Chapter 12 Intermediate Accounting

Types of Intangible Assets

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

Accounting for R&D Activities

1. Materials, equipment, and facilities -Expense the entire costs, unless the items have alternative future uses. If there are alternative future uses, carry the items as inventory and allocate as consumed, or capitalize and depreciate as used 2. Personell -expenses as incurred salaries, wages, and other related costs of personnel engaged in R&D 3. Purchased intangibles - Recognize and measure at fair value. After initial recognition, account for in accordance with their nature (as either limited-life or indefinite-life intangibles) 4. Contract services -Expense the costs of services performed by others in connection with the R&D as incurred 5. Indirect costs - include a reasonable allocation of indirect costs in R&D costs, expect for general and administrative cost ,which must be clearly related in order to be included in R%D

Costs Similar to R&D Costs

1. STart-up costs for a new operation 2. Initial operating losses 3. Advertising costs 4. Computer software costs For the most part, these costs are expensed as incurred, similar to the accounting for r&D costs

Intangible Asset Characteristics

1. They lack physical existence. -tangible asset such as PPE have physical form -intangible assets derive their value from the rights and privileges granted to the company using them 2. They are not financial instruments -Assets such as bank deposits, accounts receivable, and long-term investements in bonds and stocks also lack physical substance. Financial istruments derive their value from the right (claim) to receive cash or cash equivalents in the future. Financial instruments are not classified as intangibles. Intangible assets provide benefits over a period of years. Therefore, companies normally classify them as long-term assets

Impairment of Goodwill

Goodwill must be tested for impairment at least annually The impairment rule for goodwill is a fair value (quantiative) 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 and the company does not have to do anything else if fair value exceeds the carrying amount of the net assets of the reporting unit, no impariment recognized -if fair value less than carrying amount, impairment is measured Companies may instead perform an optional qualtiative assement to dtermine whether it is more likely htan not that goodwill is impaireed -if the optional qualitative assesment indicates that the fair value of the reporting unit is more likely than not to be greater than the carrying value, the company need not continue with the fair value impairment test

Advertising Costs

Must expense advertising costs as incurred or the first time the advertising takes place -whichever of these two appraoches is followed, the results are essentially the samae On the other hand, companies record as assets any tangible assets used in advertising, such as billboards or blimps. - The rationale is that such assets do have alternative future uses the profession has taken a conservative approach to recording advertising costs because defining and measuring the future benfits can be so difficult

Initial Operating Losses

Some contend that companies should be allowed to capitalize initial operating losses incurred in the start-up of a business -argue that such operating losses are an unavoidable cost of starting a business GAAP requires that operating losses during the early years should not be capitalized -in short, the accounting and reporting standards should be no different for an enterprise trying to establis ha new business than they are for other enterprises

Internally Created Intangibles

Sometimes a company may incur substantial research and developement costs to create an intangible Costs incurred internaly to create intangibles are generally expensed Some argue that the costs incurred internally to create intangibles often bear no relationship to their real value -therefore, expensing these costs is appropriate Difficult to associate internal costs with a specific intangible Others contend that due to the underlying subjectivity related to intangibles, companies should follow a conservative approach- that is, expense as incurred Companies capitalize only direct costs incurred in developing this intangible, such as legal costs, and expense the rest

Computer Software Costs

Special problem arises in distinguishing R&D costs from selling and administrative activities -the FASB's intent was that companies exclude from the defintiion of R&D activities the acquistion, developmnet, or improvement of a process for use in their selling or administrative activities

Development Activities

Translation of research findings or other knowledge into a plan or design for a new product or process or for a signficiant improvement ot an existing product or process whether intended for sale or use

Research and Development Costs

not in themselves intangible assets present the accounting for R&D activities frequently in the development of patents or copyrights (such as a new product, process, idea, formula, composition, or literary work) that may provide future value Two difficulties arise in accounting for R&D expenditures: (1) identifying the costs associated with particular activities, projects, or achievements, and (2) determining the magnituede of hte future benefits and length of time over which such benefits may be realzied because of these latter uncertainties, the FASB has simplified the accounting practice in this area Companies must expense all research and development costs when incurred R&D activities do not include routine or periodic alterations to existing products, production lines, manufaturing processes, and other ongoing operations, even though these alterations may represent improvements

Research Activities

planned search or critical investigation aimed at discovery of new knowledge

Amortization of Intangibles

the allocation of the cost of intangible assetes in a systematic way is called amortization Intangibles have either a limited (finite) useful life or an indefinite useful life Amortize limited-life intangible assets, don't amortize indefinite-life

