Caveats And Possible Abuse Of IP Accounting: A Look At Research In Motion

Feb.24.12 | About: BlackBerry Ltd. (BBRY)

Intellectual property has been pushing the boundaries of business for some time now. Acquisitions of companies solely for their patents, patent infringement suits, patent trolls, and even the concept of patent exchanges are all current reality and ubiquitous with the exception of the latter (Reuters). The technology industry is one of the most critically impacted arenas of commerce with regard toward IP. However, one crucial but often overlooked area that has been particularly challenged by IP is accounting. One company that illustrates this challenge poignantly is Research In Motion (RIMM).

Numerous levels of questions require further discourse than this article is intended to provide. However, one such fundamental question is how does one valuate intangible assets (intangible is the relatively broad accounting term used to describe intellectual property, defined as: an identifiable nonmonetary asset without physical substance Summary of IAS 38)? Which is really to ask, how do we quantify the unquantifiable?

This question is most simply answered by simple supply and demand economics. An entity, unquantifiable as it may be, is fundamentally worth whatever the market will pay for it. A question that is arguably harder to answer is how should companies account for these intangibles? The answer is not an exact science. Current IP accounting standards provide partial transparency at best to the average investor, and opportunity for deliberate misrepresentation at worst (Journal of Accounting Research).

Most investors have a basic knowledge of accounting. That is to say that they look at the "bottom line" and other commonly referred to metrics such as earnings per share or various ratios to aid their decision-making. Investors might even scan the financial statements of a company, which the Securities and Exchange Commission requires publicly traded companies to file on a regular basis. Financial statements are designed to be reliable and accurate in an effort to protect investors, creditors, and even the IRS by providing them with relevant and current company information.

Investors often have a cursory understanding of the components of financial statements and what they mean. Unfortunately, investors often do not know much about how the numbers are derived. In addition, the vocabulary can become recondite, and the concepts complex. For those who have more comprehensive accounting knowledge, most realize that the "bottom line" is sometimes not as clear as it appears in IP intensive industries.

Some accounting practices can differ from company, to industry, to country of origin. Although there are national (Generally Accepted Accounting Principles GAAP, FASB) and international (International Financial Reporting Standards IFRS, IASB) accounting standards that public companies must abide by, these standards have yet to adequately adjust to the importance that IP now plays. These relatively nascent rules and consequent accounting practices can actually decrease the clarity of financial statements if misinterpreted or deliberately misused.

Even financial professionals have been shown to be misinformed and misunderstanding of crucial accounting concepts of IP in the technology industry. As a result one such CFA recently valued RIMM's liquidation value at nearly 40% higher than a conservative estimate should have been. The equation used was plausible, however, the data derived from the financial statements was misinterpreted.

When companies are acquired by other entities, they are most basically evaluated using the book value of their assets and the expected returns minus liabilities of those assets (this omits the chance that demand for the company will rise above book value at the time of sale). In accounting terms, these assets are broken up into tangibles; property, plant, & equipment, and intangibles; patents and goodwill. They are normally listed in financial statements as way of taking a snapshot of company baseline health. In simpler terms, tangibles are hard assets like property or inventory, while intangibles assets are things like ideas, designs, and patents (IP).

The values of intangibles are traditionally attached to expected future revenue streams, such as licensing revenue from a patent. However there has been a shift in the "tradition" so to speak. More so than ever the assets of technology companies are predominantly being evaluated by their intangible assets, whereas they were once barely acknowledged. Intangible assets are thus playing a larger role in the market value of companies. However, the way companies account for these assets can play a significant role in the bottom line of investors. Intangibles can easily be over and understated.

For the accounting world, the implications of intangibles have been an ongoing discussion pre-dating the dot-com bubble (World Intellectual Property Organization). Initially the mechanics of the accounting was relatively simple, goodwill being the reflection of any premium paid above the book value of an acquisition. So when a company paid more than book value for an acquisition, the difference was simply credited to goodwill. Then during the influx of IP created during the dot-com bubble, accountants called for greater valuation of intangibles. Instead of only valuing intangibles when they were acquired, it was suggested that they be accounted for at inception and thereafter. However, as some accountants at the same time asserted, it could create opportunities for management to manipulate earnings when implemented.

In a stripped down example, when company X acquires company Y, company X will normally add the assets of company Y to their own balance sheet and subtract the cost of company Y from the same. It seems quite straightforward. However, when intangibles are considered, it can become much more obtuse. Primarily this is because under current accounting standards the costs of acquired intangibles are commonly amortized. This means that when company X acquires Y, X can spread out the cost of the intangibles that came with Y over time on their books (often 36 months, the average relevant lifespan of a technology product).

