Business Combinations, Goodwill and Intangibles FASB 141 and 142

Intangible assets generally result from legal or contractual rights which do not have a physical substance. Copyright Artist: B. Joel Song: Uptown Girl U.S. Patent Holder: P. Bye Process: no-fade, brake fluid

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.

When a company internally develops an intangible asset, only certain costs can be capitalized such as legal and related costs. U.S. Patent Holder: P. Bye Process: no-fade, brake fluid

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.

For financial reporting purposes, identifiable and unidentifiable intangible assets are treated the same - they are both capitalized. XYZ Co. Balance She 12/31/9 Cash Equipment 54 Goodwill 32,010 Patents 1,430 But . . . Only if purchased!

Identifiable vs. Unidentifiable 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. Page 149 The purchase method raises a problem in how to allocate the purchase price to the various assets acquired.

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. OK

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. Purchase Agreement Price $100,000 Appraisal Land $10,000 Bldg. 40,000 FMV $50,000 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 Page 149 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

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

Page 186 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

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 Page 187 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

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

Journal entry to record purchase A/R $50,000 Inventory 95,000 PP&E 200,000 Patent 50,000 Investments 30,000 Goodwill 75,000 Liabilities $100,000 Cash 400,000 Total $500,000 $500,000 Page 152

Compute amortization of goodwill expense for 1998: $75,000 / 40 years = $1,875 per year Dr Cr Amortization Expense $1,875 Goodwill $1,875

Under FASB 142: New Rules 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

What if purchase price is LESS than fair value of net assets? “negative goodwill” situation

Assume purchase price was $300,000 Page 153 A/R $ 50,000 Inventory 95,000 PP&E 200,000 Intangible asset 50,000 Marketable securities 30,000 Less liabilities -100,000 Net fair value $325,000 Purchase price $300,000 NEGATIVE Goodwill = ($ 25,000)

“Negative Goodwill” Page 152 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”

“Negative Goodwill” New Rules 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.

Reduce noncurrent assets to eliminate negative goodwill Page 153 Fair values - Noncurrent assets: PP&E $200,000 80% Patent 50,000 20% Total $250,000 100% $20,000 $ 5,000 $25,000 Record PP&E = $200,000 – 20,000 = $180,000 Patent = $50,000 – 5,000 = $ 45,000 Goodwill = $ 0

Journal entry to record purchase A/R $50,000 Inventory 95,000 PP&E 180,000 Patent 45,000 Investments 30,000 Liabilities $100,000 Cash 300,000 Total $400,000 $400,000

Tax Issues Amortization of Goodwill may or may not be tax deductible Amortization of goodwill acquired BEFORE 8-11-93 is NOT tax deductible It is a permanent difference between book income and taxable income Page 154

Tax Issues Amortization of goodwill acquired AFTER 8-10-93 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

Current accounting principles require that an intangible asset be amortized over its economic life, but not to exceed 40 years. Page 183 Amortization Expense = Cost Economic life

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 Page 183 – NEW MATERIAL – FASB 142 Amortization of Intangibles   Finite Useful Life Indefinite 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.

Determining useful life Expected use by the organization Expected useful life of similar or related assets Legal, regulatory or contract provisions and provisions for renewal/extension. Patents max, 17 years Copyrights max 50 years after death of author. Page 183

Determining useful life Renewal or extension provisions under laws, regulations or contracts Effects of obsolescence, demand, competition, technological change. Level 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: New Materials - FASB 142 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 Page 185

Amortization Methods Residual value is presumed to be zero unless New GAAP - FASB 142 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 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 Page 188 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?

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

Marketing-related intangibles Trademarks, tradenames Trade dress (unique color, shape, package design) Newspaper mastheads Internet domain names Noncompetition agreements New GAAP - FASB 141 & 142

Customer related Legal or contractual rights Separable Customer lists 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 Separable 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