The first approach to IC reporting incorporates reporting on limited and defined items of IC as part of the financial accounting system. Under that approach there is a potent inconsistency in reporting on acquired as opposed to internally developed intellectual assets, creating even more confusion and unbalanced treatment. Despite this, the first approach fits with the 500-year-old tradition and thus is one which allows slow yet sure adjustment of some of the limitations of the financial reporting system. The problem, however, is that these changes are not based on a well-thought-out methodology, or review of the accounting/reporting system but rather are spurred by market and investors' pressures .

The second approach goes beyond the traditional accounting system and develops a new lan­guage to report on IC. Being a new language, the second approach suffers from inconsistency in definitions and choice of measures, and built-in idiosyncrasies caused by lack of agreed-upon standards. The following is an examination of these two approaches.

The First Approach - IC Reporting in Financial Statements

In the United States and other developed economies, certain types of IC have made it into the financial reports. To date the most tangible forms of IC, also known as hard assets - intellectual property or structural capital - are the ones that made this leap. Still, reporting on a collection of "soft" IC or assets is allowed by reporting on acquired goodwill. Some changes have happened

in the United States in 2001 to distinguish between the two - the identifiable intangible assets and the general pool of intangible assets that can be grouped as goodwill - again only in relation to acquired assets. Now corporations in the United States are required not only to report on the acquired intangible assets and goodwill but to reevaluate them periodically. This has directed top management attention to the role of IC reporting in the United States, as now they have to continu­ally assess the value of at least their acquired IC. The divergence in dealing with acquired and inter­nally developed IC remains one of the main malfunctions of this approach. Let's have a closer look.

Acquired Intangible Assets. Financial Accounting Standard (FAS) No. 141 (Business Combi­nations) and FAS No. 142 (Goodwill and other Intangibles), effective June 30, 2001, introduced the following changes:

•   Eliminated pooling of interests requiring companies to report on all acquired intangibles.

•   Eliminated the amortization4 of goodwill. Goodwill now should be examined and sepa­rated from identifiable intangible assets (e.g., brands, patents and contractual agree­ments). Goodwill comprises all other unidentifiable elements that enhance the future earning potential of the company (e.g., corporate image and customer loyalty). Goodwill should then be allocated to a reporting unit where its value should be subject to impair­ment tests5 on an annual basis, or completely written off, whenever circumstances war­rant such adjustment.

•   Identifiable intangible assets6 are separated and treated according to their useful lives. Assets with indefinite life are to be treated similarly to goodwill, while those with a def­inite useful life are to be amortized over their useful life. Both types should be allocated to a reporting unit, and in the latter case impairment tests are carried whenever circum­stances warrant, to adjust for changes in the value or the useful life.

The new rules are promising, as the accounting community is increasingly acknowledging the need for transparency in relation to merger transactions which are arguably driven by the need to strengthen the IC of the enterprise. The rules, which are similar to standards developed by the International Accounting Standards Committee (IASC), coupled with the lack of reporting on similar IC assets just because they are developed internally, rather than acquired, may grievously misrepresent the value of the IC base of the enterprise. Reporting only on acquired items of IC while failing to report on similar internally developed items will not only deepen the disparities between the actual and reported value of the enterprise, but may also result in an erroneous valu­ation of the enterprise. This risk is multiplied even further by disparities created by the rules per­taining to reporting on internally developed intellectual assets, as outlined next.

Internally Developed Intangible Assets. Internally developed intangible assets are treated dif­ferently under accounting rules and standards. Investments in the development of intangible assets and IC are generally treated as costs that should be written off as incurred, a method referred to as expensing. Seen as a business expense rather than investment in assets, expendi­tures on developing intangible assets suffer under the constant pressure on organizations to cut their business expenses and show short-term profits. If seen as investment, then such costs can be accounted as assets on the basis that they will create future value (generate revenue or save cost) over their useful lives, a method referred to as capitalizing. The strong contrast in the accounting principles as they stand now is that acquired intangibles are capitalized (and hence amortized over their useful life) while their internally developed counterparts have to be expensed.

The rationale of the FASB behind this differential treatment is the uncertainty involved regard­ing returns from developing intangible assets. Opinion No. 17 provides that the cost of develop­ing intangible assets may be capitalized only if the period of expected future benefits can be determined. FASB Statement No. 2 took the position that research and development (R&D) costs should be expensed based on the high degree of uncertainty and the lack of causal relationship between R&D costs and the benefits received. FAS No. 86 on the other hand modifies this slightly when it comes to computer software programs and provides that costs can be capitalized after the technological feasibility7 of the software has been established, and be amortized on a product-by-product basis over the useful life. It is hard to see why the same standard cannot be applied to development of other intangibles upon establishing their technological or market fea­sibility.

The latter is the position taken by the IASC and a number of European accounting standards boards. For example the Netherlands allows the capitalization of both research and develop­ment costs while New Zealand allows the capitalization of development costs only. Germany on the other hand requires the expensing of both. It is worth noting that both Australia and the United Kingdom allow for the capitalization of the costs of brand development, unlike the United States.

The importance of IC, or as the FAS B calls it intangible assets, to the performance of the com­pany is clearly demonstrated by the various assets that forced their way into financial statements. It is true that to a great extent the most tangible forms of IC, also called hard assets - intellectual property or structural capital - are the ones that made this leap. Still, the preservation of goodwill as a collection of soft IC or assets, despite the strict scrutiny of corporate acquisitions - provided by the requirement of separating goodwill from identifiable intangible assets and reevaluating its value - is a positive indication. The rules, however, create confusion and inconsistency by treat­ing identical items of IC differently based on whether they are internally developed or acquired, and whether R&D relates to software or other technology. The question also still remains on the viability of financial reporting to reflect the value of human and customer capital to the organi­zation's future earning potential. The rules developed under the first approach not only fall short of reporting on all types of IC but they also confuse IC reporting by mixing and matching depending on the pressures of the time instead of developing a comprehensive approach. That is when initiatives developed under the second approach come in with attempts to develop new methodologies to address the dilemma of IC reporting. To that we now turn.