FACT: A study a few years ago by an international accounting firm revealed that intangible assets accounted for almost 80% of the S&P 500’s total value. These companies are not new economy companies, but instead are in low-tech industries like banking, oil and retail. It is then remarkable that, based on this study, the market value of the majority of corporate America’s balance sheets is about four times their book value. Even if their market value is inflated, reducing it by half still produces a huge gap between their market capitalization and book value. To reconcile the difference between the book value a company and the stock value assigned by the market, we must first define exactly what is an intangible asset.
Tangible assets can generally be touched and are simpler to value. Inventory, land, buildings and equipment are examples of tangible assets. On the other hand, intangible assets do not have tangible qualities and are more difficult to value. Examples include goodwill and software developmental costs. Under Generally Accepted Accounting Principles (GAAP), with limited exception, intangible assets purchased by a company are recognized on the company’s balance sheet at cost, which is equal to the cash, liabilities or stock exchanged for the asset. If their values appear on the balance sheet, then there is no debate that these assets exist.
The debate, instead, is over the existence and value of intangible assets not recognized on the balance sheet illustrated by the following: Company A invested millions of dollars to develop software. Company B valued Company A’s intangible asset and agreed to purchase the software for $5 million. Once it makes the purchase, Company B recognizes the software on its balance sheet. The same intangible asset, however, never appeared on Company A’s balance sheet. Had Company B backed out of the deal, Company A’s intangible asset would have been ‘trapped’ within the company. Although just a scenario, major banks, as a practical example, have generally lent 30% of the valuation of a brand name because of the incremental profit it provides. By filing appropriate legal documents, these banks even obtained a perfected security interest in the brand name. The preceding examples illustrate that intangible assets exist and are valuable though often unrecognized on balance sheets.
A recent article defined intangible assets as ‘economic phenomena’. The authors concluded that, for an intangible asset to exist, it should have a specific bundle of legal rights. Their ‘tests’ for determining their legal existence are, in the form of questions, as follows:
- Is it subject to specific identification and recognizable description?
- Is it subject to legal existence and protection?
- Is it subject to the right of private ownership that can be legally transferable?
- Is there some tangible evidence its existence such as a contract, a document, listing file, printout, registration statement or flow chart?
- Was it created or did it come into existence at an identifiable time or as a result of an identifiable event?
- Is it subject to being destroyed or its existence terminated existence at an identifiable time or event?
The distinction between an intangible asset’s legal existence and its economic value is important because, the authors argue, intangible assets can exist without economic value. For instance, a patent that is never used has legal existence but no economic value. The tests or questions of economic value are as follows:
- Does the owner or user receive some measurable economic benefit?
- Does it enhance the value of other assets?
- Does the owner or user enjoy a high market share?
- Does the owner or user enjoy high profitability?
- Does the owner or user enjoy a positive reputation?
- Does the owner or user enjoy a monopoly position?
- Does it have market potential?
This economic benefit is valued in several ways using net income, net operating income and net cash flow. The intangible asset’s economic benefit is measured by comparing the income stream received by the owner or user to the income stream had the intangible asset not otherwise existed. Intangible assets may enhance the owner’s or user’s operating assets, tangible personal property, real estate or even other intangible assets.
Other than in intangible assets, valuations business valuation analyst are important in financial, tax and litigation matters.
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.