1 Intangibles C hapter 11

2 1.Explain the accounting alternatives for intangible assets. 2. Record the amortization 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, trademarks and tradenames, franchises, and computer software costs. Objectives

3 6.Account for unidentifiable intangibles including internally developed and purchased goodwill. 7.Understand goodwill amortization. 8.Understand the disclosure of intangibles. 9.Explain the conceptual issues regarding intangibles. 10. Estimate the time value of goodwill. Objectives

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. They may have indeterminate (but not necessarily indefinite) lives. 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. They may have indeterminate (but not necessarily indefinite) lives.

5 Classification of Intangibles Purchased Identifiable Capitalize and amortize over the economic life, not to exceed 40 years Unidentifiable (goodwill) Capitalize and amortize over the economic life, not to exceed 40 years

6 Classification of Intangibles Internally Developed Identifiable Capitalize and amortize over the economic life, not to exceed 40 years, except research and development, which is expensed as incurred Unidentifiable Expense as incurred

7 Amortization of Intangibles  Legal, regulatory, or contractual provisions that place a limit on the maximum economic life.  Provisions for renewal or extension of rights or privileges covered by specific intangible assets.  Effects of obsolescence, customer demand, competition, rate of technological change, and other economic factors. Factors to consider when estimating the useful life of an intangible asset: ContinuedContinued

8 Amortization of Intangibles  Possibility that the economic lives of intangibles may be related to life expectancies of certain groups of employees.  Expected actions of competitors, regulatory bodies, and others.  An apparently unlimited economic life cannot be reasonably projected.  An intangible may be a composite of many factors. Factors to consider when estimating the useful life of an intangible asset:

9 Amortization of Intangibles The estimated life of an intangible should be made after considering all relevant factors, but in no case may it exceed 40 years.

10 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 Patent (or Accumulated Amorti- zation: Patent)8,500

11 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.

12 Research and Development Costs Costs associated with activities excluded from R&D are either expensed or capitalized.

13  Materials, equipment, and facilities  Personnel  Intangibles purchased from others  Contract services  Indirect costs  Materials, equipment, and facilities  Personnel  Intangibles purchased from others  Contract services  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:

14 Identifiable Intangible Assets Cost of Intangibles R&D Expense In period cost incurred Amortize over service life Intangible Assets Patents Copyrights Trademarks and Tradenames Franchises Computer Software Costs Leasehold Improvements Goodwill

15 Patents A patent is an exclusive right granted by the federal government giving the owner control for 20 years.

16 Patents 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.

17 Copyrights © 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

18 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 for 20 years. The right is renewable indefinitely as long as it is used continuously.

19 Franchises A franchise is an agreement 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

20 Computer Software Costs Technological Feasibility General Release R & D ExpenseCapitalize Expense

21  The preliminary stage is completed.  Management authorizes and commits to funding a company software project.  Interest costs is incurred when developing the software. Computer Software Costs Internal-Use Software Capitalization of costs begins when---

22 Leases and leasehold improvements Deferred charges (a catch-all category in which several individually immaterial items are accumulated) Organization costs Other Intangibles

23 Goodwill Purchased goodwill is the difference between the purchase price (market value) of the company as a whole and the fair value of the identifiable net assets.

24 Goodwill 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.

25 Goodwill At year-end an entry is needed to amortize the goodwill. Goodwill of $70,000 is amortized over 20 years. Goodwill Amortization Expense3,500 Goodwill3,500 Goodwill is amortized over 15 years for computing taxable income. Therefore, there is a timing difference between financial income and taxable income.

26 Disclosure of Intangibles FASB Statement No. 2 requires that a company disclose its total R&D expense either through a line item on the company’s income statement or by notes to the financial statement. APB Opinion No. 17 requires that a company disclose the method and period of amortization. The SEC requires that accumulated amortization be disclosed on filed reports.

27 Conceptual Issues An argument for expensing R&D is that capitalization would require amortization and it is very difficult to identify the revenues generated against which the amortization should be matched. If capitalizing purchased goodwill is supported, it can be argued that it would be more consistent also to capitalize R&D. Click here to skip Appendix material.

28 Steps Used In Estimating the Value of Goodwill (Appendix)  Estimate the average future earnings from the identifiable net assets.  Estimate the rate of return that should be earned by the company on its identifiable net assets.  Estimate the current fair value of the identifiable net assets.  Compute the estimated excess annual earnings. ContinuedContinued

29 Steps Used In Estimating the Value of Goodwill (Appendix)  Estimate the expected life of the excess annual earnings.  Compute the present value of the estimated excess annual earnings.  Compute the total value of the company being considered for purchase.  Apply sensitivity analysis. Two additional steps may follow the calculation of the value of goodwill:

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

31 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$120,000 Estimated income taxes (30%)(36,000) Expected average annual earnings$ 84,000

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

33 Steps Used In Estimating the Value of Goodwill (Appendix) 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 fully amortized 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

34 Steps Used In Estimating the Value of Goodwill (Appendix) 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

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

36 Steps Used In Estimating the Value of Goodwill (Appendix) 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 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 Present value of estimated excess annual earnings (goodwill)$73,735

37 Steps Used In Estimating the Value of Goodwill (Appendix) 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 Apply sensitivity analysis.

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