What’s it: Intangible assets are types of assets with no physical substance but identifiable and flow the economic benefits to the company. Such benefits can be in the form of additional revenue, cost savings, or increasing market share. Examples are patents, trademarks, and copyrights. They aren’t like property, plant, and equipment (PP&E), which you can see physically.
The company gets them from internal development or from externals. Because of the limitations of accounting methods, and they are challenging to measure reliably, some intangible assets are unrecognized in its balance sheet.
How intangible assets affect business value + Example
Intangible assets are vital to long-term success. Although they have no physical substance, they often provide a higher value than tangible assets. Brand, customer relations, corporate image, intellectual property, and human capital determine the company’s competitiveness.
Goodwill usually arises when the company acquires another company (target) and pays higher than its fair value. The acquirer benefits from intangible assets (such as brand equity, trademarks, etc.) and the synergy of the target company’s resources and capabilities, allowing for more significant value creation. For this reason, the acquirer is willing to pay a premium.
Brand equity represents the perceived value of a brand. That explains why consumers prefer certain brands over others. Strong brand equity drives customer loyalty, keeping them buying.
Companies could charge a premium price for products with strong brand equity. Companies can also expand their product lines, taking advantage of this strong brand image, allowing the company to make more money.
Apple, for example, is one of the premium brands in the electronics industry. The company leverages its strong brand equity to develop various products, from laptops to mobile phones. Although pricey, customers are still enthusiastic about buying, even queuing to get it.
The company uses a trademark (a combination of words, symbols, or phrases) to differentiate its products from competitors’ brands. Besides, the other party couldn’t use it.
Trademarks create positive relationships with customers. They can easily identify a product and associate it with the product’s attributes, such as quality and price.
Copyright protects intellectual property to prevent other parties from publishing, copying and distributing the company’s works. That allows money to keep flowing to the company.
If competitors can sell it easily without problems, then they can exploit it to generate sales. That means money will move from the company to the competitor.
Patents give the company the exclusive right to monetize its inventions. And as long as it is still valid, other parties cannot use it without obtaining permission from the company.
Franchising and Licensing
Franchising gives the other party the right to operate the business using the franchisor’s brands and products. Licensing is also similar to franchising, where other parties can use the intellectual property or goods belonging to the licensor.
Both flow money to the franchisor and the licensee through royalty payments and profit-sharing, depending on the agreement. The owner can immediately grow his business more quickly and in a shorter period than competitors.
How companies report intangible assets in financial statements
Under IFRS, a company reports an intangible asset, whether obtained from the acquisition or from internal development, as long as the asset provides economic benefits to the company and its cost can be measured reliably. In this case, the company cannot recognize the intangible assets that arise at the research stage. Thus, expenses incurred at the research stage must be recognized as expenses when they are incurred. Meanwhile, expenditures incurred during the development stage can be recognized as assets only if they meet the criteria.
Under US GAAP, most of the internally generated intangible assets are not recorded on the balance sheet. The company only recognizes intangible assets that are acquired from other companies or purchased individually. Even though unrecognized on the balance sheet, you can estimate the success of developing internal intangible assets by evaluating its long-term growth rate of income, margins, and cash flow. Meanwhile, all research and development expenditures must be recorded as an expense in the income statement and not recorded as assets on the balance sheet.
The company recognizes intangible assets from the acquisition at the purchase price. They fall into two categories:
- Intangible assets with limited useful lives, such as patents. They are amortized and must undergo regular impairment testing. The amortization method is the same as when you would calculate the depreciation of property, plant, and equipment (PP&E), using the straight-line method.
- Intangible assets with unlimited useful lives, such as goodwill, trademarks, and perpetual franchises. They are unamortized but are tested for impairment annually.
Goodwill case example
Goodwill consists of two, namely accounting goodwill and economic goodwill. The first happens when the company acquires another company and pays higher than the fair value of the target company’s net assets (total assets minus total liabilities). Economic goodwill derived from internal development and are not reflected on the balance sheet of the company.
For example, suppose a company acquires a target company with net assets of Rp50 million. The acquirer paid Rp60 million, considering that the target has a strong position in the market due to strong brand equity, customer loyalty, and strategic location. Hence, after the acquisition, the acquirer would report Rp10 million’s goodwill under its long-term assets of the balance sheet.
The company capitalizes the accounting goodwill. Because of having an indefinite useful life, the company does not amortize it but must test it for impairment annually.