What are intangible assets?
Intangible assets are valuables that are not physical in nature and can be converted to cash such as goodwill, patent, trademarks, and copyrights. In the latter part of this article, we will look at these examples.
It is possible for businesses to either create or acquire intangible assets. If a company creates this form of an asset, it will not appear on the balance sheet and they have no recorded book value.
We can classify an intangible asset as either definite or indefinite. The brand name of a company is considered an indefinite intangible asset because it remains with the company for as long as it continues its operations. It is not limited based on age, contract, or regulatory obligations. A definite intangible asset has a limited life and an example is a legal agreement to operate under another company’s patent with no plans of extending the agreement. We consider them definite because there is a foreseeable end to the value of the asset which takes place at the end of the legal agreement for the patent.
Although intangible assets have no obvious physical value to a factory or equipment, they can prove valuable for a firm and be critical to its long-term success or failure. For example, a firm such as Coca-Cola would not be nearly successful as it is without the money made through brand recognition. Coca-Cola has a vast inventory, but intangible assets (like brand recognition and good reputation) have greatly increased the value of that inventory. Although brand recognition is not a physical asset that one can see or touch, it can have a meaningful impact on generating sales.
One key factor that makes intangible assets stand out from other forms of assets is that they are not physical in nature and they do not have any physical value attached to them. However, this does not make them less valuable. They are most common among businesses and are classified by their growth and value over time. They are long-term assets that a company plans to use for more than a year.
Sooner or later, businesses will acquire an intangible asset whether they are obtaining an operating license, building a brand name that brings about a direct increase in profit, or trademarking something. They can acquire these assets by purchasing them, receiving government grants, or creating them in-house.
Characteristics of intangible assets
- No physical presence
- Business control
- Future economic benefits
- Valuation cost determination
- Cannot be used as collateral
No physical presence
As the name implies, intangible assets do not have a physical presence or existence. However, this does not make them less valuable than other forms of assets. They are of great value to a firm and they are essential for its success.
Another characteristic of intangible assets is that they must be identifiable and there are two main components to being identifiable. The first component is that the asset comes from a legal contractual right such as an existing agreement to supply a given customer. the second component is that the asset is capable of being separated from assets and being sold or otherwise transferred to its own right.
This type of asset must be under the business’s control. This implies the ability to gain from the use of the asset, for example, by having the right to make products protected by a trademark. There should also be a reasonable expectation that these gains will continue in the future. In essence, a business should have the power to obtain benefits from the asset.
Future economic benefits
The asset must possess future economic benefits in several ways such as revenue from the sale of the products, .cost-saving, etc.
Except for goodwill, intangible assets are amortized over their years of useful life. This is similar to depreciation which is applicable to fixed assets.
Valuation cost determination
It is challenging for firms to determine their valuation costs. This is because sometimes, it is difficult to see the future benefits of holding them. Other times, it is difficult to measure the total life of an intangible asset, that is why it is important to amortize them over a certain period of time.
Cannot be used as collateral
Unlike tangible assets that lenders can seize if the loan is not paid back, this form of assets cannot be used as collateral for obtaining loans for business expansion.
Intangible assets examples
- Trademark and trade dress
- Patented technology, computer software, databases, and trade secrets
- Customer relationships and lists
- Contractual agreements
- Brand equity
- Intellectual properties
Goodwill is the most common form of intangibles. We oftentimes hear that the business of any specific entity is purely running based on the goodwill either they have earned or purchased in the acquisition. it is generally the premium paid for the purchase of any business for getting leverage in the market. It has an indefinite life, therefore, does not get amortized over a period of time.
Goodwill does not always make it to the balance sheet and if it does, it will show up on a separate line than other intangible assets, because it is difficult to measure them directly from the standpoint of valuation.
Trademark and trade dress
Trademark is a sign, design, or expression that is recognizable. It identifies the product or services of a particular source from others. In essence, trademarks exclusively identify the commercial source of products and services. It is a contributing factor to cash flows as it increases the volume of sales or enables the owner to charge the brand.
Trade dress refers to a unique color, shape, or packaging of the product. If a company registers this with the government registrar, then it fulfills the criterion of a legal contract.
For example, a particular company manufactures cookies and biscuits. This company has a trademark and trade dress that relates to the size, shape, packing material quality, color, look, etc. On the basis of such trademark and trade dress owned in their name, no other manufacturer in that country can undertake the production of cookies and biscuits in that manner.
