As a new entrepreneur or self-employed worker, the area where you may struggle the most is accounting and finance.
Because you’re focusing so much on the day-to-day operations of your business, you may not feel as though you have time to brush up on tricky accounting terms.
If this sounds familiar, you’re not alone.
For instance, a recent Nav Survey polled small business owners and found that “45% did not know they have a business credit score, 72% did not know where to find information on their business credit score, and 82% didn’t know how to interpret the score.”
Business finances can be very different from personal finances.
One example is intangible assets.
Not something that you’ll see when balancing your personal books, intangible assets can play a significant role in your financial accounting practices.
So what is an intangible asset?
Today, we’ll explain what it is and why it’s essential.
We’ll also break down the types of intangible assets so you have a better understanding of how they apply to your company.
What Is an Intangible Asset?
When you’re looking at your balance sheet, you’ll find numerous different types of assets.
Assets can include things like cash on hand, inventory, and accounts receivable.
Assets are basically things that belong to your company.
An intangible asset is an asset that lacks physical substance but has a multi-period useful life.
This means that you cannot hold it or touch it, and that you expect to use it over and over again.
A computer, for example, is a tangible asset that does have physical substance.
A brand is an intangible asset that lacks physical substance.
Intangible assets can be subjective and somewhat confusing, but they typically refer to things like intellectual property that you have legal rights to.
Some examples of intangible assets include:
- Trade names
- Computer software
- Licensing agreements
- Domain names
- Research and Development
The International Accounting Standards Board (IASB) attempts to provide some clarity in the situation.
The board says that an intangible asset is “an identifiable non-monetary asset without physical substance.”
The group also says that an asset is one that has an actual past event, is controllable, and projects to have future economic benefits.
Intangible assets must also meet these requirements.
Perhaps the critical determining factor is that an intangible asset arises from a contractual or legal right, and that it is technically separable from the entity.
Separable assets are those that you can sell, license, or trade.
The Importance of Intangible Assets
Intangible assets can provide you with fair value for your innovation and creativity.
Tracking intangible assets could be useful when it comes to pitching to investors.
If you’ve ever watched shows like Shark Tank, you may understand the importance of intellectual property and patents.
It seems as though the sharks are always asking the business owner whether they’ve secured a patent on the product.
The reason for this is because having something like a patent or trademark shows that you are the legal owner of that concept.
If someone were to steal it from you, you could sue them.
Basically, you are the only one who can make money off the product.
The following scenario demonstrates why intangible assets can be so critical.
During a pitch to an investor, one of the first things he or she will ask for is your company’s balance sheet and income statement.
They want to measure your cash flow and take a look at your financial assets.
However, during this evaluation, they notice that you don’t have any real assets.
They ask, “What gives?”
You then explain to them that you have an idea for a new product.
The investor responds with something along the lines of, “That’s cool — so does every other business owner that I work with.”
You then inform the investor that you have secured a patent.
The investor is much more interested because you are the sole owner of the concept.
If the product or service is going to make money, it’s going to be with you.
Even though you can’t measure the physical value of the product yet, the investor can estimate how much it’s going to make.
The Value of Intangible Assets
Some companies report that they have a much higher market value than their financial statements indicate.
Intangible assets are one of the reasons for this.
There’s no way to know precisely how much intangible assets are worth.
If companies value them highly, it could cause their perceived net worth to increase even if their books indicate otherwise.
This is noticeably different from physical assets, which are much more common and much easier to measure the value of.
They have a physical presence and a limited life.
Physical assets include things like property and equipment — think things like machinery and office buildings.
Because you can measure how much you paid for the asset and when it will expire, you can make concrete measurements of the value and depreciation of the asset.
Tangible assets are subject to depreciation, which is a decrease in value during the life of the asset.
But this is not something that you can measure with intellectual property, which is what makes intangible assets so unique.
Companies can determine the valuation of intangible assets by using Calculated Intangible Value (CIV).
To calculate this figure, you’ll need your company’s pre-tax earnings from the last three years.
You’ll also need your return on assets (ROA), which you can calculate by dividing net income by total assets.
You should also gather the industry-average ROA for the last three years as well as your average income tax rate.
To calculate CIV, multiply your total assets by the industry ROA average.
Then, subtract this result from your pre-tax earnings average.
This will show you how much you earned from intangible assets.
Then, divide this number by your cost of capital to receive the net present value of your intangible assets.
The Amortization of Intangible Assets
All intangible assets, except for goodwill, are subject to amortization.
Amortization is an accounting term that involves spreading out the book value of an asset across its useful life.
For instance, patents carry 20-year protection. After 20 years, the patent expires, and others can begin using the information.
The amount of time remaining on the useful life of an idea or product determines its value.
For instance, if you just submitted a patent and plan to have it for the next two decades, an investor would find this far more exciting than a patent that will expire in two years.
The longer the useful life remaining on an intangible asset, the greater the competitive advantage you have.
Typically, accountants will use a straight-line method when amortizing products.
The straight-line method calls for accountants to divide the total value of the asset against the remaining duration of the useful life.
Imagine you’re a graphic designer and you buy a $2,000 computer for your business.
You estimate that the computer has a useful life of five years.
You divide $2,000 by five.
The yearly intangible asset figure on the balance sheet would be $400.
Different Types of Intangible Assets
As we’ve mentioned, there are a few different types of intangible assets available.
We’ve provided a breakdown of some of the more common ones below.
Copyrights give creators legal rights to their work.
Journals, magazines, art, and books are all examples of works that may have copyrights.
Copyrights can apply to both published and unpublished works.
Patents are very similar to copyrights in that they protect an individual’s or business’s work.
The only difference is that patents protect inventions, while copyrights protect artistic property.
Trademarks protect things like brand names and brand recognition.
Trademarks are also similar to copyrights and patents.
They can cover things like logos and other designs.
If you try to purchase another company, these costs would fall under goodwill.
Goodwill includes the cost of trying to buy the business minus the fair market value of the company’s other tangible assets and any liabilities obtained during the purchase.
Goodwill would come into play if the purchase price for the company was more than the fair market value of the company’s assets.
For instance, if you’re buying a company with a strong brand name or customer base, you may end up paying more than what that company’s assets are worth.
Building Your Intangible Assets
If you’re an entrepreneur with a grand idea, you’ll want to find ways to boost the value of your new company.
One of the best ways to do so is to build your intangible assets.
You should make efforts to protect your intellectual property.
Not only will this increase your value to investors, it will protect your ideas as well.
Remember though that intangible assets won’t provide monetary value immediately, so your business may be strapped for cash for a while.
Consider using equity crowdfunding sites or passive income opportunities to boost your cash flow in the meantime.