Accounting Horizons

Vol. 21, No. 1

March 2007
pp. 2341

Unrecorded Intangible Assets:

Abnormal Earnings and Valuation
Mark Kohlbeck and Terry D. Warfield
SYNOPSIS: We use the unique banking industry setting to demonstrate the impact of
unrecorded intangible assets on abnormal earnings and equity valuation in the context
of the residual income valuation model. We show that the persistence of bank abnormal
earnings and, consequently, the pricing multiples on bank abnormal earnings, vary with
the level of unrecorded intangible assets. Our evidence suggests that unrecorded intangible assets are important in understanding the persistence and valuation of abnormal earnings in the banking industry. The analysis framework introduced in this
paper could also be used to examine the valuation impacts of intangible assets in other
industries.
Keywords: intangible assets; abnormal earnings; persistence; residual income model.
Data Availability: Data are available from the sources listed in the paper.

INTRODUCTION
arnings persistence is an important property of financial information that investors
incorporate in assessing firm value. We examine whether unrecorded intangible assets are a source of earnings persistence and how such persistence is priced. We use
the residual income model (RIM) setting in the banking industry and provide evidence that
the pricing of abnormal earnings1 is conditional on the level of unrecorded bank intangible
assets. We use the RIM to investigate the effect of unrecorded intangible assets because
(1) the RIM (Ohlson 1995; Feltham and Ohlson 1995, 1996) currently commands significant
popularity, and (2) the model provides a link from unrecorded intangible assets to valuation
that can be empirically investigated.
The accounting for many intangible assets is biased due to the predominant use of
historical cost accounting that does not reflect some assets or fair values. In general, the

Mark Kohlbeck is an Assistant Professor at Florida Atlantic University and Terry D.

Warfield is an Associate Professor at the University of WisconsinMadison.
We appreciate comments received from David Guenther (associate editor), Robert Lipe (editor), two anonymous
referees, Lisa Bryant, Qiang Cheng, Steve Henning, Tom Linsmeier, Matthew Magilke, Mary Lea McAnally, John
Wild, and workshop participants at the University of Wisconsin and the American Accounting Association Midwest
Regional Meeting. Financial support from the Wisconsin Alumni Research Foundation and the University of Wisconsin, School of Business is greatly appreciated. Professor Warfield also acknowledges support from the
PricewaterhouseCoopers Foundation.
1

Abnormal earnings are the excess of earnings over a required rate of return that is based on book value.

Submitted: July 2005

Accepted: August 2006
Corresponding author: Terry D. Warfield
Email: twarfield@bus.wisc.edu

23

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Kohlbeck and Warfield

future benefits of intangible assets are considered uncertain, and as a result, the vast majority
of internally generated intangible assets are not recognized in the financial statements
(AICPA 1970; FASB 2001).2 Consequently, economic rents, growth opportunities, and other
factors associated with intangible assets are not fully captured in the accounting system.
And future earnings are likely to exceed the normal return on book value of equity because
of these accounting biases (referred to as conservative accounting). That is, internally generated (and unrecorded) intangible assets represent a major source of abnormal earnings.
In straightforward scenarios, unrecorded intangible assets should lead to abnormal earnings. However, prior research has not empirically investigated why the two are related or
the implications of unrecorded intangible assets for valuation estimates.3 Significant investments in unrecorded intangible assets, if successful, should generate more persistent
abnormal earnings. We document the impact of unrecorded intangible assets on the persistence of abnormal earnings and the resulting effects on the pricing of abnormal earnings
for a sample of 1,065 bank-year observations.
We focus on banks because they exhibit a high degree of homogeneity in their operations, which reduces cross-sectional variation in factors that might otherwise affect valuation estimates (Beaver et al. 1989; Beaver et al. 1997). Although most other RIM studies
exclude banks from their samples, banking represents a good context to study the role of
unrecorded intangible assets in valuation. Due to a high proportion of financial assets and
liabilities, banking firms are less subject to conservative accounting with respect to their
on-balance-sheet items. In addition, methods for estimating intangible assets are more developed in the banking industry. Isolating the valuation role of intangible assets outside of
the bank setting is more challenging because non-bank firms generally have higher levels
of tangible assets, which are subject to conservative accounting practices. In addition, nonbank companies have a broader array of intangible assets, many of which are less susceptible to reliable measurement.
The primary bank intangible assets arise from a single sourcecustomer relationships
related to deposit, lending, and asset management operations. The largest of these intangibles, the core deposit intangible, quantifies a banks ability to obtain cash from depositors
at a relatively low cost. Three other bank intangibles have similar characteristics, reflecting
additional cash flows arising from existing customer relationships for mortgage servicing,
credit cards, and trust operations.
While these intangible assets give rise to economic rents, they generally receive conservative accounting treatment. However, unlike other contexts (e.g., research and development) for which estimates of unrecorded intangible assets can only be derived from
historical costs, existing bank disclosures permit the derivation of reasonable fair value
estimates of specific intangible assets. Previous research documents substantial valuerelevant unrecorded intangible assets for most banks (Kohlbeck 2004), but it does not
explore the link between the unrecorded intangible assets and abnormal earnings
persistence.
We first investigate the persistence of abnormal earnings conditional on the level of
unrecorded intangible assets. We show higher persistence of abnormal earnings for banks
2

Capitalization of software costs, movie rights, and mortgage servicing rights are permitted in specific situations
(Lev 2001).
Our study complements and extends Begley et al. (2006). While their study considers a theoretical approach to
modify the RIM for use with banks because of the existence of unrecorded intangible assets, we take a more
direct and focused approach. First, we consider a wider range of intangible assets and use actual measures of
unrecorded intangible assets. Second, we focus on how unrecorded intangible assets influence valuation through
the persistence of abnormal earnings, and we provide insight into why intangible assets affect valuation.

