Presentation on theme: "Business Combinations, Goodwill and Intangibles FASB 141 and 142."— Presentation transcript:
Business Combinations, Goodwill and Intangibles FASB 141 and 142
U.S. Patent Holder: P. Bye Process: no-fade, brake fluid Copyright Artist: B. Joel Song: Uptown Girl Intangible assets generally result from legal or contractual rights which do not have a physical substance.
Intangibles may be purchased from others or developed internally.
The costs of internally developed unidentifiable intangible assets, such as employee training, are expensed as incurred.
U.S. Patent Holder: P. Bye Process: no-fade, brake fluid When a company internally develops an intangible asset, only certain costs can be capitalized such as legal and related costs.
Tangible and intangible assets have the following common characteristics: Held for use and not for investment Expected life greater than one year Derive their value from their ability to generate revenue (future cash inflows) Can have an indefinite life (not depreciated or amortized) Can have a limited life (depreciated or amortized)
Intangible assets have four unique characteristics that distinguish them from tangible assets: More uncertainty about future benefits Value subject to wider fluctuations Value may be applicable to only one particular company. Indeterminate lives.
XYZ Co. Balance She 12/31/9 Cash Equipment 54 Goodwill 32,010 Patents 1,430 But... Only if purchased! For financial reporting purposes, identifiable and unidentifiable intangible assets are treated the same - they are both capitalized.
Identifiable vs. Unidentifiable Identifiable: –Patents –Copyrights –Trade names, trade marks –Secret formulas –Franchise –License Unidentifiable: –Goodwill Many new types of intangible assets are discussed in FASB 141
Acquisition of an Entire Company --Business Combination There is one way to account for a business combination-- pooling of interest and purchase. The purchase method raises a problem in how to allocate the purchase price to the various assets acquired. Page 149
Acquisition of an Entire Company --Business Combination Compared to pooling of interest, the purchase method records assets at their fair market value, which results in lower earnings in subsequent years due to higher amortization and depreciation charges. Despite opposition from the business community, the FASB has eliminated the pooling of interest method in FASB 141. Page 149
Acquiring an entire company When we acquire an entire company, the specific assets may be worth LESS than we paid This difference is called GOODWILL -- an intangible asset
Goodwill Defined: “The excess amount paid for a company in a business combination over the fair market value of the company’s identifiable assets.” Recording Goodwill 1.Write identifiable assets up to FMV. 2.Record excess purchase price over net assets at FMV as goodwill. OKOK
Purchase Agreement Price $100,000 Appraisal Land $10,000 Bldg. 40,000 FMV $50,000 Purchased goodwill arises when a company is acquired and is the difference between the purchase price of a company and the fair market value of its identifiable net assets. Page 149
Sources of Goodwill Going concern goodwill Combination goodwill FASB ended up not using this terminology in the actual standards that they issued. There is no requirement that we distinguish between the different sources of goodwill.
Going concern goodwill The ability of the acquiree as a stand- alone business to earn a higher rate of return on an organized collection of net assets than would be expected if those net assets had to be acquired separately –reflects the synergies of the net assets of the business and factors related to market imperfections such as monopoly profits Page 149
Combination goodwill Fair value of synergies from combining the acquirer’s and acquiree’s businesses and net assets –Stems from synergies that result from the combination -- would be unique to each combination
Goodwill Defined in FASB 142: –The excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed. The amounts assigned are fair values Goodwill includes all intangible assets that do not meet the criteria for recognition as an asset apart from goodwill. –You only have goodwill if you've purchased another entire company.
The “Plug” Figure Goodwill is what it takes to balance the journal entry when you record the purchase of another company. Procedures Value all identifiable assets and liabilities. Difference between cost and fair value of net assets = Goodwill. Usually positive but occasionally the fair value is GREATER than purchase price. This is sometimes called "Negative Goodwill."
