1. 1IntangiblesIntangibles C hapter 11 An electronic presentation by Douglas Cloud Pepperdine University An electronic presentation by Douglas Cloud Pepperdine University

2. 2 1.Explain the accounting alternatives for intangibles. 2.Understand the amortization or impairment of intangibles. 3.Identify research and development costs. 4.Explain the conceptual issues for research and development costs. 5.Account for identifiable intangible assets including patents, copyrights, franchises, computer software costs, and trademarks and tradenames. ObjectivesObjectives ContinuedContinued

3. 3 6.Account for unidentifiable intangibles including internally developed and purchased goodwill. 7.Understand the disclosure of intangibles. 8.Explain the conceptual issues regarding intangibles. 9.Estimate the value of goodwill. (Appendix) Objectives

4. 4 Characteristics that Distinguish Intangibles There is generally a higher degree of uncertainty regarding the future benefits that may be derived. Their value is subject to wider fluctuations because it may depend to a considerable extent on competitive conditions. They may have value only to a particular company. Goodwill and intangible assets with indefinite lives are not expensed. There is generally a higher degree of uncertainty regarding the future benefits that may be derived. Their value is subject to wider fluctuations because it may depend to a considerable extent on competitive conditions. They may have value only to a particular company. Goodwill and intangible assets with indefinite lives are not expensed.

5. 5 Classification of Intangibles Purchased Identifiable Capitalize the cost incurred to acquire an intangible assets with a finite life and amortize over its useful life. Unidentifiable (i.e., goodwill) Capitalize the cost incurred to acquire goodwill and review it for impairment at least annually.

6. 6 Classification of Intangibles Internally Developed Identifiable Unidentifiable Expense research and development costs as incurred Capitalize certain costs incurred for an intangible asset with a finite life and amortize over its useful life Capitalize certain costs incurred for an intangible asset with an infinite life and amortize over its useful life Expense costs as incurred

7. 7 1.Purchased Identifiable Intangibles. A company may purchase an intangible asset from another company. The purchase is handled in the same manner as the acquisition of a single asset, in a group of assets, or in an exchange of similar or dissimilar assets. Accounting for the cost of intangibles is discussed in FASB Statement No. 142 as follows: ContinuedContinued Accounting of Intangibles

8. 8 2.Purchased Unidentifiable Intangibles. A company capitalizes the cost of a purchased unidentifiable intangible asset. The principal example of an unidentifiable intangible is goodwill. Accounting for the cost of intangibles is discussed in FASB Statement No. 142 as follows: ContinuedContinued Accounting of Intangibles

9. 9 3.Internally Developed Identifiable Intangibles. When a company internally develops an intangible assets, it can capitalize only certain costs. The expensing of research and development costs represents an exception to the general rule of capitalizing of internally developed identifiable intangibles. Accounting for the cost of intangibles is discussed in FASB Statement No. 142 as follows: ContinuedContinued Accounting of Intangibles

10. 10 Accounting of Intangibles 4.Internally Developed Unidentifiable Intangibles. A company expenses the costs of internally developed unidentifiable intangibles as incurred even thought they may be expected to have benefits extending beyond the current period. Accounting for the cost of intangibles is discussed in FASB Statement No. 142 as follows:

11. 11 Intangible Assets With a Finite Life Are Amortized. The calculation of the amortization of intangible assets follows the same principles as the depreciation of tangible assets. Amortization of Intangibles

12. 12 Amortization of Intangibles A company purchases a patent for $85,000. Patent85,000 Cash85,000 At year-end the patent is amortized over 10 years (no expected residual value). Amortization Expense (or Factory Overhead)8,500 Accumulated Amorti- zation: Patent8,500

13. 13 Impairment of an Intangible A company purchased a trademark several years ago for $60,000. As the company considered the trademark to have an indefinite life, the trademark has a carry value of $60,000. At the end of the current year, the company determines that the fair value of the trademark is $20,000. An entry is needed to record the $40,000 loss in fair value. Impairment Loss on Trademark40,000 Trademark40,000

14. 14 Research and Development Costs Research is the planned search or critical investigation aimed at discovery of new knowledge. Development is the translation of 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. Research is the planned search or critical investigation aimed at discovery of new knowledge. Development is the translation of 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.

15. 15 Research and Development Costs Costs associated with activities excluded from R&D are either expensed or capitalized according to normal capitalization criteria.

