Although prepared in accordance with Generally Accepted Accounting Principles (GAAP), many clients’ balance sheets are missing their most valuable assets. A recent study by the Association for Financial Professionals revealed that the average U.S. company’s book value represented only 28% of its market value in 1998 — down from 95% two decades earlier.

The primary reason the study cited for the decreased correlation between book value and market value is the growing importance of intangible assets, also known as intellectual property.

Conservative accounting conventions only require a company to record intangible assets when purchased from an outsider or as part of a business combination. Therefore, if a company develops its intangibles in-house — as many do — its balance sheet will not reflect its intellectual property.

In large part, the significance of intangible assets depends on the company’s industry. For example, retailers, manufacturers and construction companies typically rely more on hard assets than intangibles. Conversely, professional service companies and high- tech companies rely heavily on intellectual assets.

Recent accounting standard
At one time, intangible assets were commonly lumped into one catchall category called “goodwill,” which represented a company’s incremental value beyond its net tangible value. Because intangibles now play a pivotal role in many companies’ success, however, companies must differentiate goodwill from other types of intellectual property.

In 2001, the Financial Accounting Standards Board (FASB) issued Statement No. 141, Business Combinations, which provides five categories of intangible assets: customer-related; artistic-related; contract-based; technology-based; and marketing-related.

Within each category, FASB provides specific examples; for instance, a copyright is an artistic-related intangible and a patent is a technology-based intangible.

When to value intangibles
With the growing significance of intangible assets has come an increased need for their valuations. Common situations that require companies to estimate their intellectual property value include:

Management consulting. To make informed decisions, a company’s management often needs to estimate an intangible asset’s value. Such estimates, for example, help management select reasonable royalty rates or decide on the viability of an asset purchase or business combination.

Tax planning. In some cases, a valuator must know an intangible asset’s value to calculate a company’s federal or state income taxes. For instance, a valuation expert may need to calculate an intercompany transfer price or a charitable deduction that involves an intangible. Furthermore, intangible assets may also be valued for a business owner’s personal estate-planning purposes.

Litigation support. Bankruptcy, economic damages, marital dissolutions and shareholder disputes are just a few examples of the types of lawsuits that might necessitate an intangible asset valuation.

Your assets’ market value
As FASB continues its efforts to bring financial reporting closer to market reality, the fair market value of companies’ assets — including their intangibles — will be increasingly relevant.