Characteristics of Intangible Assets
Intangible assets are identifiable non-monetary assets that cannot be seen, touched, or physically measured.
Differentiate between legal intangibles and competitive intangibles
- Intangible assets are either legal or competitive in nature, and can be very valuable to a company’s competitive position.
- Intangible assets can have either identifiable or indefinite useful or legal lives.
- The nature of an intangible asset will determine what costs are initially capitalized and how expenses related to the intangible asset are subsequently recognized.
- intangible asset: 1. Assets that are non-current, non-monetary, and non-physical.
- monetary unit assumption: the business should have one dollar (or corresponding currency) to record its transactions
- monetary: 1. Of, pertaining to, or consisting of money.
Intangible assets are defined as identifiable non-monetary assets that cannot be seen, touched or physically measured, and are created through time and effort. Intangible assets are identified separately on a company’s financial statements, and come in two primary forms: legal intangibles and competitive intangibles.
Legal intangibles are also known as intellectual property, and include trade secrets, copyrights, patents, and trademarks. An example would be Coca-Cola’s drink formula which is a closely held trade secret that only a few employees know; this is an example of an internally developed intangible asset.
Competitive intangibles include collaboration, leverage, structural activities, and customer loyalty. Human capital is the primary source of competitive intangibles.
Goodwill is technically an intangible asset, but is usually listed separately on a company’s balance sheet. Goodwill is only recognized through an acquisition of a company or business combination and is calculated as the difference between the amount of money paid to acquire a company and the fair or book value of the acquired company’s net assets. Goodwill is a type of intangible asset that is acquired and recorded due to a business acquisition or combination rather unlike other intangible assets, which may be internally developed by the company.
Company [latex]X[/latex] is a car dealership with assets consisting of 10 cars valued at $100,000, an office valued at $150,000, and long-term debt valued at $25,000. Company [latex]X[/latex]‘s net assets total [latex]$100,000 + $150,000 – $25,000 = $225,000[/latex]. Company [latex]X[/latex] has a top-performing sales personnel who are loyal to the company and refuse to leave. Company [latex]Y[/latex] is a larger car dealership in the area and decides to purchase Company [latex]X[/latex] for $300,000 in order to capitalize on Company [latex]X[/latex]‘s sales force. The extra [latex]$300,000 – $225,000 = $75,000[/latex] that Company [latex]Y[/latex] paid above Company [latex]X[/latex]‘s net assets are recognized by Company [latex]Y[/latex] as Goodwill on their balance sheet.
Intangible assets have a useful life that is either identifiable or indefinite. Intangible assets with identifiable useful lives are amortized on a straight-line basis over their economic or legal life, which ever is shorter. Intangible assets with indefinite useful lives are assessed each year for impairment. Impairment losses are determined by subtracting the asset’s market value from the asset’s book/carrying value. If an impairment loss is found it is recognized on the income statement and the intangible asset value is reduced.
Under US GAAP, intangible assets are classified into: Purchased vs. Internally Created Intangibles, and Limited-Life vs. Indefinite-Life Intangibles.
Financial Statement Recognition
Firms initially record intangible assets at cost, however only costs associated with the outright purchase in the acquisition of an intangible asset. Research and development costs incurred during the internal development or self-creation of an intangible asset are not costs that can be capitalized. This then means that some companies have very valuable assets that they are not allowed to recognize on their balance sheets under US GAAP.
Valuation of Intangible Assets
The valuation of intangible assets are primarily derived from transactions involving intangible assets.
Summarize how to calculate the value of an intangible asset
- Intangible assets include items such as patents, copyrights, software, trade secrets, and goodwill. However, not all intangible assets are recognized on the financial statements of a company.
- The costs to acquire and defend intangible assets are used by accountants to establish intangible asset values.
- Valuation is an estimate that is subject to change based on market conditions and advances in technology.
- Trademark: A word, symbol, or phrase used to identify a particular company’s product and to differentiate it from other companies’ products.
- valuation: An estimation of something’s worth.
Valuation of Intangible Assets
Valuation models can be used to value intangible assets such as patents, copyrights, software, trade secrets, and customer relationships. Since few sales of intangible assets are observable, benchmarking the value of intangible assets can be difficult. As a result, present value models or estimating of the cost to recreate an intangible asset are often used to is these valuations.
Although they have no physical characteristics, intangible assets have value because of the advantages or exclusive privileges they provide to a business. Intangible assets generally arise from two sources: (1) exclusive privileges granted by governmental authority or by legal contract, such as patents, copyrights, franchises, trademarks and trade names; and (2) superior entrepreneurial capacity or management know-how and customer loyalty, which is called goodwill.
Intangible assets are initially recorded on financial statements at their purchase price, or the cost of acquiring the asset. If an intangible asset is internally generated, its cost is immediately expensed.
