular importance are data on customer online purchases (complementing the traffic data discussed above). For example, in the 1999 Christmas season, a J.C. Penney’s customer spent, on average, $151 in online purchases, second only to Ebay successful take of $152 per customer.[136]

9. The all-important bottom line.

The accounting system provides the fundamental information on earnings and cash flows. Additional relevant bottom-line information includes data on productivity gains from R&D activities and the cash “burn rate” (number of quarters of operations that can be supported by available liquid resources) for start-ups. Given the popularity of various measures of “value added,” namely earnings minus a charge for the cost of equity capital, it seems reasonable to report these measures.[137]

10. Growth options.

Economic theory postulates that the value of a business enterprise equals the value of “assets in place” (i.e., the firm’s assets minus liabilities) plus the present value of growth options. The latter is the present value of future “abnormal earnings,” namely the part of earnings that exceed the cost of equity capital. For most modern enterprises, the component of value derived from the growth options far exceeds that related to “assets in place,” which are mostly physical and financial assets, as evidenced by the market-to-book ratio (Figure 1, Part I). Accordingly, information on growth options—hard data rather than “dreams”—is an important part of the value chain scoreboard.[138]

Growth option information includes data supporting products in the pipeline and expected launch dates (routinely disclosed, for example, by pharmaceutical and car companies; see FASB, 2000), information on expected cost savings from restructuring activities, planned major capital expenditures (provided, for example by chemical companies; FASB, 2000), and expected growth of markets in which the firm operates, and its expected shares in those markets (provided according to FASB (2000) by chemical companies). For pharmaceutical companies, information detailing “off-patent products” (the expiration dates of patents for major products) is of considerable importance for assessing growth option.

A Parsimonious Scoreboard?

At first blush, the large number of measures outlined above may seem overwhelming and, therefore, impracticable. This is not so. The list is large because it covers the relevant information of a wide variety of enterprises. A typical company will have a parsimonious set of 10–12 key value chain indicators. For example, I expect a biotech company to report the following value chain scoreboard:

Discovery/Learning

1. Investment in internal and acquired R&D, classified by types of R&D.

2. Investment in alliances/joint venture; total number of such alliances; active and dormant ventures (including data on the investments of alliance partners).

3. Investment in information technology.

Implementation

4. Number of new patents, and attributes of (e.g., citations to) the company’s patent portfolio. Trademarks and copyrights, if any.

5. Cross-licensing of patents and royalty income from patent licensing.

6. Results of clinical tests and FDA approvals.

7. Employee retention data and workforce structure (e.g., ratio of scientists and R&D personnel to total employees).

Commercialization

8. Innovation revenues (percentage of revenue from recent products).

9. Revenues from alliances/joint ventures.

10. Cash burn rate.

11. Product pipeline; expected launch dates of new products; products off patents.

12. Market potential for major new products.

This is obviously a parsimonious list of indicators, providing an important complement to currently disclosed data.

V.6 Eliciting Disclosure

The proposed value chain scoreboard is aimed at informing both managers and investors—at different levels of detail and frequency, of course—about the company’s innovation activities. Corporate decision makers will presumably secure value chain information as needs arise. But how will investors obtain such information? What will motivate managers to publicly disclose this information in a systematic and consistent manner?

Some believe that it is a matter of time until managers realize that a need exists for extensive, intangibles-related information, and that they will then provide the information. In the meantime, it is argued, “a period of experimentation” with new information modes should be encouraged. Defying this approach is that it flies in the face of reality: if after 10–15 years of unprecedented growth in the value and economic impact of intangibles the FASB (2000, p. 5) still concludes that there is “lack of meaningful and useful disclosures about intangible assets,” one must ask whether this “experimentation process” is working, and how long might it last?

The second approach at eliciting information from managers centers around the creation of the “right incentives for information disclosure.” By right incentives the advocates of this approach generally mean the strengthening of safe-harbor rules shielding managers from shareholder litigation. There are two major problems with this approach. First, there are already reasonably strong safe-harbor rules for forward-looking managerial disclosures. Any considerable strengthening of these rules will come close to completely immunizing managers from shareholder litigation. Is this in the public’s interest? Moreover, economic theory (“optimal signaling”) postulates that, for a message to be credible and effective, there must be a considerable penalty for misinformation. Clearly, the more effective the safe-harbor rules, the less credible the disclosed information will be. The second problem with the proposal to enhance safe-harbor rules in order to motivate the disclosure of intangibles-related information is that most of this information is historically based (factual), rather than forward looking. For example, of the 10 links in the proposed value chain scoreboard (Figure 6), the first nine deal with factual information. Safe-harbor rules are largely immaterial for such information.

