Intangible asset
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The lead section of this article may need to be rewritten. The reason given is: lacks a definition and introductory context. (July 2013) |
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The examples and perspective in this article may not represent a worldwide view of the subject. (February 2010) |
Intangible assets have been argued to be one possible contributor to the disparity between company value as per their accounting records, and company value as per their market capitalization.[1] Considering this argument, it is important to understand what an intangible asset truly is in the eyes of an accountant. A number of attempts have been made to define intangible assets:
- Prior to 2005 the Australian Accounting Standards Board issued the Statement of Accounting Concepts number 4 (SAC 4).[2] This statement did not provide a formal definition of an intangible asset but did provide that tangibility was not an essential characteristic of an asset.
- International Accounting Standards Board standard 38 (IAS 38)[3] defines an intangible asset as: "an identifiable non-monetary asset without physical substance." This definition is in addition to the standard definition of an asset which requires a past event that has given rise to a resource that the entity controls and from which future economic benefits are expected to flow. Thus, the extra requirement for an intangible asset under IAS 38 is identifiability. This criterion requires that an intangible asset is separable from the entity or that it arises from a contractual or legal right.
- The Financial Accounting Standards Board Accounting Standard Codification 350 (ASC 350) defines an intangible asset as an asset, other than a financial asset, that lacks physical substance.
The lack of physical substance would therefore seem to be a defining characteristic of an intangible asset. Both the IASB and FASB definitions specifically preclude monetary assets in their definition of an intangible asset. This is necessary in order to avoid the classification of items such as accounts receivable, derivatives and cash in the bank as an intangible asset. IAS 38 contains examples of intangible assets, including: computer software, copyright and patents.
Contents
Research and development
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This section does not cite any references or sources. (November 2013) |
IAS 38 requires any project that results in the generation of a resource to the entity be classified into two phases: a research phase, and a development phase.
Research is defined as "the original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. For example, a company can carry a research on one of its products which it will use in the entity of which results in future economic income.
Development is defined as "the application of research findings to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems, or services, before the start of commercial production or use."
The accounting treatment of such expenses depends on whether it is classified as research or development. Where the distinction cannot be made, IAS 38 requires that the entire project be treated as research and expensed through the Statement of Comprehensive Income.
As research expenditure is highly speculative, there is no certainty that future economic benefits will flow to the entity. As such, prudence dictates that research expenditure be expensed through the Statement of Comprehensive Income. Development expenditure, however, is less speculative and it becomes possible to predict the future economic benefits that will flow to the entity. The matching concept dictates that development expenditure be capitalised as the expenditure will generate future economic benefit to the entity.
The classification of research and development expenditure can be highly subjective, and it is important to note that organisations may have an ulterior motive in its classification of research and development expenditure. Less scrupulous directors may manipulate financial statements through their classification of research and development expenditure.[citation needed]
Financial accounting
General standards
The International Accounting Standards Board (IASB) offers some guidance (IAS 38) as to how intangible assets should be accounted for in financial statements. In general, legal intangibles that are developed internally are not recognized and legal intangibles that are purchased from third-parties are recognized. Wordings are similar to IAS 9.
Under US GAAP, intangible assets are classified into: Purchased vs. internally created intangibles, and Limited-life vs. indefinite-life intangibles.[citation needed]
Expense allocation
Intangible assets are typically expensed according to their respective life expectancy.[3] Intangible assets have either an identifiable or indefinite useful life. Intangible assets with identifiable useful lives are amortized on a straight-line basis over their economic or legal life,[4] whichever is shorter. Examples of intangible assets with identifiable useful lives include copyrights and patents. Intangible assets with indefinite useful lives are reassessed each year for impairment. If an impairment has occurred, then a loss must be recognized. An impairment loss is determined by subtracting the asset's fair value from the asset's book/carrying value. Trademarks and goodwill are examples of intangible assets with indefinite useful lives. Goodwill has to be tested for impairment rather than amortized. If impaired, goodwill is reduced and loss is recognized in the Income statement.