The valuation of intangible assets with identifiable useful lives such as patents, trademarks, and copyrights are initially valued at acquisition costs. The value of these assets can be increased or decreased, based on the outcomes of court proceedings. If a company incurs legal costs to successfully defend an intangible asset, those costs are capitalized and increase the value of the intangible. On the other hand, if a company is unsuccessful in defending an intangible asset, the intangible is worthless and the company is required to write it off.
U.S. GAAP has very specific rules regarding the recognition of intangible assets on financial statements. With that said, a company can still have very valuable intangible assets that are not recognized on its financial statements. From an accounting perspective, intangible asset valuation is primarily derived from acquisition costs. An acquisition identifies the value one party was willing to pay for an asset while at the same time identifying the value another party was willing to accept to relinquish that asset.
Goodwill is an excellent example of how intangible assets are valued. Let’s say Company A has net assets equal to 150,000 and is acquired by Company B for 200,000. Why would Company B pay a 50,000 premium? Goodwill! Company B believes that Company A has value in excess of their net identifiable assets, and was willing to pay an additional 50,000 to acquire it. The 50,000 value of Company A’s goodwill was derived from a transaction.
Amortization of Intangible Assets
The costs of intangible assets with identifiable useful lives are amortized over their economic/legal life.
Explain how to amortize an intangible asset
- Intangible assets are amortized using the straight line amortization method.
- Goodwill is an intangible asset that is not amortized, but is instead tested for impairment on an annual basis.
- The economic or useful life of an intangible asset is based on an estimate made by management and is subject to change under certain market conditions.
- goodwill: The value of an asset that is considered intangible but has a quantifiable “value” in a business. For example, a reputation the firm enjoys with its clients.
- Indefinite: Without limit; forever, or until further notice; not definite
- impairment: When the carrying value exceeds the fair value.
Amortization of Intangible Assets
Under US GAAP, the cost of intangible assets are either amortized over their respective useful/legal lives, or are tested for impairment on an annual basis. Amortization is the systematic write-off of the cost of an intangible asset to an expense, which effectively allocates a portion of the intangible asset’s cost to each accounting period in the economic or legal life of the asset (an amortization expense). Only recognized intangible assets with finite useful lives are amortized. This differs from tangible assets which are depreciated (resulting in a depreciation expense) over their useful life.
Intangible assets have a useful life that is either identifiable or indefinite. Intangible assets with identifiable useful lives are amortized on a straight-line basis over their economic or legal life, whichever is shorter. The finite useful life of an intangible asset is considered to be the length of time it is expected to contribute to the cash flows of the reporting entity. Pertinent factors that should be considered in estimating the useful lives of intangible assets include legal, regulatory, or contractual provisions that may limit the useful life.
Costs of Intangible Assets
Firms may only include the immediate purchase costs of an intangible asset, which do not include the costs associated with internal development or self-creation of the asset. If an intangible asset is internally generated in its entirety, none of the costs related to the asset are capitalized.
Straight Line Amortization vs. Testing for Impairment
An intangible asset is amortized if the asset has an identifiable useful life. The annual expense recognized as a result of straight line amortization is simply the cost of the intangible asset divided by the number of years in it’s estimated useful life. The amortization expense recognized each year will be the same, and the value of the intangible asset will be 0 at the end of its useful life
Company X purchases a patent for $17,000, which enables the owner to manufacture, sell, lease, or otherwise benefit from an invention for 17 years. Company X would recognize an intangible asset valued at $17,000 and amortize that cost over 17 years. Each year, Company X will recognize an expense of $1,000 in addition to decreasing the value of the patent reported on the balance sheet by $1,000. See the figure below for an example of a U.S. patent.
Scenario A: After 5 years Company X is sued for patent infringement and is required to hire a lawyer. The patent lawyer charges $10,000 and is successful in defending Company X’s patent. The $10,000 spent to defend the patent is capitalized to the value of the patent on Company X’s balance sheet and then amortized over the remaining 12 years of the patent’s legal life.
Scenario B: After 5 years Company X realizes that their patent is worthless due to advances in technology. As a result of the useful life of their patent being reduced from 17 years to just 5 years, the remaining unamortized value of $12,000 is expensed and the patent is written down to a value of $0.
Goodwill is an example of an intangible asset that has an indefinite useful life, and is therefore tested for impairment on an annual basis as opposed to being amortized on a straight line basis. A company cannot purchase goodwill by itself; it must buy an entire business or a part of a business to obtain the accompanying intangible asset. Under current US GAAP, firms are required to compare the fair value of reporting units to the respective reporting unit’s book value, which is calculated as assets plus goodwill less liabilities. If the fair value of the reporting unit is less than its carrying value, goodwill has been impaired. An impairment loss is recognized on the income statement and the goodwill account is reduced. The impairment loss is calculated by subtracting the fair value of a reporting unit’s net assets from the reporting unit’s carrying value.