Indefinite-life intangibles

if no factors limit the useful life of an intangible asset, a company considers its useful life indefinite An idefinite life means that there is no forseeable lmit on the period of time ver which the intangible asset is expected to provide cash flows A company does not amortize an intangible asset with an indefinitey life Companies should test idefinite-life intangibles for impairment at leas annually The impairment test for indefinite-life intangibles differes from the one for limited-life intangibeles; there is no recoverability test for these intangibles idefinite-life intangible assets might never fail the undiscounted cash flows recoverability test because cash flows could extend indefinitely into the future

Start-up costs

incurred for one-time activities to start a new operation -ex: opening a new plant, introducing a new product or service, or conducting business in a new territory Start up costs include organizational costs, such as legal and state fees incurred to organize a new business entity Expense start-up costs as incurred Start-up activities commonly occur at the same time as activities involving the acqusition of assets

Artistic-Related Intangible Assets

involve ownership rights to plays, literary works, musical works, pictures, photographs, and video and audiovisual material Copyrights protect these ownership rights A copyright is a federally granted right that all authors, painters, musicians, sculptors, and other artists have in their creations and epressions A copyright is granted for the life of the creator plus 70 years. -it gives the owner or heirs the exclusive right to reproduce and sell an artistic or published work. Copyrights are not renewable Copyrights can be valuable Companies capitalize the costs of acquiring and defending a copyright -they amortize any capitalized costs over the useful life of the copyright if less than its legal life (life of the creator plus 70 years)

Impairment summary

limited life -recoverability test, then fair value test Indefinite life other than goodwill -fair value test Goodwill -fair value test on reporting unit *optional qualitative assessment may be performed to determine whether the fair value test needs to be performed

Limited-Life Intangibles

Companies amortize their limited-life by systematic charges to expense over their useful life. The useful life should reflect the periods over which these assetes will contribute to cash flows Factors considered in determining useful life: 1. the expected use of the asset by the company 2. the expected useful life of another asset or a group of assets to which the useful life of the intangible asset may relate 3. any legal, regulatory, or contractual provisions that may limit the useful lfie 4. any provisions that enable renewal or extension of the asset's legal or contractual life without substantial cost. This factor assumes that there is evidence to support renewal or extension. 5. the effects of obsolesence, demand, competition, and other economic factors. 6. the level of maintenance expenditure required to obtain the expected future cash flows from the asset the amount of amortization expense for a limited-life intangible asset should reflect the pattern in which the company consumes or uses up the asset, if the company can reliabily determine that pattern The amount of an intangible asset to be amortized should be its cost less residual value -the residual value is assumed to be zero unless at the end of its useful life the intangible asst has value to another company What happens if the life of a limited-life intangible asset changes? -in that case, the remaining carrying amount should be amoritzied over the revised remaining useful life -comapnie should, on a regular basis, evaluate the limited-life intangibles for impairment An impairment loss hsould be recognized if the carrying amount of the intangible is not recoverable and its carrying amount exceeds its fair value

Goodwill

Companies do record mateiral amounts of intangible assets when purchasing htem, particularly in situations involving a business combination Goodwill is measured as the excess of the cost of the purchase over the fair value of the identifiable net assets (assets less liabilities) purchased -measured as a residual rather than measured directly -sometimes referred to as a plug, a gap filler, or a master valuation account Represents the future economic benefits arising from the other assets acquired in a business combination that are not individually identified and separately recognized -identified only with the business as a whole -only way to sell goodwill is to sell the business

Purchased Intangibles

Companies record at cost intangibles purchased from another party Cost includes all acquisition costs plus expenditures to make the intangible asset ready for its intended use -typical costs include purchase price, legal fees, and other incidental expenses Sometimes companies acquire intangibles in exchange for stock or other assetes -in such cases, the cost of the intangible is the fair value of the consideration gieen or the fair value of the intangible recievd, whichever is more clearly evident accounting treatment for purchased intangibles closely paralells that for purchased tangible assets

Presentation of Research and Development Costs

Companies should disclose in the financial statements (generally in the notes) the total R&D costs charged to expense each period for which they present an income statment

Impairment of Indefinite-Life Intangibles Other than Goodwill

Companies should test indefinite-life intangibles otehr than goodwill for impairment at least annually The impairment test for an indefinite-life intangible asset other than goodwill is a fair value test -this test compares the fair value of the intangible asset with the asset's carrying amount -if the fair value is less than the carrying amount, the company recognizes an impairments -companies use this one-step test becaues many indefinite-life assetes easily meet the recoverability test -companies do not use the recoverability test Companies have the option to perform a qualitative assement to determine whether it is more likely than jnot that an indefinite-life intangible asset is impaired -if the optional qualitative assesment indicates that the fair value of the reporting unit is more likely than not to be greater than the carrying value, the company need not continue with the fair value test -use of the optional qualitative assement should reduce both the cost and complexity of performing the impairment test