16. 16  Materials, equipment, and facilities  Personnel  Intangibles purchased from others  Contract services  Indirect costs—R&D includes a reasonable allocation of indirect costs. Research and Development Costs Expenditures for the following elements of R&D activities are included in R&D costs and thus expensed as incurred:

17. 17 Research and Development Costs Kent Company incurred the following costs for R&D activities: Materials used from inventory$50,000 Wages and salaries90,000 Allocation of general and administrative costs20,000 Depreciation on building housing R&D activities25,000 Machine purchased for R&D project that has no alternative future uses30,000 ContinuedContinued

18. 18 Research and Development Costs The company includes all these costs in R&D expenses, and records them as follows: Research and Development Expense215,000 Cash, Payables, etc.140,000 Inventory50,000 Accumulated Depreciation, Building25,000

19. 19 Identifiable Intangible Assets Cost of Intangibles Expense In period cost incurred Identifiable Intangible Assets That Are Typically Amortized Patents Copyrights Franchises Computer Software Costs Leasehold Improvements Amortize over service life ContinuedContinued R & D

20. 20 Identifiable Intangible Assets Cost of Intangibles Identifiable Intangible Assets That Are Typically Reviewed for Impairment Trademarks and tradenames Licenses that may be renewed indefinitely Recognize loss when impaired ContinuedContinued

21. 21 Identifiable Intangible Assets Cost of Intangibles Unidentifiable Intangible Assets That Are Reviewed for Impairment Goodwill Recognize loss when impaired

22. 22PatentsPatents A patent is an exclusive right granted by the federal government giving the owner control… …of the manufacture, sale, or other use of an invention for 20 years from the date of filing.

23. 23PatentsPatents A company can capitalize the costs of successfully defending the legal validity of a patent. If the suit is lost, all legal costs are expensed.

24. 24CopyrightsCopyrights A copyright is a grant by the federal government to publish, sell or otherwise control literary or artistic products for the life of the author plus 70 year. Books Music Films

25. 25FranchisesFranchises Franchises are agreements entered into by two parties in which, for a fee, one party gives the other party the right to perform certain functions or sell certain products or services. Burger King McDonald’s Midas Muffler KFC

26. 26 Computer Software Costs Technological Feasibility General Release R & D ExpenseCapitalize Expense Technological feasibility is established either on the date the company completes a detail program design or, in its absence, when it completes a working model of the product.

27. 27 (1)the preliminary stage is completed, (2)management authorizes and commits to funding a company software project, and (3)interest costs are incurred when developing the software. Computer Software Costs Internal-Use Software AICPA Statement of Position No. 98-1 specifies that the capitalization of costs begins when---

28. 28 Trademarks and Tradenames Registration of a trademark or tradename  with the U.S. Patent Office establishes a right to exclusive use of a name, symbol, or other device used for product identification for 20 years. The right is renewable indefinitely as long as it is used continuously.

29. 29 Deferred charges (a catch-all category in which several individually immaterial items are accumulated) Organization costs Other Intangibles Legal fees, stock certificate costs, underwriting fees, accounting fees, promotional fees

30. 30GoodwillGoodwill Purchased goodwill arises when a company is acquired. It is the difference between the purchase price of the acquired company as a whole and the fair value of the reported identifiable net assets.

31. 31GoodwillGoodwill Sara Company purchases all the assets of Trevor Company for $790,000 cash and Trevor Company is dissolved. Trevor Company’s identifiable assets had a fair value of $920,000 and its liabilities totaled $200,000. Assets920,000 Goodwill70,000 Liabilities200,000 Cash790,000 Individual assets and liabilities actually would be debited or credited.

32. 32 Impairment of Goodwill A company must review its goodwill for impairment annually at the reporting unit level.

33. 33 Impairment of Goodwill A company must also review its goodwill for impairment whenever events or changes in circumstances occur that would more-likely-than- not reduce the fair value of the goodwill below its carrying value.

34. 34 Impairment of Goodwill The Kent Company acquired the Devon Company as a subsidiary several years ago. The Devon Company has a book value of $3.6 million, including goodwill of $400,000. Kent Company estimates that its fair value is $3 million. If Kent Company allocates $2.7 million of the fair market value to Devon Company’s identifiable assets and liabilities, this means that $300,000 is implied for goodwill. Thus, there has been an impairment loss of $100,000. Impairment Loss on Goodwill100,000 Goodwill100,000

35. 35 Disclosure of Intangibles FASB Statement No. 142 requires a company to disclose certain information about its intangible assets, in either the financial statement or it notes, including: 1.In the period it acquires intangible assets: a. The cost of any intangible asset acquired, separated into categories. b.For assets subject to amortization, the residual value and the weighted-average amortization expense for the next five years. c.The cost of any R&D acquired and written off, and where it is included in the income statement. ContinuedContinued

36. 36 Disclosure of Intangibles FASB Statement No. 142 requires a company to disclose certain information about its intangible assets, in either the financial statement or it notes, including: 2.In each period for which it presents a balance sheet: a. For intangible assets that are amortized, the total cost, the accumulated amortization, the amortization expense, and the estimated amortization expense for the next five years. b.For intangible assets that are not amortized, the total cost and the cost of each major intangible asset class. ContinuedContinued

37. 37 Disclosure of Intangibles FASB Statement No. 142 requires a company to disclose certain information about its intangible assets, in either the financial statement or it notes, including: 2.In each period for which it presents a balance sheet: c. For goodwill, the amount of goodwill acquired, the amount of any impairment losses recognized, and the amount of goodwill included in the disposal of a reporting unit. d.For any intangible asset impairment, the facts and circumstances leading to the impairment, the amount of the loss, and the method used.

