“Non-physical assets such as franchises, trademarks, patents, copyrights, goodwill, equities, mineral rights, securities and contracts (as distinguished from physical assets) that grant rights and privileges, and have value for the owner.”
International Glossary of Business Valuation Terms (IGBVT)
What is an Intangible Asset?
According to Investopedia, an intangible asset is one that is not physical in nature. Due to their long-lived nature, intangible assets are considered non-current assets, as they have useful lives greater than a year. Companies typically acquire or create these assets for use in normal business operations and to provide benefits over future fiscal periods.
In contrast, tangible assets are those of a physical nature, like cash, supplies, inventory, property, plant, and equipment. It is also worth noting that there are some assets not considered intangible assets despite not being physical. These assets would include accounts receivable, stocks, and bonds.
Intangible assets can vary widely. The more common intangible assets are intellectual property (patents, trademarks, franchises, copyrights) and goodwill. Patents, copyrights, trademarks, and other intellectual property rights represent intangible assets that are specifically identifiable. Goodwill is an example of an intangible asset that is not specifically identifiable.
How to Value Intangible Assets
The value of an asset comes from the future economic benefit it is expected to provide to its owner. Examples of economic benefits would be revenues, savings, or improved brand recognition. Companies can benefit from these assets either through directly using them in their business or through licensing them to a third party.
The actual calculation of the value of an intangible asset depends on its life. If it has a finite life, then the value would be the initial cost less amortization and other applicable impairment charges. For those with indefinite lives, the value would be the initial cost less impairment. Note that intangible assets with indefinite lives are not subject to amortization because a useful life is needed to determine the periodic amortization expense. The concepts of amortization and impairment are explored later in this article.
How Do Companies Get a Hold of Intangible Assets?
Acquiring Intangible Assets
One way would be to acquire the intangible. Acquiring an intangible asset is a pretty straightforward process. As it would for any other asset, the company would simply pay a purchase price for the intangible asset from another company in an arms-length transaction. For this process, the acquiring company could capitalize the intangible asset at the acquisition cost. The company would also capitalize any legal and registration fees incurred in the acquisition process.
Created Intangible Assets
Another way would be for the company to create the intangible asset internally. Many companies dedicate tremendous amounts of funds towards research and development (R&D). R&D represents a company’s committed effort to discover new information that will help it create a new product, service, or process that will improve current operations and provide a competitive advantage.
US GAAP prohibits companies from capitalizing R&D costs. So, when a company internally creates an intangible asset, it must expense all related costs immediately as incurred. Examples of these expenses would include trademarks, goodwill from advertising, and the cost of maintaining/restoring goodwill.
There are a few exceptions. The first is if the equipment used for R&D has an alternative future use. For this, the company would capitalize the equipment and depreciate it over its useful life, which results in a delay in the expense. The other exception is if a company does R&D on behalf of another entity. In this case, the purchaser of the R&D will expense as they make payments; the provider of the R&D will expense costs incurred as cost of sales. Additionally, any costs that can be associated with internally developed intangibles that are specifically identifiable can be capitalized. Those include legal fees related to the successful defense of an intangible asset, registration/consulting fees, design costs, and other direct costs associated with securing the asset.
Useful Life
The economic life of an intangible asset is either determined or indeterminable. In other words, it can either be finite or infinite. For those intangible assets with a finite life, the company must amortize the asset over its life. Intangibles with finite lives are typically intellectual properties. If the intangible does not have a determinable life, the company would have to impair the asset. It’s worth noting that, the most notable intangible asset with an indefinite life is goodwill.
Intellectual Property
Intellectual property usually represents a legal right or protection to a creator’s idea or some form of competitive advantage of a company. The most common examples of intellectual property are patents, copyrights, and trademarks.
Amortization
As noted above, intangibles with finite lives (typically intellectual properties) are subject to amortization. In GAAP, the value of an intangible asset declines over its lifetime. As a result, a company must amortize the asset to reflect this. The large majority of companies utilize the straight-line method of amortization for intangible assets. The only exception would be if a company can present a reasonable method that is more appropriate for its business. Regardless of the method, the company must disclose it in the notes to the financial statements in its annual report. If there is a change to the useful life of the intangible asset, the company would amortize the remaining book value over the new remaining useful life of the asset.
Types of Intellectual Property
Patents
A patent is when an inventor is granted exclusive rights for a specific process, design, or invention. It is worth noting that the protection provided by a patent has a limited life. According to the US Patent Office, for applications after June 8, 1995, patents are protected for 20 years after the patent is issued. However, design patents have an even shorter protection life of 14 years.