The Dual Role of Accounting Policy

Accounting policymakers such as the FASB, the Securities and Exchange Commission (SEC), and the American Institute of Certified Public Accountants (AICPA) (and corresponding bodies in other countries) have dual roles: they prescribe (mandate) information structures (e.g., a cash flow statement) and individual items (e.g., employee stock option information) that have to be disclosed in financial reports, and they attempt to establish standards—a common language of disclosure. The former, regulatory role of policymakers is widely known and often contested by corporate managers. The latter, standardization role is much less appreciated. An example of the standardization role of accounting policymaking is the FASB’s “conceptual framework,” which consists of six extensive statements outlining the nature and measurement of financial information items, such as assets, liabilities, revenues, and expenses; as well as the fundamental postulates underlying accounting principles, such as relevance, reliability and materiality.[139]

Notably, there is no regulation (required disclosure) in the “conceptual framework,” rather an attempt to create a uniform standard of measurement and disclosure. The discussion of “assets,” for example, outlines the characteristics required from an asset to be recognized in financial reports (e.g., future economic benefits, the enterprise has control over these benefits, etc.), as well as valuation criteria for assets (e.g., write-off in case of impairment).[140] Such standardization creates a useful language; it enables users of financial reports to understand the meaning of the numbers presented in financial statements (e.g., that asset values on the balance sheet refer to historical costs, and not current values), and to compare the information across companies. Such standardization through common-language creation is, I believe, required to elicit wide disclosure of intangibles-related information to investors.

Standardizing Information on Intangibles.

I propose that an appropriate accounting policymaking body, preferably the FASB with strong encouragement and oversight by the SEC, will take upon itself the major task of standardizing intangibles-related information. By standardization, I mean the following: (a) creating a coherent structure of information, and (b) defining the individual information items composing the information structure. By information structure, I mean a comprehensive set of interrelated reports, such as the current balance sheet/income statement/cash flow statement nexus that constitutes the backbone of conventional financial statements, or the value chain scoreboard outlined in this report. The individual information items that make up the intangibles report—such as expenditures on customer acquisition, Internet traffic measures, or innovation revenues—will require careful definition (e.g., what goes into customer acquisition costs), and valuation criteria must be clearly specified (e.g., should customer acquisition costs be amortized—and how?).

This is obviously not the place to delve into the details of the proposed standard-setting task; but, given the extent and pervasiveness of intangibles, it is obviously a major endeavor. However, the extensive experience of accounting policymakers in setting standards for financial information will come handy.

I strongly believe that if a coherent, well-defined and information-relevant system will be developed to reflect major attributes of intangible assets and their role (along with other assets) in the overall value creation process (business model) of the enterprise, most managers will respond by disclosing the proposed information. The reason for my optimism is that the availability of a new disclosure structure, endorsed by the major accounting policymaking institutions—and perhaps by other influential bodies (e.g., the big-five accounting firms)—will initiate the “information revelation process” discussed in Part IV. Enterprises with “good news” (e.g., high innovation revenues, successful alliances) will start disclosing, in effect “forcing” others to join ranks. No news is bad new in capital markets—silence is penalized.

V.7 Takeaway Thoughts

¨ The key to achieving substantial improvement in the disclosure of information about intangibles is to construct a comprehensive and coherent information structure that focuses on the big picture—the value creation (innovation) process of the enterprise—and places intangible assets in their proper role within this structure. This will clarify to managers what is rather obscure now, i.e., what is useful information about intangibles.

¨ While focusing on what information yields functionality through disclosure, it is equally important to clarify what does not. In particular, managers should not be expected to disclose values of intangibles, despite the frequent calls for such information by commentators. Determination of asset and enterprise value is better left to outsiders (e.g., financial analysts).

¨ Short of enacting new disclosure regulation, for which there is no current appetite, the way to induce the release of meaningful information about intangibles is for policymakers to establish an information standard. Standards have previously worked wonders in eliciting production and widespread participation. A standard scoreboard, such as the one outlined above, portraying the innovation process of businesses and focusing on the intangible investments generating this process, will drive a large number of companies to provide new and useful information, internally and externally.

[1] Philip Bardes Professor of Accounting and Finance

Stern School of Business

New York University

(212)998–0028

blev@stern.nyu.edu

www.baruch-lev.com

This manuscript will be published by the Brookings Institution in 2001. This version is missing the bibliography and two appendices.

[2] For example, Thomas Stewart’s book Intellectual Capital (Doubleday, 1997) was among the first comprehensive books in the area and still is an excellent source on intangible (intellectual) assets.

[3]. By a recent count, Merck has close to 100 R&D and marketing alliances (Tompson )!