Accounting Horizons, March 2007

Unrecorded Intangible Assets: Abnormal Earnings and Valuation

25

with greater relative levels of unrecorded intangibles assets. Our second set of analyses
considers the pricing implications of the differential persistence levels by estimating a
valuation model for banks conditional on the magnitude of unrecorded intangible assets.
The abnormal earnings of banks with higher levels of unrecorded intangible assets are more
persistent and receive higher pricing multiples. We also estimate a valuation model with
book value of equity and abnormal earnings adjusted for the impact of the unrecorded
intangible assets in our sensitivity tests. We find that adjusted book value of equity is
valuation sufficient, consistent with the unrecorded intangible assets being the primary
source of bank abnormal earnings.4
Investors and financial analysts are increasingly interested in intangible assets. Our
findings imply that intangible asset measures or factors that are indicative of intangible
assets should be considered when assessing value. That is, our research shows that unrecorded intangible assets are important in the determination of bank value through the persistence of abnormal earnings, which complements the growing area of intangible asset
research. Although our evidence is based on banking firms and the RIM, it suggests the
need to consider intangible assets with other valuation models and/or other industries.
The remainder of this paper is organized as follows. Background and motivation are
provided in the next section followed by the presentation of our analysis framework. The
results are discussed in the fourth section, and concluding remarks follow.
BACKGROUND AND MOTIVATION
Residual Income Model
We investigate the influence of unrecorded intangible assets on earnings persistence
and valuation in the residual income model (RIM) setting for two reasons. First, the RIM,
as reintroduced by Ohlson (1995) and Feltham and Ohlson (1995, 1996), currently commands significant popularity in academic and financial circles. Second, the model provides
a link between unrecorded intangible assets (goodwill) and abnormal earnings. This link
can be empirically investigated to improve our understanding of the influence of unrecorded
intangible assets on abnormal earning as an alternative to including the unrecorded intangible assets as other value-relevant information in the RIM.
The RIM starts with the assumption that firm value equals the present value of expected
dividends. When combined with a clean surplus accounting assumption, the model produces a valuation based on current book value of equity and expected abnormal earnings.5
The addition of the linear information dynamics assumption (Ohlson 1995) relates future
abnormal earnings to current abnormal earnings and permits Equation (1) to be stated in
current measures:
MVt BVt AEt vt.

(1)

In Equation (1), MV is the market value of equity; BV is the book value of equity; and AE
is abnormal earnings, all as of the current period. The parameter incorporates the persistence of abnormal earnings (as well as time value of money and the risk properties of
4

Valuation sufficiency means that when considering an accounting information item (e.g., book value), no other
information item (e.g., earnings) is necessary to determine price.
See Ohlson (1995) and Feltham and Ohlson (1995) for the complete derivation of the RIM model. The clean
surplus assumption implies that when some value-relevant items are excluded from current book value (for
conservatism or other accounting reasons), the value implications of those items will be reflected in expected
abnormal earnings.

Accounting Horizons, March 2007

26

Kohlbeck and Warfield

abnormal earnings). Persistence measures the extent to which current year abnormal earnings are predictive of future abnormal earnings.
As indicated in Equation (1), an important insight of the RIM is that value is derived
from both the book value of equity and abnormal earnings elements. The relative valuation
weights attached to these elements depends on how well the book value component captures
all value-relevant information. For example, the book value element may be nearly or
completely valuation-sufficient when a company has few growth opportunities or when all
value-relevant assets are recorded. In this context, current period abnormal earnings have
nothing to add, and equals 0. In contrast, the earnings element plays a more important
role when book value excludes some value-relevant assets and/or when recorded assets
have significant growth prospects that are not reflected in their historical costs. For these
companies, the extent to which current abnormal earnings are useful in predicting future
abnormal earningsin other words, the persistence of abnormal earningsis important in
assessing value and can be significantly greater than 1.
Prior RIM research examines the determinants of abnormal earnings. Analytic studies,
such as Zhang (2000), conclude that economic rents and conservative accounting contribute
to non-zero abnormal earnings. Empirically, Cheng (2005) finds that both the level and
persistence of differential abnormal return on equity increase with market share, firm size,
firm-level barriers to entry, and firm-level conservative accounting factors (as captured by
expensing R&D). Similarly, Jansen (2002) decomposes residual income into economic and
accounting components and documents the association of these components with market
power and accounting bias.6
In summary, intangible assets are associated with economic rents, and these assets
generally are unrecorded until realized. Intangible assets can represent the expected additional cash inflows arising from a firms recorded investments that create or prolong competitive advantages (one source of economic rents). Intangible assets can also represent
other internal projects (for example, R&D) that generate additional future cash inflows, but
the expenditures are expensed in the current period (conservative accounting). As indicated
in Cheng (2005), both economic rents and conservative accounting are associated with
earnings persistence. We therefore consider the joint effects of a specific source of economic
rents and conservative accounting by examining the effect of unrecorded bank intangible
assets on the persistence of abnormal earnings and how the market responds to different
persistence levels.
In the next section, we develop the theoretical linkages between unrecorded intangible
assets and valuation in our bank setting.
Theoretical LinkagesIntangible Assets
RIM valuation theory suggests that abnormal earnings can arise due to either economic
rents or conservative accounting (Ohlson 1995; Feltham and Ohlson 1995). In either case,
future earnings are not recorded in the current period balance sheet. We refer to these as
unrecorded intangible assets. Our context is similar to Feltham and Ohlson (1995) where
6

Prior RIM research also examines the underlying assumptions of the model by exploring the persistence in
abnormal operating earnings, growth in operating assets as a component of book value, and conservatism in
reporting operating assets (Feltham and Ohlson 1996; Liu and Ohlson 1999; Zhang 2000; Ahmed et al. 1998).
The results from these studies generally support the RIM assumptions. Other studies comparing the accuracy of
RIM value estimates to those from competing valuation models yield mixed results (Bernard 1995; Francis et
al. 2000; Penman and Sougiannis 1998; Dechow et al. 1999; Begley et al. 2006). Efforts to improve the accuracy
of RIM valuation estimates generally focus on the time-series properties of abnormal earnings (Myers 1999;
Francis et al. 2000).

