- Nick Olson; Summer Associate; Paul, Weiss, Rifkind, Wharton & Garrison LLP
In 1971, an assistant professor at Portland State University was trying to get his start-up company, then called “Blue Ribbon Sports,” up off the ground. While teaching a class on accounting, the professor noticed one of his students—Carolyn Davidson—had a gift for design, so he asked her if she could help him come up with a logo for his company. Carolyn agreed, and after some back-and-forth and several rejected designs, the professor eventually settled on one particular logo and paid Carolyn $35 for her work. The professor wasn’t crazy about the logo at the time—in fact, when he accepted the design, he told Carolyn, “I don’t love it, but it will grow on me.”
Well, it didn’t take long for the design to grow on that professor. Nor did it take long for that design to become well-known throughout the world. After all, that business professor and entrepreneur in 1971 was Phil Knight. The company? It was renamed “Nike.” And the $35 design? It was the classic Nike “swoosh”—one of the most recognized and most valuable trademarks in the world—with an estimated value today of more than $13 billion.
However, because the Nike logo was purchased for only $35, and because intellectual property is accounted for at cost under Rule 141 of the Financial Accounting Standards, Nike’s balance sheet currently lists its logo as worth only the $35 that Phil Knight paid for it. And that is the story of how an outdated accounting rule caused Nike’s balance sheet to be off by tens of billions of dollars.
A similar story involves one of the most valuable patents in the world: Viagra. In 1991, Pfizer gave some of its employees a large R&D budget in the hopes that the company’s chemists could come up with a pill that could be used to treat heart problems, chest pain, and high blood pressure. The chemists tried several compounds out, but nothing seemed to have any significant effect on the patients’ chest pains. One strain, however, produced a rather “noticeable” side effect on its patients during the clinical trial. Pfizer quickly realized that the compound could be marketed, not as a medication for chest pain, but as a solution to erectile dysfunction. With its patent and FDA approval, Pfizer brought Viagra to market. Since then, Pfizer has made tens of billions of dollars off Viagra, making the drug one of the world’s most valuable patents.
So what do these two stories have in common? They both involve incredibly valuable assets that—due to an outdated accounting rule—are considered valueless on a company’s balance sheet. Under Rule 141 of the Financial Accounting Standards, GAAP (Generally Accepted Accounting Principles) requires companies to list intangible assets—including IP like the Nike “swoosh” or the Viagra patent—at cost. In other words, if you look up Nike’s balance sheet, you will see that the company currently values its $13 billion logo at $35. And if you look up Pfizer’s balance sheet, you will not find the value of Viagra anywhere, because its R&D costs were expensed, resulting in an accounting disparity in the billions.
That discrepancy taints the usefulness of financial statements everywhere, especially with the rising importance of intellectual property. Despite the fact that Nike’s trademark may now be worth tens of billions of dollars, it is recorded at a pittance on Nike’s balance sheet. And that is for a footwear company! The inaccuracies are even more extreme with technology companies. A periodic mark-to-market system, or periodic appraisals and valuations, would make financial statements far more accurate and reliable. It would make financial statements between companies more comparable. It would greatly improve investor relations. It would save accountants, lawyers, and investors tons of trouble. And it would encourage merger and acquisition activity.
As IP becomes more and more prominent in the values of companies, sooner or later GAAP will have to adjust to allow IP and other intangibles to be reflected accurately in financial statements. But until that time, don’t go running to accountants or their financial statements if you want an accurate picture of how much your company’s IP assets are worth.