This chapter covers intangible assets, amortization expense, goodwill computation, goodwill impairment, limited and unlimited life intangibles.
Introduction to Intangible Assets
Goodwill Calculation, and Impairment of Goodwill
Example: Goodwill Impairment
Accounting for Computer Software Cost
Example: Asset Impairment
Initial Operating Losses, and Advertising Costs
Start-Up Costs for New Operations
Research and Development Costs (R&D)
Example: Research and Development Cost
Chapter 12 discusses the basic conceptual and reporting issues related to intangible assets.
Characteristics of Intangibles
The characteristics of intangible assets are: (1) they lack physical existence, and (2) they are not a financial instrument. The most common types of intangibles reported are patents, copyrights, franchises, licenses, trademarks, trade names, and goodwill.
Valuation of Intangibles
Cost is the appropriate basis for recording purchased intangible assets. Like tangible assets, cost includes acquisition price and all other expenditures necessary in making the asset ready for its intended use—for example, purchase price, legal fees, and other incidental expenses. When intangibles are acquired in exchange for stock or other assets, the cost of the intangible is the fair value of the consideration given or the fair value of the intangible received, whichever is more clearly evident. Costs incurred to create internally-created intangibles are generally expensed as incurred.
Amortization of Intangibles
Intangibles have either a limited (finite) useful life or an indefinite useful life. An intangible asset with a limited life is amortized over its expected useful life. An intangible asset with an indefinite life is not amortized.
The expiration of intangible assets is called amortization. Limited-life intangibles should be amortized by systematic charges to expense over their respective useful lives. The useful life should reflect the periods over which these assets will contribute to cash flows.
The amount of amortization expense for a limited-life intangible asset should reflect the pattern in which the asset is consumed or used up, if that pattern can be readily determined. If not, the straight-line method of amortization should be used. When intangible assets are amortized, the charges should be shown as expenses, and the credits should be made either to the appropriate asset accounts or to separate accumulated amortization accounts. The amount of an intangible asset to be amortized should be its cost less residual value.
If no legal, regulatory, contractual, competitive, or other factors limit the useful life of an intangible asset, the useful life is considered indefinite. An intangible with an indefinite life is not amortized, instead it is tested for impairment.
Marketing-Related Intangible Assets
Marketing-related intangible assets are those assets primarily used in the marketing or promotion of products or services. Examples are trademarks or trade names, newspaper masthead, Internet domain names, and noncompetition agreements.
A trademark or trade name is a word, phrase, or symbol that distinguishes or identifies
a particular company or product. The right to use a trademark or trade name, whether it is registered or not, rests exclusively with the original user as long as the original user continues to use it. Registration with the U.S. Patent and Trademark Office provides legal protection for an indefinite number of renewals for a period of 10 years each. When the total cost of a trademark or trade name is insignificant, it can be expensed rather than capitalized. In most cases, the life of a trademark or trade name is indefinite, and therefore its cost is not amortized.
Customer-Related Intangible Assets
Customer-related intangible assets occur as a result of interactions with outside parties. Examples are customer lists, order or production backlogs, and both contractual and noncontractual customer relationships.
Artistic-Related Intangible Assets
Artistic-related intangible assets involve ownership rights to plays, literary works, musical works, pictures, photographs, and video and audiovisual material. These ownership rights are protected by copyrights. A copyright is a federally granted right that all authors, painters, musicians, sculptors, and other artists have in their creations and expressions.
A copyright is granted for the life of the creator plus 70 years, and is not renewable. It gives the owner, or heirs, the exclusive right to reproduce and sell an artistic or published work. Generally, the useful life of the copyright is less than its legal life (life of the creator plus 70 years). Costs of defending a copyright are capitalized. The costs of the copyright should be allocated to the years in which the benefits are expected to be received.
Contract-Related Intangible Assets
Contract-related intangible assets represent the value of rights that arise from contractual arrangements. Examples are franchise and licensing agreements, construction permits, broadcast rights, and service or supply contracts. They can have limited or indefinite lives. The cost of a contract-related intangible with a limited life should be amortized as operating expense over the life of the franchise; whereas those with an indefinite life should be carried at cost and not amortized.
One contract-related intangible asset is a franchise, an arrangement under which the franchisor grants the franchisee the right to sell certain products or services, to use certain trademarks or trade names, or to perform certain functions, usually within a designated geographical area.
A license or permit is a contract arrangement commonly entered into by a governmental body and a business enterprise that uses public property.
Technology-Related Intangible Assets
Technology-related intangible assets relate to innovations or technological advances. Examples are patented technology and trade secrets. A patent gives the holder exclusive right to use, manufacture, and sell a product or a process for a period of 20 years without interference or infringement by others. If a patent is purchased from an inventor (or other owner), the purchase price represents its cost. Research and development costs related to the development of the product, process, or idea that is subsequently patented must be expensed as incurred. All unrecovered legal fees and other costs incurred in successfully defending & patent are charged to the patent account. The costs of the patent should be amortized over its legal life or its useful life, whichever is shorter.
