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The strategic implications of IFRS for intellectual assets

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  • Published In: Intellectual Asset Management
  • Author: Thayne Forbes
  • Spokesperson: Joint managing director of Intangible Business

Thayne Forbes, joint managing director of Intangible Business, discusses the implications of the new IFRS 3 standard for IP

Attitudes towards intellectual property are all set to change. European legislation is being changed to introduce new accounting standards from January 2005 which will effectively require all European listed companies to report the value of their acquired intellectual property on their balance sheet. This has far reaching implications for the financial, legal and marketing world and creates a significant opportunity to influence, determine and manage intellectual asset strategy. The mechanism by which this will be enacted is through International Financial Standards (IFRS).

For those in charge of the commercial application of intellectual property or for those responsible for its continual registration and maintenance, whether in a legal, financial, marketing, administrative or management capacity, IFRS is an opportunity to leverage the value of intellectual property to drive through new revenue generating initiatives. This article highlights the main benefits to be gained from a thorough understanding and exploitation of these new standards and how to use it as a catalyst for strategic advantage.

IFRS will dramatically improve the appreciation of intellectual property and consequently the status of those responsible for them. Valuing intellectual property for IFRS will identify the value contribution made by different IP assets in the portfolio and assist in the identification of strengths and weaknesses. Positive communication of this will improve relationships with shareholders and investors which will help in the procurement of funds and be reflected in the share price. Stakeholder relationships too, once better informed of the intellectual property valuation, will improve, assisting in the generation of positive PR and in the recruitment of new customers and new business. Intellectual property valuation can also be used as a measurement of return on investment (ROI) bringing accountability to the performance of both the intangible assets and its guardians. IFRS also differs in areas from its US counterpart, US GAAP, effecting European subsidiaries of US listed companies in areas of mergers and acquisitions, licensing and in the establishment of royalty rates. An understanding of these new developments will empower those responsible for intellectual property with more effective strategic management of their assets resulting in maximum value being extracted.

Background
The rationale for this new development stems from the need for greater transparency in accounting for business combinations (acquisitions) in company accounts. Intangible assets command an increasingly large proportion of a company's value and this value has largely not been recognised. In heavily branded consumer businesses such as Coca Cola or Nike, brands account to up to 80% of the company's value. In other industries, such as the pharmaceutical, patents and copyrights are more prominent.

Taking a lead from the US, the International Accounting Standards Board (IASB) has released a new set of standards called the IFRS, under which this new legislation falls. The standards state that any identifiable and measurable intangible asset acquired as part of a business combination after the company's transition date after 31 March 2004, needs to be recognised on the balance sheet from 2005.

Increased status
An intellectual property valuation for a portfolio will highlight the importance of both the assets and the people responsible for them. The work necessary to maintain control of these assets will no longer be seen as administrative but strategic. IFRS is an appreciation of intellectual property and effective implementation will present the asset guardians with clear responsibilities and with it considerable strategic advantages.

IFRS stipulates that only acquired brands must be recognised. Internally generated brands are not currently allowed to be put on the balance sheet. However, a company can elect to retrospectively apply IFRS to past acquisitions.

Value contribution analysis
Valuing a portfolio of intellectual property identifies the value contribution each makes to the overall profitability of a business. Only with this information can effective strategy be decided. This process is particularly rewarding for trademark, copyright or patent led businesses which can have thousands of intellectual assets - lots of which are often lying dormant. Frequently, intellectual property gets stored away and forgotten about, taking up valuable resource and incurring unnecessary costs such as storage facilities, patent renewal fees, IT and legal resource, print costs and general administration. A thorough intellectual property valuation will recognise those assets that drive revenue and those that are currently unexploited. Using this analysis, a strategic decision then needs to be made to optimise these assets value: cull it, activate it, contain it.

In 1999, a portfolio analysis review revealed Unilever had over 1,600 brands. In February 2000, it unveiled its five year strategic plan, ‘Path to Growth'; the cornerstone of which was to reduce the brand portfolio to focus on the top 400 leading brands. This would have the effect of cutting the costs of managing the non-profitable brands, reducing the overheads necessary to maintain them, increasing the focus on its core brands to bring them to new markets, extending them into different categories and driving them through new channels to increase operating margins by more than 16% and improve annual top line growth to 5-6%. Unsurprisingly, this did not work. The sentiments were right, but focusing on 400 brands? The desire to have a portfolio of no more than 400 brands, based on no discernable strategic thinking or analysis, was fundamentally flawed. There should be strategic reasons for deciding how many, if any, brands to cull - not just an apparently excessively large and arbitrary figure which is still impossible to focus on and manage.

Japan Tobacco International (JTI) had a similar issue with its cigarette brands. It had hundreds of global cigarette brands generating billion revenue a year but even 100 was too many to focus on as core brands. Following a portfolio value analysis the brands were categorised into three main groups according to the value they generated and the markets they operated in. Global Flagship Brands, including Camel, Winston, Salem and Mild Seven, was the drivers of growth group whose brands were marked for continuous investment and development. Brands in the Key Regional Brands category were to be invested in selectively and the brands in the Tactical Regional Brands group were the least important and selected for harvesting. Incremental opportunities across markets and portfolios were then easier to identify and develop. Brand valuation for IFRS can highlight which intellectual properties are actually worth keeping and the best strategies for maximising their value.

