Roundtable Meeting and Discussion of "Accounting for Goodwill"

Statement of
David Martin
M-CAM Inc.

10:00 a.m., Wednesday, June 14, 2000

Mr. Chairman, distinguished committee members, fellow panelists and guests, I would like to thank you for your invitation to discuss with you the increasingly important issues surrounding the use of intangible assets in domestic and international finance and business. My name is David Martin and I am the founder and chief executive officer of M•CAM Inc. M•CAM is the first company which built heuristics to reproducibly and auditably determine secondary market monetized value for intellectual property and intangible assets.

Two miles from our offices in downtown Charlottesville, Virginia one of this country's greatest statesman defined a fundamental doctrine which conveyed to each American the right to the ownership of thought and ingenuity. When, in 1790, Thomas Jefferson lobbied Congress to refine the Crown's historical practice of conveying statutory limited monopolies for the protection of innovation, he and his visionary colleagues realized that empires of the future would be built on intellectual property, not simply on the annexation of the globe. However, for the past 210 years, this right has languished in the ether – relegated to the conveniently flat-earth term – intangible.

In the midst of an unprecedented economic renaissance this Committee and many of its distinguished affiliates have begun to tackle one of the single greatest economic challenges facing today's economy. From whence does value come and how can it be represented? We've been inundated with "pool-of-interest" talk on the one hand and "one-click-shopping" cliché on the other. The FASB together with countless industry, academic and professional interests have identified an accountability deficiency in current accounting practices which allows, through the use of strategic reporting methods, incorrect representation of business combinations– both on the part of the acquiring and the acquired. An effort to bring discipline into chaos is a laudable effort. However, to lay antiquated methodology over a knowledge-based economy is inappropriate. To tax, through the amortization of the ill-conceived term "goodwill", those entities conducting business in the high technology and intellectual property rich markets is an egregious error. For to do so, one must make the assumption that prior to business combinations, the assets of both companies have been faithfully represented. This we know is not the case. Accountants, and the businesses they attempt to represent, have never appropriately taken into consideration the value of intellectual property and intangible assets.

Let us take a moment to review why we are here. Over the past three decades, an increasing proportion of our Gross Domestic Product and our gross exports have taken the form of knowledge and technology products. In a recent study by PricewaterhouseCoopers LLP, a trend analysis of intellectual asset management revealed that, in 1998, intellectual assets accounted for more than 78% of the total value of the S&P 500. 1 However, if one tunnels beneath the surface of this report, it is more accurate to state that over 75% of the value of the S&P 500 is not captured by the notion of "book value". This is not to say that all of that value should be described as an asset. This report taken together with numerous other studies and articles, highlights a fundamental limitation in the recent efforts taken by this Committee and the FASB to clarify the concepts embedded in what has been nefariously dubbed "goodwill".

As a practical matter, the words "intangible assets and intellectual property" and "goodwill" should not be used in the same breath. To do so is to state a lack of understanding of the U.S. Code, the Uniform Commercial Code, and most state property statutes. Assets including patents, copyrights, databases, trademarks (with some limitations), licenses, and business documents exist as property, are conveyed by right, can be severable through the exercise of a lien or sale, and enjoy protective rights to the same degree as other forms of personal and commercial property. Failure to understand them does not mean that they simply don't exist. The inability for present accounting practices to place them reliably on the balance sheets of America should not penalize the burgeoning majority of corporations for whom these serve as the chief assets of the enterprise. Book value, value investing, and new economy business do not have to be polar opposites. They are viewed as such, solely based on the insufficiency of present market metrics. It is my intent to illuminate two general areas of concern – asset definition and valuation – and then make recommendations on how this Committee and other interested parties may elect to add dimension to the historically flat 15th century horizon.

Asset Definition

Current federal and state law is largely adequate to accommodate the use of intellectual property and intangible assets in the same way "bricks and mortar" assets have been used. The title to, assignment of interest in, and sale of patents, copyrights, databases, licenses and other executory contracts are covered adequately in statute. The absence of these assets from the balance sheet is unconscionable. Consider the recent bankruptcy of an internationally known U.S. corporation which is best known for underwear and sports attire. While looms, inventory, and mills were listed as assets of the corporation, no value inured to the benefit of the creditors for the naming rights to a professional sports complex. No value was on the books for the right to place the likeness of sports teams and cartoon characters on t-shirts and under shorts. As a creditor, I certainly would rather have the naming rights for ProPlayer Stadium than a cotton mill! Yet, given current accounting standards, that option for value attributed to that real property interest didn't exist.

