The Valuation of Intangible Assets - Case Study Example

Valuation of Internally Generated intangible assets The topic deals with the key issue that radical changes are required in the company regarding valuation for intangible assets including those of an internally generated nature. An intangible asset could be said to be one without physical existence but which could increase the income- generating capacity of the company. In essence, an intangible asset has the characteristics like ability of being separately recognized, ability to produce future benefits to the company and the use of the asset results in either reduction of costs or increase in revenues to the company. 1. Ability to be separately recognised: Since the asset can be separately quantified, relative commercial transactions such as sale, transfer or exchange could be carried out, Further, the creation of an intangible asset is out of an agreement or other legal imposition, 2. Ability to produce future benefits: Software development expenses is example of an intangible asset that has the ability to produce future benefits. For the same reason, special distribution and selling rights, trademarks and intellectual properties ownerships also constitute intangible assets 3. Ability to reduce costs or augment revenues. The application of the intangible assets results in an increase in the revenue generating capacity of the company. Intangibles can be acquired either externally or through internal means. Intangible assets acquired externally are through buying, transfer or leasing process and the internally generated ones are established by way of the companies’ own efforts and market reputation. The main aspect to be considered with regard to intangible assets is that it must be compatible to quantitative analysis and future benefits. Whether the intangible assets are self generated or acquired externally. If this parameter is not met the investment would be “recognised as an expense when it is incurred [IAS 38.68]1” and not as an intangible asset. Goodwill: The aspect of intangible asset which is self generated refers to determination of goodwill and its accounting treatment. In real effect, goodwill represents “the excess paid for a firm over its adjusted net asset value.”2 (p.992). The goodwill amount refers to the special ability of the firm to generate revenue by way of its current market standing and also its future earning capacity. Goodwill is only seen in the context of business mergers and acquisitions representing the difference between the purchase prices and the net value of assets acquired. The aspect of goodwill in accounting cannot be undermined because “when Philip Morris acquired Seven Up for a price of $ 520 Million, approximately $ 390 million of the purchase price represented goodwill,”3 (p.992) that is around 75% of the purchase price representing internally generated intangible assets. The normal valuation of intangible assets is done on the following basis: 1. For especially identifiable intangible assets the valuation is based on fair value, what is fair value would be the amount actually spent for the identifiable intangible assets. For example, the research and development costs for a company would be all the expenditures incurred for maintaining the R & D facility. 2. For purchased identifiable intangible assets- it is done on actual cost incurred basis. If a company has invested $50 million for new Patent, it may be seen that the actual amount paid is capitalised and amortised over its useful life. 3. For a finite life intangible asset, the period of five years is considered its life and the value of the asset is amortised over this period. Any period above this can be considered only if the management is confident that the lifespan of the asset would be for over 5 years. However these varieties of assets should be tested for review, since there may be changes in the valuation of these intangible assets. 4. For infinite intangible assets, the approximate useful life is the asset is determined and on that basis, the asset value is amortized. But it is to be subject to tests for review and impairment in each accounting year since it is quite possible that the asset value would have decreased due to wear and tear, technical obsolescence, passage of time etc. Radical Changes to be made: In today’s business world, intangible assets like brands and customer– and employee-related intangibles – “account for between 30% and 70% of a typical company’s market value.4” But this is not correctly reflected in the balance sheets of companies primarily because only acquired or purchased intangible assets are taken into account and, at present, goodwill is not permitted to be amortized over a period of time, but is accounted only during takeovers or mergers only. It would be appreciated that the goodwill of the company is also subject to fluctuations due to market changes, If the effect of the company’s performance is not reflected in the valuation of goodwill, especially when conspicuous market changes take place, it would not show a true and fair valuation in the Balance Sheet of the Company. Nowadays, many companies do not account for intangible assets separately but show it under goodwill justifying that the amount was paid for acquiring ‘valuable customer base’, ‘excellent technology’ and ‘world-class brands.5’ This practice needs to be addressed to, since, the stakeholders have the right to know the facts and figures regarding intangible assets outside the scope of goodwill. Other intangible assets like software development costs, R& D costs, preliminary and pre-incorporation expenses are all other intangible assets and thus needs to be separated shown for balance sheet purposes. Under the IAS-38.71, if a company wished to change a previous expenditure into an intangible asset at a subsequent date, it is not allowed to do so. The Standard which “prohibits6” this needs to be reviewed because the fact that an asset has been previously wrongly treated as an expense earlier, reduces the profits of the company to that extent, and as such, the treatment of this transaction has not been correctly shown in profit statements. The Summary of Statement no.142 of FASB requires the disclosures of information about “carrying amount of goodwill” and other intangible assets in the year subsequent to the year of their acquisition in order that the users of financial statements should be able to judge the investments and its future performance7. The Balance Sheet of a company is meant to show the financial health of the company on a particular date. The left hand side shows the company’s assets whereas the liabilities and equities are shown on the right hand side. The assets are arranged according to their liquidity i.e. “the time taken to convert them into cash,”8 (p.33) and the liabilities and equity in order of time of payoffs, except shareholders equity which need to be paid only upon liquidity of the company. It needs to be mentioned in this context that the Balance sheet of companies change on day- to- day basis depending on increase/decrease in assets and also changes in liabilities. The directors of the company need information about the company’s intangible assets since they are the final authority for management of assets. The valuation of intangible assets reflects on the profitability and declaration of dividends and these effects the stakeholders too, since it would have implications on Return on Investments. If there were an overvaluation of intangible assets, it would mean an exaggerated net worth of the company, which would affect the interest of lending bankers, financial institutions and other lending bodies who have financial stakes in the company. In this case of a takeover, it is important that the valuations of shares are done on a conservative and fair manner, keeping in view the expected net worth of the company on future cash flows and estimated projections of profits over the coming 5 years or so. In case the share valuation is overvalued due to window dressing of intangible assets, the buyers are cheated since they are paying higher prices for non- existent benefits. Similarly, if the shares are undervalued, the selling company is losing since it is selling at a lower price than its net worth. It is felt that the correctly valued intangible assets should definitely be taken in the Balance Sheet, since they constitute a large part of the assets of the company, and it is their correct treatment and presentation in the balance sheet that should be taken in consideration. Further, only by including the intangible assets would the company be able to present a true and fair view of the state of financial affairs of the company. Bibliography Deloitte., Touche., Tohmatsu. IAS Plus 2007. http://www.iasplus.com/standard/ias38.htm (accessed March 2, 2007). Brigham. F. Eugene., Ehrhardt. C. Michael. Financial Management. Theory and Practice 10th Edition 2002. Thomson Asia Pte Ltd-Singapore. Accountancy age: Intangible Assets: the Right Balance? VNU business Publications Ltd 2007. http://www.accountancyage.com/financial-director/features/2171661/rightbalance (accessed March 2, 2007). What’s New at KPMG. http://www.kpmg.com (accessed March 2, 2007). Financial Accounting Standards Board. Summary of Statement No.142. http://www.fasb.org/st/summary/stsum142.shtml (accessed March 3, 2007) Read More