Managing the culling of brands is one option, activation is another. A leading UK refrigeration brand had steadily been losing market share. Consumer research, however, revealed the value of the brand to be significantly greater than its sales performance indicated. The brand owners, therefore, decided to activate the brand. It did this not by investment but by offering the brand on license to manufacturers of small domestic appliances. Brand awareness would thereby increase, a new revenue stream would be created and the core refrigeration brand rejuvenated - all at no extra direct cost. A portfolio value analysis often reveals unexploited intellectual assets which just need a bit of attention for them to spring back to life. It also reveals equity still present in a dormant or dying brand.

The third option when evaluating intellectual asset value in a portfolio is neither to cull nor activate an asset but to contain it, preventing competitors from benefiting. This is what Allied Domecq did in a review of its coffee liquor brands Tia Maria and Kahlua. As these were the only major coffee liquor brands in the market, Allied Domecq decided to retain both brands and focus investment on one brand. After a thorough strategic global value analysis, it selected Kahlua. What then to do with Tia Maria? Rather than sell it to a competitor, the decision was taken to maintain the brand as it would be more advantageous to manage the category, remove potential competitive threats and retain strategic opportunities for the future.

The Growth/opportunity portfolio analysis (as illustrated in the pdf) features a hypothetical model of a company with a portfolio of brands in the soft drinks market. This analysis highlights marketing investment in relation to market growth rates and value. Fruit-based, sports and dairy based products are clearly identifiable as unexploited assets since they are in a high growth area yet are supported by the least amount of marketing investment. Funding to carbonates on the other hand should be carefully monitored as it is in a low growth area yet has the most investment. Such analysis comes as a by-product of a robust application of IFRS and is useful for ongoing strategic intellectual property management.

Investor & shareholder relations
The opportunity to carry out a portfolio value analysis is just one of the benefits of applying IFRS for intellectual property. Valuing intellectual assets can also greatly improve relationships with shareholders. This can be an effective strategy to boost share price or solicit funds. Trademarks, patents, copyrights and other intellectual assets need to made transparent so the investment communities and stakeholders at large can appreciate the potential value of intellectual property in the hands of the company. Through careful communication of the valuation findings, it can be explained to shareholders and potential investors that it is these intangible assets that generate cash for businesses. Profit is invariably derived from the premium that brands, through the emotional attachment they create, enable manufacturers and retailers to charge. Patents and copyrights are often all that distinguishes the raw product from the competition. Know-how and trade secrets prevent the competition from copying formulae and trademarks are all that protect a name. Without these intangible assets there would be little left for a company to sell. When an actual figure is put to these intangibles as part of this new legislation, investors will be conscious of the strategic need to allocate adequate resource to maintain and grow these assets that generate revenue - and to extract maximum value from them. Consequently, IFRS will facilitate the procurement of marketing and intellectual asset investment.

Stakeholder relations
Positive communication of brand value to a company's various stakeholders has its advantages too and should be fully integrated into corporate strategy. Informing the trade and business press of the value of the intangible assets and what it means to the company can result in positive coverage - the benefits of which are obvious. Trade and business press communication is equally as important for consumer-facing companies as it is for business-to-business companies. Positive communication of a brand's value, comparable to its competitors, inspires confidence in the brand in the eyes of the consumer which can directly lead to increased sales.

Internal communication is also an extremely beneficial and economical method of increasing awareness and understanding of a brand and its values. Informing employees of the value attributable to intellectual property alongside its associated strategy and their role in generating value through the brands will ensure that a positive and consistent brand picture is painted as well as enabling a more cohesive application of human resource. This is important for both consumer and business-facing companies as all interaction with customers reflects positively or negatively on the brand and other intellectual property.

Strategy should also include communicating the brand valuation findings directly to a company's customers. This can be done indirectly through PR or directly through other means such as the corporate website.

ROI measurement
IFRS states that all intellectual assets on the balance sheet must be valued annually for impairment. This necessity creates an opportunity to build in a strategic tool to the overall management of a business to monitor return on investment (ROI). Monitoring value fluctuations in intellectual property enables strategists to determine more accurately how particular properties respond to investment. As well as monitoring ROI, this strategy has the dual benefit of providing benchmarks for distributing resource based on pre-determined measures.

Taking brands as an example, since they are frequently the most valuable asset, various measures can be introduced to determine an overall brand score, from which strategy can be influenced. Five defined brand valuation parameters could be awareness, favourability, familiarity, customer satisfaction and brand preference. Every market, channel, segment and sector that the brand operates in compiles research to produce a scorecard with a component brand score. The total brand score is the sum of all the component brand scores. This model pinpoints brand strengths and weakness, enabling companies to adapt to this change and set strategy accordingly. It also quickly identifies underperforming areas preventing potential problems from growing and maximising the chance of value enhancement.