Accounting Horizons, March 2007

Unrecorded Intangible Assets: Abnormal Earnings and Valuation

27

abnormal earnings are related to operating activities and not financial activities. However,
in a bank setting, the financial activities are the operating activities. We therefore focus on
the unrecorded bank intangible assets associated with the financial assets and liabilities as
sources of abnormal earnings.
We first consider whether the persistence of abnormal earnings varies with the level of
unrecorded bank intangible assets. Prior empirical research of the determinants of abnormal
earnings is generally consistent with this assumption (for examples, see Cheng 2005; Jansen
2002). However, Chengs (2005) findings of barriers to entry and market share as sources
of persistence are less applicable to a bank setting. The banking industry, with over 9,000
commercial banks in 1998, and the largest bank holding just 6 percent of U.S. deposits, is
generally competitive with low barriers to entry and no dominant members.
Customer relationships are a primary source of bank abnormal earnings. Banks invest
in customer relationships when managers believe the investment will provide future returns
by increasing revenue or decreasing costs. Banks offering superior service and products
will likely experience lower customer turnover, and managers will attempt to protect operations and products that provide above average returns. In this context, Begley et al.
(2006) consider lending and deposit activities as sources of positive net present value, but
their focus is on theoretically developing and then validating a valuation model that is based
on the RIM. While we also use the RIM setting, our study investigates unrecorded intangible assets themselves and their association with persistence of abnormal earnings and
differential valuation effects.
Significant investments in customer relationships, superior service and products, and
above-average returns also are consistent with higher levels of unrecorded intangible assets.
For example, bank managers cite economies of scale in customer relationships as the basis
for bank merger activity during the past decade. While economies of scale will likely
influence the level of bank intangibles and the effects of bank intangibles on the persistence
of abnormal earnings, the banking economics literature (e.g., Hughes et al. 2002) suggests
that banks may experience diminishing returns to their investment in these unrecorded
intangible assets.
The common attribute across bank intangible assets is therefore the maintenance of the
customer relationship. By maintaining the customer relationship, the bank creates a lasting
intangible asset that in turn increases the sustainability of future abnormal earnings. Thus,
the first link we establish is that between the level of unrecorded intangible assets and the
persistence of abnormal earnings. Individually and collectively, the above factors suggest
that banks with higher levels of unrecorded intangible assets will exhibit greater persistence
of abnormal earnings.
If estimates of unrecorded bank intangible assets are associated with differing persistence levels, will investors price this difference? As indicated in Equation (1), persistence
is a determinant of the pricing coefficient on abnormal earnings. As a result, differences in
abnormal earnings persistence levels should be manifested in pricing effects. We therefore
expect that the abnormal earnings of firms with higher levels of unrecorded intangible assets
will exhibit higher pricing coefficients arising from higher persistence of abnormal earnings
associated with unrecorded intangible assets. That is, if abnormal earnings of firms with
higher levels of unrecorded bank intangible assets are more persistent, then firm valuations
should reflect a premium because investors value persistent earnings. Thus, the second link
we establish is the positive pricing effect associated with increased persistence of the abnormal earnings for companies with higher levels of unrecorded intangible assets.
In the next section, we describe the framework for empirically documenting these
linkages in the context of the banking industry.
Accounting Horizons, March 2007

28

Kohlbeck and Warfield

ANALYSIS FRAMEWORK
We first discuss the empirical proxies for bank intangible assets. We then develop the
measurement of abnormal earnings persistence and related tests of the association between
unrecorded intangible assets and abnormal earnings persistence. Finally, we present the
empirical models for investigating the effect of differing unrecorded intangible asset levels
on the pricing of abnormal earnings.
Bank Intangible Assets
We examine the following bank intangible assets: core deposits, mortgage servicing,
credit cards, and trust operations. The core deposit intangible reflects a banks favorable
deposit financing benefit and is based on deposits being a banks primary source of funding.
The interest cost to banks in accepting core deposits is generally less than alternatives such
as certificates of deposits or debt financing. Lower interest costs combined with the stable
and long-term nature of core deposit accounts creates an intangible asset that is realized
through future reduced financing costs. The value of mortgage servicing rights is the present
value of future servicing fee income after accounting for prepayment risk and related expenses incurred during the loans life. Similarly, credit card and trust operations intangible
assets represent the present value of future fees to be generated from existing customer
bases. Each of these intangible assets represents expected net future cash flows derived
from existing customer relationships. Banks also can generate earnings by capitalizing on
these relationships to cross-sell other bank services.
These bank customer relationships therefore give rise to important intangible assets.
However, the values of these customer relationships are generally not reflected in bank
book values and represent unrecorded intangible assets. Previous research documents substantial unrecorded intangible assets in almost all banks (see Kohlbeck 2004). We use
discounted cash flow techniques that are based in part on methodologies used by valuation
experts to estimate these intangible assets (mortgage servicing rights, credit card intangible,
core deposit intangible, and trust operations intangible.)
Our general approach is to determine future net income amounts (future economic
rents) by estimating (1) the net income related to the intangibles assets value, (2) a decay
rate to account for attrition of the existing asset or liability portfolio, and (3) the period of
benefit. The projected net income is discounted to arrive at intangible asset estimates using
bank- and time-period-specific weighted average cost of capital.
The general form of our measurement process is as follows:

tMi,t,k

IAESTk,i,t

jt1

E (CFk,i,t,j) (1 T)
.
(1 Di,t,j)(jt)

(2)

In Equation (2), IAEST is the estimate of the kth intangible asset type for bank i at time t;
M is an estimate of the period of benefit; E(CF) is an estimate of future cash flows related
to intangible asset k; T is the marginal tax rate (assumed to be 40 percent); and D is the
banks weighted average cost of capital. Additional discussion of estimation of each intangible asset measure is included in the appendix.
From the sum of each banks intangible asset estimates, we subtract the amount already
recorded by the bank as identified intangible assets to arrive at the unrecorded portion:

Accounting Horizons, March 2007

Unrecorded Intangible Assets: Abnormal Earnings and Valuation

IAEST

29

UIAi,t

k,i,t

IAi,t.

