Presentation on theme: "Business Combinations, Goodwill and Intangibles"— Presentation transcript:
1 Business Combinations, Goodwill and Intangibles FASB 141 and 142
2 Intangible assets generally result from legal or contractual rights which do not have a physical substance.CopyrightArtist: B. JoelSong: UptownGirlU.S. PatentHolder: P. ByeProcess: no-fade,brake fluid
3 Intangibles may be purchased from others or developed internally.
4 The costs of internally developed unidentifiable intangible assets, such as employee training, are expensed as incurred.
5 When a company internally develops an intangible asset, only certain costs can be capitalized such as legal and related costs.U.S. PatentHolder: P. ByeProcess: no-fade,brake fluid
6 Tangible and intangible assets have the following common characteristics: Held for use and not for investmentExpected life greater than one yearDerive 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)
7 Intangible assets have four unique characteristics that distinguish them from tangible assets: More uncertainty about future benefitsValue subject to wider fluctuationsValue may be applicable to only one particular company.Indeterminate lives.
8 For financial reporting purposes, identifiable and unidentifiable intangible assets are treated the same - they are both capitalized.XYZ Co.Balance She12/31/9CashEquipment 54Goodwill ,010Patents ,430But Only if purchased!
9 Identifiable vs. Unidentifiable PatentsCopyrightsTrade names, trade marksSecret formulasFranchiseLicenseUnidentifiable:GoodwillMany new types of intangible assets are discussed in FASB 141
10 Acquisition of an Entire Company --Business Combination There is one way to account for a business combination--pooling of interest and purchase.Page 149The purchase method raises a problem in how to allocate the purchase price to the various assets acquired.
11 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
12 Acquiring an entire company When we acquire an entire company, the specific assets may be worth LESS than we paidThis difference is called GOODWILL -- an intangible asset
13 GoodwillDefined: “The excess amount paid for a company in a business combination over the fair market value of the company’s identifiable assets.”Recording Goodwill1. Write identifiable assets up to FMV.2. Record excess purchase price over net assets at FMV as goodwill.OK
14 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.PurchaseAgreementPrice $100,000AppraisalLand $10,000Bldg ,000FMV $50,000Page 149
15 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.
16 Going concern goodwill Page 149The 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 separatelyreflects the synergies of the net assets of the business and factors related to market imperfections such as monopoly profits
17 Combination goodwillFair value of synergies from combining the acquirer’s and acquiree’s businesses and net assetsStems from synergies that result from the combination -- would be unique to each combination
18 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 valuesGoodwill 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.
19 The “Plug” FigureGoodwill is what it takes to balance the journal entry when you record the purchase of another company.ProceduresValue 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."
20 Value all identifiable assets and liabilities Fixed assets--may be undervaluedPatent--might not be on books if internally developed.Trade names will probably not be recordedEstimate for doubtful accounts could be off.Unrecorded liabilities, particularly contingencies.See new FASB 141 guidance on valuing assets and liabilities on page 156
21 Impairment Losses - Goodwill At same time each year, the goodwill of a reporting unit is subjected to a two step impairment testNew GAAP - FASB 141 & 142
22 Page 1862-step impairment test1. Determine fair values of all identifiable tangible and intangible assets (other than goodwill) and the fair values of all liabilitiesIf fair value is greater than carrying value, no impairment loss is recordedIf fair value is LESS than carrying value, perform step twoNew GAAP - FASB 141 & 142
23 2-step impairment testImplied goodwill is the difference between the fair values as determined in step 1 and the carrying value without goodwill2. If implied goodwill is less than the carrying value of goodwill, recognize an impairment loss for the differenceNew GAAP - FASB 141 & 142
24 2-step impairment testPage 187Detailed evaluation can be carried forward to the next year without change ifNo significant changes in assets and liabilities in the reporting unitMost recent evaluation indicated substantial margin of implied goodwill over the carrying value of goodwillThe likelihood that a current fair value determination would be less than the current carrying value is considered remoteNew GAAP - FASB 141 & 142
25 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 climateUnanticipated competitionLoss of key personnelAdverse action or assessment by a regulatorNew GAAP - FASB 141 & 142
26 Income Statement Presentation Impairment losses on goodwillPresented in aggregate on income statement as separate line itemPresented before income from continuing operationsNew GAAP - FASB 141 & 142
28 On Jan. 1, 1998, Diversified Inc. purchased all the assets and assumed all the liabilities of Target Company for $290,000A/R were estimated to be worth $50,000Inventories were worth $95,000PP&E were worth $200,000Marketable securities were worth $30,000The patent is worth $50,000The liabilities were correctly stated
29 At what amount, if any, should goodwill be recorded? Steps to work the problem:Estimate fair value of the identifiable assetsCompare fair value of identifiable assets to purchase priceGoodwill is the difference
30 Fair values of identifiable assets A/R (overvalued by $10,000) $ 50,000Inventory (under by $5,000) ,000PP&E (under by $10,000) ,000Intangible assets (under by 40,000) ,000Marketable securities (ok) ,000Less liabilities (ok) ,000Fair value of net assets $325,000
31 Difference between purchase price and fair value Fair value of net assets $325,000Purchase price ,000Goodwill $ 75,000
33 Compute amortization of goodwill expense for 1998: $75,000 / 40 years =$1,875 per yearDr CrAmortization Expense $1,875Goodwill $1,875
34 Under FASB 142:New RulesGoodwill is not amortized because it has an indefinite life.Instead, a two-stage impairment test is performed at least annuallyIf 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
35 What if purchase price is LESS than fair value of net assets? “negative goodwill” situation
37 “Negative Goodwill”Page 152If 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 assetsEXCEPTIONS:Marketable securities carried at fair valueSee notes for other exceptionsYou can go all the way to ZERO if necessary to eliminate the “negative goodwill”
38 “Negative Goodwill”New RulesIf 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.