[4]. Hearing held on July 19, 2000. Testifying experts (alphabetically) were: Robert Elliott (KPMG), Baruch Lev (New York University), Steve Samek (Arthur Andersen), Peter Wallison (American Enterprise Institute), and Michael Young (Willkie Farr & Gallagher).

[5]. I will elaborate on these biases in Section XXX.

[6]. This, of course, is an oversimplification, since physical assets and some financial assets are presented on the balance sheet at historical cost. Market values will reflect the difference between the current and historical costs of these assets. However, even when this difference is accounted for by computing Q-ratios (market values to replacement cost of assets), this ratio currently surpasses 3 (See Hall 2000), indicating that the value of intangible assets is three times larger, on average, than that of physical assets.

[7]. I intentionally avoid in this report popular clichés, such as new economy, information revolution, etc.

[8]. Movement “up the value chain,” such as Ford’s outsourcing and spinning off car supplies, pushes suppliers “down the value chain”: “Lear Corp., doesn’t make Internet switching gear in Palo Alto, Calif. Instead, the Southfield, Mich., company makes seats, electrical systems and other interior parts for the cars and trucks that New Economy millionaires rush out to buy with their stock gains—and Lear gets precious little respect from Wall Street…Despite growth profiles and profits that put many Internet companies to shame, Lear seems to have a permanent lease in the Dow’s Doghouse." (The Wall Street Journal, July 21, 2000, p. B4).

[9]. “It [the industrial era corporation] was asset intensive, because the first companies in each sector that could exploit the economies of scale and scope gained a formidable advantage vis-à-vis new entrants. At the same time, it was very highly vertically integrated, because the need to ensure the right level of throughput, at a time when the market for intermediate goods was just developing, forced companies to take direct control of their suppliers and distribution systems.” (Zingales, 2000, p. 28). See also Chandler (1977, 1990).

[10]. “Physical assets, which used to be the major source of rents, have become less unique and are not commanding large rents anymore. Improvements in capital markets, which have made it easier to finance expensive assets, have certainly contributed to this change, as has the drop in communication costs, which reduced the importance of expensive distribution channels, which favors the access to the market of newly formed companies. Increased competition at the worldwide level has increased the demand for process innovation and quality improvement, which can only be generated by talented employees. Thus, the quest for more innovation increases the importance of human capital.” (Zingales, 2000, p. 29).

[11]. The New York Times has recently reported XXX

[12]. Robert Gordon, for example, argues that recent information-related innovations do not measure up to many previous ones:

“I have argued that the current information technology revolution does not compare in its quantitative importance for MFP [multi-factor productivity—productivity gains generally ascribed to innovation and technological change] with the concurrence of many great inventions in the late nineteenth and early twentieth century that created the modern world as we know it. There are four major clusters of inventions to be compared with the computer, or chip-based IT broadly conceived. These are:…electricity, including both electric light and electric motor…the internal combustion engine, which made possible personal autos, motor transport, and air transport…petroleum and all the processes that “rearrange molecules,” including petrochemicals, plastics and pharmaceuticals…the complex of entertainment, communication and information innovations that were developed before World War II [e.g., telephone, radio, movies, television, recorded music].” (Gordon, 2000, pp. 35–36).

[13]. The emergence of innovation as a major economic activity is also reflected in the development of “growth theory” in the economic literature. Early models (e.g. Solow **) considered innovation, or technological change, as exogenous, namely outside the scope of the economic system (Manna from heaven). Recent growth models, in contrast, consider innovation as endogenous, namely an economic activity on par with the employment of capital and labor (on endogenous growth models, see Romer 1988, 1990).

[14]. Nakamura (2000, p. 19–20) writes: “Schumpeter…argued that what is most important about a capitalist market system is precisely that it rewards change by allowing those who create new products and processes to capture some of the benefits of their creations in the form of short-term monopoly profits…These monopoly profits provide entrepreneurs with the means to (1) fund creative activities…(3) widen and deepen their sales networks so that new products are quickly made known to a large number of customers…Thus, while Adam Smith saw monopoly profits as an indication of economic inefficiency, Joseph Schumpter saw them as evidence of valuable entrepreneurial activity in a healthy, dynamic economy.”

[15] After all, the accounting for physical assets in financial statements is as deficient as the accounting for intangibles. True, physical assets are capitalized (i.e., recognized as assets), but they are recorded at historical costs, and depreciated by ad hoc, unrealistic schemes (e.g., 10-year straight-line depreciation). What economic inferences about value and performance of physical assets can be drawn form their balance sheet values? Essentially none. For the sake of concreteness, think about the relevance to current managerial or investors’ decisions of the cost of commercial property constructed in New York 10 years ago, or of mainframe computers acquired five years ago.

