Measurement bases and intangible assets

A balance sheet with several yardsticks

The balance sheet lists what a company owns (assets), what it owes (liabilities) and the owners' residual claim (equity) at one date. It is tempting to read every number as 'what the item is worth today', but that is not how it is built.

Many items sit at historical cost or amortised cost: what was paid, adjusted for depreciation, amortisation, repayments or impairment. Others, such as many investments and derivatives, are carried at fair value, the price at which an asset would be sold or a liability transferred in an orderly market transaction. And some resources, such as a strong reputation or a skilled workforce, are not recognised at all.

Two companies with identical businesses can therefore report different balance sheets because they chose, or were required to use, different measurement bases. The accounting policy notes say which basis applies to each line, and an analyst reads them before comparing ratios across companies.

What counts as an intangible asset

An intangible asset has no physical form and is non-monetary (it is not cash or a right to a fixed amount of cash). The key word is identifiable: the asset either can be separated from the company and sold, licensed or transferred on its own, or it arises from contractual or legal rights. Patents, licences, trademarks, copyrights, franchises and customer lists all qualify.

Under IFRS an identifiable intangible is recognised when future economic benefits are probable and its cost can be measured reliably. Goodwill is the major intangible that is not separately identifiable; it arises only in acquisitions and has its own lesson.

Some valuable resources never reach the balance sheet because they are not identifiable and the company does not control their benefits well enough: management talent, technical know-how of staff, market share, name recognition, customer goodwill. In principle their value shows up in the share price, and an acquirer may later record it as goodwill.

Measurement, useful life and amortisation

Under IFRS, a company chooses the cost model (cost less accumulated amortisation and impairment) or the revaluation model (fair value less subsequent amortisation and impairment). Revaluation is allowed only when there is an active market for the intangible, which is rare. Both models work the same way as for property, plant and equipment. US GAAP permits only the cost model.

Each intangible is assessed as having a finite or an indefinite useful life. A finite-life intangible is amortised systematically over the best estimate of its life; the method and the life are reviewed at least once a year, and impairment testing follows the PP&E rules.

An indefinite-life intangible (for example, a trademark that can be renewed indefinitely at little cost) is not amortised. Instead, at least annually the company tests it for impairment and checks that 'indefinite' is still a reasonable assumption.

Home-grown versus purchased intangibles

Putting a reliable cost on something a company built itself is hard and subjective. So the default under both frameworks is that internally created intangibles are expensed as incurred.

IFRS adds an exception. A project is split into a research phase (searching for new knowledge, products or processes) and a later development phase (designing, building and testing prototypes or models). Research costs are always expensed. Development costs are capitalised once specific criteria are met, including technical feasibility, the ability to complete the asset and the ability to use or sell it. Costs that are not directly part of the development work, such as general administrative overhead, stay in expense.

US GAAP prohibits capitalising most internally developed intangibles and research and development costs: all of it is expensed. By contrast, intangibles bought from outside are capitalised under both frameworks, provided they come from contractual rights (a licence), other legal rights (a patent) or can be separated and sold (a purchased customer list).

• Typically expensed under both frameworks: internally generated brands, mastheads, publishing titles and customer lists;
• start-up costs and training costs;
• administrative and other general overhead;
• advertising and promotion;
• relocation and reorganisation costs, and redundancy or other termination costs.

How analysts treat intangibles

Analysts tend to be sceptical of reported intangibles, goodwill above all. A common adjustment removes intangibles from assets and equity, giving tangible book value, and adds any related amortisation or impairment back to pretax income.

Writing every intangible down to zero by reflex is not good practice. A purchased licence that generates cash is a real asset. The better approach is to examine each listed intangible and decide whether an adjustment is justified, using the notes on useful lives, amortisation methods and rates, and impairment losses recognised or reversed.

The accounting creates a comparability problem: a company that buys its patents shows them as assets, while a rival that invents the same patents in-house (especially under US GAAP) shows nothing on the balance sheet and lower profits along the way.