An Analysis of Corporate Lobbying on ED 49, Accounting for Identifiable Intangible Assets
Peter G. Gerhardy* and Lisa Wyatt**
* School of Commerce, Flinders University of South Australia; and
** former student, School of Commerce, Flinders University of South Australia.
School of Commerce Research Paper Series: 00-14
ISSN: 1441-3906
Abstract
In this paper content analysis is used to examine the lobbying positions of public companies making submissions on ED 49, Accounting for Identifiable Intangible Assets. A number of content analysis measures are used in an attempt to gain additional insights into the strength of lobbying positions held. The influence of debt contracting and political costs variables upon lobbying position on capitalisation and amortisation of identifiable intangible assets is investigated. While significant relationships are found with the explanatory variables interest coverage, company size and membership of a politically sensitive industry, these relationships are not consistent across the different measures of lobbying position, highlighting the need for examination and refinement of the methods used to measure positions taken by parties lobbying on proposed accounting standards.
Acknowledgment
We would like to express our appreciation to Tania Pacecca for her helpful input and comments on this paper.
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1.Introduction
This paper examines the lobbying positions of public companies making submissions in 1989 to the Australian Accounting Research Foundation (AARF) on exposure draft ED 49, Accounting for Identifiable Intangible Assets. This exposure draft proposed accounting methods and disclosure requirements for identifiable intangible assets. The issue of ED 49 highlighted the existence of a range of opinions on how to account for identifiable intangible assets. A lack of consensus at the time on the issue, both nationally and internationally, led to the exposure draft being withdrawn in 1992 (AARF Media Release, 1992). Australia is still without a standard regulating accounting for identifiable intangibles. However, as part of the ongoing process of international harmonisation it is expected that a new exposure draft, based at least in part upon the requirements of IAS 38, Intangible Assets, will be issued in the not too distant future.[1] Such an exposure draft is likely to propose accounting treatments which represent significant departures from current practices in Australia, and may well evoke debate and disagreement similar to that which occurred in 1989 on release of ED 49.[2]
Given that reconsideration of the accounting treatment of intangible assets is imminent, an understanding of the determinants of accounting method preferences in relation to this issue would help to inform the ensuing debate. A costly contracting framework is therefore adopted to investigate the economic factors which influenced the lobbying position of public companies making submissions, in 1989, on ED 49, in relation to capitalisation and amortisation of identifiable intangible assets. Lobbying position is analysed based on content analysis of submissions to the AARF on ED 49. Previous research has utilised content analysis to examine the lobbying position taken in submissions. Most such studies have adopted a dichotomous categorisation of the lobbying position taken, which views submissions as a vote either for or against the proposed standard
(Holthausen & Leftwich, 1983; Walker & Robinson, 1993). It has been suggested (Tutticci et al., 1992; Walker & Robinson, 1993) that this is inconsistent with the view that lobbying presents participants in the standard setting process with a means of persuasion that is greater than a casting vote. The results of a study by Tutticci et al. (1992) of lobbying on ED 49 suggest that respondents do view their submissions as having more influence than a casting vote. This study attempts to extend the research of Tutticci et al. (1992) by examining the strength of submissions on ED 49 within a costly contracting framework. As well as using basic content analysis measures, a polychotomous categorisation, rather than the more commonly adopted dichotomous categorisation, is used to assist in identifying lobbying positions of different strengths.
The remainder of this paper is organised as follows. Section 2 summarises the specific accounting issues relating to identifiable intangibles investigated in this study, with the formal hypotheses being developed in Section 3. Section 4 provides details of the research methods utilised to investigate the hypotheses. The results and analysis are presented in Section 5. The final section then summarises the major findings of the study and discusses its implications for policy and future research.
2.Accounting for Identifiable Intangibles
Accounting for identifiable intangible assets, and the broader area of accounting for intangibles in general, has been surrounded with controversy for many years. An absence of clear definitions and the availability of alternative accounting methods has created diversity in the way in which companies account for intangibles (McCahey & McGregor, 1990; Miller & Carnegie, 1990; Wines & Ferguson, 1993; Heazlewood & Ryan, 1999). While guidance on accounting for goodwill, or unidentifiable intangibles, has existed since the issue of AAS 18 in 1984[3], the release of ED 49 in 1989 represents the first and only attempt in Australia to issue comprehensive guidance on how to account for identifiable intangibles. The unprecedented move by standard setters of withdrawing the exposure draft in 1992 is testament to its controversial nature.