Taxation
For personal income tax purposes, some costs with respect to intangible assets must be capitalized rather than treated as deductible expenses. Treasury regulations generally require capitalization of costs associated with acquiring, creating, or enhancing intangible assets.[5] For example, an amount paid to obtain a trademark must be capitalized. Certain amounts paid to facilitate these transactions are also capitalized. Some types of intangible assets are categorized based on whether the asset is acquired from another party or created by the taxpayer. The regulations contain many provisions intended to make it easier to determine when capitalization is required.[6]
Definition of "intangibles" differs from standard accounting, in some US state governments. These governments may refer to stocks and bonds as "intangibles. "[7]
See also
References
1. Lev, Baruch; Daum, Juergen (2004). "The dominance of intangible assets: consequences for enterprise management and corporate reporting". Measuring Business Excellence 8 (1): 6–17. doi:10.1108/13683040410524694.
2. "SAC 4: Definition and Recognition of the Elements of Financial Statements". Australian Accounting Standards Board. Retrieved 19 December 2012.
3. "IAS 38". International Accounting Standards Board. Retrieved 19 December 2012.
4. For international legal lives by class of intangible asset, see the table in Tax amortization lives of intangible assets
5. Treas. Reg. § 1.263(a)-4.
6. Donaldson, Samuel A. Federal Income Taxation Of Individuals: Cases, Problems and Materials (2nd ed.). St. Paul: Thomson West, 2007. pg. 200.
Goodwill: Guide to simplified valuations
Posted by Steve Collings PM | on Mon, 25/02/2013 - 15:34 16177 6 comments
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Accounting for goodwill has always been one of the more controversial issues faced by accountants for many years, explains Steve Collings.
AccountingWEB recently covered the issue concerning goodwill and intangible assets in an earlier article which addressed the accounting requirements for goodwill, as well as intangible assets.
Many accountants will associate goodwill as being the value inherent in the business due to a built upon reputation or the value attributed to a well-known brand or company name. Lord MacNaghten in the case of Commissioners of Inland Revenue v Muller & Co Margarine (1901) AC215 defined goodwill as follows:
“What is goodwill? It is a thing very easy to describe, very difficult to define. It is the benefit and advantage of the good name, reputation and connection of the business. It is the attractive force which brings in custom. It is the one thing which distinguishes an old established business from a new business at its first start. Goodwill is composed as a variety of elements. It differs in its composition in different trades and in different businesses in the same trade. One element pay preponderate here, and other there.”
Lord MacNaghten merely defined goodwill in his summing up, which is one thing. The challenge for accountants is how such goodwill is valued.
Valuation techniques
There are various techniques associated with the valuation of goodwill which can be split into the three most common:
1. Simple multiple approach
2. Turnover approach
3. Whole company approach
Simple multiple approach
The simple multiple approach is more appropriate for small, straight-forward businesses (typically owner-managed businesses). In a nutshell the way this works is to apply a multiple to sustainable profits before management/owners’ remuneration.
The range of multiples used in the calculation of goodwill usually varies between one and five. Typically where a business is showing strong growth and is experiencing high levels of profitability, the multiples used will be at the higher end of the scale. On the flip side, if a business is in decline, the multiples used will typically be at the lower end.
Illustration
Company A Limited is a husband and wife run company. The following information is relevant:
- The company operates in the publication of e-books through a website
- The company has witnessed steady growth over the last few years and have started to see an increased number of subscribers to their products
- Turnover for the last financial year amounted to £1m and profit before taxation is £70,000 after directors’ salaries of £30,000
- Net assets are very low with computer equipment being the only real assets owned by the company as the business is operated from a converted garage at the marital home. Net assets amount to £15,000
The couple have asked you to value the goodwill in their business and provide them with a business valuation.
£70,000 pre-tax profit plus £30,000 remuneration results in profit of £100,000. If you opt for a multiple at the lowest end of the scale (one), this will give rise to goodwill of £100,000. Add to this the net assets of the business of £15,000 and this will give a business valuation of £115,000.