(3)

k1

In Equation (3), UIA is each banks estimated unrecorded intangible assets; IAEST is the
estimate of each type of intangible asset from Equation (2); and IA is the net book value
of each banks identified intangible assets included in the balance sheet.7
Persistence of Abnormal Earnings
As discussed earlier, the link from unrecorded intangible assets to bank value is manifest through abnormal earnings, and in particular, the persistence of abnormal earnings.
Intuitively, persistence refers to the extent to which current year abnormal earnings are
predictive of future abnormal earnings. Consistent with prior RIM research, we measure
persistence based on the correlation between current and prior year abnormal earnings.8
We use the following regression of one-period-ahead abnormal earnings on current abnormal earnings to estimate the persistence of abnormal earnings (the firm subscripts are
omitted here and in subsequent equations):9
AEt1 0 1AEt t1.

(4)

In Equation (4), AE represents abnormal earnings and is defined as income available for
common shareholders before extraordinary items less the time-specific risk-free return on
beginning of year book value of common equity.10 The estimated coefficient for abnormal
earnings in Equation (4), 1, represents an overall estimate of its persistence. We examine
the impact of the level of unrecorded intangible assets on the persistence of abnormal
earnings (our first link) by examining whether banks with higher levels of unrecorded
intangible assets exhibit higher abnormal earnings persistence.
Pricing of Abnormal Earnings
To provide evidence on the pricing effects of unrecorded intangible assets, we use the
following model based on Equation (1):11
7

10

11

If the recorded intangible asset exceeds the total of our estimate, then we set the unrecorded intangible asset to
zero. This affects only seven observations, or less than 1 percent of the observations. We also separate the
unrecorded intangible asset estimate into its three known componentsunrecorded mortgage servicing rights,
unrecorded credit card intangible, and unrecorded other identifiable intangible assets consisting of the core
deposit and trust operations intangible assetsand repeat our analyses. Our overall results appear to be driven
by the other identifiable intangible assets and to a lesser extent the credit card intangible. The increased recognition of mortgage servicing rights under existing accounting principles may be responsible for its weaker
results.
This process is referred to as autoregressive with one lag (or AR1). Findings of prior empirical research (for
example, see Dechow et al. 1999; Bar-Yosef et al. 1995) are generally consistent with this assumption. We also
analyzed the abnormal earnings process for our data (untabulated) and find that an AR1 process is reasonable.
This equation and subsequent estimating equations are scaled by beginning of period book value of equity to
control for scale effects (Christie 1987; Brown et al. 1999). Note that a separate 1 is estimated for each bank.
We assume risk-neutrality consistent with Ohlson (1995) and use a risk-free rate to maximize sample size. Lo
and Lys (2000) suggest that in cross-sectional tests, a firm-specific discount rate should be used in the measurement of abnormal earnings. In sensitivity tests, we allow the discount rate to vary by firm by using a firmspecific discount rate that is calculated as the risk-free rate plus the firms beta (calculated using weekly returns
over the preceding year and the Capital Asset Pricing Model) times a fixed market premium. Although the
alternative measurements increase the number of bank observations with negative abnormal earnings, by virtue
of a higher minimum return, our findings are not significantly affected.
We measure the share price as of the end of the first quarter following the fiscal year-end to capture the
information lag from releasing annual financial information after year-end.

Accounting Horizons, March 2007

30

Kohlbeck and Warfield

MVt 0 1BVt 2 AEt t.

(5)

To test whether the pricing coefficient of abnormal earnings varies with the level of
unrecorded intangible assets (due to variation of the persistence of abnormal earnings), we
estimate the model for different subgroups of the sample, based on level of unrecorded
intangible assets.12 If abnormal earnings of high unrecorded intangible asset banks are more
persistent, then we should observe a higher estimated coefficient on abnormal earnings for
groups of banks with higher levels of unrecorded intangible assets.13
EMPIRICAL RESULTS
Data
Financial data from 1992 to 1998 for publicly traded bank holding companies are
gathered from annual financial reports, annual regulatory reports, and the Center for Research in Security Prices (CRSP) research tapes. We start with a sample of 347 bank holding
companies over six years (1,492 bank-years). We first exclude 190 bank-year observations
that lack one-period-ahead abnormal earnings that are necessary for our persistence analysis. Second, prior research reports that coefficients differ between firms with positive and
negative earnings (Collins et al. 1999; Leibowitz 1999), and we anticipate that similar
differences will also exist with respect to abnormal earnings. Because negative abnormal
earnings are less persistent than positive abnormal earnings, we exclude 237 bank-year
observations with negative abnormal earnings. In order to provide a consistent sample
between our tests, we perform both our persistence and pricing tests after both eliminations.
The final sample consists of 1,065 bank-year observations.
Descriptive statistics for the sample are presented in Table 1. The pooled sample data
exhibit significant variation in bank size, operations, growth, profitability, and estimated
unrecorded intangible assets. The estimated unrecorded intangible assets are substantial
averaging 40.7 percent of book value of equity. Note that banks also have significant recorded intangible assets (4.3 percent of book value of equity), primarily arising from deposit
relationships, mortgage servicing, credit cards, and trust operations that were acquired in
business combinations.14
In Table 2, we report the means of the financial data reported in Table 1 for the bankyear observations partitioned into deciles according to the magnitude of total UIA divided
by prior year-ends book value of equity. The data reveal that banks with the lowest levels
of UIA are smaller and have lower deposits to assets, abnormal earnings, and return on
equity. Not surprisingly, given the conservative accounting treatment for UIA, the marketto-book ratios generally increase as we move from the lowest to highest UIA deciles. The
largest UIA decile has the highest asset growth and return on equity. UIA for banks in the
highest UIA decile comprise approximately 90 percent of book value of equity.
Figure 1 plots the average total estimated intangible assets (IA) for each UIA decile as
a bar, and the average UIA is displayed as a line. In addition, each bar is split according
12

13

14

In estimating Equation (5), we make a simplifying assumption that persistence level is constant across all banks
except for the impact of unrecorded intangible assets. This assumption restricts the overall persistence level to
be equal for all banks within the subsample. This restriction may introduce noise that could bias against detecting
the role of persistence in the pricing of bank shares.
To formally test the association between unrecorded intangible assets and abnormal earnings persistence and
variation in valuation conditional on the level of unrecorded intangible assets, we use a regression model with
interaction terms. These models and results are discussed in the next section.
GAAP requires identifiable intangibles acquired in a business combination to be recorded at fair value. Similar
intangibles that are internally developed cannot be recorded.