2.1Recognition of Identifiable Intangible Assets
While ED 49 does not explicitly define identifiable intangible assets, it does so by implication. It defines ‘intangible assets’ as:
non-monetary assets without physical substance and includes but is not restricted to brand names, copyrights, franchises, intellectual property, licences, mastheads, patents and trademarks (para. .03)
Further, it defines ‘unidentifiable assets’ as:
those assets which are not capable of being both individually identified and specifically brought to account (para. .03)
with ‘goodwill’ defined as ‘the future economic benefits from unidentifiable assets’ (para. .03).
Thus, by implication ‘identifiable intangible assets’ are those included in the definition of ‘intangible assets’ (‘non-monetary assets without physical substance …’) which are able to be both individually identified and specifically brought to account. In order to bring them to account, the criteria for recognition of identifiable intangibles contained in ED 49 (para. (iv)) were to be satisfied. These criteria mirror those required by the Australian conceptual framework in SAC 4 (para. 38) for the recognition of assets in general; namely that it must be probable that the future benefits embodied in the asset will eventuate, and that it possess a cost or other value that can be reliably measured.
The requirements of ED 49 relating to recognition of identifiable intangibles are complicated by the distinction made between purchased and internally developed identifiable intangibles. It points out (para. (vi)) that the criterion of reliable measurement will be less often satisfied in the case of internally developed identifiable intangibles than for those which are purchased. However, as a means of facilitating recognition of internally developed identifiable intangibles, it proposed they be brought to account either at the costs incurred in the current reporting period to develop them, or at an independent valuation of the lowest current cost of acquisition (para. .21). Purchased identifiable intangibles were, on the other hand, only to be initially brought to account at their cost of acquisition (para. .11).
The potential of ED 49 to change extant practice regarding recognition of identifiable intangibles at the time of its release is clear. It introduced requirements to not only recognise those identifiable intangibles which were purchased, but requirements which would in many cases see companies having to bring to account those identifiable intangibles which had been developed internally. As indicated by surveys of practice (see for example Wines & Ferguson, 1993; and Ryan, et al., 1990), this represented a significant change from practice at the time the exposure draft was issued.
2.2Amortisation of Identifiable Intangible Assets
Tutticci et al. (1994) indicate that the requirement for identifiable intangible assets to be amortised was an issue which received significant attention on the release of ED 49. Coombes, Otto and Stokes (1996) also suggest that amortisation of identifiable intangible assets has for sometime been a contentious issue in Australia (see also English, 1990; and Reilly, 1989). Two major issues arise in relation to amortisation of identifiable intangible assets. First, the broad question of whether or not identifiable intangible assets which have been capitalised should be written off over time, that is amortised, as opposed to carrying them in the balance sheet unamortised indefinitely. It is sometimes argued that intangibles such as brands and trademarks, which are receiving continued support from a company, have an unlimited life and should therefore not be subject to any requirement to amortise the asset (Ferris & Hall, 1989). While identifiable intangible assets are required to be amortised under AAS 4/AASB 1021, Depreciation,[4] it appears that many companies do not comply with these requirements (AAG 5, 1985; Carnegie & Kallio, 1988; Kirkness, 1987; Wines & Ferguson, 1993; Heazlewood & Ryan, 1999)[5]. Therefore many identifiable intangible assets are included in the balance sheet indefinitely. By not complying, companies are able to avoid the impact of amortisation on the profit and loss statement. ED 49 proposed to remove any discretion in relation to amortisation of identifiable intangibles that have been recognised in the accounts. Paragraph .40 explicitly required them, whether purchased or internally developed, to be systematically amortised.