Patented technology, computer software, databases and trade secrets
A patent refers to a combination of rights that a nation grants to an inventor for a limited period in lieu of detailed disclosure of an invention. Patents have a useful life of twenty (20) years. They contribute to cash flows, not only in the enhancement of products made by the firm but also from the royalty income when they are licensed out.
A trade secret is a formula, practice, or design that others do not know about. Based on this, the firm can achieve an economic advantage over competitors or a group of competitors.
For example, Coca-Cola has had a trade secret formula for producing famous coke since its inception. They also have patent and trad secrets for flavors that they use in manufacturing for over 100 years.
Generally, copyrights protect plays, literary works, pictures, photographs, and audio-visual materials. The owner of the copyright receives royalty payment or remuneration on granting permission for the usage of copyright property. the valuation of assets that are artistically related is most challenging because a creative asset has no market comparable.
For example, a movie producer produced a mission possible movie. With the release of the movie, the producer is having all satellite and broadcasting rights. Based on such rights, this producer is having full authority to determine the theatre in which this movie will be released and on which television channel the same movie will be displayed.
Customer relationships can be contractual and non-contractual. Long-term customer relationships possess great intangible value for any business. They develop from past contracts that have given a different edge to the trade relationships. The value of customer contracts and related customer relationships is bound to flow either an increase in cash flows owing to the contract or potential new contracts from the same customers. Therefore, a firm’s relationship with customers has significant value. This value can also be referred to as the customer lists on financial statements. Customer lists can help a business to increase and sustain profits.
For example, a bank that is a credit card company has a broad customer base and these customers undertake a broad variety of transactions. The list of such transactions possesses huge value because it will give a picture of the taste and preferences of specific locations.
Contract-based intangibles represent the value of rights that arise from contractual agreements. It is easy to identify such agreements since they meet the contractual legal criterion. The contracts can be classified as intangible if they are assessed to bring about cash flow for the contracting party in the future or intangible liability. These contracts include license agreements, broadcasting permits, exploration rights, use rights, right of way, lease agreements, franchise agreements, etc. Such rights are conferred based agreement that permits one to carry on a business.
Brand equity is the representation of a brand’s worth and its ability to generate sales and profit for the company. Depending on the company, the brand name can be critical to the business’s success. When a company has positive brand equity, there is a tendency for customers to be more willing to pay a high price for its products even if they could get the same thing from its competitors at a lower price.
An example here is the brand recognition of Pepsi for PepsiCo. It possesses an intangible value that significantly impacts the sales for PepsiCo as well as the success of the business.
Intellectual properties, also known as IPs are created in the mind of an individual and can be used to produce a positive result, service, or product.
Some examples of IPs include copyrights, trademarks, franchises, patents, literary works, designs, and trade secrets. They are valuable to a company and its products or services. Research and development (R&D) is another form of intellectual property. It makes reference to when a company performs research with the objective of developing a new product or solution. IP and R&D work together because the research alone may not produce a valuable asset but the development side will.
Another example of an intangible asset is a license. It can be something that legally enables the operation and money-making of a business. A business may also purchase licenses to make use of particular software in order to operate and make sales.
Amortization of intangible assets
Amortization of intangible assets is the method by which a company expenses the cost of intangibles over a specific period of time. In other words, it involves the consistent reduction in the recorded value of an intangible asset over its projected life. It is making reference to the write-off of an asset over its expected years of useful life.
Usually, a company purchases intangible assets from other entities. They can be recorded as a result of the acquisition of another entity and are less frequently recorded in the books of account than tangible fixed assets. However, intangibles recorded as part of acquisitions are most times of considerable size. With this, the amortization method and useful life that are associated with them can have a profound and negative effect on the reported profits of the acquiring entity. It is common for an acquiring entity to experience years of losses as it gradually writes off the intangible assets associated with an acquisition.
As soon as amortization begins, it is rarely changed, except there is evidence that the value of the asset that is being amortized has become impaired. If this happens, then there is an immediate write-down in the remaining value of the intangible asset in the amount of the impairment. At this point, it is necessary to evaluate whether the asset’s useful life has also changed, and then modify the amortization calculation to incorporate not only the useful life but also the remaining or reduced carrying amount of the asset. A company should properly document these changes since the company auditors will examine them as part of the annual audit.
We can consider the case of a business organization that buys a patent for $15,000 for 15 years. The company can utilize the patent to its benefit for this period. The total value of the patent which is $15,000 is amortized over the period of 15 years. Each year, the company will amortize an expense of $1,000 and deduct the value from the value of the patent on its balance sheet every year. It is in this manner that the total value of the patent is expensed by the amortization method during the patent’s years of useful life.
