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How do you account for a new idea in external financial statements (part 2)

Colin Garvie, Assistant Professor

Faculty Blog

Tangible or intangible asset – does it matter?

In the first blog in this series, I discussed the issue of distinguishing capital from revenue expenditure in a set of accounts when accounting for an entrepreneur’s idea. Now I am going into a bit more detail at what the entrepreneur has actually spent his money on and how it might be accounted for.

Let’s imagine that the entrepreneur’s idea is to produce a revolutionary gizmo that, when switched on, will immediately stop a baby crying, make it happy and send it to sleep. The potential market is huge… all parents of restless young babies are potential buyers. Undreamt-of riches potentially await the entrepreneur!

A prototype has been made and the next stage is to ‘road-test’ it. To put progress into monetary context, let’s assume that the entrepreneur has spent £70,000 over the last year as follows:

  • Design and build of a prototype gizmo: £50,000
  • Application for worldwide patent: £20,000

The entrepreneur, at some as yet unspecified future date, envisages revenue and profit being generated from his device. Somewhat cynically, one might refer to this as ‘subjective viability’! The thought that the idea may fail is given no traction at this stage.

It is his company’s year-end. He is persuasive in his vision and succeeds in convincing the accountant that all of the £70,000 expenditure incurred so far should be treated as an asset and recorded in his company’s balance sheet and not written off to the profit and loss account as revenue expenditure.

The accountant has been convinced that all £70,000 spent is an asset but now she has to make a decision as regards its tangibility. Can she see, touch or hear the entrepreneur’s idea?

Presumably the prototype can be seen, touched and heard (if the claims about its effects on a baby are to be believed) and so it certainly is tangible in that sense. But is it a tangible asset in accounting-speak? Although it has a physical presence, its potential is as yet untried and untested, so in essence it is still just an idea and therefore maybe intangible.

And what about patent application spend, where there is as yet nothing to show for it? If it is an asset, then it certainly is intangible and will remain so until a patent is approved and granted.

Tangible or intangible asset: does it matter? For accountants, yes it does. If tangible, it requires to be depreciated, if intangible it requires an annual impairment test and if the asset’s value has fallen, this fall is amortised. Yet more accounting jargon I hear you say. Indeed!

Depreciation might be defined as an assessment of the consumption of the value of an asset. Accounting rules dictate that annual depreciation is written off against the value of the tangible asset at an agreed rate and charged as an expense against profit.

Amortisation, which in reality is just another word for ‘depreciation of an intangible asset’, involves assessing the value of the intangible asset each year to see if has reduced in value and requires amortised (reduced in value) to a newly assessed lower value. This amortisation could therefore be anything between 0% and 100% of the value of the intangible asset.

In our example, the entrepreneur will argue that all of the £70,000 is intangible as he believes that the value of all of his spend has suffered no impairment in value and should therefore not be subject to depreciation.

Because his company has no revenue yet, if the asset is depreciated, his profit and loss account will show a loss equal to the depreciation charged… and no entrepreneur likes to declare losses!

Luckily, the accountant agrees with him… for now. Things may change when the prototype is ‘road-tested’.

To be continued.