The second major issue that arises in relation to amortisation of identifiable intangible assets is whether a maximum period of amortisation should be set. Reilly (1989) suggests that not setting a maximum amortisation period for identifiable intangible assets allows directors to argue for longer amortisation periods, and therefore to reduce the year to year impact of amortisation. This may also provide an incentive for companies to recognise identifiable intangible assets rather than goodwill, which must be amortised over a maximum period of 20 years.[6] ED 49 (para. .40) proposed that identifiable intangible assets be amortised over the period the benefits from the asset were expected to arise. It required that this period be finite. Paragraph (xi) suggests that few assets could be expected to provide benefits in excess of a 20 year period. Detailed disclosures were required if this 20 year period was to be exceeded (para. .70(g)).
In specifying that identifiable intangible assets be recognised and that they be amortised over a finite period, ED 49 proposed the introduction of significant change to how Australian companies account for such items. It is therefore not surprising that its release prompted debate and lobbying by interested parties. One form which such lobbying can take is submissions to the standard setting bodies. In the next section hypotheses regarding the lobbying positions taken by companies on these two aspects of accounting for identifiable intangibles are developed within a costly contracting framework.
3.Hypothesis Development
Within the costly contracting framework the contracting and political processes are used as the basis for investigating firms’ accounting method choices. One way in which such choices manifest themselves is in the expressed preferences of firms which make submissions to regulators during the standard setting process. In this section testable hypotheses are developed relating to the influence of two motivations derived from the framework, namely debt covenants and political sensitivity. Their relationships to companies’ expressed preferences in submissions to the AARF on the two central issues dealt with in ED 49, as discussed in Section 2, are developed.
3.1Debt Covenants
Contracting cost theory establishes a link between closeness to breach of debt covenants and managers’ preference for accounting methods that increase profit. Such methods are preferred as they reduce the probability of breaching such covenants, and avoid incurrence of the consequential costs of default.
In Australia the most commonly used ratio in specifying such covenants in trust deeds supporting listed public debt issues is liabilities to total tangible assets (Whittred & Zimmer, 1986; Stokes & Leong, 1988). Exclusion of intangible assets from the denominator suggests that the choice of methods when accounting for identifiable intangibles will not affect a firm’s proximity to a leverage constraint. According to Whittred and Zimmer (1986), most trust deeds usually require that patents, trademarks, goodwill, preliminary expenses and other assets which, according to usual accounting practice are regarded as intangible, be deducted from the value of a firm’s total assets. The studies by Whittred and Zimmer (1986) and Stokes and Leong (1988) are confined to examining covenants in the Australian public debt market. Mather (1998), from interviews with Australian bank officers, identifies commonly used financial covenants in Australian bank loan contracts as debt or leverage ratios and minimum interest coverage ratios. He finds that debt to total tangible assets and debt to equity are the two most commonly used leverage ratios. However, he observes that while the leverage ratio often excludes identifiable intangibles, occasionally borrowers are permitted to include such intangibles. Intangibles are included where the items are an integral part of cash flow generating capacity of the firm, and where the assets are regularly independently revalued (Mather, 1998). A common example is the value of mastheads in the media industry. This is an important exception, because it indicates that lenders are willing to accept some identifiable intangible assets when considering leverage ratios. Had ED 49 proceeded to the status of an accounting standard, its guidelines on accounting for identifiable intangible assets could conceivably have increased the use of identifiable intangible assets in such ratios, by providing strict recognition criteria. Further, no definition of intangibles is provided by Mather (1998) or earlier studies (Whittred & Zimmer, 1986; Stokes & Leong, 1988). This lack of a standard definition of an intangible asset suggests it is possible that some items covered by the ED 49 definition of an identifiable intangible asset could in practice be included in the calculation of leverage ratios.
If identifiable intangibles are capitalised, as was proposed in ED 49, then managers could still potentially choose an accounting treatment to minimise the impact of this requirement by their choice of the term over which to amortise the asset. This term is a continuum from 100% amortisation in the year of purchase to an infinite period. The longer the period, the closer is the company to charging no amortisation, and the more predictable and less variable is the effect on assets and profit. Thus, the closer a firm is to breaching a debt covenant the more likely it is to lobby for an accounting method which does not require amortisation of identifiable intangible items, or at least does not specify a maximum period of amortisation.
