Intangible Assets and Goodwill

Intangible Asset Issues

Characteristics

  • Intangible assets lack physical existence.
  • They are not financial instruments.
  • They are typically classified as long-term assets.

Common Types of Intangibles

  • Patents
  • Copyrights
  • Franchises or licenses
  • Trademarks or trade names
  • Goodwill
  • Example: Coca-Cola's success is attributed to its secret formula, not its physical facilities.

Valuation of Purchased Intangibles

  • Recorded at cost.
  • Includes all costs to make the asset ready for its intended use.
  • Typical costs:
    • Purchase price
    • Legal fees
    • Other incidental expenses

Valuation of Internally Created Intangibles

  • Recorded at cost.
  • Generally expensed.
  • Only direct costs incurred in developing the intangible are capitalized (e.g., legal costs).

Underlying Concepts

  • There is a debate on whether R&D expenditures meet the definition of an asset.
  • If R&D costs meet that definition, expensing all R&D costs would overstate expenses and understate assets.

Amortization of Intangibles

Limited-Life Intangibles

  • Amortize to expense over the useful life.
  • Credit the asset account or accumulated amortization.
  • Useful life should reflect the periods the asset contributes to cash flows.
  • Amortization should be cost less residual value.
  • Evaluate for impairment.

Indefinite-Life Intangibles

  • No foreseeable limit on the time the asset provides cash flows.
  • Must test for impairment at least annually.
  • No amortization.

International Perspective

  • IFRS requires capitalization of some development costs.

Types of Intangible Assets

Six Major Categories

  1. Marketing-related
  2. Customer-related
  3. Artistic-related
  4. Contract-related
  5. Technology-related
  6. Goodwill

Marketing-Related Intangible Assets

  • Examples: trademarks or trade names, newspaper mastheads, Internet domain names, and non-competition agreements.
  • In the U.S., trademarks or trade names have legal protection for an indefinite number of 10-year renewal periods.
  • Capitalize acquisition costs.
  • No amortization.

Customer-Related Intangible Assets

  • Examples: customer lists, order or production backlogs, contractual and non-contractual customer relationships
  • Capitalize acquisition costs.
  • Amortize to expense over useful life.
  • Illustration: Green Market Inc. acquired a customer list for 6,000,000 and amortizes it evenly over three years, resulting in 2,000,000 amortization expense each year.
    • Journal Entry
      • Jan. 1 2017
        Customer List 6,000,000
        Cash 6,000,000
      • Dec. 31 2017 2018 2019
        Amortization Expense 2,000,000
        Customer List * 2,000,000

Artistic-Related Intangible Assets

  • Examples: plays, literary works, musical works, pictures, photographs, video and audiovisual material
  • Copyright granted for the life of the creator plus 70 years.
  • Capitalize costs of acquiring and defending.
  • Amortized to expense over useful life.

Contract-Related Intangible Assets

  • Examples: franchise and licensing agreements, construction permits, broadcast rights, and service or supply contracts
  • Franchise (or license) with a limited life should be amortized to expense over the life of the franchise.
  • Franchise with an indefinite life should be carried at cost and not amortized.

Technology-Related Intangible Assets

  • Examples: patented technology and trade secrets granted by the U.S. Patent and Trademark Office
  • Patent gives the holder exclusive use for 20 years.
  • Capitalize costs of purchasing a patent.
  • Expense any R&D costs in developing a patent.
  • Amortize over legal life or useful life, whichever is shorter.
  • Illustration: Harcott Co. spends 180,000 to defend a patent with a 12-year useful life. Amortization expense is 15,000 per year.
    • Journal Entry:
      • Jan. 1
        Patents 180,000
        Cash 180,000
      • Dec. 31
        Amortization Expense 15,000
        Patents (or Accumulated Amortization) 15,000

Goodwill

  • Represents future economic benefits from assets acquired in a business combination that are not individually identified and separately recognized.
  • Only recorded when an entire business is purchased.
  • Goodwill is the excess of the cost of the purchase over the fair market value (FMV) of the identifiable net assets (assets less liabilities) purchased.
  • Internally created goodwill should not be capitalized.

Recording Goodwill

  • Example: Multi-Diversified, Inc. buys Tractorling Company for 400,000. Tractorling's net assets have a fair value of 350,000. Goodwill is 50,000.
    • Fair Values
      Cash 25,000
      Accounts receivable 35,000
      Inventory 122,000
      Property, plant, and equipment, net 205,000
      Patents 18,000
      Liabilities (55,000)
      Fair value of net assets 350,000$
  • Example: Global Corporation purchases Local Company for 300,000. The fair value of Local Company's net assets is 200,000. Goodwill is 100,000.
    • Journal Entry recorded by Global:
      Cash 15,000
      Receivables 10,000
      Inventory 70,000
      Equipment 130,000
      Goodwill 100,000
      Accounts Payable 25,000
      Cash 300,000

Goodwill Write-Off

  • Goodwill is considered to have an indefinite life.
  • Should not be amortized.
  • Only adjust carrying value when goodwill is impaired.

Bargain Purchase

  • Purchase price is less than the fair value of net assets acquired.
  • The amount is recorded as a gain by the purchaser.

Impairment of Intangible Assets

Impairment of Limited-Life Intangibles

  • Same as impairment for long-lived assets in Chapter 11.
    1. If the sum of the expected future net cash flows (undiscounted) is less than the carrying amount of the asset, an impairment has occurred (recoverability test).
    2. The impairment loss is the amount by which the carrying amount of the asset exceeds the fair value of the asset (fair value test).
  • The loss is reported as part of income from continuing operations, “Other expenses and losses” section.
  • Illustration: Lerch's patent has a carrying amount of 60 million. Expected future net cash flows are 35 million. The fair value is 20 million. The asset is impaired by 25,000,000.
    • Journal Entry:
      Loss on Impairment 40,000,000
      Patents 40,000,000
  • Companies may not recognize restoration of the previously recognized impairment loss.

Impairment of Indefinite-Life Intangibles Other than Goodwill

  • Should be tested for impairment at least annually.
  • Impairment test is a fair value test.
    • If the fair value of the asset is less than the carrying amount, an impairment loss is recognized for the difference.
    • Recoverability test is not used.
  • Illustration: Arcon Radio has a broadcast license with a carrying amount of 2,000,000. The fair value is 1,500,000. The loss on impairment is 500,000.

Impairment of Goodwill

  • Goodwill must be tested for impairment at least annually.
  • The impairment rule for goodwill is a fair value (quantitative) test.
  • A company compares the fair value of the reporting unit to its carrying amount, including goodwill.
  • If the fair value of the reporting unit exceeds the carrying amount, goodwill is not impaired.
  • Illustration: Kohlbuy Corporation purchased Pritt Products four years ago for 2 million. Pritt Division’s net assets is 2,400,000.
  • If the fair value of Pritt Division is 2,800,000, no impairment is recognized.
  • If the fair value of Pritt Division is 1,900,000, the loss on impairment is 500,000.

Research and Development Costs

Accounting for R&D Activities

  • Costs Associated with R&D Activities:
    • Materials, Equipment, and Facilities
    • Personnel
    • Purchased Intangibles
    • Contract Services
    • Indirect Costs