In the United States, patents granted are only applicable within the country. However, patents granted in Europe can be done at a continent level. Applying for a European patent would provide protection in all countries that participate in the European Patent Convention (EPC). This means that a patent granted in Europe is applicable in all countries on the continent.
Both use a first-to-file system. This means that the first person to file a patent has their intellectual property protected, regardless if they were the first one to invent it.
Copyrights
Copyright represents the right protected by law granted to the creator or individual assigned to print, publish, record, film, publish, etc. specific artistic material. The individual also has the right to authorize others to do the same. Usually, the individual would ask for payment in return for allowing others to use their work.
These rights are typically only for a set amount of time, and the inventor must detail all information about their invention as well. According to copyright.gov, copyrights after January 1, 1978, are eligible for protection for the duration of the author’s life plus 70 additional years.
One limit of copyright protection is the concept of ‘fair use.’ According to Stanford University, fair use is “any copying of copyrighted material done for a limited and ‘transformative’ purpose, such as to comment upon, criticize, or parody a copyrighted work.” Any instance of fair use would not require the owner’s permission and would serve as a legal defense against claims of copyright infringement. The United States has a rather broad allowance of fair use, as Europe does not even allow fair use in their countries. Instead, Europe provides specific exceptions to copyright protection.
The United States and several European Union nations have work-made-for-hire laws. This means that any copyrighted work made by an employee for a company becomes the copyrighted property of the company. If you ever worked at a company, it is likely that you filled out a form consenting to this as part of your onboarding.
Trademark
The US Patent Office defines a trademark as “any word, phrase, symbol, design, or a combination of these things that identifies your goods or services.” Trademarks are typically how consumers identify and distinguish a company from others. Just think of prominent logos, like Nike’s ‘Swoosh’ or Adidas’ three stripes.
Unlike copyrights and patents, trademark protection does not have an expiration date. The protection will exist as long as the owner continues to use the trademark in its business. Once the US Patent Office grants the trademark protection, the company must continue the use of the trademark in its ordinary course of business.
In the US, an individual can receive trademark protection for their IP just by using it first in their business. They would not necessarily have to register it. On the other hand, those in Europe would always have to register the intellectual property to receive any trademark protection. Additionally, in the US, the owner of a trademark must use it in commerce. It either has to fall under one of two categories: “use-in-commerce” or “intent-to-use.” In Europe, one does not have to use the trademark or have the intent to use the trademark. However, after five consecutive years of not using the trademark, another party could file an appeal and attempt to invalidate the trademark due to not being in use.
The US uses a two-tiered system for trademark protection. Trademark owners may register their mark at the state level or with the federal government through the USPTO. Under the Lanham Act, a federal registration gives the registrant rights throughout the entire US. Whereas, a state trademark registration only protects the trademark in the state where it was registered. Trademark law in the EU is composed of one system valid throughout the entire European Union. It is not possible to limit the geographical scope of protection of an EU trademark to specific member states. If you want to register your trademark in a specific country, you must go through the national trademark office of that particular country (i.e., the Spanish Patent and Trademark Office for Spain).
Trademark Protection Example
There was actually a very prominent legal battle over trademarks that is interesting. The World Wildlife Federation claimed that they had the right to the trademark initials ‘WWF.’ At the time, most of the public identified these initials with the World Wrestling Federation. The wildlife charity sued for protection of the initials, as there were concerns that the wrestling company would ruin its image. This became a heated legal battle, which the wildlife charity would win. The ruling was the result of the World Wildlife Federation using the trademark first, which resulted in the World Wrestling Federation becoming the now-known WWE.
Different Ways for Companies to Utilize Intellectual Property
Licensing
Licensing is when a company authorizes a third party to use its intellectual property, such as a copyright, patent, trademark, or trade name, in exchange for payment. If the individual or company is not actively utilizing its intellectual property, this can be a very lucrative opportunity. This is a very passive form of income generation, and it can allow companies to have exposure in foreign markets with a major investment.
However, there is a massive downside to licensing. It is rather difficult for the owner of the intellectual property to ensure quality control. There is a possibility that the licensed material is used in a manner that could ruin the image of the IP’s owner or the IP itself. If this were to happen, it could be very difficult to amend and could result in a decline in future business opportunities.