Given the above, the following hypotheses regarding the relationship between leverage and the expressed preferred treatment of identifiable intangibles assets in submissions on ED 49 are tested:
H1: The higher the debt to equity ratio, the more likely it is that a firm will lobby for capitalisation of identifiable intangible assets.
H2: The higher the debt to equity ratio, the more likely it is that a firm will lobby for a lower rate of amortisation.
Whittred and Zimmer (1986) found that interest coverage ratios were commonly used in debt covenants. Mather (1998) found that interest coverage ratios were almost always used in bank loan contracts, but that on occasions the effects of identifiable intangible assets were excluded from profit.
It is suggested that firms with lower interest coverage ratios are expected to prefer the capitalisation of identifiable intangible assets. This is because having a stable profit is less likely to cause a violation of the interest coverage ratio constraint. A similar argument can be developed for choice of amortisation rate if the identifiable intangible has been capitalised. The lower the amortisation rate the more predictable is profit, making violation of the minimum interest coverage ratio less likely. The expenses arising from either not recognising (ie. immediate expensing of their cost), or from capitalisation and subsequent amortisation of the identifiable intangible assets, are not usually added back when calculating the interest coverage ratio for public debentures (Coombes, Otto & Stokes, 1996). Thus, capitalisation of identifiable intangible assets leads to relatively higher profit, increasing the numerator of the ratio, therefore improving the overall calculated level of interest coverage. The following hypotheses are tested:
H3: The lower the interest coverage ratio, the greater the likelihood that a firm will lobby for capitalisation of identifiable intangible assets.
H4: The lower the interest coverage ratio, the greater the likelihood that a firm will lobby for a lower rate of amortisation for identifiable intangible assets.
Leftwich (1981) suggests that if a debt covenant needs to be renegotiated it is more costly to renegotiate public than private debt. This is because a trustee for publicly held debt cannot approve modifications to the debt contract without the approval of the debtholders (Leftwich, 1981). If there is a change in accounting practice which alters the terms of a debt contract, it would be less costly to renegotiate terms of a private contract (Deakin, 1989). This suggests firms which use public debt are more likely to prefer accounting principles which assist in avoiding covenant restrictions (Daley & Vigeland, 1983). In the context of the current study the following hypotheses are suggested:
H5: Firms with more public debt are more likely to lobby for capitalisation of identifiable intangible assets.
H6: Firms with more public debt are more likely to lobby for a lower rate of amortisation for identifiable intangible assets.
3.2Political Costs
According to contracting cost theory accounting numbers influence the political visibility and therefore the political sensitivity of a firm. It suggests that if accounting numbers such as reported profit are used as the basis for transferring wealth away from the firm, it will be in managers’ interests to adopt or to lobby on proposed standards for accounting methods which help to avoid political visibility and therefore wealth transfers (Holthausen & Leftwich, 1983; Lim, 1996).
Traditionally studies investigating political sensitivity have adopted firm size as the proxy for political sensitivity, hypothesising that ‘Ceteris paribus, the larger the firm, the more likely the manager is to choose accounting procedures that defer reported earnings from current to future periods’ (Watts & Zimmerman, 1986, p. 235). However, when considering the immediate expensing versus capitalisation of identifiable intangible assets this argument works differently. According to the size hypothesis, by immediately expensing an identifiable intangible asset an organisation could greatly reduce its reported profits for that period and therefore would be less politically visible. However, because there would be no amortisation expense recognised in the following periods, profits in those future periods would appear abnormally high and would therefore increase the political visibility of the organisation in those periods. Therefore, this study adopts a different approach, which is more concerned with income volatility in relation to political visibility. Consistent with other studies, it suggests that organisations may prefer to adopt accounting methods which produce a more stable profit figure to reduce the overall likelihood of negative wealth transfers (Pacecca, 1995). The more stable the profit figure, the less likely it is that there will be large abnormal profits in any one period which would draw public attention to the company. This suggests that more politically sensitive companies will prefer capitalisation and a low level of amortisation, because this limits the impact on profit each year, and therefore increases the stability of the profit figure.