Intermediate Accounting: Chapter 12

Customer-related Intangible Assets

Customer-related intangible assets result from interactions with outside parties. Examples include customer lists, order or production backlogs, and both contractual and noncontractual customer relationships.

Describe the Characteristics of Intangible Assets.

Describe the Characteristics of Intangible Assets. Intangible assets have two main characteristics: (1) They lack physical existence, and (2) they are not financial instruments. In most cases, intangible assets provide services over a period of years and so are normally classified as long-term assets.

Presentation of Intangible Assets

The reporting of intangible assets is similar to the reporting of property, plant, and equipment. However, contra accounts are not normally shown for intangibles on the balance sheet. On the balance sheet companies should report as a separate item all intangible assets other than goodwill. 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.

Impairment of Limited-life Intangibles

The rules that apply to impairments of property, plant, and equipment also apply to limited-life intangibles. A company should review property, plant, and equipment for impairment at certain points—whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. In performing this recoverability test, the company estimates the future cash flows expected from use of the assets 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 would measure and recognize an impairment loss.

Impairment of Intangible Assets

Underlying Concepts The basic attributes of intangibles, their uncertainty as to future benefits, and their uniqueness have discouraged valuation in excess of cost.

Artistic-related Intangible 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.

Impairment of Goodwill

Impairment of Goodwill The impairment rule for goodwill is a two-step process. First, 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. The company does not have to do anything

Start-up costs

Start-up costs Incurred for one-time activities required to start a new operation. Companies expense start-up costs as incurred.

Amortization

Amortization The allocation of the cost of intangible assets in a systematic way.

Types of Intangible Assets

As indicated, the accounting for intangible assets depends on whether the intangible has a limited or an indefinite life. There are many different types of intangibles, often classified into the following six major categories. Marketing-related intangible assets. 2. Customer-related intangible assets. 3. Artistic-related intangible assets. 4. Contract-related intangible assets. 5. Technology-related intangible assets. 6. Goodwill.

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 statement. Merck & Co., Inc., a global research pharmaceutical company, reported both internal and acquired research and development in its recent income statement.

Describe the Accounting Procedures for Recording Goodwill.

Describe the Accounting Procedures for Recording Goodwill. To record goodwill, a company compares the fair value of the net tangible and identifiable intangible assets with the purchase price of the acquired business. The difference is considered goodwill. Goodwill is the residual. Goodwill is often identified on the balance sheet as the excess of cost over the fair value of the net assets acquired.

Impairment

Impairment Measures the extent to which the book value of an intangible asset is greater than the fair value. An impairment is recorded for limited-life intangibles conditional on a recoverability test. Indefinite-life intangibles are assessed for impairment every period based on a fair value test.

Indicate the Presentation of Intangible Assets and Related Items.

Indicate the Presentation of Intangible Assets and Related Items. On the balance sheet, companies should report all intangible assets other than goodwill as a separate item. Contra accounts are not normally shown. If goodwill is present, it too should be reported as a separate item. On the income statement, companies should report amortization expense and impairment losses in Continuing operations. The notes to the financial statements have additional detailed information. Financial statements must disclose the total R&D costs charged to expense each period for which an income statement is presented.

Initial Operating Losses

Initial Operating Losses 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 establish a new business than they are for other enterprises.

Intangible assets

Intangible assets Assets that lack physical substance and that are not financial instruments. Intangible assets derive their value from the rights and privileges granted to the company using them. They are normally classified as long-term assets. Companies write off (amortize) limited-life intangible assets over their useful lives and they periodically assess indefinite-life intangibles for impairment.

License (permit)

License (permit) An agreement by which governmental units or agencies grant rights to a privately owned company to use public property in performing its services. Examples are the use of public waterways for a ferry service, the use of public land for telephone or electric lines, and the use of the airwaves for radio or TV broadcasting. A license or permit is a contract-related intangible asset. Companies amortize the cost of a license or permit with a limited life to operating expense over the life of the agreement, and they also treat as operating expenses any annual payments made under the agreement.

Recoverability test

Recoverability test A test to determine whether an impairment of a long-lived asset has occurred. If the sum of the expected future net cash flows (undiscounted) is less than the carrying amount of the asset, the asset is considered impaired. If the test indicates impairment has occurred, the company then computes the amount of the impairment loss to record, based on a fair value test.