In the example (Brand valuation by channel, as illustrated in the pdf) the constituent brand values are given for the major channels of the alcoholic drinks brands. This can be broken down further and values given to the components of each channel, such as the supermarket chains for instance, and again further into region, territory, category or market. This builds up a picture of exactly where value is coming from and which elements require attention. The five parameters that derive profitability (here referred to as a royalty rate) can be broken down further to include additional information. This can be benchmarked against competitors to give an accurate brand position. This process gives an overall position of the relative strength of the brand, as well as supporting the overall brand valuation process.

Brand valuation is a necessary constituent of IFRS compliance for companies which have acquired brands. Rather than creating a one-off brand valuation model purely to satisfy the accountants, it is worth expanding its use for ongoing strategic brand management. This is now common practice for leading-edge companies' management information. However, IFRS impairment legislation prohibits recognising an increase in an intangible asset's value on the balance sheet; only the same or a lower value may be recognised.

Retrospective application of IFRS - putting the value of historically acquired intangibles on the balance sheet - is an optional requirement with its own benefits and strategic advantages. Companies, however, can only retrospectively apply to the balance sheet acquired intellectual property the first time they apply IFRS. You only get the one chance. Retrospective application sends a strong statement to the investment community and is also a good opportunity to bring a company in line with competition if they do the same. If the competition is not retrospectively applying IFRS then this presents a good opportunity for differentiation.

US differences
The way brands and other intellectual property appear on US balance sheets was revamped in June 2001 under US GAAP. There are a few technical differences in the accounting principles between US GAAP and IFRS in areas such as goodwill amortisation, negative goodwill and hedge accounting, but the overriding benefit of applying IFRS is comparability to US companies. This is especially beneficial for European subsidiaries of US listed companies as the differences between UK/European and US GAAP balance sheets can be eliminated.

Previously, users of company accounts (shareholders, investors, venture capitalists, management...) were presented with a great difficulty when looking at accounts from both sides of the Atlantic - they were written in a different financial language. For companies whose strategy is expansion through merger or acquisition (either acquirer or the acquired) IFRS will assist the decision making process.

Licensing
Greater accounting homogeny will make global strategic management of intellectual property less complicated. This will be evident in both internal and external licensing. The licensing of intellectual property between US parent companies and their European subsidiaries can be an effective measure of profit contributions from different territories and business divisions, something which companies such as Walt Disney, Dolby and IBM use to great effect. Licensing intellectual property to subsidiaries also forces them to appreciate and develop the intangible asset value they are paying for and responsible for applying in the market. With the introduction of IFRS, many of the differences between the financial reporting of these assets will be reduced and comparisons will therefore be more comparable. The NYSE recognises financial statements under US GAAP and the LSE is about to recognise financial statements under IFRS. More comparable accounts will give strategists a more balanced view of the value contribution from intellectual property.

For European companies too, such as Nestlé, this new legislation will facilitate internal licensing and support strategic intellectual asset management. Nestlé holds all its intellectual property centrally in Switzerland. Its different global subsidiaries pay a royalty for the use of its trademarks, patents and licenses. With a more common accounting standard the amount of revenue generated by subsidiaries will be more comparable. IFRS will also help highlight which intangible assets are generating most revenue and from which division, territory and subsidiary.

Royalty rates for external licensing agreements will be able to be set more accurately. The value of intangible assets on the balance sheet of competitors could be used as an additional benchmark for setting royalty rates for comparable intellectual property.

M&A decisions
Another strategic benefit of greater transparency of accounting information on intellectual property will arise following a merger or acquisition. ebookers bought rivals Travelbag and Bridge the World in 2003 for £55m, it now had three travel service companies and valuable intellectual properties in its brands. Following the acquisition, ebookers planned to benefit from an increased scale with higher margins and improved buying power; cost synergies would be realised; there was strong growth opportunity and a stronger customer appeal. There was, however, a potential crossover of the most valuable intangible assets - the brands. Deciding which of the acquired brands were the most effective required a brand valuation; the Bridge the World brand was valued at £2m and the Travelbag brand value was £32m. If ebookers' key motivation for purchasing the companies was for the extra reach and growth potential from the customer lists and employees and not the brands, then the decision on which brand to keep and which one to dispose of, suddenly became very easy - they had the value of both brands. As it transpired, ebookers decided to keep both the acquired brands as they complemented the overall ebookers strategy. In different circumstances, however, having the value of the intangibles already on the balance sheet in mergers or acquisitions would make the choice a lot simpler.

The final analysis
What becomes apparent from a thorough understanding of the implications IFRS has for intellectual assets is the amount of potential benefits and strategic advantages it creates, specifically for capitalising unexploited intellectual property. The key thing, however, is the word potential. It is possible to leave IFRS in the hands of the accountants and this will serve no purpose other than straight compliance. To fully realise intellectual property equity and to extract maximum value from it, it is necessary to fully commit to building intellectual property valuations into overall strategic intellectual asset management.

December 29, 2004 ● Legal

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