Chapter 12: Intangible Assets and Goodwill
Objective 1 – Understand the importance of goodwill and intangible assets from a business perspective and describe their characteristics.
The Business Importance and Characteristics of Goodwill and Intangible Assets
- Intangible assets are difficult to identify and measure – but are a key focus of many companies and standard setters.
Characteristics of Goodwill
- Goodwill – An asset representing future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized.
- The difference between fair value of consideration transferred to acquire a business and the fair value amounts assigned to identifiable net assets.
- Fair value of consideration transferred – fair value of the assets acquired/liabilities assumed.
Characteristics of Intangible Assets
- Identifiable non-monetary assets that lack physical substance.
- Intangibles possess 3 characteristics:
1. Intangible assets are identifiable.
- Asset results from contractual or legal rights, and it is separable from the entity and sold, transferred, etc.
2. Intangible Assets lack physical substance.
- Value of intangibles comes from rights and privileges granted to the company using them.
3. Intangibles are non-monetary.
- Assets lack a monetary value based on the right to receive amounts of money. (So it excludes A/R, long-term loans, etc.)
- Intangible assets typically provide economic benefits over a period of years – can be revenue and classified as a long-term asset due to this long duration of benefit.
- E.g. Patents, copyrights, franchises, licensing agreements, secret formulas, software.
Objective 2 – Identify and apply the recognition and measurement requirements for purchased intangible assets.
Recognition and Measurement of Intangible Assets
Recognition and Measurement at Acquisition
- Recognition criteria for intangibles is the same as PP&E – It is measured at cost at acquisition.
- It is probable that the entity will receive the expected future economic benefits.
- Asset’s cost can be reliably measured.
- There is more uncertainty about the future economic benefits for intangibles.
- Measured at cost –
- Costs not capitalized are those related to product introduction and promotion, conducting business in a new location or with new customers, or administration and general overhead.
- Direct costs are accounted for as additions or replacements and are capitalized with exceptions.
- Delayed payment terms – Interest is a financing expense.
- Acquired with shares – Cost is the asset’s fair value unless it can’t be measured reliably, then use the shares’ fair value.
- Acquired with nonmonetary assets – Cost of the intangible is the more reliably measured of: fair value of what is given up or the fair value of the intangible asset.
- Assuming Commercial Substance and reliably measured fair values.
- Acquired with a Government Grant – Use the asset’s fair value.
Intangibles Purchased in a Business Combinations
- Purchase the intangibles in a “basket,” we must allocate cost to each intangible based on relative fair value.
- Business Combination – An entity acquires control over 1+ businesses, so it must account for the acquired assets regardless of whether or not they are recognized in the acquired business’ records.
- Identifiable assets are separately recognized whereas non-identifiable are considered part of Goodwill.
- Acquisition cost assigned to identifiable intangibles are at fair value of the assets.
- They are recognizable.
- A prepaid asset is recognized initially as a prepaid expense – the prepayment is recognized only as an asset if the entity pays for goods before delivery or services before receiving services.
- Asset is the right to receive the goods/services – When received, costs are expensed.
Objective 3 – Identify and apply the recognition and measurement requirements for internally developed intangible assets.
Recognition and Measurement of Internally Developed Intangible Assets
Identifying Research and Development Phase Activities
- Generating the intangible is broken down into 2 parts: Research and Development phases.
- Research – Planned investigation undertaken with the hope of gaining new scientific or technical knowledge and better understanding.
- Development – Translation of research findings or other knowledge into a plan or design for new or substantially improved materials, devices, etc.
- Uncertainty about phases – classify as a Research Phase Activity.
Accounting for Research Phase Costs
- No costs incurred on research or during research phase are recognized as an asset.
- Depreciation of machines or equipment, etc. are still recorded however.
- Costs are expensed when incurred.
- Contractual Agreement – Entities conduct research activities for other companies under contract.
- The contract specifies the reimbursement, which is an inventory or a receivable.
Accounting for Development Phase Costs
- Recognize the intangible asset when the entity demonstrates feasibility and intention/ability to generate future economic benefits from it.
- Six Mandatory Conditions for Capitalization
- Technical feasibility of completing the intangible asset.
- Entity’s intention to complete it for use or sale.
- Entity’s ability to use or sell it.
- Availability of technical, financial, and resources needed to complete it, and to use/sell it.
- The way in which future economic benefits will be generated: including existence of a market for the asset or its usefulness to the entity.
- Ability to reliably measure costs associated with and attributed to the intangible asset during its development.
- An entity capitalizes development phase costs only when future benefits are reasonably certain.
- Previous expenditures are not capitalized and added to the asset’s cost until the criteria are met.
- Several items are not recognized as internally generated intangibles:
- Brands, mastheads, publishing titles, customer lists, etc.
Costs Included and Excluded
- Types of expenditures capitalized are familiar: all directly attributable costs for manufacturing include:
- Materials and services used or consumed to generate the asset.
- Direct costs of personnel, such as salaries, wages, payroll taxes, and related employee benefit costs.
- Fees needed to register a legal right.
- Amortization of other intangibles needed to generate the new asset.
- Interest or borrowing costs.
- Excluded: selling, administrative, and other general overhead costs.
- Organization Costs – Costs of start-up activities such as legal and other costs of incorporation – they are all expensed.
- Relocation/reorganization costs are also not capitalized.
Objective 4 – Explain how intangible assets are accounted for after initial recognition.
Recognition and Measurement after Acquisition
- Two models are used to measure intangible assets after initial recognition: Cost Model (CM) and Revaluation Model (RM).