[16].Paul Romer (e.g., 1997, 1998) has elaborated on the nonrival, or non-scarcity attribute of intangibles (“Software” in his terminology), particularly in the context of economic growth theory.

[17]. Sunk cost means that if the drug or software fails the market test, the initial investment has no alternative use.

[18]. Good management can, of course, extract considerable efficiency gains from physical assets, too. The Economist (November 13, 1999, p. 72) describes the experience of Ryanair minimizing service cost and turnaround time of airplanes by using secondary airports, thereby gaining three hours from six turnarounds, and letting each aircraft make two more flights a day than otherwise possible. Such gains, though significant, ultimately reach decreasing returns.

[19]. This case was prepared by Professor Bruce Weber, 1998, Baruch College, City University of New York.

[20]. In December 1999, AMR announced its intention to distribute to shareholders its 83% ownership interest in Sabre, thereby transforming Sabre to a 100% publicly traded company.

[21]. From Forbes, November 29, 1999, p. 54.

[22]. See Shapiro and Varian (1999, ch. 7) for an illuminating discussion of network effects.

[23]. See Goolsbee and Klenow (1999) for the positive network effects on the adoption of home computers (people are more likely to buy their first home computer in areas where a high fraction of households already own computers).

[24]. From testimony on the state of competition in the airline industry before the Committee on the Judiciary, House of Representatives, May 19, 1998.

[25]. From www.sabre.com (investor relations).

[26]. See Shapiro and Varian (1999, pp. 208–223) for fascinating case histories of the evolution of standards in railroad gauges, AC system of electrical power, color television, and high-definition television.

[27]. Assuredly, a certain degree of standardization is desirable for most products, not just intangibles. Thus, for example, standardization of the height of car bumpers will reduce damage in minor collisions.

[28]. Nevertheless, the number of first mover success stories is almost matched by the number of first mover “disasters.” The $5B Iridium project, a pioneer of satellite service is now in bankruptcy. Similarly, the Newton, Apple’s pioneering entrant in the hand-held computer market, is now defunct.

[29]. The generality of “positive feedback” (path dependence) and “lock in” phenomena were recently contested by Leibowitz and Margolis (1999). Based on careful research, the authors argue that even the classic lock in—the QWERTY case of keyboard arrangement of typewriters and computers, where an allegedly inferior arrangement survives because of lock-in—is in fact unsubstantiated. There is no evidence, according to the authors, that competitor systems were more efficient than QWERTY. They argue that lock-in cases, where inferior technologies survive, are rare and perhaps nonexistent.

[30]. In some cases, “first movers” can secure temporary monopoly rents even without a patent. AOL is a case in point.

[31]. Consider, for example, the complicated and risky strategies discussed by Shapiro and Varian (1999, chs. 7 and 9) for success in network markets.

[32]. Only when the training is perfectly “company specific,” namely of no use to others (e.g., training in a production system unique to the company), is the investing company excluding others from the benefits of training. Such company-specific human capital is, of course, rare.

[33]. See Hall and Ham (1999) for a reconciliation of this survey evidence with the significant rise in the rate of patenting in the past decade.

[34]. Bell Laboratories (Bell Labs) was a subsidiary of AT&T until the spin-off of Lucent Technologies by AT&T in September 1996. Bell Lab is now a subsidiary of Lucent.

[35]. The data for this example are taken from Freeman and Soete (1997, p. 178).

[36]. For elaboration on the television patents and major actors, see “Who Really Invented Television?” Technology Review, September–October 2000, pp. 96–106.

[37]. An information-sharing system of this type—Eureka—was developed by Xerox for its 25,000 technicians. Such formal systems, however, are still rare.

[38]. Until 1993, when Louis Gerstner became IBM’s CEO, patent licensing income was negligible. Gerstner set up a licensing operation, which is estimated to have generated more than $1B revenues in 1998 (see X).

[39]. For control as related to asset recognition, see ***.

[40]. Nakamura (2000, p. 20) writes: “The more valuable the product, the greater the reward to its creator [private return] should be. And that’s exactly what a patent or copyright does…At the same time, it remains true that the temporary monopoly [from a patent] itself deprives society of the full value of the creation, since, to secure their monopoly profits, firms limit supply. Thus, the full value of the creation is realized only when the monopoly ends.”

[41]. In statistics and decision theory, risk is distinguished from uncertainty. Risk is the situation where the random variable is defined by a reasonably known probability distribution, such as the distribution of the rates of return on stocks. Uncertainty is the case where even the distribution of the random variable (e.g., the payoffs from a radically new drug under development) is unknown. Despite this conceptual distinction, I will use in the Bayesian tradition the terms risk and uncertainty interchangeably.

