Intangible assets

Although they have no physical characteristics, intangible assets have value because of the advantages or exclusive privileges and rights they provide to a business. Intangible assets generally arise from two sources: (1) exclusive privileges granted by governmental authority or by legal contract, such as patents, copyrights, franchises, trademarks and trade names, and leases; and (2) superior entrepreneurial capacity or management know-how and customer loyalty, which is called goodwill.

All intangible assets are nonphysical, but not all nonphysical assets are intangibles. For example, accounts receivable and prepaid expenses are nonphysical, yet classified as current assets rather than intangible assets. Intangible assets are generally both nonphysical and noncurrent; they appear in a separate long-term section of the balance sheet entitled “Intangible assets”.

Initially, firms record intangible assets at cost like most other assets. However, computing an intangible asset’s acquisition cost differs from computing a plant asset’s acquisition cost. Firms may include only outright purchase costs in the acquisition cost of an intangible asset; the acquisition cost does not include cost of internal development or self-creation of the asset. If an intangible asset is internally generated in its entirety, none of its costs are capitalized. Therefore, some companies have extremely valuable assets that may not even be recorded in their asset accounts.

Amortization is the systematic write-off of the cost of an intangible asset to expense. A portion of an intangible asset’s cost is allocated to each accounting period in the economic (useful) life of the asset. All intangible assets are not subject to amortization. Only recognized intangible assets with finite useful lives are amortized. The finite useful life of such an asset is considered to be the length of time it is expected to contribute to the cash flows of the reporting entity. (Pertinent factors that should be considered in estimating useful life include legal, regulatory, or contractual provisions that may limit the useful life). The method of amortization should be based upon the pattern in which the economic benefits are used up or consumed. If no pattern is apparent, the straight-line method of amortization should be used by the reporting entity.

Recognized intangible assets deemed to have indefinite useful lives are not to be amortized. Amortization will however begin when it is determined that the useful life is no longer indefinite. The method of amortization would follow the same rules as intangible assets with finite useful lives.

Straight-line amortization is calculated the same was as straight-line depreciation for plant assets. Generally, we record amortization by debiting Amortization Expense and crediting the intangible asset account. An accumulated amortization account could be used to record amortization. However, the information gained from such accounting would not be significant because normally intangibles do not account for as many total asset dollars as do plant assets.

Watch this video to see a demonstration:

Let’s look at another example.  A patent is a right granted by the federal government. This exclusive right enables the owner to manufacture, sell, lease, or otherwise benefit from an invention for a limited period. The value of a patent lies in its ability to produce revenue. Patents have a legal life of 17 years. Protection for the patent owner begins at the time of patent application and lasts for 17 years from the date the patent is granted.

When purchasing a patent, a company records it in the Patents account at cost. The firm also debits the Patents account for the cost of the first successful defense of the patent in lawsuits (assuming an outside law firm was hired rather than using internal legal staff). Such a lawsuit establishes the validity of the patent and thereby increases its service potential. In addition, the firm debits the cost of any competing patents purchased to ensure the revenue-generating capability of its own patent to the Patents account.

The firm would amortize the cost of a purchased patent over its finite life which reasonably would not exceed its legal life. If a patent cost  $40,000 and has a useful life of 10 years, the journal entries to record the patent and periodic amortization are:

For a patent that becomes worthless before it is fully amortized, the company expenses the unamortized balance in the Patents account.

A copyright is an exclusive right granted by the federal government giving protection against the illegal reproduction by others of the creator’s written works, designs, and literary productions. The finite useful life for a copyright extends to the life of the creator plus 50 years.  Most publications have a limited (finite) life; a creator may amortize the cost of the copyright to expense on a straight-line basis or based upon the pattern in which the economic benefits are used up or consumed.

A franchise is a contract between two parties granting the franchisee (the purchaser of the franchise) certain rights and privileges ranging from name identification to complete monopoly of service. In many instances, both parties are private businesses. For example, an individual who wishes to open a hamburger restaurant may purchase a McDonald’s franchise; the two parties involved are the individual business owner and McDonald’s Corporation. This franchise would allow the business owner to use the McDonald’s name and golden arch, and would provide the owner with advertising and many other benefits. The legal life of a franchise may be limited by contract.

The parties involved in a franchise arrangement are not always private businesses. A government agency may grant a franchise to a private company. A city may give a franchise to a utility company, giving the utility company the exclusive right to provide service to a particular area.

In addition to providing benefits, a franchise usually places certain restrictions on the franchisee. These restrictions generally are related to rates or prices charged; also they may be in regard to product quality or to the particular supplier from whom supplies and inventory items must be purchased.

If periodic payments to the grantor of the franchise are required, the franchisee debits them to a Franchise Expense account. If a lump-sum payment is made to obtain the franchise, the franchisee records the cost in an asset account entitled Franchise and amortizes it over the finite useful life of the asset. The legal life (if limited by contract) and the economic life of the franchise may limit the finite useful life

A trademark is a symbol, design, or logo used in conjunction with a particular product or company. A trade name is a brand name under which a product is sold or a company does business. Often trademarks and trade names are extremely valuable to a company, but if they have been internally developed, they have no recorded asset cost. However, when a business purchases such items from an external source, it records them at cost and amortizes them over their finite useful life.

A lease is a contract to rent property. The property owner is the grantor of the lease and is the lessor. The person or company obtaining rights to possess and use the property is the lessee. The rights granted under the lease are a leasehold. The accounting for a lease depends on whether it is a capital lease or an operating lease.  The proper accounting for capital leases for both lessees and lessors has been an extremely difficult problem. We leave further discussion of capital leases for an intermediate accounting text.

In accounting, goodwill is an intangible value attached to a company resulting mainly from the company’s management skill or know-how and a favorable reputation with customers. A company’s value may be greater than the total of the fair market value of its tangible and identifiable intangible assets. This greater value means that the company generates an above-average income on each dollar invested in the business. Thus, proof of a company’s goodwill is its ability to generate superior earnings or income.

A goodwill account appears in the accounting records only if goodwill has been purchased. A company cannot purchase goodwill by itself; it must buy an entire business or a part of a business to obtain the accompanying intangible asset, goodwill.  Specific reasons for a company’s goodwill include a good reputation, customer loyalty, superior product design, unrecorded intangible assets (because they were developed internally), and superior human resources. Since these positive factors are not individually quantifiable, when grouped together they constitute goodwill. The intangible asset goodwill is not amortized. Goodwill is to be tested periodically for impairment. The amount of any goodwill impairment loss is to be recognized in the income statement as a separate line before the subtotal income from continuing operations (or similar caption). The goodwill account would be reduced by the same amount.