Goodwill Write-Off

Companies that recognize goodwill in a business combination consider it to have an indefinite life and therefore should not amortize it Although goodwill may decrease in value over time, predicting the actual life of goodwill and an appropriate pattern of amortization is extremely difficult -investors find the amortization charge of little use in evaluating financial performance Investment community wants to know the amount invested in goodwill -companies adjust its carrying value only when goodwill is impaired (can signficiantly impact income statement) Some bellieeve that goodwill's value eventually disappears -argued that companies should cahrge goodwill to expense over the periods affected, to better match expenses with revenues Nonamortization of goodwill combined with an adequate impairment test should provide the most useful financail information to the investment community

Internally created goodwill

Goodwill generated internally should not be capitalized in the accounts Measuring the components of goodwill is simply too complex, and associating any costs iwth future benefits is too difficult -the future benefits of goodwill may have no relationship to the costs incurred in the development of that goodwill -goodwill may even exist in the absence of specific costs to develop it -because no objective transaction with outside parties takes palce, a great deal of subjectivity may occur

Purchased Goodwill

Goodwill is recorded only when an entire business is purchased To record goodwill, a company compares the fair value of th enet tangible and identifiable assets with the purchase price of the acquired business -the difference is considered goodwill Goodwill is the residual- the excess of cost over fair value of the identifaible net assets acquired Normally, differences between current fair value and book value are more common among long-term assets than among current assets. Cash obviously poses no problems as to value. Receivables normally are fairly close to current valuation although they may at times need certain adjustments due to inadequate bad debt provisions. Liabilities usually are stated at book value. However, if interest rates have changed since the company incurred the liabilities, a different valuation (such as present value based on expected cash flows) is appropriate. Careful analysis must be made to determine that no unrecorded liabilities are present. In many cases, the values of long-term assets such as PPE and intangibles may have increased substantially over the years -difference could be due to inaccurate estimates of useful lives, continual expensing of small expenditures, inaccurate estimates of residual values, and the discovery of some unrecorded assets difference between purchase price and fair value=goodwill Goodwill is viewed as one or a group of identifiable values, the cost of which "is measured by the difference between thecost of the group of assets or enterprise acquired and the sum of the assigned costs of individual tangible and identifiable intangible assets acquired less liabilitie assumed -master valuation approach -assumse goodwill covers all the values that cannot be specifically identified with any identifiable tangible or intangible asset Companies often identify goodwill on the balance sheet as the excess of cost over the fair value of the net assets acquired

Bargain Purchase

In a few cases, the purchaser in a business combination pays less than the fair value of the identifiable net assets -bargain purchase Bargain purchase results from a market imperfection -seller would have been better off to sell the assets individually than in total Situations occur in which the purchase price is less than the value of the net identifable assets -this excess amount is recorded as a gain by the purchaser The FASB notes that an economic gain is inherent in a bargain purchase -the purchaser is better off by the amoutn by which the fair vaue of what is acquired exceeds the amount paid -FASB requires companies to disclose the nature of this gain transaction -such disclosure will help useres to better evaluate the quality of the earnings reported

Presentation of Intangible Assets

The reporting of intangible assets is similar to the reporting of PPE -however, contra accounts are not normally shown for intangibles on the balance sheet on the balance sheet companies should reprot as separate item all intangible assets other than oodwill -if goodwill is present, companies should report it separately The FASB concluded that since goodwill and other intangible assets differ significantly from other types of assets, such disclosure benefits users of the balance sheet On the income statement, companies should present amortization expense and impairment losses for intangible assets other than goodwill separatley and as part of continuing operations -goodwill impairment losses should also be presented as a separate line item in the continuing operations section, unless the goodwill impairment is associated with a discontinued operation The notes to the financial statemetns should include information about acquired intangible assets, including the aggregate amortization expense for each of the succeeding five years -if separate accumulated amortization accounts are not used, accumulated amortization should be disclosed in the notes -the notes should include information about changes in the carrying amount of goodwill during the period

