Do Intangibles Explain the Failure of the Value Factor?

The poor performance of factor-driven value strategies over the past decade has raised the question of whether intangible assets, such as patents and proprietary software, are properly treated. New research confirms that intangibles indeed distort valuation metrices, but there is no consensus on how to address the problem.

Under U.S. generally accepted accounting principles (GAAP), internally generated intangible assets are typically expensed on the income statement when incurred – the assets are not reported on the balance sheet, and instead of being added to book value, the costs of the intangibles are subtracted from book value. On the other hand, acquired intangible assets such as goodwill are capitalized on the balance sheet – their value is included in a firm’s total assets and book value of equity. This distinction is primarily due to the higher uncertainty around the potential of those intangibles to provide future benefits and the difficulty of identifying and objectively measuring such benefits. However, when obtained through mergers or acquisitions, internally developed intangibles of acquirees generally get recognized at their fair value (the acquirer had set their value) on the balance sheet as externally acquired intangibles.

Aside from the U.S., almost all developed and emerging market countries (China and India being two major exceptions; and in Japan only 60% of companies follow IFRS, 30% follow local GAAP, and 10% follow U.S. GAAP) now follow International Financial Reporting Standards (IFRS). Under IFRS, research expenditures are expensed on the income statement and development expenditures are capitalized on the balance sheet if certain conditions are met. As a result, international firms tend to report higher levels of internally generated intangibles on their balance sheets. In certain countries (e.g., the U.K.), this was true prior to the adoption of IFRS.