Accounting Horizons, March 2007

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Unrecorded Intangible Assets: Abnormal Earnings and Valuation

TABLE 1
Descriptive Statistics, 19921998
Variablea
(n 1,065)
Assets ($ in millions)
Deposits / Assets (%)
Abnormal Earnings ($ in
millions)
Market-to-Book Value of
Equity (%)
Adjusted Market-to-Book
Value of Equity (%)
Asset Growth (%)
Return on Assets (%)
Return on Equity (%)
Estimated Unrecorded
Intangible Assets / Equity (%)
Recorded Intangible Assets
/ Equity (%)
Total Estimated Intangible
Assets / Equity (%)
a

Mean

Median

Standard
Deviation

25th
Percentile

75th
Percentile

16,844.6
77.0
51.3

3,050.6
79.0
7.1

40,864.9
10.4
159.6

1,138.4
70.6
2.1

11,981.1
85.1
33.4

198.2

175.0

88.7

142.9

232.3

143.3

132.6

63.4

101.4

169.1

17.4
1.2
14.4
40.7

11.0
1.2
14.7
35.2

23.3
0.4
5.4
27.7

5.3
1.0
12.4
25.7

22.6
1.4
16.8
49.4

4.3

1.7

7.5

0.3

4.7

44.9

39.0

29.2

28.7

53.4

Variables are defined as follows (all amounts are as of year-end unless stated otherwise): Assets are total
assets; Deposits / Assets is the ratio of total deposits to total assets; Abnormal Earnings is the excess of
earnings over a required rate of return; Market-to-Book Value of Equity is the ratio of market value of
common equity to book value of common equity; Adjusted Market-to-Book Value of Equity is the ratio of
market value of common equity to the sum of the book value of common and an estimate of unrecorded
intangible assets; Asset Growth is percentage change in total assets during the year; Return on Assets is
income before extraordinary items divided by average assets; Return on Equity is income before extraordinary
items divided by average common equity; Estimated Unrecorded Intangible Assets is the ratio of the difference
between each banks total estimated intangible assets and its recorded intangible assets to book value of equity;
Recorded Intangible Assets is the ratio of the sum of the net book values of each banks identified intangible
assets included in the balance sheet to book value of equity; and Total Estimated Intangible Assets is the ratio
of the sum of the estimates of each banks intangible assets to book value of equity.

to intangible asset type. Examination of the components of IA presented in Figure 1 reveals

that approximately 56 percent of IA comes from deposit intangibles.15 For the middle deciles, deposit intangibles make up an even higher proportion of IA. For example, in the fifth
decile, deposit intangibles comprise 70 percent of total IA, while the credit card and trust
intangibles together account for less than 26 percent of total IA. The level of the mortgage
service rights is fairly constant across the UIA deciles with the exception of the extreme
two deciles where the levels of mortgage servicing rights are more than 50 percent greater
than in the other deciles. Interestingly, banks with the lowest and highest UIA also report
a higher proportion of recorded intangible assets. Although the middle decile banks report
lower recorded intangible assets, the proportion of UIA attributed to deposit intangibles is
higher for these middle deciles (generally over 70 percent).
15

Morgan and Cates (1994), Berkovec et al. (1997), Ausubel (1991), and Nash and Sinkey (1997) provide descriptive information about intangible assets of banks based on acquisition premium data. Our estimates of the
fair values of intangible assets are generally consistent with their results and available SFAS No. 107 disclosures.

Accounting Horizons, March 2007

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Accounting Horizons, March 2007

TABLE 2
Mean Statistics by Unrecorded Intangible Asset Decile, 19921998
1
Lowest

10
Highest

Assets ($ in millions)
Deposits / Assets (%)
Abnormal Earnings ($ in
millions)
Market-to-Book Value of
Equity (%)
Adjusted Market-to-Book
Value of Equity (%)
Asset Growth (%)
Return on Assets (%)
Return on Equity (%)
Estimated Unrecorded
Intangible Assets / Equity (%)
Recorded Intangible Assets
/ Equity (%)
Total Estimated Intangible
Assets / Equity) (%)

12,762.8
68.5
14.2

5,433.6
75.1
13.0

4,591.1
78.2
12.7

10,623.7
77.1
31.6

14,325.0
79.9
44.7

24,213.2
78.5
66.1

15,036.9
79.5
51.3

20,020.4
78.2
58.4

29,572.1
77.6
101.0

31,861.1
77.2
119.7

186.2

185.3

191.2

194.9

198.1

188.0

195.8

210.6

204.7

227.9

168.7

153.9

151.8

149.7

149.0

136.5

137.5

139.3

128.2

119.0

16.4
1.1
12.0
10.8

16.2
1.2
13.9
20.6

14.1
1.2
14.1
25.8

10.5
1.1
13.1
30.3

12.8
1.2
14.9
33.2

11.9
1.1
13.9
38.3

16.0
1.2
15.0
42.0

13.7
1.2
15.7
51.3

21.9
1.1
15.1
60.7

40.4
1.2
16.3
93.7

6.6

4.3

3.3

3.4

2.7

3.4

3.3

4.0

5.2

6.0

16.8

25.0

29.2

33.8

35.9

41.7

45.4

55.4

65.9

99.8

Refer to Table 1 for variable definitions.