An example of the confusion surrounding the deployment of intellectual property assets on the balance sheets of U.S. companies is an ambiguity that exists in the U.S. Patent and Trademark Office. In an effort to meet the increasing demands of the innovative 90's, the USPTO hired more, specially trained examiners. On the surface, this sounds like a good idea. However, patents embody two realities which make the hiring of experts antithetical to the very purpose for which it was done. First, a patent needs to be novel. That is to say that, within reason, the idea is a new one. Second, a patent needs to be non-obvious. In an effort to meet market demands, patent examiners have been meticulously combing referenced prior art to make determinations on allowance. Highly trained examiners have neither the tools or, in many cases, the knowledge to examine prior art from other business sectors. This focus has led to an unfortunate and unintentional myopia with devastating import. Many patents issued today fail to cite all relevant prior art – a reality which could lead to the re-examination and ultimate disallowance of countless properties. In a recent study our company did on electronic banking and finance, we found that, searching through patents issued over the past 23 years alone, over 2,363 patents have been issued. Using a process we call Innovation Extraction Analysis, we were able to identify over 50% of the properties in this space which failed to cite prior art. Additionally, over 15% of the innovations happened concurrently. In these cases, near identical patents issued providing statutory monopoly rights to both or neither party. Our data is not alone in identifying this exemplary problem. Marc Pearl, general counsel for the Information Technology Association of America stated,

"Educating patent examiners on what techniques and technologies exist can help boost the credibility of patents and, in the process, create a body of documentation examiners can refer to when considering patent applications."2

Any statement suggesting that one needs to "boost the credibility" of intellectual property should serve as a wake up call to Congress and Corporate America. When major corporations donate patent portfolios to non-profits for tax deductions and when the patents embedded in those donations are soon expired or likely targets for disallowance, one can see a multi-billion dollar accounting problem that transcends simple business combination debates. In short, clarifying that an asset even exists is a concern which must be addressed prior to figuring out how it is accounted.

Asset Valuation

Title 15 of the U.S. Code, the Uniform Commercial Code and Bankruptcy law all presume that businesses and financial institutions use intellectual property and intangible assets. However, failure to account for these assets under uniform accounting practices goes on. Why?

I would like to propose two hypotheses. First, much of today's economy has no traditional basis. By this I mean that one cannot, under any stretch of the imagination, cost account the value of an asset that cures cancer, facilitates wireless transmission of data, and models the buying profile of the on-line baby boomers. One of my greatest innovations was the development of a technology which allowed for the surgical removal of tumors from the spinal cord using multi-axial laser guidance. This technology and the underlying patent cost $11,089. The patent filing cost was $11,000 – the device manufacturing cost was $89 and I built it in my apartment. While an accountant could correctly amortize this property – valued at $11,089 – over a period of 20 years, would that be correct? When this property was incorporated into 5 international corporations' diagnostic equipment products, what was the basis for the value of the asset? Do you suppose, that after over $250 million in procedures have been billed, using this technology, one would concur with an accountant booking the value of this IP at barely $11,000? No. In point of fact, this asset, to three corporations was worth over $15 million of saved R&D expense. This enabling technology revolutionized a market. The correlation between the value of innovation and its cost is diminutive. Value determined by multiple historically relevant transactions, not by hypothecating future earnings, can be reliably and conservatively measured.

A second reason for this failure is the lack of specificity surrounding the amortization of assets. In an effort to build a manageable universe, depreciation is lumped into arbitrary time intervals which have no relation to the asset. The concept of asset specific amortization is technically attainable with present technology; it simply requires leadership in its deployment – something that the accounting industry has not yet done. A biopharmaceutical patent may have value for 20 years, but an integrated circuit may retain value 15 months. Hundreds of millions of dollars placed into the construction of the center fuel tank of the Space Shuttle are invested for less than 3 minutes of effective life. An innovation which enables voice to coexist with wireless data transmission may have value only until its life as proof-of-concept technology bridges the chasm to metacomputer-based routers. The fact is that historical data – even that extracted from yesterday – can be used to appropriately amortize assets. In short, given the inability to cost account from whence an asset came and the vexing problem of the duration of its use, the flat-earth solution is to simply punt and purchase account "goodwill".