Limited-life Intangibles

Limited-life Intangibles Companies amortize their limited-life intangibles by systematic charges to expense over their useful life. The useful life should reflect the periods over which these assets will contribute to cash flows. Walt Disney, for example, considers these factors 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 (such as lease rights to a studio lot). 3. Any legal, regulatory, or contractual provisions that may limit the useful life. 4. Any provisions (legal, regulatory, or contractual) 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. Disney also must be able to accomplish renewal or extension without material modifications of the existing terms and conditions. 5. The effects of obsolescence, demand, competition, and other economic factors. Examples include the stability of the industry, known technological advances, legislative action that results in an uncertain or changing regulatory environment, and expected changes in distribution channels. 6. The level of maintenance expenditure required to obtain the expected future cash flows from the asset. For example, a material level of required maintenance in relation to the carrying amount of the asset may suggest a very limited useful life. - 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 reliably determine that pattern.

Costs Similar to R&d Costs

Many costs have characteristics similar to research and development costs. Examples are: 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.

Organizational costs

Organizational costs Part of start-up costs, such as the legal and state fees incurred to organize a new business entity. Companies expense these costs as incurred.

Marketing-related Intangible Assets

ompanies primarily use marketing-related intangible assets in the marketing or promotion of products or services. Examples are trademarks or trade names, newspaper mastheads, Internet domain names, and noncompetition agreements.

Limited-life intangibles

Limited-life intangibles Intangible assets judged to have a limited useful life, which reflects the periods over which these assets will contribute to cash flows. Companies amortize limited-life intangibles by systematic charges to expense over their useful lives.

Master valuation approach

Master valuation approach A procedure for valuing goodwill. It assumes that goodwill is the difference between the purchase price for a company and the amount that cannot be specifically identified with any identifiable tangible or intangible assets, less liabilities assumed in the purchase.

Indefinite-life Intangibles

Indefinite-life Intangibles If no factors (legal, regulatory, contractual, competitive, or other) limit the useful life of an intangible asset, a company considers its useful life indefinite. An indefinite life means that there is no foreseeable limit on the period of time over which the intangible asset is expected to provide cash flows. A company does not amortize an intangible asset with an indefinite life. - Companies should test indefinite-life intangibles for impairment at least annually.

Describe the Accounting for Research and Development and Similar Costs.

Describe the Accounting for Research and Development and Similar Costs. Illustration 12.14 shows the costs associated with R&D activities and the accounting treatment accorded them. Many costs have characteristics similar to R&D costs. Examples are start-up costs, initial operating losses, and advertising costs. For the most part, these costs are expensed as incurred, similar to the accounting for R&D costs.

Describe the Types of Intangible Assets.

Describe the Types of Intangible Assets. Major types of intangibles are: (1) marketing-related intangibles, used in the marketing or promotion of products or services; (2) customer-related intangibles, resulting from interactions with outside parties; (3) artistic-related intangibles, giving ownership rights to such items as plays and literary works; (4) contract-related intangibles, representing the value of rights that arise from contractual arrangements; (5) technology-related intangibles, relating to innovations or technological advances; and (6) goodwill, arising from business combinations.

Development activities

Development activities Activities that translate research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process, whether intended for sale or use. Companies are required to expense the costs of development activities as incurred.

Explain the Conceptual Issues Related to Goodwill

Explain the Conceptual Issues Related to Goodwill. Unlike receivables, inventories, and patents that a company can sell or exchange individually in the marketplace, goodwill can be identified only with the company as a whole. Goodwill is a "going concern" valuation and is recorded only when an entire business is purchased. A company should not capitalize goodwill generated internally. The future benefits of goodwill may have no relationship to the costs incurred in the development of that goodwill. Goodwill may exist even in the absence of specific costs to develop it.

Explain the Procedure for Amortizing Intangible Assets.

Explain the Procedure for Amortizing Intangible Assets. Intangibles have either a limited useful life or an indefinite useful life. Companies amortize limited-life intangibles. They do not amortize indefinite-life intangibles. Limited-life intangibles should be amortized by systematic charges to expense over their useful life. The useful life should reflect the period over which these assets will contribute to cash flows. The amount to report for amortization expense should reflect the pattern in which a company consumes or uses up the asset, if it can reliably determine that pattern. Otherwise, use a straight-line approach.

Fair value test

Fair value test The impairment test for an indefinite-life asset other than goodwill. It compares the fair value of the intangible asset with the asset's carrying amount. If the fair value of the intangible asset is less than the carrying amount, a company recognizes an impairment. Companies should test indefinite-life intangibles for impairment at least annually.

Franchise

A company should amortize the cost of a franchise (or license) with a limited life as operating expense over the life of the franchise. It should not amortize a franchise with an indefinite life nor a perpetual franchise; the company should 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.

Bargain Purchase

Bargain purchase A situation, often the result of a market imperfection, in which the purchaser in a business combination pays less than the fair value of the identifiable net assets. - The FASB notes that an economic gain is inherent in a bargain purchase. The purchaser is better off by the amount by which the fair value of what is acquired exceeds the amount paid. Some expressed concern that some companies may attempt inappropriate gain recognition by making an intentional error in measurement of the assets or liabilities. As a result, the FASB requires companies to disclose the nature of this gain transaction. Such disclosure will help users to better evaluate the quality of the earnings reported.9

Presentation of Intangible Assets

On the income statement, companies should present amortization expense and impairment losses for intangible assets other than goodwill separately 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 statements 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.

