Valuation of Intangible Assets
Valuation models can be used to value intangible assets such as patents, copyrights, software, trade secrets, and customer relationships. Since few sales of intangible assets are observable, benchmarking the value of intangible assets can be difficult. As a result, present value models or estimating of the cost to recreate an intangible asset are often used to is these valuations.
Although they have no physical characteristics, intangible assets have value because of the advantages or exclusive privileges 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 (2) superior entrepreneurial capacity or management know-how and customer loyalty Figure 1, which is called goodwill.
Intangible assets are initially recorded on financial statements at their purchase price, or the cost of acquiring the asset. If an intangible asset is internally generated, its cost is immediately expensed.
The valuation of intangible assets with identifiable useful lives such as patents, trademarks, and copyrights are initially valued at acquisition costs. The value of these assets can be increased or decreased, based on the outcomes of court proceedings. If a company incurs legal costs to successfully defend an intangible asset, those costs are capitalized and increase the value of the intangible. On the other hand, if a company is unsuccessful in defending an intangible asset, the intangible is worthless and the company is required to write it off.
U.S. GAAP has very specific rules regarding the recognition of intangible assets on financial statements. With that said, a company can still have very valuable intangible assets that are not recognized on its financial statements. From an accounting perspective, intangible asset valuation is primarily derived from acquisition costs. An acquisition identifies the value one party was willing to pay for an asset while at the same time identifying the value another party was willing to accept to relinquish that asset.
Goodwill is an excellent example of how intangible assets are valued. Let's say Company A has net assets equal to 150,000 and is acquired by Company B for 200,000. Why would Company B pay a 50,000 premium? Goodwill! Company B believes that Company A has value in excess of their net identifiable assets, and was willing to pay an additional 50,000 to acquire it. The 50,000 value of Company A's goodwill was derived from a transaction.