Kohlbeck and Warfield

Variablea
(n 1,065)

33

Unrecorded Intangible Assets: Abnormal Earnings and Valuation

FIGURE 1
Estimated Intangible Assets by Unrecorded Intangible Asset Decile

100
Core Deposit Intangible

Mortgage Servicing Rights

90

Credit Card Intangible

Trust Operations Intangible

80

Unrecorded Intangible Assets

$/Equity

70
60
50
40
30
20
10
0
1

10

Unrecorded Intangible Asset Decile

Evidence on Linkages
The theory presented earlier indicates that future abnormal earnings are expected when
intangible assets are not recorded. We first examine the correlations between one-periodahead abnormal earnings and unrecorded intangible assets. The overall correlation of 0.324
(p-value 0.001) indicates future abnormal earnings are associated with UIA.16
To provide evidence that unrecorded intangible assets affect the persistence of abnormal
earnings, we estimate Equation (4) over UIA quartiles. As reported in Table 3, we find that
the persistence parameters, 1, for the third and fourth UIA quartiles are significantly greater
than those for the first and second UIA quartiles. These results support the first link in our
analysis and suggest that unrecorded intangible assets should play a role in the valuation
of abnormal earnings.
We also estimate a pooled regression that allows the persistence parameter to vary by
UIA level. This measure, DUIA, is developed by assigning each bank to one of ten portfolios
based on the level of unrecorded intangible assets divided by prior year-ends book value
of equity (1 lowest level, 10 highest level) and transforming the portfolio ranking to
range between 0 and 1. We formally test the differential effect of unrecorded intangible
assets on bank valuation in the following equation:
16

We also estimate by-quartile and pooled regressions of one-period-ahead abnormal earnings on unrecorded
intangibles assets and two variables based on prior research, the banking literature, and our descriptive statistics
that may be related to abnormal earningssize and growth. We confirm that unrecorded intangibles assets are
positively related to future abnormal earnings consistent with our expectation that UIA gives rise to future
profitability.

Accounting Horizons, March 2007

34

Kohlbeck and Warfield

TABLE 3
Persistence of Abnormal Earnings Conditional on Unrecorded Intangible Assets
Equation (4): AEt1 0 1AEt t1
Variablesa
n

R2

1 (Lowest UIA)

262

53.7%

268

48.2%

268

69.8%

4 (Highest UIA)

267

63.1%

UIA Quartile

Intercept
( 103)

AE

1.662
( 0.001)
1.772
( 0.001)
1.246
( 0.001)
3.234
( 0.001)

0.585
( 0.001)
0.444
( 0.001)
0.784
( 0.001)
0.751
( 0.001)

p-values for testing that the coefficient is zero are in parentheses.

a
AE is abnormal earnings. The intercept and AE are scaled by prior year-ends book value of equity, and the
portfolios are based on UIA divided by prior year-ends book value of equity.

AEt1 0 1AEt 2AEt * DUIAt t1.

(6)

We find that the persistence parameter varies positively with UIA in this pooled regression
(not tabulated). The persistence for the lowest decile (w2) equals 0.450 (p-value 0.001),
and persistence increases with the level of UIA (2 0.332, p-value 0.001). The results
are robust when we control for size, growth, and year.
We also obtain bank-specific estimates of persistence by estimating Equation (4) by
bank over the sample time period. We regress the persistence measures on the level of
unrecorded intangible assets in the latter years of our sample and find that our bank-specific
persistence measures are positively related to unrecorded intangible asset level.
We then examine the effects of UIA, if any, on the pricing of bank shares. In Table 4,
we report the estimation of Equation (5) by UIA quartile. While the pricing coefficient for
book value of equity is fairly consistent around 2.0, the pricing coefficient for abnormal
earnings generally increases with UIA.
Analogous to the persistence tests, we also assess the pricing effects using the DUIA
interaction. By interacting the ranking variable with abnormal earnings and book value
variables in Equation (5), we formally test the differential effect of unrecorded intangible
assets on bank valuation:
MVt 0 1BVt 2 AEt 3DUIAt 4DUIAt * BVt
5DUIAt * AEt t.

(7)

We find that the pricing of abnormal earnings varies positively with UIA in this pooled
regression (untabulated), with the relative UIA effect captured by an interaction variable of
abnormal earnings and UIA level (5 8.595, p-value 0.001). This pricing analysis
indicates that the incremental pricing effects are not due to the extent of UIA because the
differential persistence effect remains significant after including DUIA to capture the level
of UIA effect. Further, the main abnormal earnings effect (2) is not significant, suggesting
Accounting Horizons, March 2007

35

Unrecorded Intangible Assets: Abnormal Earnings and Valuation

TABLE 4
Market Pricing
Equation (5): MVt 0 1BVt 2 AEt t
UIA Quartile
1 (Lowest UIA)

R2

Intercept
( 103)

262

82.9%

13.719

268

89.3%

268

88.1%

4 (Highest UIA)

267

82.5%

(0.014)
16.013
( 0.001)
20.500
( 0.001)
7.011
(0.205)

Variablesa
BV

AE

1.940
( 0.001)
2.049
( 0.001)
2.054
( 0.001)
1.962
( 0.001)

4.271
(0.001)
2.031
(0.039)
4.549
( 0.001)
11.147
( 0.001)

p-values for testing that the coefficient is zero are in parentheses.

a
Variables are defined as follows: MV is market value of equity at the end of the first quarter following the
fiscal year-end; BV is the book value of equity; and AE is abnormal earnings. The intercept and all variables
are scaled by prior-year-ends book value of equity, and the quartile portfolios are based on UIA divided by
prior-year-ends book value of equity.