Technology-related Intangible Assets

Technology-related Intangible Assets Technology-related intangible assets relate to innovations or technological advances. Examples are patented technology and trade secrets granted by the U.S. Patent and Trademark Office. A patent gives the holder exclusive right to use, manufacture, and sell a product or process for a period of 20 years without interference or infringement by others. Companies such as Merck, Polaroid, and Xerox were founded on patents and built on the exclusive rights thus granted.4 The two principal kinds of patents are product patents, which cover actual physical products, and process patents, which govern the process of making products.

Amortization of Intangibles

The allocation of the cost of intangible assets in a systematic way is called amortization. Intangibles have either a limited (finite) useful life or an indefinite useful life.

Trademark, trade name

Trademark, trade name A word, phrase, or symbol that distinguishes or identifies a particular company or product. A trademark is a marketing-related intangible asset. Under common law, the right to use a trademark or trade name rests exclusively with the original user as long as the original user continues to use it. Registration with the U.S. Patent and Trademark Office provides legal protection for an indefinite number of renewals for periods of 10 years each. Thus, a company that uses an established trademark or trade name may properly consider it to have an indefinite life and do not amortize its cost.

Research and development (R&D) costs

Two difficulties arise in accounting for R&D expenditures: (1) identifying the costs associated with particular activities, projects, or achievements, and (2) determining the magnitude of the future benefits and length of time over which such benefits may be realized. 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, manufacturing processes, and other ongoing operations, even though these alterations may represent improvements. For example, routine ongoing efforts to refine, enrich, or improve the qualities of an existing product are not considered R&D activities.

Goodwill Write-off

ompanies 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. In addition, investors find the amortization charge of little use in evaluating financial performance. Furthermore, the investment community wants to know the amount invested in goodwill, which often is the largest intangible asset on a company's balance sheet. Therefore, companies adjust its carrying value only when goodwill is impaired. This approach significantly impacts the income statements of some companies.

Change in Life of a Limited-Life Intangible Asset

hat happens if the life of a limited-life intangible asset changes? In that case the remaining carrying amount should be amortized over the revised remaining useful life. Companies should, on a regular basis, evaluate the limited-life intangibles for impairment. Similar to the accounting for property, plant, and equipment, an impairment loss should be recognized if the carrying amount of the intangible is not recoverable and its carrying amount exceeds its fair value.

Explain the Accounting Issues Related to Intangible-asset Impairments.

Explain the Accounting Issues Related to Intangible-asset Impairments. Impairment occurs when the carrying amount of the intangible asset is not recoverable. Companies use a recoverability test and a fair value test to determine impairments for limited-life intangibles. They use only a fair value test for indefinite-life intangibles. Goodwill impairments require a two-step process: First, test the fair value of the reporting unit, then do the fair value test on implied goodwill.

Computer Software Costs

A special problem arises in distinguishing R&D costs from selling and administrative activities. The FASB's intent was that companies exclude from the definition of R&D activities the acquisition, development, or improvement of a product or process for use in their selling or administrative activities. For example, the costs of software incurred by an airline in improving its computerized reservation system, or the costs incurred in developing a company's management information system are not research and development costs

Advertising Costs

Advertising Costs Over the years, PepsiCo has hired various pop stars, such as Justin Timberlake and Beyoncé, to advertise its products. How should it report such advertising costs related to its star spokespeople? Pepsi could expense the costs in various ways: 1. When they have completed their singing assignments. 2. The first time the advertising runs. 3. Over the estimated useful life of the advertising. 4. In an appropriate fashion to each of the three periods identified above. 5. Over the period revenues are expected to result. - FASB ASC 720-35-05-3. [Predecessor literature: "Reporting on Advertising Costs," Statement of Position 93-7 (New York: AICPA, 1993).]

Contract-related Intangible Assets

Contract-related Intangible Assets Contract-related intangible assets represent the value of rights that arise from contractual arrangements. Examples are franchise and licensing agreements, construction permits, broadcast rights, and service or supply contracts.

Copyright

Copyright A federally granted right that all authors, painters, musicians, sculptors, and other artists have in their creations and expressions. 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. A copyright is an artistic-related intangible asset. Companies may capitalize the costs of acquiring and defending a copyright. - 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) - Companies must expense the research and development costs that lead to a copyright as those costs are incurred.