Franchising
Franchises are when a company licenses its business to an external party. The company would have to provide specialized sales or service strategies, support assistance, and potentially upfront investment for a franchise to work.
In return, these franchisees pay the corporation or company a franchise fee. These deals typically involve the franchisee following guidelines established by the franchisor. This is done to secure the integrity of the company’s brand and image, which is not available with licensing.
Without these guidelines, franchisees could change core aspects of the franchisor company’s business model and harm the company’s reputation. Franchising could allow a company to penetrate into foreign markets without needing to make a major investment in foreign countries. This is a tremendous benefit compared to other forms of foreign expansion. There is also the benefit of having control over franchises.
However, the downside of this would be that the parent company, or franchisor, needs to be actively involved in the franchise’s business. They need to provide training and actively enforce these requirements. This is not the case for licensing, which does not require any active investment. There is an evident tradeoff between the required involvement with the investment and the risk associated with the investment.
Franchisee Accounting
For those running a franchise location, US GAAP provides specific accounting guidance. A franchisee is actually required to capitalize any initial franchise fees as an intangible asset and amortize it over the expected life of the franchise.
The franchisee would expense any additional franchise fees or royalties to the franchisor as incurred. These franchise fees are normally predetermined by the franchisor. Typically, they reflect a percentage of the franchise location’s revenue. There could also be fees for franchise services, such as staff training.
The franchisor should record all fees from the franchisee as revenue as incurred.
The Importance of Intellectual Property Protection
Intellectual property protection ensures that individuals can create and innovate without having their ideas being stolen. If individuals were in fear of having their creations and inventions stolen by others, they would likely be deterred from innovating entirely. Having such a deterrent would prevent the United States from ever advancing. Technology, scientific research, and the economy would all become stagnant, as new exciting advancements would never come to be.
This concept of stolen intellectual property was at the forefront of the trade war between the US and China in 2019. During its tenure, the Trump Administration believed that loose protection policies regarding American intellectual property hurt the country’s economy. For years, China had stolen the intellectual property of American-based corporations doing business in the country. In March 2019, one in five American CFOs claimed that China had stolen their company’s intellectual property. The original trade agreement proposed that China could allow American companies to conduct business in their country without having to give the government any proprietary technology in return.
With a new administration, it is unclear how relations between the United States and China will be going forward. In January 2020, the two countries were nearing an agreement, seeing that this dispute was probably detrimental to both of them. However, this was prior to the global pandemic, and it is unclear if both countries will still want to come to an agreement now. This is especially the case for China. The Chinese economy was the only economy in the world to experience positive growth in 2020, putting it in an advantageous position on the global stage. Ultimately, it seems likely that China will not be willing to come to an agreement like it almost had in 2019 due to its current economic standing.
What is Goodwill?
When you think of goodwill, you probably either think of charity or the not-for-profit thrift store. While I do love some thrifting, goodwill in accounting has nothing to do with charitable giving.
The idea of goodwill suggests that a company is more valuable than the net assets on its balance sheet. What drives this is typically elements of a business that do not have a standalone ascertainable value. This is why goodwill cannot be separately identifiable. The elements of goodwill, like expertise of management, technical expertise, brand recognition, or customer loyalty, cannot be objectively valued on their own.
To better picture this, think of how some brands can charge double or triple the price of competitive products. Why exactly is that? Well, there are intangible advantages that some companies have that do not have a monetary value. Concepts like brand equity and customer loyalty provide tremendous value to these companies, and accountants have to record them somehow even without having an actual price tag. So, that is where goodwill comes in.
While it is also an intangible asset, goodwill contrasts with other intangible assets. As just noted, it is not separately identifiable like intellectual property. Additionally, goodwill has an indefinite life, which means it is subject to impairment, not amortization. The impairment process is much more involved than amortization.
How to Value Goodwill
Goodwill is the premium that a company pays when acquiring another company. There are two approaches to valuing goodwill, both of which are very similar. One approach is the acquisition method, where goodwill is the difference between the fair value of an acquired company and its actual book value. The second is the equity method, which is when the acquiring company purchases another company’s stock. With this method, goodwill is the difference between the stock purchase price and the book value of the acquired net assets.
It is worth noting that goodwill only appears on a balance sheet through acquisitions or business combinations. A company would not capitalize goodwill if the company created it internally instead of purchasing it. In other words, internally generated goodwill is not present on a company’s balance sheet. Also, a company would not capitalize any costs associated with maintaining goodwill. Instead, they would expense the costs as incurred.
