Due to applicable accounting standards, the intrinsic value a start-up associates with an IT or intangible asset will rarely be seen on a balance sheet. Why is this? When considering the value of information technology (IT) or intangible assets, we often think of the future revenues an asset will generate (either through its sale or its use to increase ones’ sales), or in terms of the costs incurred to acquire, create and develop the asset.
To understand the accounting process and the differences and values that will be reported on your company’s balance sheet, consider the following key factors:
- Is it a tangible or intangible asset?
- Was the asset purchased or internally developed, or a combination of both?
- Does the asset have a finite or an indefinite life?
Accounting for intangible assets
Intangible assets must meet three criteria to be eligible to be recognized as an asset. They must:
- Be identifiable
- Be controlled by the company
- Have future economic benefit (via revenues or decreased costs)
On the other hand, items such as employee workforces and know-how would not meet the criteria.
PURCHASED INTANGIBLE ASSETS
Generally, intangible assets that are purchased should be recorded at their purchase cost. However, if they are part of a larger purchase (such as the purchase of an entire business), they should be recorded as a percentage of the acquisition cost, based on the proportional weighting of the fair market value at the time of purchase.
INTERNALLY DEVELOPED INTANGIBLE ASSETS
The costs incurred in creating internally developed assets can be expensed until the company can show all of the following:
- Technical feasibility of completion
- The intention to complete
- The ability to sell or use the asset
- Adequate technical and financial resources to complete the asset
- Probable future economic benefit
- Reliable measurement of the expenditures
If you cannot meet these criteria, you will need to expense items even when you feel certain that you have moved beyond the research phase. As a result, the value that you show on your balance sheet will quite possibly be significantly less than that which you attribute to the value of the asset.
Generally, you would not record the increase in value (to show the fair value of the asset) until a sale is made, at which point you need to examine the revenue recognition criteria.
There is the possibility in some cases to revalue the asset at fair market value. However, the fair value used should be based on an active market for the asset, which is rare for intangible assets.
Accounting for tangible assets
Tangible capital assets, even for information technology, generally have less specific guidance around them as they are already more aligned with the general recognition criteria for assets.
As with intangible assets, revaluing the asset at fair market value may be an option. This is more likely to take place with tangible assets than with intangible assets as there is more often a reliable way of determining the fair value. However, using the revaluation method can be costly as the assets would need to be revalued on a regular basis to ensure that the value has not materially changed since the previous revaluation. In the extreme, this can mean having an actuary’s valuation completed annually.
Lifecycle and value of tangible and intangible assets
Where an asset has an indefinite life, it should be recorded at cost but will not be amortized. However, it will need to be tested for impairment (a decline in the recoverable amount of the asset below the cost at which it is recorded). If there is any indication that the asset is impaired (such as showing a decline in market values, a decline in economic performance, or obsolescence of the technology), the impairment will need to be assessed and a loss recorded.
If an asset has a finite life, it should be recorded and amortized over its expected useful life. For patents, this may be the 20 years that is the lifespan of the patent, or it may be significantly less if new technologies are expected to supersede the patent in the coming decade. As with assets with an indefinite life, any indicator of impairment would need to be assessed and any loss would need to be recorded.
Welch coordinates the valuation process for a number of our clients and we would be happy to assist you through this process.