Value all identifiable assets and liabilities Fixed assets--may be undervalued Patent--might not be on books if internally developed. Trade names will probably not be recorded Estimate for doubtful accounts could be off. Unrecorded liabilities, particularly contingencies. See new FASB 141 guidance on valuing assets and liabilities on page 156
Impairment Losses - Goodwill At same time each year, the goodwill of a reporting unit is subjected to a two step impairment test New GAAP - FASB 141 & 142
2-step impairment test 1.Determine fair values of all identifiable tangible and intangible assets (other than goodwill) and the fair values of all liabilities –If fair value is greater than carrying value, no impairment loss is recorded –If fair value is LESS than carrying value, perform step two New GAAP - FASB 141 & 142 Page 186
2-step impairment test Implied goodwill is the difference between the fair values as determined in step 1 and the carrying value without goodwill 2.If implied goodwill is less than the carrying value of goodwill, recognize an impairment loss for the difference New GAAP - FASB 141 & 142
2-step impairment test Detailed evaluation can be carried forward to the next year without change if –No significant changes in assets and liabilities in the reporting unit –Most recent evaluation indicated substantial margin of implied goodwill over the carrying value of goodwill –The likelihood that a current fair value determination would be less than the current carrying value is considered remote New GAAP - FASB 141 & 142 Page 187
Interim impairment tests If events and circumstances indicate that impairment is more likely than not, an interim impairment test must be conducted: –Adverse change in business climate –Unanticipated competition –Loss of key personnel –Adverse action or assessment by a regulator New GAAP - FASB 141 & 142
Income Statement Presentation Impairment losses on goodwill –Presented in aggregate on income statement as separate line item –Presented before income from continuing operations New GAAP - FASB 141 & 142
Goodwill Example “Target Company ” Page 151
On Jan. 1, 1998, Diversified Inc. purchased all the assets and assumed all the liabilities of Target Company for $290,000 A/R were estimated to be worth $50,000 Inventories were worth $95,000 PP&E were worth $200,000 Marketable securities were worth $30,000 The patent is worth $50,000 The liabilities were correctly stated
At what amount, if any, should goodwill be recorded? Steps to work the problem: Estimate fair value of the identifiable assets Compare fair value of identifiable assets to purchase price Goodwill is the difference
Fair values of identifiable assets A/R (overvalued by $10,000) $ 50,000 Inventory (under by $5,000) 95,000 PP&E (under by $10,000) 200,000 Intangible assets (under by 40,000) 50,000 Marketable securities (ok) 30,000 Less liabilities (ok) -100,000 =Fair value of net assets $325,000
Difference between purchase price and fair value Fair value of net assets $325,000 Purchase price 400,000 Goodwill $ 75,000
Compute amortization of goodwill expense for 1998: $75,000 / 40 years = $1,875 per year DrCr Amortization Expense$1,875 Goodwill $1,875
Under FASB 142: Goodwill is not amortized because it has an indefinite life. –Instead, a two-stage impairment test is performed at least annually –If goodwill appears to have declined in value, an impairment loss is recognized in net income. –We’ll talk more about this in conjunction with rules on other impairment tests in Chapter 13 New Rules
What if purchase price is LESS than fair value of net assets? “negative goodwill” situation
Page 152 “Negative Goodwill” If the fair value of the acquired net assets exceeds the purchase price, the excess is allocated as a pro rata reduction of the amounts that would otherwise have been assigned to noncurrent assets –EXCEPTIONS: Marketable securities carried at fair value See notes for other exceptions You can go all the way to ZERO if necessary to eliminate the “negative goodwill”
New Rules “Negative Goodwill” If the acquisition is a really, really great bargain, it is possible to write down all the noncurrent (non-financial) assets to zero and still need a credit to balance the journal entry. Under FASB 141, this amount would be recognized immediately (at acquisition) as an extraordinary gain.
Tax Issues Amortization of Goodwill may or may not be tax deductible Amortization of goodwill acquired BEFORE is NOT tax deductible –It is a permanent difference between book income and taxable income Page 154
Tax Issues Amortization of goodwill acquired AFTER is tax deductible over a 15 year period –It will be a temporary difference between book income & taxable income
What can be capitalized? The rules governing classification as an (purchased) intangible asset are in the chart on page 155: –Arises from contractual or other legal rights even if those rights are not transferable, or –It is capable of being separated or divided from the acquired entity and sold, transferred, licensed, or exchanged even if there is no intention to do so. Refer back to examples on page 130
Intangibles capitalized The rules governing classification as an (purchased) intangible asset are in the chart on page 155: –Valued at acquisition cost if acquired individually –When acquired in a group of other assets, acquisition cost is allocated to each item based on relative fair value
Amortization Expense = Cost Economic life Current accounting principles require that an intangible asset be amortized over its economic life, but not to exceed 40 years. Page 183
Amortization of Intangibles Apparently "unlimited" life is really just indefinite--use maximum period 40 years. Before APB Opinion #17, unlimited life intangibles were not amortized. –"Grandfather Clause" for intangible assets acquired before 11/1/70 - they do not have to be amortized.