Franchise

Franchise A contractual arrangement under which the franchisor grants the franchisee the right to sell certain products or services, to use certain trademarks or trade names, or to perform certain functions, usually within a designated geographical area. A franchise is a contract-related intangible asset. Companies amortize the cost of a franchise with a limited life as operating expense over the life of the franchise, and they also treat as operating expenses any annual payments made under the franchise agreement.

...

Goodwill The value of all favorable attributes that relate to a company over and above the cost (purchase price) of the company's identifiable tangible and intangible net assets. Goodwill is often referred to as the most intangible of intangible assets; the only way to sell it is to sell the business. Companies do not amortize goodwill because it is considered to have an indefinite life.

Internally Created Goodwill.

Goodwill generated internally should not be capitalized in the accounts. The reason? Measuring the components of goodwill is simply too complex, and associating any costs with future benefits is too difficult. The future benefits of goodwill may have no relationship to the costs incurred in the development of that goodwill. To add to the mystery, goodwill may even exist in the absence of specific costs to develop it. Finally, because no objective transaction with outside parties takes place, a great deal of subjectivity—even misrepresentation—may occur. Purchased Goodwill.

Identify the Conceptual Issues Related to Research and Development Costs.

Identify the Conceptual Issues Related to Research and Development Costs. R&D costs are not in themselves intangible assets, but R&D activities frequently result in the development of something a company patents or copyrights. The difficulties in accounting for R&D expenditures are: (1) identifying the costs associated with particular activities, projects, or achievements, and (2) determining the magnitude of the future benefits and length of time over which a company may realize such benefits. Because of these latter uncertainties, companies are required to expense all research and development costs when incurred.

Identify the Costs to Include in the Initial Valuation of Intangible Assets

Identify the Costs to Include in the Initial Valuation of Intangible Assets. Intangibles are recorded at cost. Cost includes all acquisition costs and expenditures needed to make the intangible asset ready for its intended use. If intangibles are acquired in exchange for stock or other assets, the cost of the intangible is the fair value of the consideration given or the fair value of the intangible received, whichever is more clearly evident. When a company makes a "basket purchase" of several intangibles or a combination of intangibles and tangibles, it should allocate the cost on the basis of fair values.

Impairment of Indefinite-life Intangibles Other Than Goodwill

Impairment of Indefinite-life Intangibles Other Than Goodwill Companies should test indefinite-life intangibles other than goodwill for impairment at least annually. The impairment test for an indefinite-life 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 impairment. Companies use this one-step test because many indefinite-life assets easily meet the recoverability test (because cash flows may extend many years into the future). Thus, companies do not use the recoverability test.

Indefinite-life intangibles

Indefinite-life intangibles Intangible assets for which there is no foreseeable limit on the period of time over which they are expected to provide cash flows. A company does not amortize an indefinite-life intangible asset but instead assesses it for impairment at least annually.

Purchased Goodwill.

Purchased Goodwill. As indicated earlier, goodwill is recorded only when an entire business is purchased. To record goodwill, a company compares the fair value of the net tangible and identifiable intangible 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 identifiable net assets acquired.

Research activities

Research activities Activities that involve planned search or critical investigation aimed at discovery of new knowledge. Companies are required to expense the costs of research activities as incurred.

Research and development (R&D) costs

Research and development (R&D) costs Costs incurred in research and development activities. Companies are required to expense the costs of most R&D activities as incurred.

Accounting for R&d Activities

The costs associated with R&D activities and the accounting treatments accorded them are as follows. 1. Materials, Equipment, and Facilities. Expense the entire costs, unless the items have alternative future uses (in other R&D projects or otherwise). If there are alternative future uses, carry the items as inventory and allocate as consumed, or capitalize and depreciate as used. 2. Personnel. Expense 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).11 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, except for general and administrative cost, which must be clearly related in order to be included in R&D. [12] Consistent with item 1 above, if a company owns a research facility that conducts R&D activities and that has alternative future uses (in other R&D projects or otherwise), it should capitalize the facility as an operational asset. The company accounts for depreciation and other costs related to such research facilities as R&D expenses.

R&D Underlying Concepts

The requirement that companies expense all R&D costs as incurred is an example of the conflict between relevance and faithful representation. Here, this requirement leans strongly in support of faithful representation, as well as consistency and comparability. No attempt is made to match costs and revenues.

What are Intangible assets

What exactly are intangible assets? Intangible assets have two main character-istics. 1. They Lack Physical Existence. Tangible assets such as property, plant, and equipment have physical form. Intangible assets, in contrast, 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 investments in bonds and stocks also lack physical substance. However, financial instruments derive their value from the right (claim) to receive cash or cash equivalents in the future. Financial instruments are not classified as intangibles. In most cases, intangible assets provide benefits over a period of years. Therefore, companies normally classify them as long-term assets.