[42]. The total loss prospects of intangibles are often driven by the “winner-take-all” characteristic of many information and high tech sectors (See Shapiro and Varian, 1999, ch. 7). Where winners take all, losers take nothing.

[43]. Since R&D is the only major intangible investment that is separately reported by public companies, much of the empirical research on intangibles naturally focuses on R&D.

[44]. The place of basic research in the innovation process is actively debated, and clearly varies across industries and technologies. The “linear model,” where basic research initiates the R&D process, does not always represent reality.

[45]. Shapiro and Varian (1999, p. 21) note: “The dominant component of the fixed costs of producing information are sunk costs, costs that are not recoverable if production is halted. If you invest in a new office building and you decide you don’t need it, you can recover part of your costs by selling the building. But if your film flops, there isn’t much of a resale market for its script. If your CD is a dud, it ends up in a pile of remainders at $4.95 or six for $25. Sunk costs generally have to be paid up front, before commencing production.” These comments apply equally well to many intangibles, such as R&D and investment in brands and human capital.

[46]. The decreasing risk along the innovation process was quantified by Mansfield (1977, pp. 22–32) more than 20 years ago. Examining the outcomes of individual R&D projects in 16 chemical, pharmaceutical, electronics and petroleum companies, Mansfield estimated the mean probabilities of success (evaluated across companies and projects):

1. Probability of technical success: 0.57

2. Probability of commercialization (selling a product), given technical success: 0.65

3. Probability of financial success (return on investment equal to or higher than the firm’s cost of capital), given commercialization: 0.74

As noted by Scherer et at. (1998), the above success probabilities are probably overstated, since the projects Mansfield examined were mostly from large, well-established enterprises. Nevertheless, Mansfield’s estimates corroborate the general phenomenon of decreasing level of risk (or increasing prospect of success), as products move along the innovation path.

[47]. Uncertainty is also higher at the firm or project level than at the economy or society level. Thus, for example, a specific firm faces the risk that its developed technology will be imitated by competitors. Society will often gain from such imitation (e.g., lower product prices). Bell Laboratories’ development of the transistor, cited above, demonstrates this point.

[48]. I emphasize organized markets because, in principle, markets exist whenever trade takes place. Accordingly, when firm A licenses a patent to firm B, a market exists. What distinguishes intangibles from most other assets is the absence of organized, active exchanges with numerous participants and transparent prices (e.g., stock and commodity exchanges).

[49]. “But on the whole, particularly in the case of ‘general knowledge,’ the unimportance of marginal costs compared to average costs of producing new knowledge leads to a nonfunctioning of competitive market mechanisms…” (Nadiri, 1993, p. 16).

[50]. See http://pl-x.com for a description of valuation and insurance services for patents.

[51]. For example, on August 25, 1999, Cisco Systems announced the acquisition of Cerent Corp., a maker of devices that route telephone calls and Internet traffic on and off fiber-optic lines. Cerent posted a mere $10M in sales in the six months ending June 1999, and was acquired by Cisco for an astounding price of $6.9B. Obviously, Cisco was after Cerent’s technology. The extent of the market in technology is demonstrated by the fact that Cerent is the 40^th acquisition of Cisco, itself a young company (established **).

[52]. For a survey of such exchanges, see “Technology Licensing Exchanges,” Research.Technology Management, September–October 2000, Volume 43, pp. 13–15.

[53] In 1998, for example, U.S. public companies’ expenditures on R&D were 4.8% of their total revenues (source: COMPUSTAT).

[54] See Freeman and Soete (1997, Ch. 4) for a discussion of the development and contribution of chemical R&D.

[55] The mean R&D intensity (R&D-to-sales ratio) of chemical companies in 1998 was 3.9%, compared with 12.1% for pharmaceutical companies, 11.1% for software companies, and 4.8% for all companies with R&D expenditures (Aboody and Lev, 2000).

[56] The actual estimation methodology is quite complex (described in detail in Lev and Sougiannis, 1996), using “simultaneous equations.” This methodology is designed to account (control) for the duel causality—from R&D to profits, and at the same time from profits to R&D (i.e., profitable companies can afford to spend more on R&D).

[57] Operating income is defined as income before general, financing, and income tax expenses.

[58] Recall the discussion in Section I.2 about the de-verticilization of integrated companies and the general move toward outsourcing of manufacturing operations.

[59] I refer here, of course, only to R&D increases that are economically justified and well explained to capital markets.

[60] This is the case in the U.S. In many other countries firms are not required to single out even R&D in their financial reports.

[61] For a discussion of these findings and the methodological (statistical) issues involved in analyzing the cost-benefit relationship of R&D, see Griliches (1995).