Amortization of Intangibles Finite Useful LifeIndefinite Useful Life Goodwill N/A Not amortized. Subject to impairment test annually. Any goodwill impairment is recognized as an expense. Other intangible assets Amortized over expected useful life. Not amortized. Subject to impairment test at least annually. If useful life becomes finite, the carrying value is amortized over useful life. Page 183 – NEW MATERIAL – FASB 142
Page 183 Determining useful life ÊExpected use by the organization ËExpected useful life of similar or related assets ÌLegal, regulatory or contract provisions and provisions for renewal/extension. –Patents max, 17 years –Copyrights max 50 years after death of author.
ÍRenewal or extension provisions under laws, regulations or contracts ÎEffects of obsolescence, demand, competition, technological change. ÏLevel of maintenance expenditures necessary –High future costs suggests short useful life Determining useful life
If the precise length of the useful life is not known, use the best estimate of the useful life If no known factors limit the useful life, the useful life is considered to be indefinite. –Indefinite infinite Page 184
Amortization Methods: Method should reflect the pattern in which the economic benefits are consumed or used up If pattern is unknown - use straight-line method: Amortization Expense = Cost - Residual Value Economic life New Materials - FASB 142 Page 185
Amortization Methods Residual value is presumed to be zero unless –Another entity which has committed to purchase it for a certain price at a future date –A market for intangible exists and is expected to exist at end of asset’s useful life to current owner New GAAP - FASB 142 Amortization Expense = Cost - Residual Value Economic life
Accounting for Amortization "Accumulated amortization" account not generally used -- amortize by crediting asset account directly. –Note that under FASB 142, historical cost and accumulated amortization WILL BE DISCLOSED Write-off Intangibles when it becomes evident that their value has been impaired (FASB 121). FASB 144 Page 185
Annual evaluation (other than goodwill) Evaluate estimated remaining useful life and adjust current and future amortization if needed Apply impairment test per FASB 144 and write-down if expected future cash inflows are less than carrying value New GAAP - FASB 142 & FASB 144
Impairment test for intangibles not amortized At least annually: –Compare fair value to carrying amount –If carrying amount > fair value, recognize impairment loss –In other words, write intangible down to its fair value If an impairment is recognized, the fair value at that date becomes the new carrying value –If fair value later increases, there is no restoration -- no upward adjustments are permitted! New GAAP - FASB 142 & FASB 144
Example 1 A company acquires a broadcast license that expires in 5 years. The license is renewable every 10 years if the license holder provides at least an average level of service and complies with Federal Communication Commission (FCC) rules and policies. The previous owner renewed the license twice. The new owner intends to renew the license in the foreseeable future. – What is the useful life? Should the cost be amortized or subject only to an annual impairment test? Page 188
Example 2 The company in example 1 operates the television station for 10 years (easily obtaining a renewal license as expected). The FCC decides that it will no longer renew licenses. Instead, broadcast rights will be put up for bid. The current license has five years before it expires. – What is the useful life? Should the cost be amortized or subject only to an annual impairment test?
Example 3 A direct mail marketing company acquires a customer list and expects to be to derive benefit from the information for at least one year but no more than three years. The acquiring company intends to add customer names and other information to the list in the future. Management’s best estimate of the useful life of the names on the list at acquisition (given the pattern in which the expected benefits will be consumed) is about 18 months. – What is the useful life? Should the cost be amortized or subject only to an annual impairment test?
Specific Types of Intangible Assets Page 188 Intangible assets acquired in a business combination are recognized separately from goodwill if they arise from contractual or legal rights -- or because the asset is separable
Customer related Legal or contractual rights –Order or production backlog –Customer contracts and related customer relationships Separable –Customer lists –Noncontractual customer relationships such as bank depositors New GAAP - FASB 141 & 142
Technology-based Legal or contractual rights –Patented technology –Computer software and mask works –Trade secrets such as secret formulas, processes, recipes Separable –Unpatented technology –Databases, including title plants –Trade secrets not protected by law New GAAP - FASB 141 & 142
Artistic-related Plays, operas, ballets Books, magazines, newspapers and other literary works Muscial works such as compositions, song lyrics, advertising jingles Video and audiovisual material including motion pictures, music videos, television programs New GAAP - FASB 141 & 142
Contract-based Licensing, royalty and standstill agreements Advertising, construction, management, service or supply contracts Lease agreements Construction permits Operating and broadcast rights Use rights such as drilling, water, air, mineral, timber cutting, and route authorities New GAAP - FASB 141 & 142