There can be cases where the useful life of the patent owned for 15 years no longer counts for up to 15 years. If we consider that the patent became worthless after 5 years for the company, then it means that the useful life of the asset has been reduced from 15 to 5 years. So, for only five years, the cost of the asset can be amortized and it is expensed by $1,000 yearly. Here, the remaining cost which is $10,000 which is unamortized will be expensed together and on the balance sheet, the value of the patent is being reduced to $0.
Another instance is when there is an excess of the expenses, probably because of a break in terms of a third party. In this case, there is a need for the firm to hire a lawyer. If let us assume that the firm hired a lawyer who charged the company $10,000 and successfully defended the patent. In this case, the amount that the lawyer spent which is $10,000 is being added to the value of the patent and amortized over its useful life.
Amortization of intangible assets can be used for two purposes namely;
- Tax planning
- Accounting purposes
The amortization of intangibles is useful in tax planning as well as tax deferment. The Internal Revenue Service (IRS) gives room for taxpayers to take deductions for certain expenses.
Companies amortize intangibles for accounting purposes. Amortization itself is an accounting process where a company periodically lowers the book value of an intangible asset.
Intangible asset valuation
Intangible asset valuation is a process in accounting practice used to recognize assets on business combinations at fair values. The aim is to improve acquisition accounting transparency.
Intangible assets possess an incredible value. However, determining the exact value can be quite challenging. there are well-known million-dollar brands that contribute to the overall company’s value if being sold. Determining the level of contribution of intangible assets to the overall company’s value and calculating the amount it would cost someone to duplicate your asset are both tactics for valuing an intangible asset.
As earlier pointed out, businesses can either create or acquire intangible assets. For example, a business may either create a mailing list of clients or establish a patent. If a business creates an intangible asset, expenses can be written off from the process such as filing the patent application, paying other related costs, or hiring a lawyer.
Additionally, all expenses incurred from creating the intangible are expensed. However, the intangible assets that a company creates do not appear on the balance sheet and do not have any recorded book value. It is because of this that when a company is purchased, the price is usually above the book value of assets on the balance sheet. The purchasing company keeps records of the premium as an intangible asset on its balance sheet.
Intangible asset valuation methods
- Income approach
- Market approach
- Cost approach
When valuing an intangible asset, intangible businesses adopt widely accepted approaches on the basis of a combination of income, market, and cost. These approaches have a lot in common with the use of brand valuation, business valuation, and intellectual property valuation.
This approach makes use of estimates of future estimated economic benefits or cash flows and discounts them for the associated time and risks that are involved, to a present value.
The market approach makes use of market-based indicators of value. For intangibles, this can be transactions that involve selling, buying, franchising, or licensing intangible assets usually in practice bundled with other deals.
In the cost approach, there are two considerations. These are the historic cost of creating the intangible asset and the estimated cost and time that will be needed to create an equivalent or replacement of the asset (intangible)
Audit of intangible assets
According to IAS 38, intangible assets are resources that are being controlled by the business entity and are expected to provide future economic benefits to the entity, not a physical substance, and are identifiable.
Except for those with indefinite useful lives, intangibles are very similar to fixed assets in the sense that they are subject to amortization just as fixed assets are subject to depreciation. In accordance with IAS 36, these assets need to be tested annually for impairment.
Before auditors decide on the procedures to follow, they should first identify the risks that are associated with auditing intangible assets. One of the risks associated with this activity is the risk of material misstatement. This risk is high as a lot of judgment is needed in order to determine the value of intangible assets. Examples are incorrect capitalization of costs such as research costs, wrong useful life estimates, and amortization rate as well as management bias in the impairment of the assets as it is bound to lower profit.
For an auditor to have a reasonable assurance of the balance of intangible assets, they will perform tests to cover the relevant audit assertions. The assertions applicable are;
- Completeness, where there is a proper record of all intangible asset transactions in the financial statements.
- Rights and obligations, where the entity is in full ownership of the intangible assets and has the right to them as of the reporting date.
- Valuation, where the cost of capitalization and how recoverable the assets are compared to their netbook values are properly evaluated.
- Existence in the sense that the asset reported on the balance sheet actually exists at the reporting date.
- Presentation and disclosure. There should be a correct presentation of the balance of the intangible asset as non-current assets on the balance sheet and adequate disclosures on accounting policy, significant purchases, and disposals have been made in the notes to the financial statements.