Value of Internally Generated Intangible Capital

Abstract

Based on the current U.S. GAAP, internally developed intangibles are not included in reported assets. Omission of an increasingly important class of assets reduces the usefulness and relevance of financial statement analysis, conducted using book value. Recent studies attempt to overcome this deficiency by capitalizing the outlays reported in selling, general, and administrative (SG&A) expenses and reestimating book values with capitalized intangibles, using a perpetual inventory model. However, those studies rely on one-size-fits-all mechanical rules of thumb, such as treating a uniform 30% of SG&A as investments and assuming the same life of SG&A investments across all industries. We propose a new method to estimate the industry-specific capitalization and amortization rates for research and development and SG&A outlays. Our modified book value exhibits greater association with future risk-adjusted returns, future investments, and bankruptcy probability as per the Altman Z-score model, relative to both as-reported book values and the mechanically adjusted book values. We contribute to the literature by proposing a new method for estimating intangible investments and by providing a better estimate of book value that can be used by consumers of financial statements.

Keywords: Intangibles, Book Value, Financial Statement Analysis, Valuation

JEL Classification: M21, M41