[62] See Hall (1993a); and for benchmarking estimates of returns on tangible capital, see Poterba (1997).

[63] See Griliches (1995). Related findings concern the importance of university research to industrial innovation (e.g., Mansfield, 1991; Acs et al., 1994).

[64] First-hand evidence of adverse analyst attitudes towards basic research can be found in an article by Richard Mahoney, former chairman and CEO of the Monsanto Company. He describes how, over an extended period, Monsanto developed its biotechnology capacity, while analyst “naysayers offered a constant drumbeat of advice: reduce R&D, sell off any asset that wasn’t nailed down and use the cash proceeds to buy back shares.” (The New York Times, May 31, 1998).

[65] See Mansfield (1991). Striking examples of major contributions of government sponsored R&D to industry are the Internet, funded originally by the Department of Defense as a bomb-resistant communications network, and later developed by the National Science Foundation; and the Human Genome project, which was initiated by the National Institutes of Health.

[66] R&D intensity is the ratio of R&D expenditures to sales. R&D capital, which is not reported on corporate balance sheets, is generally measured by economists using estimates of annual R&D amortization rates, which range 10–15%.

[67] The research using patent counts and citations as R&D output measures is voluminous, and is summarized in Griliches (1989) and Hall et al. (1998).

[68] See, for example, Chan et al. (1992). It was widely believed in the 1980s and early 1990s that, prodded by investors’ “obsession” with quarterly earnings, U.S. managers routinely sacrificed the long-term growth of their firms by curtailing investments, such as R&D, yielding long payoffs but immediate hits to earnings. The evidence of investors’ positive reaction to R&D increases, despite the negative effect of such increases on near-term earnings (due to the immediate expensing of R&D), largely dispels the allegation of investor myopia, at least with respect to R&D.

[69]Ben-Zion (1978), Hirschey and Weygandt (1985), Bublitz and Ettredge (1989).

[70] Chauvin and Hirschey (1993). Recall the large difference in return on R&D of large and small companies in the chemical industry study reviewed in III.1, above.

[71] See, for example, Patel and Pavitt (1995).

[72] The list of citations to previous patents or scientific studies in patent applications is of considerable importance and is checked carefully by patent examiners, since patent citations assist in delineating the “claims,” or property right boundaries, of the invention. Indeed, patent citations are used as evidence in patent infringement lawsuits, see Lanjouw and Schankerman (1997). For a detailed example of patent citations and citation-based indicators, see Deng et al. (1999).

[73] In related studies, Austin (1993) reports that patents identifiable with end products tend to be more highly valued by investors than the average patent, and Megna and Klock (1993) find that the number of patents of rival firms (i.e., technologically stronger competitors) has a negative effect on a company’s q ratio.

[74] The last two findings are from Gu and Lev (2000).

[75] See Demers and Lev (2000).

[76] See Deng and Lev (1998).

[77] Research is, of course, predicated on data availability. Since public corporations do not provide systematic data regarding human and organizational capital, there is scant research on these assets. For example, R&D and advertising expenditures are the only intangibles-specific items about which data are provided in a recent study of intangibles (Nakamura, 1999), because these are the only intangibles-related items routinely disclosed by public companies.

[78] Data obtained from Nakamura (1999, Table 1).

[79] Even this 10-fold increase is an understatement, since the S&P index does not include dividends.

[80] Hall (1999, p. 6) writes: “Firms produce productive capital by combining plant, equipment, new ideas, and organization.” (emphasis mine).

[81] Data on “computer capital” were derived from the Computer Intelligence Infocorp database, which details information technology spending for Fortune 1000 companies.

[82] Recall that the 10:1 contribution multiple of IT is evaluated after accounting for the contribution to market value by both physical assets and R&D.

[83] In fact, Hall (1999, p. 30) attributes the entire difference between market values of companies and the value of their physical assets to organizational capital: “Because the hypothesis makes the total capital stock of corporations observable as the total value of securities, it is possible to quantify otherwise elusive concepts that appear to be central to the modern economy. These are technology, organization, business practices, software, and other produced elements of the successful modern corporation.” For a skeptical view of the validity of attributing the difference between market and capital asset values to intangibles, see Bond and Cummings (2000).

[84] I will not venture here into the extensive consumer research in marketing, since the focus of this report is on intangibles.

[85] A true expense, like wages or rent, is negatively associated with stock returns; the higher the expense, other things equal, the lower the stock value.

[86] On the accounting treatment of customer acquisition costs, see Appendix A.

[87] In contrast, cost of sales, which is a regular expense, was found to be negatively related to market values.