Turnover approach
This method is commonly used in a professional practice (such as when an accountancy or solicitors’ practice is being sold). Multiples are then applied to these fees which are usually between 0.5 and 1.5 - though of course such ranges are often subjective and will depend on various factors such as the quality of the clients, financial health of the business and historical trends. As with the simple multiple approach, a business that is experiencing a higher level of growth will often have a higher multiple applied to it - this can sometimes be as high as 2.5 for a business that is experiencing a high degree of profitability and growth and as low as 0.25 for a business in decline.
When such businesses are being sold it is not uncommon to apply a multiple for a company in the same industry/profession that is quoted and to then discount this multiple back to take account of the smaller size of such a business as can be illustrated as follows:
Illustration
A firm of accountants consists of four partners and is an independent practice and not listed on any stock market. The practice has been in existence for several years, is well-established with a good client base. Two of the partners are relatively young and over the last six years have been driving the practice forward and have been successful in gaining a number of lucrative clients. The firm currently rents its offices from an unconnected third party commercial lettings agency. Financial facts are as follows:
- Turnover is £2.5m
- Margins are standard
- The corporate financiers have estimated that quoted firms are currently trading at 1.4 x turnover
The partners have asked for a valuation of the goodwill attributable to the firm.
The valuation is calculated as £2.5m turnover multiplied by 1.0 = £2.5m goodwill. You have to discount back the 1.4 multiple as this applies to a firm that is listed on a stock market. The four-partner firm above is not listed and relies on the partners as well as a lack of assets, hence the multiple selected is 1.0.
Whole company approach
This is generally a very common approach to valuing goodwill. It works by valuing the entire business and then deducting tangible/intangible assets to find the residual amount which is the goodwill.
In a nutshell, the whole company approach works by basing the valuation on a multiple that is applied to sustainable profit. Where this results in a valuation that is less than the adjusted net asset value, the assumption is that there is little (or even no) goodwill inherent in the business. The calculation uses a P/E ratio which is basically the relationship between after-tax profits of a business and its capitalised value. P/E ratios are often adjusted to take into account any ‘one-off’ items such as one-off bonus payments to directors or other exceptional items.
Illustration
A company makes post-tax profits of £200,000 and is sold for £1.5m. The P/E ratio is calculated as (£1.5m/£200,000) 7.5.
An important point also to emphasise is that assets contained within a company’s balance sheet will need to be valued at fair value, where applicable and not at the lower of cost and net realisable value which is the method often used when the balance sheet itself is constructed.
Illustration
A company is in the plant and machinery hire business and has been established for several years and has an extremely strong customer base that places a significant amount of repeat business.
The company’s turnover is £15m and post-tax profit has remained stable at £800,000 per annum. There are no exceptional items and the company’s balance sheet shows net assets of £600,000 including its building which was purchased for £100,000 several years ago and has an open market value at today’s prices of £1.2m.
The company’s external accountants have arrived at an adjusted P/E ratio of six.
The directors of the company are considering selling the business and have asked for a valuation to be placed on the company’s goodwill.
Valuation:
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Post-tax profit |
£800,000 x 6 |
£4,800,000 |
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Net assets |
£600,000 |
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Gain on property |
£1,100,000 |
£1,700,000 |
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Goodwill |
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£3,100,000 |
In this scenario the property uplift gives rise to a material difference in the goodwill valuation. Other factors that may also give rise to a difference in the goodwill valuation could include assets that are let out to third parties (hence do not contribute to the profitability of the business) and any surplus cash that may need accounting for.
Conclusion
Goodwill is (probably) one of the most controversial and subjective areas of accountancy and has the potential to lend itself to a whole host of misdemeanours. This article has concentrated on simplified valuations of goodwill, but these often become more complex in real-life situations.
Steve Collings is the audit and technical partner at Leavitt Walmsley Associates and the author of ‘Interpretation and Application of International Standards on Auditing’. He is also the author of ‘The AccountingWEB Guide to IFRS’ and ‘IFRS For Dummies’ and was named Accounting Technician of the Year at the 2011 British Accountancy Awards.