1. © Baruch Lev, April 2003. All Rights Reserved. ACCOUNTING FOR INTANGIBLES By Baruch Lev New York University Tel: 212-998-0028 Email: blev@stern.nyu.edublev@stern.nyu.edu Web: www.baruch-lev.comwww.baruch-lev.com This presentation, or any part of it, should not be reproduced, or otherwise used in any form without Baruch Lev’s written permission.

2. © Baruch Lev, April 2003. All Rights Reserved. 2 AT A GLANCE  Intangible Assets are the Major Drivers of Corporate Value and Growth.  The Economics of Intangibles: Value-Drivers and Value-Detractors.  Intangibles Challenge Investor Valuations.

3. © Baruch Lev, April 2003. All Rights Reserved. 3 AT A GLANCE - Continued  The Traditional Accounting System is of Little Help in Monitoring and Accounting for Intangibles, and in Providing Useful Information to Investors.  Despite Widespread Disbeliefs, Accounting Data Can be Adjusted, to Better Reflect Value, and Intangibles Can Be Valued.

4. Source: Testimony before the Committee on Financial Services, U.S. House of Representatives, February 27, 2002. 4 Alan Greenspan From one perspective, the ever-increasing proportion of our GDP that represents conceptual as distinct from physical value added may actually have lessened cyclical volatility. In particular, the fact that concepts cannot be held as inventories means a greater share of GDP is not subject to a type of dynamics that amplifies cyclical swings. But an economy in which concepts form an important share of valuation has its own vulnerabilities. As the recent events surrounding Enron have highlighted, a firm is inherently fragile if its value added emanates more from conceptual as distinct from physical assets. A physical asset, whether an office building or an automotive assembly plant, has the capability of producing goods even if the reputation of the managers of such facilities falls under a cloud. The rapidity of Enron's decline is an effective illustration of the vulnerability of a firm whose market value largely rests on capitalized reputation. The physical assets of such a firm comprise a small proportion of its asset base. Trust and reputation can vanish overnight. A factory cannot. I. What They Say

5. Source: Leonard Nakamura, " A Trillion Dollars a Year in Intangibles Investment and the New Economy," 2001. 5 Leonard Nakamura I argue that U.S. private gross investment in intangibles is at least $1 trillion. Most of this investment goes uncounted. This is not surprising, in that it is new: the rate of investment in intangibles, and its economic value, accelerated significantly beginning around 1980. An intangibles investment rate of $1 trillion suggests that U.S. businesses are investing nearly as much in intangibles as they are in plant and equipment. If we are investing $1 trillion a year in intangibles…then the long-run equilibrium value of intangibles is $6 trillion.

6. Source: Factset 6 S&P 500 Average Market-To-Book Ratio: 1995- 2002

7. © Baruch Lev, April 2003. All Rights Reserved. 7 II. WHAT ARE INTANGIBLES? I. DEFINITION Intangible assets are sources of future benefits which do not have a physical embodiment. II. THE MAJOR CATEGORIES OF INTANGIBLES Discovery/Learning:New products, services, patents, communities of practice, Intranet, adaptive capacity. Customers:Brands, trademarks, on-line distribution channels,marketing alliances. Human Resources:Work and compensation practices, employee training,incentives. Organizational Structure:Business structures and processes, incentive systems, information and control systems. III.ALLIANCES PREVALENT IN DISCOVERY/LEARNING AND CUSTOMERS INTANGIBLES

8. © Baruch Lev, April 2003. All Rights Reserved. 8 MANAGERIAL AND INVESTOR CHALLENGES

9. © Baruch Lev, April 2003. All Rights Reserved. 9 Merck & Co.: Return on Equity (ROE) Based on Expensing (top curve) and Capitalization (bottom curve) of R&D

10. Source: "Managing an Alliance Portfolio," MckInsey Quarterly, 2002 Number 3. 10 A MAJOR PROBLEM: MONITORING ALLIANCES “Most large companies now have at least 30 alliances, and many have more than 100. Yet despite the ubiquity of alliances—and the considerable assets and revenues they often involve—very few companies systematically track their performance. Doing so is not a straightforward task… Our experience suggests that fewer than one in four has adequate performance metrics… Few Senior management teams know whether the alliance portfolio as a whole really supports corporate strategy.”

11. © Baruch Lev, April 2003 All Rights Reserved. 11 III. Mismeasurement & Biased Reporting of Intangibles  The myth of conservative accounting: Mismeasurements of Assets and Income of Intangibles-Intensive Enterprises.  Endogenous Software Capitalization: Computer Associates-Yes; Microsoft-No.  Asymmetric Accounting: Expense Internally- Generated Intangibles, Capitalize Acquired Intangibles.

12. © Baruch Lev, April 2003. All Rights Reserved. 12 Mismeasurement and Biased Reporting of Intangibles - Continued  Manipulation with In-Process R&D.  Manipulation with R&D Expenditures (and Other Intangibles?).  Reporting Opaqueness: No Information on Employee Training, Brand Enhancement, Software and Technology Acquisitions, R&D Breakdowns, Innovation Revenues, etc., etc.  The Myth of Enron, Global Crossing and Winstar Being Intangibles-Intensive.

13. © Baruch Lev, April 2003. All Rights Reserved. 13 IV. Overcoming Accounting Limitations  Capitalizing Intangibles.  Forming Investment Strategies From Intangibles’ Values.

14. Source: Lev, Nissim, Thomas. 2001. "On the Informational Usefulness of R&D Capitalization." 14 Table 1 Descriptive Statistics

15. Source: Lev, Nissim, Thomas. 2001. "On the Informational Usefulness of R&D Capitalization." 15 Table 2 Analysis of the Change in the Association of Earnings and Book Value with Price from Capitalization and Amortizing R&D

16. Source: Lev, Nissim, Thomas. 2001. "On the Informational Usefulness of R&D Capitalization." 16

17. Source: Lev, Nissim, Thomas. 2001. "On the Informational Usefulness of R&D Capitalization." 17

18. © Baruch Lev, April 2003. All Rights Reserved. 18 Cisco Systems R&D Capitalization and Amortization ($millions)

19. © Baruch Lev, April 2003. All Rights Reserved. 19

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21. Source: Lev, Nissim, Thomas. 2001. "On the Informational Usefulness of R&D Capitalization." 21

22. Baruch Lev, 2002. All rights reserved. 22