that book value is relatively more valuation sufficient for banks with lower levels of unrecorded intangible assets where the sources of abnormal earnings are limited.
Our valuation analyses indicate that UIA are associated with bank price through the
persistence of abnormal earnings. However, our results are not strictly monotonic across
UIA quartiles, and the persistence levels do not map directly to the pricing of abnormal
earnings. Separate analyses indicate that the monotonic increase and mapping improve when
we use finer UIA partitions and allow for nonlinearity.
Overall, the second link in the framework is supportedthe pricing of abnormal earnings increases as unrecorded intangible assets increase. That is, the valuations reflect the
greater persistence of the abnormal earnings of firms with greater levels of unrecorded
intangible assets.17
Alternative Valuation Approaches
Our primary results provide evidence that the persistence and pricing coefficients for
abnormal earnings increase with the magnitude of unrecorded intangible assets. We consider
two alternative specifications of the valuation model to address other related implementation
possibilities. First, we adjust book values and abnormal earnings for unrecorded intangible assets to correct for the conservative accounting. Second, we model unrecorded intangible assets as other value-relevant information. As discussed below, our earlier findings
are corroborated by the results from these alternative specifications.
We extend our pricing analysis by estimating Equation (8) using book values and
abnormal earnings adjusted for the impact of unrecorded intangible assets:
17

We estimate the pooled regressions of Equations (4) and (5) by year, using fixed time effects, using fixed firm
and time effects, and without eliminating the negative abnormal earnings observations. We also include bank
size (total assets) and growth (year-to-year change in assets) as additional potentially value-relevant information
in Equation (5). Results are consistent with those reported. Given the promulgation of new accounting standards
for investments and mortgage servicing rights (SFAS No. 115 in 1993, and SFAS No. 122 in 1995 [FASB
1995]), we also re-examine the tests for different subperiods of the data. The primary inferences are robust to
the inclusion of interaction terms to measure the effects of SFAS No. 122 and SFAS No. 115.

Accounting Horizons, March 2007

36

Kohlbeck and Warfield

MVt 0 1BVAt 2 AEAt t.

(8)

In Equation (8), BVA is the book value of equity plus the estimate of unrecorded intangible
assets (BV UIA); AEA is abnormal earnings adjusted for estimates of unrecorded intangible assets (earnings plus the change in unrecorded intangible assets during the year less the
required rate of return based on adjusted book value of equity); and MV is as previously
defined. The change in UIA represents the income statement impact from incorporating the
estimated unrecorded intangible asset value in the balance sheet, and this impact captures
the creation of new intangible assets, changes in value estimates, and the wasting of prioryear amounts. To the extent our measure of unrecorded intangible asset captures the pricing
of unrecorded intangible assets by investors, we expect that the influence of adjusted abnormal earnings in the estimation of Equation (8) will be less than unadjusted abnormal
earnings in Equation (5). This test can, therefore, provide corroborating evidence on the
pricing effects of unrecorded intangible assets.
Table 2 demonstrates an association between unrecorded intangible assets and marketto-book ratios. Not surprisingly, the reported and adjusted market-to-book ratios are similar
for banks in the lowest decile of UIA (1.86 versus 1.68). But for banks with the highest
levels of unrecorded intangible assets, the adjusted ratio of 1.19 is quite smaller than the
reported ratio of 2.27. In Table 5, we report the results of pooled regressions based on book
values and abnormal earnings adjusted for estimated unrecorded intangible assets.18 Only
book value exhibits a significant association with price after we adjust book value and
abnormal earnings for the impact of UIA. That is, book value becomes valuation sufficient
when primary sources of abnormal earnings (UIA) are included in book value.
TABLE 5
Adjusted Residual Income Model
Equation (8): MVt 0 1BVtA 2 AEtA t
Variablesa,b
(n 628)

Equation (5)
Coefficient
t-statistic

Equation (8)
Coefficient
t-statistic

Intercept ( 103)
BV / BVA
AE / AEA
Adjusted R2

16.87***

6.57

1.94***
9.68***
83.9%

3.9
24.9
7.7

1.59***
0.07
81.7%

1.4
26.7
0.2

*** Significant at the 0.01 level.

a
Variables are defined as follows: MV is market value of equity at the end of the first quarter following the
fiscal year-end; BV is the book value of equity; BVA is the book value of equity plus the estimate of
unrecorded intangible assets; AE is abnormal earnings; and AEA is abnormal earnings adjusted for estimates of
unrecorded intangible assets. The intercept and all variables are scaled by prior year-ends book value of equity.
b
Mean statistics for the explanatory variables scaled by prior-year-ends book value of equity are as follows:

BV / BV
AE / AEA

18

Unadjusted

Adjusted

1.211
0.058

1.718
0.152

The sample size of 628 reflects the loss of observations that lack necessary lagged data to adjust book value of
equity and abnormal earnings. Similar results are obtained when we separately estimate the equation for each
UIA quartile.

Accounting Horizons, March 2007

Unrecorded Intangible Assets: Abnormal Earnings and Valuation

37

Information items, such as unrecorded intangible assets, are sometimes modeled as

other information that is useful in explaining price. In this case, rather than being viewed
as a determinant of the persistence of abnormal earnings, the unrecorded intangible asset
information is supplemental to book value of equity and abnormal earnings. We modify
Equation (7) to include UIA as an independent variable to investigate this possibility. The
results for this model (not tabulated) corroborate our earlier findings with respect to the
persistence of abnormal earnings increasing in UIA (the estimated coefficient for abnormal
earnings interacted with the UIA portfolio ranking is 8.213, p-value 0.001). Although
UIA is also significant when modeled as other information (estimated coefficient of
0.347, p-value 0.010), including UIA does not significantly increase the explanatory
power of the valuation model compared to a pooled estimation of Equation (7).
CONCLUDING COMMENTS
We examine the implications of unrecorded intangible assets for the persistence and
valuation of abnormal earnings in the banking industry. We focus on the banking industry
because it represents a context in which both economic rents and accounting conservatism
exist and because banks exhibit a high degree of homogeneity in their operations, which
reduces cross-sectional variation in factors that might otherwise affect our estimated valuation effects. In the bank setting, we can isolate the role of intangible assets in valuation.
This is because banks generally have a high proportion of financial assets; banking firms
are therefore less subject to conservative accounting with respect to their on-balance-sheet
assets. Existing bank disclosures also permit the derivation of reasonable estimates of specific intangible assets. These intangible assets reflect how existing customer relationships
related to core deposits, mortgage servicing, credit cards, and trust operations can increase
the banks future cash flows and its value.
We document that unrecorded intangible assets are related to the persistence and pricing
of abnormal earnings. First, we provide evidence of greater persistence of abnormal earnings for banks with larger unrecorded intangible assets. Second, we find that the pricing
multiples for abnormal earnings increase from lower to higher levels of unrecorded intangible assets.
Our tests are motivated in part by limited prior research on the influence of unrecorded
intangible assets on the persistence and valuation of abnormal earnings in the residual
income model. In addition, the adequacy of the current historical cost accounting model
has been challenged as it relates to the accounting for intangible assets (Lev 2001). Our
tests provide evidence on the merits of developing estimates of intangible assets when
implementing the RIM.
These findings are also important because they identify information that can lead to
improved understanding of the role of intangible assets in equity valuation. Investors and
financial analysts are increasingly interested in intangible assets. This interest appears consistent with our evidence that unrecorded intangible assets are influential in the determination of firm value in industries such as banking where relevant and reliable measures of
unrecorded intangible assets are available. Additional research is needed to examine other
industries where factors might be associated with the existence of intangible assets (for
example, R&D intensity).