Goodwill is the excess of cost over fair value of the identifiable net assets acquired when purchasing a business. In a business combination, the cost (purchase price) is assigned, where possible, to the identifiable tangible and intangible net assets, and the remainder is recorded in an intangible asset account called goodwill. Goodwill generated internally should not be capitalized in the accounts¾it is recorded only when an entire business is purchased. Goodwill is considered to have an indefinite life and therefore should not be amortized.
A bargain purchase results when the fair value of the net assets acquired is higher than the purchase price of the assets. The FASB requires that the excess be recognized as a gain and that the nature of the gain be disclosed.
Impairments of Limited-Life Intangibles
The rules that apply to impairments of property, plant, and equipment also apply to limited-life intangibles. To determine if the asset is impaired, a recoverability test is used. The first step of the test requires an estimate of the future net cash flows expected from the use of that asset and its eventual disposition to be determined. If the sum of the expected future net cash flows (undiscounted) is less than the carrying amount of the asset, an impairment has occurred. The company then uses the fair value test to measure the impairment loss by comparing the carrying amount of the asset with its fair value. The impairment loss is reported as part of income from continuing operations, generally in the “Other expenses and losses” section.
Once an impairment loss is recorded, the reduced carrying amount of an asset held for use becomes its new cost basis¾and is not changed except for depreciation or amortization in future periods or for additional impairments. Even if the fair value of an impaired asset increases, a company may not recognize restoration of the previously recognized impairment loss.
Impairments of Indefinite-Life Intangibles
Indefinite-life intangibles other than goodwill should be tested for impairment at least annually using the fair value test. This test compares the fair value of the intangible asset with the asset’s carrying amount. If the fair value of the intangible asset is less than the carrying amount, impairment is recognized.
Impairment of Goodwill
The impairment rule for goodwill is a two-step process. First, the fair value of the reporting unit should be compared to its carrying amount including goodwill. If the fair value of the reporting unit is greater than the carrying amount, goodwill is considered not impaired, and the company makes no adjustment. However, if the fair value is less than the carrying amount of the net assets, then the second step is to compute the implied fair value of goodwill by comparing the fair value of the reporting unit to the fair value of its net assets (excluding goodwill). The implied fair value of the goodwill to its carrying amount and the impairment is the difference between the carrying amount and the implied fair value.
Presentation of Intangibles and Related Items
On the balance sheet, all intangible assets other than goodwill should be grouped together and reported as a separate line item. If goodwill is present, it should be reported as another separate line item.
On the income statement, amortization expense and impairment losses for intangible assets other than goodwill should be presented as part of continuing operations. Goodwill impairment losses should also be presented as a separate line item in the continuing operations section, unless the goodwill impairment is associated with a discontinued operation.
Research and Development Costs
Research activities consist of planned research or critical investigation aimed at discovery of new knowledge. Development activities consist of 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 whether intended for sale or use. In general, research and development costs are charged to expense when incurred.
The costs associated with R&D activities and the accounting treatment accorded them are as follows:
- Materials, Equipment, and Facilities. Expense the entire costs, unless the items have alternative future uses (in other R&D projects or otherwise), in which case carry as inventory and allocate as consumed; or capitalize and depreciate as used.
- Personnel. Salaries, wages, and other related costs of personnel engaged in R&D should be expensed as incurred.
- Purchased Intangibles. Recognize and measure at fair value. After initial recognition, account for in accordance with their nature (either limited-life or indefinite-life intangibles).
- Contract Services. The costs of services performed by others in connection with the reporting company’s R&D should be expensed as incurred.
- Indirect Costs. A reasonable allocation of indirect costs shall be included in R&D costs, except for general and administrative cost, which must be clearly related in order to be included and expensed.
Start-up costs, initial operating costs, and advertising costs are also expensed as incurred. Computer software costs are discussed on the book’s companion website.
IFRS permits revaluation on limited-life intangible assets, revaluations are not permitted for goodwill and other indefinite-life intangible assets under GAAP. IFRS permits some capitalization of internally generated intangible assets if it is probable there will be a future benefit and the amount can be reliably measured; GAAP requires expensing of all costs associated with internally generated intangibles. IFRS requires an impairment test at each reporting date for long-lived assets and intangibles and records an impairment if the asset’s carrying amount exceeds its recoverable amount; under GAAP, impairment loss is measured as the excess of the carrying amount over the asset’s fair value. IFRS allows reversal of impairment losses when there has been a change in economic conditions or in the expected use of limited-life intangibles; under GAAP impairment losses cannot be reversed for assets to be held and used—the impairment loss results in a new cost basis for the assets.