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It is easy to undervalue an enterprise when relying solely on its financial statements as, frequently, significant assets, or in some instances, the largest assets, are not reported on the enterprise’s balance sheet. International Financial Reporting Standards (“IFRS”), Canadian Generally-Accepted Accounting Principles (“GAAP”), U.S. GAAP and other generally-accepted accounting principles do not allow the recognition of most internally-generated intangible assets on the balance sheet. Moreover, accounting frameworks prohibit the recognition of intangible assets at their fair market values on the balance sheet — although they often depart significantly from their book values. This article aims to illustrate that intangible assets, including internally-generated intangible assets, can constitute a significant part of the value of an enterprise and therefore, require careful examination.
The value of an enterprise is comprised of the value of its monetary assets (cash, net receivables, etc.), the value of its tangible assets (machinery, equipment, building, etc.) and the value of its intangible assets.
The fair market values of monetary assets rarely depart significantly from their book values. The fair market values of tangible assets are often greater than their book values since accounting depreciation of fixed assets tend to be greater than their actual decrease in value. However, this difference does not generally understate enterprise value materially in the case of a going-concern, operating business. Conversely, the fair market value of intangible assets is not reported on the balance sheet and can represent a significant part of the enterprise value, as discussed below. Thus, when analyzing the balance sheet of a company, one must use care, and consider the relevant intangible assets.
Intangible assets are usually marketing-related, customer-related, artistic-related, contracts-based or technology-based. A summary of the most common intangible assets in different industries is set out below.
The following sets out the various types of intangible assets:
Intangible assets in medical and dental practices are generally customer-related. The location in which the practice is located and the area’s demographics also drive the practice’s values, as these factors define the clientele. Intangible assets in specialty practices are created by customer lists and referral agreements with other clinics. In some instances, referrals and customer lists can be attached to one particular practitioner, in which case, the intangible asset, deemed to be personal goodwill, would have little value, since its benefits would not be transferable. Thus, it is essential to distinguish the different types of goodwill generated by businesses (discussed below) to determine if there is commercial value to that goodwill (i.e., is it transferable?).
General business goodwill is the product of factors such as good employee relations; an experienced, competent management team; amicable relationships with lenders, investors, suppliers and customer; etc. General business goodwill is transferable and thereby has commercial value in a transaction setting.
Individual goodwill is the economic advantage that accrues to a business by virtue of its employment of a person who has abilities, business contacts, a good name and reputation. If that person left the employment of the business and competed with it, this would be damaging to the profitability of the business. However, in contrast to personal goodwill (see below), the business has the ability to substitute other people with similar skills and experience in the subject role.
A business can often earn high profits as a result of an individual’s personal talents, skill, effort and reputation. Such profits will diminish or disappear entirely upon the death or retirement of that person. Personal goodwill cannot be transferred to another individual and thereby does not have commercial value in a transaction setting.
In retail businesses, intangible assets are generally both marketing- and customer-related. Significant value can arise from effective delivery systems and product distribution channels. Awareness of retail stores’ brands can also attract consumers, thereby creating value. The location of retail stores can also represent a significant intangible asset as the demographic of consumers and the level of visibility of the store can have a significant impact on revenues.
Manufacturing businesses generally have intangible assets that are customer-related, contract-based and technology-based. Customer lists, order backlogs, binding contracts with suppliers and distributors, as well as know-how and technological advantages can give rise to intangible assets having significant value.
Intangible assets in pharmaceutical businesses are generally contract- and technology-based. The fair market values of patents and licenses are generally not fully reflected on the balance sheets of pharmaceutical companies. A quality research and development department can provide a business with new products and innovation that can give rise to significant intangible value. The recognition and awareness of a brand or trademark also allows companies to charge a premium on the price of their products, thereby creating intangible value.
In the energy industry, most intangible assets are contract-based. Power purchase agreements, as well as permits and contracts required for operations are important sources of value. Rights to reserves, often not recorded on the balance sheet, can also have substantial value.
Internally-generated intangible assets in the IT industry are, of course, generally technology-based. Computer software, quality research and development and databases are the main drivers of intangible value in the IT industry. With respect the IT consulting business, the know-how is often considered to be an important intangible asset for the business, assuming it is not attached to an individual (or personal goodwill).
As it is important to identify any intangible assets in your business, or the business subject to your analysis, it is equally as important to determine their value. In any planning, restructuring or transaction situation, this knowledge will permit management of a business to allocate the necessary resources to protect and maintain these assets and their related benefits. The significance of these assets is further illustrated in the table below:
The above table compares the ten most valuable brands in 2016, as determined by the annual study conducted by Interbrand, with the book value of the intangible assets of the subject companies as of December 31, 2016. As shown above, it is evident that the brand value (an intangible asset) of these companies is not reflected on their balance sheets as, in many cases, the brand value far surpasses the recorded value of intangible assets. In addition, it is important to note that for most of these companies, the brand name is only one of the internally-generated intangible assets not recorded on the balance sheet at fair market value. For example, Apple also benefits from internally-generated intangible assets such as databases, computer software and an established network, all of which are not recorded on Apple’s balance sheet. This further emphasizes that the value of intangible assets recorded on the balance sheet is not representative of the fair market value of the intangible assets owned by a business.
It is beneficial for a business owner, manager or a potential purchaser to consider the existence of internally-generated intangible assets as they may represent a significant portion of the value of a business and are generally not recorded on the balance sheet. Assigning a value to key intangible assets helps managers dedicate the required resources to protect their value and also provide a buyer and / or seller of a business with valuable insight into the real worth of a business.
Retaining the services of an experienced and qualified Chartered Business Valuator to identify and assess the value of, intangible assets owned by an enterprise can assist potential purchasers and sellers to close transactions at the right price.
For more information, contact JP Langevin, CPA, CA, CFA, CBV, CFF at 514-228-7805 or [email protected] or Frederic Johnson Legault, CPA, CA at 514.906.4641 or [email protected]
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