Impairment
Intangible assets with indefinite lives are subject to impairment instead of amortization. The asset most commonly subject to an impairment is goodwill. Companies make charges to impairment at the reporting unit level. In other words, each operating segment of a company undergoes its own goodwill impairment. A company must impair goodwill (or other intangible assets) if its carrying value of a reporting unit is greater than the fair value. The impairment charge would equal the difference between the two.
An impairment can be the result of a decline in the projected performance of the acquired entity. If the newly acquired company is projected to perform worse than expected, its fair value may also decline. In this case, the company that acquired the entity would have to perform a series of tests to determine whether or not an impairment is appropriate.
The Process of Determining Goodwill Impairment
Under US GAAP, the goodwill impairment test allows companies to perform a qualitative impairment evaluation prior to determining if a quantitative impairment test is necessary. The company may test the following qualitative factors: macroeconomic performance, fiscal performance of the company, relevant legal proceedings of the company, bankruptcy concerns, threats of a recession, conditions of the market or industry, any changes made to management, concerning declines in share price, and any declines in cash flows or earnings.
Based on the results of the qualitative test, if the company determines that it is more likely than not that the fair value of goodwill is less than the carrying amount, it must perform a quantitative evaluation of goodwill impairment. Otherwise, a quantitative test is not necessary.
In a quantitative evaluation, a company is comparing the carrying value of a reporting unit to its fair value. If the fair value exceeds the carrying value, an impairment is not necessary. However, if the carrying value exceeds the fair value, then the company must make an impairment charge equal to the difference between the two.
The impairment charge cannot exceed the value of the goodwill balance. Further, once a company makes a charge against the goodwill balance, it cannot reverse it.
Alternatives to Goodwill Impairment
Private companies, under US GAAP, may opt to use an alternative goodwill valuation method. These companies can choose to amortize goodwill on a straight-line basis over 10 years, or less depending on the company’s ability to demonstrate that another useful life is more appropriate. The company also could make an accounting policy election to test goodwill for impairment when there is a triggering event.
Example of Goodwill Impairment
Acrobat Inc. acquired Building Co. for $500,000. At the time of acquisition, Building Co. had $400,000 in net assets. This results in Acrobat Inc. booking $100,000 towards goodwill allocated to the reporting unit Building Co. ($500k purchase price – $400k book value).
A year after the acquisition, Building Co.’s business has declined substantially, resulting in a worsened outlook for its cash flows. After performing qualitative and quantitative evaluations, Acrobat determined that the fair value of Building Co. is now only $250,000. Because the carrying value of the Building exceeds its fair value, Acrobat needs to make an impairment charge to goodwill.
The total impairment is the difference between the carrying value and the fair value, which is $150,000 here ($400k carrying value – $250k new fair value). However, because the original goodwill allocated to Building Co. was only $100,000, Acrobat cannot book an impairment charge of $150,000. Remember, a company cannot book an impairment charge greater than the goodwill allocated to the reporting unit.
In this case, because goodwill allocated to Building is $100,000, Acrobat will book an impairment charge of $100,000 in relation to this reporting unit. The journal entry related to this would be:
DR: Loss due to impairment $100,000
CR: Goodwill $100,000
This entry completely zeroes out or eliminates the goodwill balance associated with Building Co. as a reporting unit. The credit to goodwill represents a decline in the company’s assets, as goodwill is an asset account. The debit in this entry is ‘loss due to impairment.’ This results in a decrease in the company’s net income, which will consequently cause a decline in retained earnings and equity.
Why You Should Know This
If you are looking to be an investor, accountant, or a participant in the financial industry, you should look to understand as much of the balance sheet as possible. A basic comprehension of intangible assets would expose you to more advanced accounting concepts, such as goodwill impairment and amortization, which could enhance your knowledge of business processes. Knowing these ideas and concepts could allow you to stand out amongst peers in your industry. It could also allow you to better evaluate companies if you are looking to invest. After reading this article, you may determine that goodwill is not something you value as an investor. Thus, you may look to remove it from your stock valuations.
Further, understanding intellectual property could provide you with dividends. Learning how to license and franchise can be lucrative financial opportunities, even at an individual level. Properly licensing your IP is one of the best examples of passive income. (Albeit, creating such IP could be time and money-consuming).
In business (and life), it never hurts to learn as much as possible. Learning more allows you to grow as a person, stand out amongst others, and identify potential opportunities when they present themselves.