Impairment of Limited-Life Intangibles

The rules that apply to impairments of PPE also apply to limited-life intangibles a company should review PPE for impairment at certain points -in performing the recoverability test, the company estimates the future cash flows expected from use of the asset and its eventual disposal -if the sum of the expected future net cash flows (undiscounted) is less than the carrying amount of the asset, the company measures and recognizes an impairment loss To measure the impairment, the company uses the fair value test -this test measures the impairment loss by comparing the asset's fair value with its carrying amount -the impairment loss is the carrying amount of the asset less the fair value of the impaired asset -the loss on the limited-life intangible is reproted as part of income from continuing operations -generalyl reportedi n the "other expenses and losses" section of the income statmeent After recognizing the impairment, the reduced carrying amount of the patentsis its new cost basis -a company should amortize the patent's new cost over its remaining useful life or legal life, whichever is shorter -a c ompany may not recognize restoration of the previously unrecognized impairment loss

Marketing-related intangible assets

primarly used in the marketing or promotion of products or services ex: trademarks, trade names, newspaper mastheads, internet domain names, and noncompetition agreements Trademark/trade name- word, phrase, or symbol that distinguishes or identifies a particular company or prouct -under common law, the right to use a trademark or trade name, whether registered or not, rests exclusively with the original user as long as the original user continues to use it -registration with the US patent and trademark office provides legal protection for an indefinitey number of renewals for periods of 10 years each - a company that uses an established trademark or trade name may properly consider it to have an indefinite life and does not amortize its cost if a company buys a trademark or trade name, it capitalizes the purchase price as the cost of the asset -if a company developes a trademark or trade name, it capitalizes costs realted to securing it, such as attorney fees, registration fees, design costs, consulting fees, and successful legal defense costs, but it excludes research and development costs when the total cost of a trademark or trade name is insignificant, a company simply expenses it The value of a marketing-related intangible can be substantial Company names also identify qualities and characteristics that companies work hard and spend much to develop

Technology-Related Intangible Assets

relate to innovations or technological advances ex: patented technology, trade secrets granted by the US Patent and Trademark Office A patent gives the holder exclusive right to use, manufacture, and sell a producto r process for a period of 20 years without interference or infringement by others The two principal kinds of patents are product patents, which cover actual physical products, and process patents, which govern the process of making products Can capitalize costs incurred in connection with securing a patnent, as well as attorney fees and other unrecovered costs of a successful legal suit to protect the patent, as part of the patent cost -it must expense as incurred any research and developmentcosts related to the development of the product, process, or idea that it subsequently patents Companies should amortize the cost of a patent over its legal life or its useful life (the period in which benefits are received), whichever is shorter Changing demand, new inventions superseding old ones, inadequacy, and other factors often limit the useful life of a patnet to less than the legal life Companies capitalize the costs of defending copyrights -the accounting treatment for a patent defense is similar A company charges all unrecovered legal fees and other costs incurred in successfully defending a patent suit to Patents, an asset account -such costs should be amortized along with acquistion cost over the remaining useful lifeof the patent Amortization expense should reflect the pattern, if reliabily determined, in which a company uses up the patnet - a company may credit amortization of patents directly to the Patent account or to an Accumulated Amortization account if companies make small modifications or additions that lead to a new patent -if the new patent provides essentially the same benefits, a company can apply the unamortized costs of the old patent to the new patent -if a patent becomes impaired because demand drops for the product, the asset should be written down or written off immediately to expense

Contract-related intangible assets

represent the value of rights that arise from contractual arrangements ex: franchise and licensing agreements, construction permits, broadcast rights, and service or supply contracts A franchise is a contractual agreement under which the franchisor grants the franchisee the right to sell certain products or services, to use certain trademarks or tradenames, or to perform certain functions, usually within a designated geographical area The franchisor, having developed a unique concept or product, protects its concept or product through a patent, copyright, or trademark or trade name -the franchisee acquires the right to exploit the franchisor's idea or product by signing a franchise agreement Another type of franchise, granted by a governmental body, permits the business to use public proprety in performing its services -ex: use of city streets for a bus line or taxi service -such operating rights are referred to as licenses or permits Franchises and licenses may be for a definite period of time, for an indefinite period of time, or perpetual -the company securing the franchise or license carries an intangible asset account (entitled Franchises or Licneses) on its books, only when it can identify costs with the acquisiton of the operating irght ( Such costs might be legal fees or an advance lump-sum payment) A company should amortize the cost of a franchise (or license) with a limited life as an operating expense over the life of the franchise -it should not amortize a franchise with an indefinite life not a perpetual franchise; the company shhould instead carry such franchises at cost Annual payments made under a franchise agreement should be entered as operating expenses in the period in which they are incurred -these payments do not represent an asset since they do not relate to future rights to use the property

Customer-Related Intangible Assets

result from interactions with outside parties ex: customer lists, order or production backlogs, and both contractual and noncontractual customer relationships Companies should assume a zero residual value unless the asset's useful life is less than the economic life and reliable evidence is available concerning the residual value