41 Tax Issues Amortization of Goodwill may or may not be tax deductible Amortization of goodwill acquired BEFORE is NOT tax deductibleIt is a permanent difference between book income and taxable incomePage 154
42 Tax IssuesAmortization of goodwill acquired AFTER is tax deductible over a 15 year periodIt will be a temporary difference between book income & taxable income
44 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, orIt 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
45 Intangibles capitalized The rules governing classification as an (purchased) intangible asset are in the chart on page 155:Valued at acquisition cost if acquired individuallyWhen acquired in a group of other assets, acquisition cost is allocated to each item based on relative fair value
46 Current accounting principles require that an intangible asset be amortized over its economic life, but not to exceed 40 years.Page 183Amortization Expense =CostEconomic life
47 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.
48 Amortization of Intangibles Page 183 – NEW MATERIAL – FASB 142Amortization of IntangiblesFinite Useful LifeIndefinite Useful LifeGoodwillN/ANot amortized. Subject to impairment test annually. Any goodwill impairment is recognized as an expense.Other intangible assetsAmortized 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.
49 Determining useful life Expected use by the organizationExpected useful life of similar or related assetsLegal, regulatory or contract provisions and provisions for renewal/extension.Patents max, 17 yearsCopyrights max 50 years after death of author.Page 183
50 Determining useful life Renewal or extension provisions under laws, regulations or contractsEffects of obsolescence, demand, competition, technological change.Level of maintenance expenditures necessaryHigh future costs suggests short useful life
51 Determining useful life If the precise length of the useful life is not known, use the best estimate of the useful lifeIf no known factors limit the useful life, the useful life is considered to be indefinite.Indefinite infinitePage 184
52 Amortization Methods: New Materials - FASB 142Amortization Methods:Method should reflect the pattern in which the economic benefits are consumed or used upIf pattern is unknown - use straight-line method:Amortization Expense =Cost - Residual ValueEconomic lifePage 185
53 Amortization Methods Residual value is presumed to be zero unless New GAAP - FASB 142Amortization MethodsResidual value is presumed to be zero unlessAnother entity which has committed to purchase it for a certain price at a future dateA market for intangible exists and is expected to exist at end of asset’s useful life to current ownerAmortization Expense =Cost - Residual ValueEconomic life
54 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 DISCLOSEDWrite-off Intangibles when it becomes evident that their value has been impaired (FASB 121). FASB 144Page 185
55 Annual evaluation (other than goodwill) Evaluate estimated remaining useful life and adjust current and future amortization if neededApply impairment test per FASB 144 and write-down if expected future cash inflows are less than carrying valueNew GAAP - FASB 142 & FASB 144
56 Impairment test for intangibles not amortized At least annually:Compare fair value to carrying amountIf carrying amount > fair value, recognize impairment lossIn other words, write intangible down to its fair valueIf an impairment is recognized, the fair value at that date becomes the new carrying valueIf fair value later increases, there is no restoration -- no upward adjustments are permitted!New GAAP - FASB 142 & FASB 144
57 Example 1Page 188A 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?
58 Example 2The 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?
59 Example 3A 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?
60 Specific Types of Intangible Assets Page 188Intangible 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
62 Customer related Legal or contractual rights Separable Customer lists Order or production backlogCustomer contracts and related customer relationshipsSeparableCustomer listsNoncontractual customer relationships such as bank depositorsNew GAAP - FASB 141 & 142
63 Technology-based Legal or contractual rights Separable Patented technologyComputer software and mask worksTrade secrets such as secret formulas, processes, recipesSeparableUnpatented technologyDatabases, including title plantsTrade secrets not protected by lawNew GAAP - FASB 141 & 142
64 Artistic-related Plays, operas, ballets Books, magazines, newspapers and other literary worksMuscial works such as compositions, song lyrics, advertising jinglesVideo and audiovisual material including motion pictures, music videos, television programsNew GAAP - FASB 141 & 142
65 Contract-based Licensing, royalty and standstill agreements Advertising, construction, management, service or supply contractsLease agreementsConstruction permitsOperating and broadcast rightsUse rights such as drilling, water, air, mineral, timber cutting, and route authoritiesNew GAAP - FASB 141 & 142