The Treatment of Intangibles

Attitudes to intangibles are changing. Bankers traditionally thought of intangible assets as worthless, and deducted them from net worth to arrive at tangible net worth; they then used tangible net worth in calculating leverage and other ratios for analysis and for covenants in loan agreements.

Businessmen and economists use the word ‘goodwill’ to describe the intangible and unquantifiable aspects of a company which give it an earning power, and therefore a value, beyond that of its mere assets: things such as the quality of service, reliability, style, innovative flair, and imagination. Accountants, however, allow goodwill only when one company acquires another, and then only as an arithmetic differential; in effect, they define it as any amount paid by the acquirer above the book (i.e. accountant’s definition of) value of the acquired company, regardless of the reason why a buyer was prepared to pay that additional amount.

‘Assets’ in this chapter are those which remain in a company’s ownership continuously. They help to provide the goods and services the sale of which generates cash flow; or, in the case of ‘investment assets’, earn cash while the investment achieves some other objective. Assets in this sense exclude cash, receivables, inventory, or other current assets; these generate cash when they themselves are sold or collected, rather than via a stream of income or products.

Capitalised expenses are, as an asset, pure accounting fiction; as such they are intangible in a sense that is different from anything we have so far discussed; they are truly worthless and should be so treated.

We have talked so far about accounting treatment of intangibles, and about values in normal conditions, with a passing bow to the impact made by the threat of insolvency. This chapter will talk about how intangibles affect non-accountants, mostly banks but also investors and trade creditors. Partly this means how to adjust to the present inadequacies of accounts; how to assess the value of intangibles to each bank, investor, etc. and how to allow for them in decisions they make about their business with or ownership of the company concerned. It will discuss how banks should adapt covenants in loan agreements to the existence of intangibles, and how different types of brand name may affect this process. And a later section will talk about the impact of insolvency, or the threat of it, on the value of various types of asset, tangible and intangible. In some cases the threat of loss of value in insolvency will help to avoid insolvency, adding to the value to people who would suffer most in liquidation; in others, the same factors which cause the insolvency will undermine the value of the assets; in yet others it will be the loss of value itself which causes the insolvency.

For years banks assessed the credit standing of their borrowers on the basis of ‘liquidation analysis’, also often referred to as ‘gone-concern analysis’; some still do. Liquidation analysis, in its simplest form, values a company on what it would be worth in liquidation, i.e. at forced-sale prices. Unless this valuation shows that the company could pay its debts even in liquidation, the bank will not lend; or at least that is the theory.