As you move further down a balance sheet, there are additional assets that are recorded in certain situations. Moving past line items such as cash and physical equipment, you will see items that are intangible assets. Cash can be spent, and equipment and property are tangible items (meaning you can actually touch them). Intangible assets are items that you can’t necessarily put a hand on, but still create value for a company. Here are a few different examples of intangible assets:
Goodwill
Not to be confused with the nonprofit organization, in finance “goodwill” is a term used to valuate intangible assets such as brand recognition and reputation. For example, a company with a brand that is recognized internationally will be valued at a higher rate than a company with a local or regional brand presence. Goodwill shows up on balance sheets when a merger or acquisition occurs, meaning one company buys another company.
The reason goodwill is associated with the purchase of a company is that it is used to value the difference between a company’s book value and the actual selling price. Let’s use an example:
A coffee chain, we’ll call “XYZ Coffee” is looking to buy another company. “ABC tea” is currently looking for a buyer. The book value of ABC Tea is 20 million dollars. However, XYZ coffee spends 60 million in buying the tea company. The 40 million dollar difference is recorded on a balance sheet as goodwill. Goodwill justifies the purchase of the tea company for the XYZ coffee balance because even though ABC tea is valued at 20 million dollars, the tea company’s international brand presence, reputation for quality products, and popularity among consumers all add to its value. This allows ABC tea to ask for a higher asking price.
Prepaid Assets
The further down a balance sheet you move, the more complex assets become. A company may have a line item for prepaid assets. The easiest way to explain this type of asset is to consider rent. For example, a startup company signs a lease for a small office space for $ 2,000 a month. Because startups are known for not having the best credit, the leasing company requires the payment for the entire year of rent in one payment upfront.
If the lease starts in September, the company is not going to want to put the entire $24,000 expense (2,000 a month for 12 months) under the September expense report. Even though the money was spent, the purchase doesn’t get used right away but rather a little bit each month. To accommodate this type of arrangement, a company will create a pre-paid asset line on the balance sheet. The full amount of $24,000 is recorded as a prepaid asset.
When you divide the lump sum for rent over the 12 months of the lease, each month $2,000 is recorded as an expense. As the months progress, the prepaid asset column decreases. So in September, the prepaid asset line will show $22,000 (the prepaid amount minus the one month for rent) and in October, the prepaid line will show $20,000 (the prepaid amount minus the two months that have passed).
Now that we have reviewed the assets portion of a balance sheet, we’ll move on to the liabilities of a balance sheet in our next post.