The appraisal industry has been equally unable to clarify the notion of intangible assets and intellectual property. Two schools of thought have been vocal in the value attribution debate. On the one hand, numerous economists and accounts have developed valuation methodologies driven largely from royalty or infringement damages matrices. On the other, investment bankers and consulting firms have tried to divine value from measuring prospective market trajectories. Neither of these provide the basis for the FASB's proposed guidance for "reliably measured" asset characterizations. 3 The inherent flaw in the appraisal methodologies is the same that is endemic to other hypothecated prospective tools – namely, the tools do not capture the dynamics associated with the collapse of the modeled sector. As evidenced by the banking industry's recent recoiling from enterprise lending and subordinated debt, when one links value attribution directly to an enterprise or a sector, the collapse of either implodes the model and its resultant predictions. This has led innovative institutions like Bank of America, SunTrust, CS First Boston, Ernst & Young and others to explore new collateralization concepts to find equity alternatives in today's market.

I would like to reiterate the fact that monetized value for intellectual property and intangible assets can be measured based on historical transactions when they are taken in context of the full underlying asset conveyance. Using licensing and sales precedents, the ability to characterize the transaction value associated with present and prospective innovation is modelable – not using prospective equity models but rather relying on historical data. Hybridizing pro forma revenue assumptions and building models of what value the future might hold cannot be reduced to a standard with any level of reliability in the face of wildly fluctuating equity markets.


1. Inform the Debate

While numerous parties have risen to defend or assault pooling of interest accounting practices thereby catching intellectual property and intangible assets in the "goodwill crossfire", I believe that it is imperative for Congress to publicly reinforce the fact that intangible assets and intellectual property exist by statute in all debates. Failure to put these assets onto the books and therefore, failing to adequately measure the gross domestic product, while a great national concern, should not confuse the fact that these assets do and will exist as severable property. No recommendation in any direction by the FASB or any other body alters this fact. For America to correctly support the basis of its economy and its currency, the ever-overlooked assets upon which our future rests, need to "count" in the GDP.

2. Applaud Efforts for Accountability

The FASB has addressed a significant problem facing corporate America's financial reporting. Technically, purchase method accounting can be embraced if two realities are addressed. Prior to implementing purchase method accounting, the FASB needs to provide guidance on how to place IP and intangibles on ALL corporate books. While this sounds simple, it isn't. Contemplate for a moment the following: conservatively assume that 45% of the U.S. economy is built on a "knowledge based" reality. Assume that an entire asset class, which has always existed but has never been accounted, shows up on the books. How do companies handle the earnings and tax consequences? Do we provide a restatement amnesty period so that, in one single moment, all companies get to appropriately audit and place on the books, their IP? While one day, I believe purchase method accounting will enjoy its role as THE standard, that day can only come when ALL assets are counted. Additionally intellectual property, intangible assets, and other assets for that matter, need to be amortized with greater specificity. Anyone who would recommend that Microsoft amortize the code for Windows NT over 20 years should encounter appropriate resistance. Why? Because the asset doesn't last that long. The laptop upon which this testimony is typed will exist on my company's books 5 years after I've finished using it. If CISCO purchases an enterprise for 500 times "book value" and integrates the resultant technology into the global market with great success, then 20-year amortized goodwill is wrong. Incorrect use of amortization will continue to force companies to inappropriately expense into oblivion the very assets upon which their value lies. The FASB can immediately solve a significant portion of the pooling problem immediately by enacting asset specific amortization. Failure to do so will encourage active and passive misstatement of financials. The Federal government should not allow this error to persist.

3. Vigorously Oppose Short-Term Solutions With Sweeping Ramifications

Pooling-of-interest accounting is prone to error. Purchase accounting without proper statement of assets is guaranteed to error. Fixing the pooling problem cannot be done by passively allowing it to persist in an M&A frenzied equity market. The FASB, this Committee, and in fact, the national interest is served by reliably putting into play an entire asset class built by Constitutional Right and Congressional acts 200 years ago. When our economy rises and falls on the emotions of the equity markets rather than anchoring itself to the fortitude of the assets underpinning our constituent enterprises, we should unite to jettison those flat-earth concepts which keep us from exploring a round globe. We can account ex nihilo.

I view, as a distinct pleasure, the ability to invite this Committee and all today's participants to explore the perspectives that our enterprise has aggregated. Our voice will join the chorus of those who strive to accurately represent the value existant in the business of today while capturing the tools necessary to adapt to the inevitable organic changes of tomorrow. Mr. Chairman and distinguished colleagues, let us not inadvertently regress – let us all move forward.

1 - BusinessWire. Intellectual Assets Account for 78 Percent of Total Value of S&P 500, PricewaterhouseCoopers Analysis Finds. April 17, 2000.

2 - Tillet, L. Scott. Patent Office Takes a Fresh Look at the Net. Internet Week, May 15, 2000.

3 - Jenkins, Edmund L. Testimony before the Subcommittee on Finance and Hazardous Materials of the Committee on Commerce. May 4, 2000.

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