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.
Copyright
Artist: B. Joel
Song: Uptown
Girl
U.S. Patent
Holder: P. Bye
Process: 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. Patent
Holder: P. Bye
Process: no-fade,
brake fluid

6. 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)

7. 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.

8. 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 ,010
Patents ,430
But Only if purchased!

9. 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

10. 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.

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 paid
This difference is called GOODWILL -- an intangible asset

13. 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

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

17. 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

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 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.

19. 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."

20. 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

21. 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

22. 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

23. 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

24. 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

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 climate
Unanticipated competition
Loss of key personnel
Adverse action or assessment by a regulator
New GAAP - FASB 141 & 142

26. 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

27. Goodwill Example “Target Company”
Page 151

28. 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

29. 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

30. Fair values of identifiable assets
A/R (overvalued by $10,000) $ 50,000
Inventory (under by $5,000) ,000
PP&E (under by $10,000) ,000
Intangible assets (under by 40,000) ,000
Marketable securities (ok) ,000
Less liabilities (ok) ,000
Fair value of net assets $325,000

31. Difference between purchase price and fair value
Fair value of net assets $325,000
Purchase price ,000
Goodwill $ 75,000

32. Journal entry to record purchase
A/R $50,000 Inventory ,000 PP&E ,000 Patent ,000 Investments ,000 Goodwill ,000 Liabilities $100,000 Cash ,000
Total $500,000 $500,000
Page 152

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

34. 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

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

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

37. “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”

38. “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.

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

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

41. 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

42. 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

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, 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

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 individually
When 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 183
Amortization Expense =
Cost
Economic 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 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.

49. 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

50. 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

51. 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

52. 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

53. 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

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 DISCLOSED
Write-off Intangibles when it becomes evident that their value has been impaired (FASB 121). FASB 144
Page 185

55. 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

56. 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

57. 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?

58. 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?

59. 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?

60. 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

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

62. 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

63. 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

64. 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

65. 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