38. 38 Conceptual Issues Expensing internally generated goodwill is justified on the basis that measuring the cost of internally generated goodwill with a reasonable degree of reliability is very difficult. Capitalization of internally generated goodwill would require amortization. It would be very difficult to identify the revenues generated and therefore to decide over which periods, and by which method, to match the amortization expenses against the benefits.

39. 39 Click here to skip Appendix material. Appendix: Estimating the Value of Goodwill

40. 40 Steps Used In Estimating the Value of Goodwill (Appendix Steps Used In Estimating the Value of Goodwill (Appendix) 1.Estimate the average future earnings from the identifiable net assets. 2.Estimate the rate of return that should be earned by the company on its identifiable net assets. 3.Estimate the current fair value of the identifiable net assets. 4.Compute the estimated excess annual earnings. ContinuedContinued

41. 41 Steps Used In Estimating the Value of Goodwill (Appendix) 5.Estimate the expected life of the excess annual earnings. 6.Compute the present value of the estimated excess annual earnings. 7.Compute the total value of the company being considered for purchase. 8.Apply sensitivity analysis. Two additional steps may follow the calculation of the value of goodwill:

42. 42 Steps Used In Estimating the Value of Goodwill (Appendix) STEP 1: Estimate the average future earnings. 1.Eliminate unusual gains or loss, extraordinary items, the results of discontinued operations, and the effects of changes in accounting principles. 2.Adjust for differences in accounting principles. Select a number of years to determine the trend of the firm’s earnings.

43. 43 Average annual revenue$628,000 Average annual cost of goods sold $266,000 Average operating expense 180,000 Expected annual increase in wages not to be recovered by increased revenues40,000 Increase in annual depreciation on the current fair value of the assets12,000 Annual amortization of new intangibles 10,000 Expected expenses(508,000) Expected average annual earnings before taxes$120,000 Estimated income taxes (30%) (36,000) Greenfield Company Expected average annual earnings$84,000

44. 44 Steps Used In Estimating the Value of Goodwill (Appendix) STEP 2: Estimate the rate of return. Based on the risk of the investment, Greenfield assumed a 10% return after income taxes.

45. 45 Steps Used In Estimating the Value of Goodwill (Appendix) STEP 3:Estimate the current fair value of the identifiable net assets. Book value of identifiable net asset$570,000 Revaluation of LIFO inventory to fair value90,000 Increase in allowance for uncollectible accounts(10,000) Revaluation of property, plant and equipment to fair value120,000 Fair value of trademark150,000 Revaluation of bonds payable (lower interest rate)(60,000) Unfunded projected benefit obligations of pension (140,000) Current fair value of identifiable net assets$720,000

46. 46 Steps Used In Estimating the Value of Goodwill (Appendix) STEP 4: Compute the estimated excess annual earnings. Average expected annual earnings$84,000 10% return on fair value of identi- fiable net assets (72,000) Estimated excess annual earnings$12,000

47. 47 Steps Used In Estimating the Value of Goodwill (Appendix) STEP 5: Estimate the expected life of excess annual earnings. Greenfield Company estimates that the excess annual earnings will last for ten years.

48. 48 Steps Used In Estimating the Value of Goodwill (Appendix) STEP 6: Compute the present value of the estimated excess annual earnings. Estimated excess annual earnings$12,000 Present value factor for an annuity of 10 periods at 10%x 6.144567 Present value of estimated excess annual earnings (goodwill)$73,735 Estimated excess annual earnings$12,000 Present value factor for an annuity of 10 periods at 10%x 6.144567 Present value of estimated excess annual earnings (goodwill)$73,735

49. 49 Steps Used In Estimating the Value of Goodwill (Appendix) STEP 7: Compute the total value of the company. Fair value of the assets$720,000 Goodwill 73,735 Total value of the company$793,735 Fair value of the assets$720,000 Goodwill 73,735 Total value of the company$793,735 STEP 8: Apply sensitivity analysis.

50. 50 C hapter 11 The End

51. 51