Tangible and intangible assets
In accounting, an asset is defined as a current economic resource that an entity controls because of past events and that has the potential to produce economic benefits. It is recorded on the balance sheet only if it is likely to produce future economic benefits.
Two different types of assets are recorded on the balance sheet: current and non-current assets. Current assets include any assets that the entity expects to realize, sell or consume in its normal operating cycle, that it holds for trading, that it expects to realize within 12 months of the reporting date, and cash in hand. All other assets are recorded as long-term assets.
Current assets generally include the following:
- Cash in hand
- Accounts receivable and other receivables
- Prepaid expenses
Investments recorded under current assets are those that can be realized quickly, such as marketable securities, treasury bills, certificates of deposit and demand loans.
Current assets must be recorded separately because they are used to calculate a company’s working capital.
Current assets are those that the company will realize in the normal course of business or within 12 months after the end of the fiscal year. Non-current assets are resources that the company will use over more than one period.
“In the balance sheet, the most liquid assets are recorded first,” says Florence Bessette, Business Advisor, BDC Advisory Services. In current assets, for example, cash is recorded at the top of the balance sheet because it is the most liquid asset. Cash is followed by accounts receivable, because they should be collected in the normal course of business to settle current liabilities.
What are intangible assets?
Assets may be tangible or intangible. An intangible asset is a non-monetary asset that has no physical substance (i.e. it cannot be seen or touched). “Patents or goodwill are good examples,” says Bessette.
Monetary assets are financial assets, such as cash, accounts receivable and investments, because they represent an entity’s right to receive cash or another financial asset from another party, the customer.
Examples of intangible assets
- A trademark
- Internally generated intangible assets (during the development phase)
What are tangible assets?
A tangible asset is an asset that has physical substance. Examples include inventory, a building, rolling stock, manufacturing equipment or machinery, and office furniture. There are two types of tangible assets: inventory and fixed assets
Examples of tangible assets
- Raw materials
- Goods in process
- Finished products
- Fixed assets
- Office furniture
- Rolling stock
- Computer equipment
- Leasehold improvements
Fixed assets are tangible assets that the company holds to produce goods or provide services, or holds for rental or administrative purposes, and that the entity intends to use on a long-term basis.
The same logic applies to intangible assets, such as patents. Because they are held on a long-term basis and will be used to generate economic benefits, they will also be recorded as non-current assets on the balance sheet.
An asset is not an expense because a tangible or intangible asset will allow the company to generate future economic benefits throughout its use. Their cost is thus capitalized.
What is the difference between tangible and intangible assets?
The valuation of fixed assets differs from the valuation of intangible assets. This is because fixed assets normally have a finite life. Rolling stock is a good example of equipment that wears out over time and has a limited life, whereas this is not always the case for intangible assets, such as the trademark of an acquired entity.
Valuing fixed assets
Because the company holds fixed assets for long-term use, their acquisition cost is amortized. The company can use either the straight-line or declining balance method to amortize categories of fixed assets.
Land, which is a tangible asset, is never amortized because its life is unlimited.
To reflect wear and tear on its rolling stock, for example, as well as the rate at which revenue will be generated from its use, a company might decide to amortize the cost of a tractor-trailer on a declining-balance basis, at a rate of 30% per year, because it believes that as the tractor-trailer is used, it will be less productive and will require more maintenance and repair, and thus produce less economic benefit for the company.
The balance sheet will then report the net book value of the asset (i.e. its acquisition cost less accumulated amortization), while the income statement will show the annual amortization expense. The amortization expense for the previous year will be included in retained earnings, under shareholders’ equity. The image below shows these links between the various financial statement documents.Enlarge the image
Example of a declining balance depreciation
Because the rate is declining, the amortization expense will be smaller in subsequent years. “Let’s say a company buys a tractor-trailer at a cost of $100,000 at the beginning of fiscal year 2020,” says Bessette. “It decides to amortize it on a 30% declining balance basis. During the first year of use, the $100,000 cost will be amortized at a rate of 30%.”
The company will therefore record the net book value of this asset at $70,000 in the year of purchase on the balance sheet under non-current assets, and will add a $30,000 annual amortization expense in that same year on the income statement.
In the following fiscal year, the amortization expense recorded in the income statement will be $21,000 ($70,000 x 30%). On the balance sheet, the net book value will be $49,000, which is the $100,000 cost less the $51,000 accumulated amortization.
If the company had instead chosen to amortize the same asset on a straight-line basis over five years, the annual amortization expense recorded in the income statement would have been $20,000 per year until the end of its useful life.
|Year||Amortization (expense in the income statement)||Accumulated amortization||Net book value (recorded on the balance sheet)|
Valuing intangible assets
Unlike tangible assets, some intangible assets do not have a useful life. “Take a trademark that’s been acquired, for example” says Bessette. “A trademark has no lifespan. It will exist as long as the company does. It is therefore difficult to amortize the cost of this trademark to reflect its use.”
Therefore, it cannot be amortized. The intangible asset will then be carried at cost and impaired if there is an indication of impairment. To calculate its value, it will be necessary to use other methods. Let’s look at two examples.
First of all, it is important to differentiate between a trademark developed internally and a trademark acquired through a business acquisition. Internally developed software is never recognized in financial statements because it does not meet the criteria for recognition as an intangible asset. For an intangible asset to be recognized in the balance sheet, it must be separable from the entity that develops it, which is not possible in this case. When an entity operates a business, it incurs various operating expenditures. It is therefore very difficult to evaluate the cost of developing the trademark separately.
However, Bessette says the value of an externally acquired trademark can be assessed. A portion of the purchase price of the business will be allocated to the trademark at the date of the transaction. This will require the services of a business valuation specialist.
“You often have to bring in specialists to perform this kind of valuation” says the business consultant.
Goodwill is the excess acquisition cost over the fair value of the net identifiable asset. As with trademarks, it is very difficult to assess the useful life of goodwill. For this reason, accounting standards state that goodwill does not have a finite life.
In order to evaluate goodwill in financial statements, the company will then have to determine its fair value by performing an impairment test.
“Suppose we buy a company, but it starts losing money, customers and market share, and generates operating losses,” says Bessette. “It is advisable to take a critical look at the valuation of goodwill. We may have paid too much to buy the shares of this company. To avoid overvaluing the asset, an impairment test will be performed.”
This will allow the company to determine whether a goodwill loss should be recorded in the income statement related to goodwill. The company will recognize a loss if the carrying value of goodwill exceeds its fair value. For example, one method used to calculate the fair value of goodwill is to discount the estimated and expected future cash flows (i.e. the cash inflows and outflows from the operation of the acquired business).
Are there as many tangible and intangible assets in all industries?
The number of tangible and intangible assets held by companies can vary significantly between industries.
A manufacturing company will generally have more tangible assets. It will have fixed assets, such as property, plant (if it decides to buy rather than lease the space) and inventory. A service business, whose main expense is labour, will have relatively more intangible assets, some of which may not be on the balance sheet, such as customer lists.
Because a service sector firm normally has fewer tangible assets, the firm may find it more difficult to secure financing. In these cases, banks will not accept a real estate or chattel mortgage. They will require other types of collateral for their loans.