Accounting Horizons, March 2007

38

Kohlbeck and Warfield

APPENDIX
Measuring Intangible Assets
This appendix provides a brief discussion of the each of the intangible assets considered
in this paper (see Kohlbeck [2004] for further discussion).
Mortgage Servicing Rights
The value of mortgage servicing rights is the present value of future servicing fee
income after accounting for prepayment risk and related expenses incurred during the loans
life. It is calculated as follows:

tMi,t

MSRi,t

jt1

Li,t

(Ri,t,j1 Ri,t,j)
SR (1 Expi,t) (1 T)
2
(1 Di,t,j)(jt)

(A1)

where MSR is the mortgage servicing rights for bank i at time t; L is the outstanding balance
of mortgage loans serviced for others; R is the estimated percentage of the portfolio balance
remaining in year j of the loan portfolios life of M years, where R is determined using the
Public Securities Association (PSA) prepayment rates to account for prepayments and defaults; SR is the service revenue rate assumed to be 37.5 basis points, the rate typically
charged for mortgage-backed securities insured by government agencies and corporations;
Exp is the banks overall expense ratio calculated as the ratio of total salary and occupancy
expense to operating revenue; T is the marginal tax rate assumed to be 40 percent; and D
is the banks weighted average cost of capital.19
Credit Card Intangible
Ellsworth (1991) developed a model to value credit card premiums based on discounted
cash flows and the existing customer base. We estimate fee income levels using the Federal
Reserve Functional Cost Analysis (FCA) survey data and base the expenses on the banks
overall expense ratio.20 The estimated income is then discounted over an arbitrary five-year
period as follows:

t5

CCi,t

jt1

CCLi,t (CCRevt)(1 Expi,t)(1 T)

(1 Di,t,j)(jt)

(A2)

where CC is the credit card intangible; CCL is the outstanding balance of credit card loans;
CCRev is noninterest revenue (exchange and consumer fees) per dollar of outstanding credit
card loans for a given year and is obtained from the FCA; and Exp, T, and D are as
previously defined.
19

20

The weighted average cost of capital is a linear combination of the banks alternative funding rate and riskadjusted return on equity using the banks leverage ratio as the weighting factor. The zero-coupon Treasury
instrument yield curve is used to proxy the alternative funding rate because of its availability and similarity to
the retail certificate of deposit yield curve (Miller 1995). The return on equity is derived using the Capital Asset
Pricing Model and daily return data from the Center for Research in Security Prices research tapes over the
preceding year.
The Functional Cost Analysis is an annual survey of approximately 100 banks conducted by the Federal Reserve
Banks where member banks choose to participate (FRB 19911996). The summarized data are commonly used
in bank valuations and intangible asset estimation when bank-specific data are unavailable (Miller 1995).

Accounting Horizons, March 2007

39

Unrecorded Intangible Assets: Abnormal Earnings and Valuation

Core Deposit Intangible

The core deposit intangible quantifies a banks favorable deposit financing benefit and
is based on deposits being a banks primary source of funding. The cost to banks in accepting core deposits is generally less than alternatives such as certificates of deposits or
debt financing. Lower costs combined with the stable and long-term nature of core deposit
accounts creates an intangible asset that is realized through future reduced financing costs.
We quantify the intangible assets value by estimating after-tax earnings rates for each core
deposit type, applying the rates to estimated remaining deposits, and then discounting the
cash flows. The following formula is adapted from Miller (1995):

CDIi,t

tMi,t

k1 jt1

CDi,t,k

(RRi,t,j1 RRi,t,j)
(INTi,t Ii,t,k MTNt,k)(1 T)
2
(1 Di,t,j)(jt)

(A3)

where CDI is the core deposit intangible for bank i at time t; CD (core deposits) are total
deposits of type k of N total types where demand, savings, and money market accounts are
deposit types; RR is the deposit retention rate for year j in the average deposit life of M
years;21 INT is the average interest rate of the banks interest earning assets times the
percentage of investable deposits; I is the average interest rate paid on deposits of type k;
MTN is the operating costs associated with the each type of core deposits for a given year
and is obtained from the FCA; and T and D are as previously defined.
Trust Operations Intangible
The trust operations intangible asset value is derived from the present value of the
expected future income on trust assets currently under management. The current trust income earned by a bank proxies for expected trust income because it is based on the existing
level of assets under management and fee rates are normally constant as a percentage of
assets managed. Because the duration of the income benefit is unknown, we assume a fiveyear life. The estimation model is as follows:

t5

TRUSTi,t

jt1

TRevi,t(1 Expi,t)(1 T)
(1 Di,t,j)(jt)

(A4)

where TRUST is the trust operations intangible; TRev is annual amount of each banks
revenue disclosed as trust-related activities; and Exp, T, and D are as previously defined.

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