[88] Investors’ skepticism of the validity of customer acquisition costs as assets is also due to the manipulation of this item by some Internet companies. As reported, for example, in “Fess-Up Time” (Forbes, September 18, 2000, pp. 80, 84), several companies included various shipping costs and discounts given to customers in reported marketing expenses. This was done in an effort to reflect a higher gross margin (these costs should have been included in costs of sales, rather than in marketing expenses). Obviously, when such accounting games are played by companies, the validity of reported items becomes questionable.

[89] For example, the customer acquisition costs of B2C companies that folded in 2000 (**) are by and large lost.

[90] Innovation sales refers to a measure indicating the percentage of total revenues from products/services introduced in recent years.

[91] For a general discussion of brand management, see Aaker (1996).

[92] Similar to the Brynjolfsson and Yang (1999) findings on the valuation of computer capital mentioned earlier (III.3), it may be that the brand and customer satisfaction measures found to be associated with market values serve as proxies for other company attributes valued by investors, such as growth or geographical extension.

[93] An example of trademark acquisition: in July 1998, Sara Lee Corp. has acquired the domestic trademarks of the Lovable Co. for $9.5 million.

[94] For elaboration on Internet traffic measures, see Demers and Lev (2000).

[95] From Amazon.com 1999 annual report—Form 10-K.

[96] Public companies have to provide information in the financial report on obligations for pensions and other post-retirement benefits, as well as information on the value of assets covering these obligations. Public companies have also to provide information on employee incentive plans and stock options. These disclosures, however, do not convey direct information relevant to the value of human resource intangibles.

[97] I am not familiar with reliable, comprehensive (large sample) data on the extent of these investments. This void is demonstrated, for example, in an OECD statistical publication on the knowledge-based economy (“Science, Technology and Industry Scoreboard, 1999,” Organization for Economic Cooperation and Development, Paris, France), which does not provide any enterprise-based data on investment in human resources, while providing extensive data on R&D, for example.

[98] For example, asset impairment rules (Financial Accounting Standards Board (FASB) statement No. 121, **), require the periodic evaluation of total expected benefits of assets against book values.

[99] See Cappelli and Neumark (1999) for a survey of the available evidence. See Huselid (1998) for evidence of a link between human resource practices and market values.

[100] Interestingly, while the Lev–Schwartz methodology for estimating human capital was, to the best of my knowledge, not adopted by U.S. companies, it has been adopted by several Indian companies. For example, Infosys Technologies Limited (a software company), in its 1999–2000 annual report, estimates the “value” of its employees as Rs. 2,23,741 lakhs.

[101] The major exception in the U.S. to the immediate expensing of intangibles is the requirement to capitalize (i.e., recognize as asset) software development costs beyond the attainment of project feasibility, see Aboody and Lev (1999). See Appendix A for a detailed description of generally accepted accounting principles (GAAP) concerning intangibles, around the world.

[102] Smullyan’s statement is quoted in Yuji Ijiri’s (1989) important, though not widely read book on momentum accounting.

[103] A dramatic example of the uncertainty associated with customer warranties is the current (second half of 2000) predicament of Bridgestone/Firestone and Ford Motor Co. concerning the massive Ford Explorer tire recall.

[104] Clearly indicating the uncertainty of intangible investments is the attitude of financial analysts towards AOL’s customer acquisition costs. When AOL capitalized some of these costs in 1995–1996, claiming that these are investments rather than expenses, it was blamed by analysts as manipulating earnings, since, they argued, these costs will in all likelihood not generate future benefits. Continuously harassed by analysts and the Securities and Exchange Commission (SEC), AOL gave up in 1997, and wrote off all the previously capitalized acquisition costs, to the tune of $385M.

[105] Aboody and Lev (2000) empirically demonstrates that information on the technological feasibility of software programs is relevant to investors’ decisions.

[106] Of course, in what economists call a “rational expectations environment,” where people base decisions on optimal expectations, the full revelation process will evolve instantaneously, as those with bad news know that the market will ultimately “force” them to disclose. So, why wait?

[107] Financial Accounting Standards Board, Business Reporting Research Project, 1^st Draft of Steering Committee report, September 2000, pp.4–5 (emphasis mine).

[108] See Deng and Lev (1998) for an empirical analysis of the IPR&D phenomenon.

[109] During that period, Cisco had additional acquisitions that were accounted for by the “pooling method,” including the $6.9B Cerent acquisition. Under “pooling,” however, there is no IPR&D.

[110] Data derived from Cisco System’s 1999 annual report, p. 42.

[111] If those acquisitions were considered an asset, as it should be for an arms-length acquisition, this asset would have been amortized against future revenues.

[112] Indeed, when IBM announced its third quarter 1995 loss of $538M, mentioned above, its stock price did not decrease.