In accounting, the concept of amortization (also depreciation) is based on averaging out the cost of purchasing an asset over the expected useful life of the asset. Secondarily however, the value of the intangible assets from Y can be recognized in an up front lump sum style on the books of X. So the immediate reflection on the balance sheet is a lessened cost of the acquisition and recognition in full of the acquired assets. While the cost of acquisitions can be amortized over several years, the assets acquired can be recorded immediately in full.

Assuming that the acquired intangible assets were previously valued fairly, this alone raises questions of propriety. And if coupled by the possibility that the acquired intangibles were under or over-valued it brings more uncertainty. What complicates it further is the possibility that a company will deliberately use this weakness in accounting to bolster or delay the appearance of their financial statements, in effect hiding the naked health of the enterprise by turning what would normally be a one time expense into multiple smaller ones.

Research In Motion (henceforth RIMM) can be used to illustrate this dilemma. RIMM is a Canadian technology firm that at one time spearheaded the blossoming telecommunications industry. They grew to prominence by providing communications devices for business and government entities. RIMM provides products and accompanying services largely encompassed by their brand BlackBerry. In 2008 their publicly traded share price neared $150, an all time high.

However, RIMM has since seen relatively rapid deterioration of dominance and arguably future promise due to a failure to supply competitive products and services and to recognize the importance of the growing consumer demand for such products. In 2011 RIMM lost over 70% of their stock price in spite of increasing their customer base and reporting positive earnings. In 2011 stakeholders publicly petitioned and asked RIMM co-CEOs and co-Chairmen Jim Balsillie, Mike Lazaridis, and some company directors to either take (new) action and/or step down (RIMM Press Releases).

In early 2012 RIMM announced that unrelated to public outcry, their rare dual management structure and corresponding persons would be changed. The CEO roles were condensed and given to Thorstein Heins, the former company COO. And the Chairpersonship was condensed and was appointed to Barbara Stymiest. Balsillie and Lazaridis remained as board directors and the two largest shareholders of the enterprise. RIMM shares are currently trading for approximately $15 with a market capitalization of approximately 8 billion USD.

Per their most recent financial disclosures, RIMM has no notable debt, liquid assets in excess of 1 billion USD, and has in spite of the aforementioned setbacks, has been profitable on an earnings per share basis to date. However, during 2011 RIMM made several technology acquisitions in hopes of adding value and features to their products and services. The book value of these acquisitions was largely intangible in nature. Thus, in more specific accounting terms, RIMM acquired a significant portion of goodwill, intangible assets, and what they label as "other assets".

According the most recent ninety-five-page RIMM 10Q filing (2012 fiscal year, RIM Financials), the assets purchased (both intangible and tangible) in 2011 were recorded in full on their books. Additionally, the disclosure details plans to amortize over 1.8 billion USD in costs of the corresponding assets into 2016. In 2012 (2013 fiscal) they plan to record nearly one billion in amortized costs to the RIMM balance sheets, and nearly another 800 million USD in the following three years. Had these costs been recognized in the quarter in which they were incurred, the "bottom line" would have shown a loss rather than positive earnings in at least one quarter of 2011 (2012 Fiscal).

In spite of not showing any direct expected revenues (such as licensing or use in new products) from the acquired intangibles in 2011, the costs were amortized over several years. Ignoring the possibility that the intangible assets could be inaccurately valued to begin with, the amortization in many senses contravenes one of the most central principles of accounting, that expenses should be matched against revenues in the same accounting period. Moreover, given the current embattled position RIMM currently experiences and a new long awaited crop of business developments slated to arrive soon, it is easy to see why RIMM might be tempted to over-amortize their acquisitions, and maintain a more favorable outer appearance for the time being.

From the investor's perspective, this might cause them to retain hope in their losing investment, and hold their position rather than realizing a loss and preventing further losses. In an opposing vein, it is possible that RIMM could be under-estimating the value of their IP, thus showing a weaker position than actual. Either way the already cloudy picture is unnecessarily darkened, and investors need to be extra savvy when analyzing companies such as RIMM. One clear problem is that the lag of accounting adaptation behind business adaptation is leaving gaps that put stakeholders in unknowingly risky positions.

As aforementioned, these concepts and their implications deserve far greater discourse and have no simple or final solution. For now, as illustrated with RIMM, the intellectual property accounting in public companies is failing to make financial statements as transparent as they should be. The public disclosure of financial statements is by design intended to protect investors, but with intellectual property it can portray not only incomplete but even deliberately misleading information.

This puts individual investors and even professionals without esoteric knowledge at risk of placing too much trust in some of the most widely used investment metrics and baselines of valuation, which are derived from financial statements. The bottom line with this ongoing discussion is that investors in intellectual property heavy industries should know that the "bottom line" might not be exactly as it seems.

Disclosure: I am short RIMM.