Assets are resources owned to produce economic benefits in future and are classified into tangible and intangible assets. Valuation of tangible and intangible assets determines its true worth or value. The tangible and intangible assets valuation is important for tax & financial reporting, litigation support, analysis of merger & acquisition transactions and bankruptcy filing. Let’s understand tangible and intangible assets in more details below:
A tangible asset possesses physical substance and can be seen and touched. Buildings, machinery and land are examples of tangible assets. Also referred as real assets or hard assets.
The following are the classification of Tangible assets:
Fixed assets are long term assets that cannot easily be converted into cash for more than one year. Example: Property, plant and equipment.
Current assets are liquid assets that can easily be converted into cash within a year.
Valuation of Tangible Assets
Valuation of Tangible assets involves the following methods:
- Appraisal method: Fair market value of assets is estimated by considering the current state of asset including depreciation and obsolescence.
- Liquidation method: Fair market value of assets is determined at liquidation, sale or closure.
- Reproduction cost method: The cost to reproduce an identical asset at current costs.
- Replacement cost method: The cost of creating the assets with similar characteristics at current costs.
Tangible asset valuations are important for financial reporting, tax purposes, asset monitoring, bankruptcy filing and insurance purpose.
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An intangible asset lacks physical substance and are difficult to quantify or recognize. Types of intangible assets are artistic, consumer, technology, contract and market related. Examples include goodwill, patents, trademarks, software and customer relationships.
The following are the classification of Intangible assets:
Definite life or Indefinite-life
Definite intangible assets have an expected economic life and may cease in some time. These assets are amortized over their useful life, using a straight-line method. Patents and copyrights are examples of limited-life intangible assets.
Indefinite-life intangibles have an unlimited useful life and have perpetual existence. There are no legal, regulatory, contractual or economic limiting factors. Indefinite-life intangibles are not amortized and tested for impairment annually. Examples include trademarks and perpetual franchise agreements.
Purchased or internally created intangibles
Purchased intangibles are recorded at cost, which includes the acquisition costs as well as expenses incurred to bring the asset in ready state.
Internally created intangibles are costs incurred internally to create intangibles are generally expensed as incurred and only direct costs are capitalized and not recorded on the balance sheet. Examples include research & development cost and legal costs.
Valuation of Intangible Assets
Valuation of Intangible assets involves the following methods:
Income approach: Cash flows and earnings of intangible assets are discounted to the present value by discounted cash flow or capitalization of cash flow method.
- Excess earnings method: Excess earnings are calculated by subtracting the earnings of net tangible assets from total earnings. The capitalized excess earnings value is obtained by dividing excess earnings by capitalization rate. The capitalized excess earnings value is added to value of tangible assets to calculate total business value. It is generally used to determine the value of business goodwill.
- Relief from royalty method: Value is based on saving the payment of licence fees to third parties as employing an intangible asset.
Market approach: Comparable market-based transactions of similar intangible assets are not available easily. The transactions are related to sales or licenses of comparable intangible assets. The problems of comparability and timing are there. The measures for comparison are price multiples based on profit margins, growth rates and return on assets.
Cost approach: It is based on the principle of replacement and usually ignores the cash flows associated with intangible assets. The cost of intangible asset is determined by reproduction or replacement method and adjusted for depreciation & obsolescence. Cost based approach are used for valuing workforce and internally developed software.
Intangible asset valuations are important for tax & financial reporting, dispute resolution, licensing & franchising, corporate deals and investor relations.
Differences Between Tangible and Intangible Assets
|Physical form||Abstract form|
|Easily liquidated||Not easily liquidated|
|Cost can be easily determined||Harder to evaluate|
|Salvage value exists||No salvage value|
|Used as collateral to obtain loans||Not used as collateral to obtain loans|
|Reported on balance sheet||Not reported on balance sheet|
|Managed by control||Managed by alignment|
|Easily duplicated||Difficult to duplicate|
|Limited application||Multiple applications|
Both tangible and intangible assets are extremely important for the company. When a company is initially created, it depends on tangible assets and in later stages relies on intangible assets. The tangible assets assist in the production of goods and services and the intangible assets are drivers of value and growth. Intangible assets are much more worthy than tangible assets. Intangible assets have preference over tangible assets in operating a company.