Chapter 8 Valuation of Intangibles – CS Professional Valuations and Business Modelling Study Material is designed strictly as per the latest syllabus and exam pattern.
Valuation of Intangibles – CS Professional Valuations and Business Modelling Study Material
Question 1.
State under what conditions/assumptions the following statements are true (state only one important condition/assumption for each):
A Company can show Goodwill in its Balance Sheet. (June 2019, 5 marks)
Answer:
A company can show Goodwill in its Balance Sheet.
It must be noted that a company cannot show its own goodwill in its own balance sheet; however, it buys / acquires goodwill from someone, then goodwill can be shown in the balance sheet. As per AS 26, the self-generated goodwill / own goodwill / internally generated goodwill are termed as unidentified intangible assets whose cost cannot be measured reliably. So they are not recognized in books / financial statements.
Question 2.
Why do Companies want to measure intellectual capital and what are the pitfalls in valuation of such assets. (June 2019, 5 marks)
Answer:
There a number of reasons why firms want to measure intellectual capital and the predominant reasons have been for strategic or internal management purposes. Specifically, the reasons include:
(i) Alignment of intellectual capital resources with strategic vision. To support the implementation of a specific via a general upgrading of the work with the companies’ human resources (support and maintain a strategy concerning the composition of staff as regards seniority, professional qualifications, and age. Through the description of the staff profile, measuring, discussion and adjustment become possible).
(ii) To support or maintain various parties’ awareness of the company.
(iii) To help bridge the present and the past (stimulates the decentralized development of the need for constant development and attention towards change).
(iv) To ensure that stock prices valued fairly, by making several competencies visible to current and potential customers.
(v) To make the company appear to the employees as a name providing an identity for the employees and visualizing the company in the public. Knowledge of employees and customers will stimulate the development of a set of policies to increase customer satisfaction and customer loyalty.
(vi) Assessing effectiveness of a firm’s intellectual capital utilization- Allocate resources between various business units. Extract full value from acquisition and joint ventures.
(vii) Determine the most effective management incentive structures.
Pitfalls in Valuation of Intellectual Capital – The first problem with intangibles starts with identifying them unlike physical assets, intangible assets have no specific lifetime and are not marketable in the conventional sense, meaning no market exists where they can be sold and priced readily.
This not only increases the likelihood of information asymmetry where the same asset will be priced differently by people with different levels of information, but also of the risk of not being able to sell the asset. Moreover, the absence of intangible assets from the Balance Sheets leads to misleading profitability metrics and hence the decisions based on these metrics are flawed.
For example, the absence of intangible assets will understate the total assets in the Balance Sheet, so ratios like Return on Asset and Return on Equity will be overstated. In the opposite case, if intangible assets are priced without any standardized method, there may be a tendency to overprice these intangible assets, leading to understated profitability ratios. In both cases, the investors are not getting the proper picture of a company’s financial situation.
Alternate Answer:
Intellectual capital (IC) is increasingly recognized as an important strategic asset for sustainable corporate competitive advantages. Intellectual capital is one of the most important intangible assets in the firm. Empirical evidences suggest that intellectual capital has direct effect in the firm’s value and performance. Companies may want to measure intellectual capital for internal and external reasons.
Internal Reasons
First, measuring intellectual capital can help an organization formulate business strategy. By identifying and developing its intellectual capital, an organization may gain a competitive advantage.
Second, measuring intellectual capital may lead to the development of key performance indicators that will help evaluate the execution of strategy. Intellectual capital even if measured properly, has little value unless it can be linked to the firm’s strategy.
Third intellectual capital may be measured to assist in evaluating mergers and acquisitions, particularly to determine the prices paid by the acquiring firms.
Fourth, using nonfinancial measures of intellectual capital can be linked to an organization’s incentive and compensation plan.
External Reasons
To communicate to external stakeholders what intellectual property the firm owns. Improving external reporting of intellectual capital can:
- Close the gap between book vrlue and market value,
- Provide improved information about the “real value” of the organization,
- Reduce information asymmetry,
- Increase the ability to raise capital by providing a valuation on intangibles, and
- Enhance an organization’s reputation.