[113] Except, of course, for major failures, such as Motorola’s investment in the Iridium project, AT&T’s acquisition of NCR, or the recent (September 29, 2000) sale for virtually nothing of the Learning Company, acquired 16 months earlier by Mattel Inc., for $3.5 billion. This latter failure was a major factor in the resignation of Mattel’s CEO Jill Barad.

[114] The two studies linking disclosure to cost of capital that I am familiar with are Botosan (1997) and Sengupta (1998). The latter, for example, reports that the cost of capital difference between firms with the best and worst disclosure is 1.1 percentage point only.

[115] Some relatively minor intangibles, such as movie rights and commissions paid for life insurance and mortgages, can be capitalized; see Appendix A. Also capitalized is goodwill, which is the difference between the price paid for a business enterprise in an acquisition (accounted for by the “purchase method”) and the fair value of the acquired assets net of liabilities.

[116] The capitalization of software development costs is required by FASB statement No. 86 (1985).

[117] See Aboody and Lev (1999) for a description of the software development costs capitalization requirements and for data on the characteristics of companies following and ignoring the accounting standard. For a comprehensive annual survey of the accounting practices of software companies, see Delloite ***.

[118] Association for Investment Management and Research (AIMR).

[119]In many developed countries, even this is not required. See Appendix A for details.

[120] The requirement in the United States to separately report R&D expenditures leaves open the question of what should be defined as R&D. This is largely left to managers’ discretion, adding to the uncertainty surrounding information about intangibles. There has been an attempt by ** to define and classify R&D expenditures (the Frascati manual), but it is not biding in the USA, and clearly requires updating, given the technological changes that occurred since its formulation in 19**.

[121] A recent case in point: “The Securities and Exchange Commission has ordered an investigation into possible insider trading of Bristol–Myers Squibb Co. Shares, the pharmaceutical giant confirmed. The SEC is focusing on trades made between Nov. 8, 1999, and April 19, 2000, when the New York-based company disclosed that it was withdrawing its application to the FDA for its experimental blood pressure drug, Vanlev. The news sent its shares plummeting 23%.” (The Wall Street Journal, October 12, 2000, p. B5).

[122] A similar result in the real markets was derived by Akerlof (1970) in the famous “lemons” (defective used cars) case.

[123] The authors control, of course, for other factors known to affect spreads, like company size.

[124] Examples of research in the securities mispricing area are as follows: DeBondt and Thaler’s (**) study documenting investors’ overreaction to good/bad news, and Bernard and Thomas (**) study recording systematic underreaction to earnings surprises. Lakonishok et al. (**) documented systematic positive return differential for “value stocks” (stock with low market value relative to fundamentals—book value or earnings) relative to “glamour stocks.” They ascribe this finding to a systematic over pricing of glamour (growth) stocks, which is reversed by contrarians.

[125] Some readers may find the evidence of undervaluation of certain R&D-intensive companies counter intuitive. Aren’t all technology stocks overpriced (at least through mid-2000)? The answer is that not all technology stocks enjoy lofty valuations. Only the very profitable ones (the Microsofts, Intels, Ciscos) perform thus. Many other companies struggle in the capital markets. During 1999, for example, while stock indexes soared to new heights, most stock prices of individual companies actually fell. Of the Standard & Poor’s 500 companies, the stock prices of 256 companies declined during 1999 (The Wall Street Journal, January 18, 2000, Heard on the Street).

[126] The estimates of insider gains based on information filed with the SEC are, of course, downward biased. Egregious violations of trading on inside information are likely not reported to the SEC, such as trades made through friends or relatives.

[127] Here, as elsewhere in empirical research, the focus on R&D is due to the fact that it is the only intangible investment disclosed by public companies.

[128] In contrast, if R&D were capitalized, changes in periodic R&D expenditures would have a protracted effect on earnings.

[129] The title of a 1902 essay by Leo Tolstoy on poverty (material, not information).

[130] “Penney Wise, “ Forbes, September 4, 2000, p.72.

[131] The ultimate test, of course, is the extent of purchases by the web site visitors. On this, later.

[132] Except for the bottom box of the right column in Figure 6—Growth Options.

[133] There may still be valid managerial concerns with benefiting competitors with detailed value chain information.

[134] The Economist, September 2, 2000, p. 66.

[135] Indeed, empirical research has established an association between the extent of innovation revenues and market values of companies (see ***).

[136] Source, Forbes, September 4, 2000, p. 72

[137] Indeed, the FASB (2000) survey indicates that some companies already provide data on economic value added.

[138] Note that this is the only link out of 10 that is not based in fact.

[139] Financial Accounting Standards Board, Statements of Financial Accounting Concepts, 1978–1985.

[140] FASB, Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements, December 1985, paragraphs 25–34.