- Cost model is most widely used, and the only option for ASPE.
- Revaluation is not commonly used because it only applies to intangibles with a fair value determined in an active market. (items must therefore be homogenous)
- All the assets in the same class must also apply the same method of RM – which doesn’t work if one asset doesn’t have an active market. (Use CM)
- Same accounting method as PP&E – RM doesn’t require an annual revaluation, only that the carrying amount is not materially different from fair value.
- Refer to Chapter 10-11 for these methods.
- Indefinite Life – There is no foreseeable limit to how long the asset will generate positive net cash flows for the entity.
Cost Model (CM)
- At Acquisition
- Recognized and measured at Cost
- After Acquisition
- Carried at cost less accumulated amortization and accumulated impairment losses.
- On Disposal
- Difference between asset’s carrying amount and proceeds on disposal is gain/loss reported in net income.
Revaluation Model (RM)
- At Acquisition
- Recognized and Measured at Cost
- After Acquisition
- Carried at fair value at date of revaluation les subsequent accumulated amortization and subsequent impairment losses.
- Revaluation Increase
- Record credit to Revaluation Surplus (OCI) unless it reverses a previous decrease recognized in income, if so then recognize the increase in income.
- Revaluation Decrease
- Record debit to Revaluation Surplus (OCI) to the extent there is a balance associated with the same asset. Remaining amount is a charge to income.
- Apply the Proportional Method (both asset and accumulated amortization balances continue and are adjusted so that net amount = asset’s new fair value) or Asset Adjustment Method (accumulated amortization is closed to the asset account and begins again at zero, asset is revalued to new amount).
- On Disposal
- Either bring asset to fair value, account for revaluation increase/decrease, and recognize no gain/loss on disposal, or recognize a gain/loss on disposal in net income equal to Proceeds on Disposal – Carrying Amount
- Revaluation Surplus Account Balance
- Either transfer amounts directly to Retained Earnings each period or wait until asset id disposed off and transfer balance remaining in account to Retained earnings.
- No amortization is taken on these types of intangibles – retain the asset in the accounts until it is determined to be impaired.
Limited Life Intangibles
- Intangibles are amortized by systemic charges to expense over its useful life with the CM or RM methods.
- Factors in determining useful life:
- Expected use of the asset or expected use of other assets that may affect its useful life.
- Legal, regulatory, or contractual provisions that limit useful life or allow renewal or extension of the life.
- Effects of obsolescence, demand, competition, and other economic factors.
- Level of maintenance expenditure to obtain expected future cash flows.
- Amortization should reflect the pattern of use of the asset’s economic benefits.
- E.g. Amortizing a license to produce vaccines follows the production of each unit of vaccines.
- Reported as an expense, crediting the Accumulated Amortization accounts.
- Amortize the carrying amount less residual value – the residual value is typically zero due to uncertainty. (overturn if the asset is expected to be of use to another party)
- Indefinite-life intangibles are not amortized.
- E.g. A trademark that is renewable every 10 years at minimal cost.
- Management should review the properties of the asset to see if it is still indefinite so that they may make changes to carrying amount impairment.
Objective 5 – Identify and explain the accounting for specific types of intangible assets.
Marketing-Related Intangible Assets
- Mainly used in the marketing/promotion of products or services and derive their value from the contractual or legal rights they contain.
- E.g. Trademarks, trade names, newspaper mastheads, internet domain names.
- Trademark – word, symbol, or design (or combination) used to distinguish goods/services from those of others.
- Purchasing a mark or name – Capitalizable cost is the purchase price and other direct costs.
- Developing the mark or name – Costs may be capitalized when the 6 criteria are met.
- Otherwise, it is expensed.
- Trademarks are typically finite, but may provide benefits to an enterprise indefinitely.
Customer-Related Intangible Assets
- Result from Interactions with Outside parties and their value may be derived from legal-contractual rights or because they are separable.
- E.g. Customer lists, order/production backlogs, and customer contracts.
- The customer-related intangible assets typically have a limited life due to customer factors.
- Debit Intangible Assets
- Credit Cash
- Debit Amortization Expense
- Credit Accumulated Amortization
- If there is residual value, deduct it from the cost to find amortizable amount.
Artistic-Related Intangible Assets
- Involve ownership rights to plays, literary works, musical works, pictures, photographs, and video/audiovisual material.
- Protected by copyrights and have value due to legal-contractual nature.
- Copyright – Exclusive right to copy a creative work or allow someone else to do so.
- Acquired automatically when the work is created but may be registered to grant the copyright for the life of the creator + 50 years.
- Not renewable.
- Costs of acquiring/defending a copyright may be capitalized, but research costs are expensed as incurred.
- Generally, useful life < legal life due to different consumer habits and market trends.
Contract-Based Intangible Assets
- Value of rights that come from contractual arrangements.
- E.g. licensing arrangements, lease agreements, construction permits, broadcast rights, and service/supply contracts.
- Franchise – Contractual agreement under which the franchiser grants the franchisee the right to sell certain products/services, use trademarks, or perform functions.
- Similar to Licensing Agreements.
- Licenses & Permits – Granted to permit the use of public property for an enterprise to perform services.
- Recognize the intangible asset account when there are costs identified with acquisition.
- Amortization – A limited life means it is amortized over the lesser of legal or useful life. An indefinite life is amortized if the useful life is deemed to be limited.
- Favorable Lease – Contractual understanding between lessor (property owner) and lessee (property renter) that grants the lessee the right to use the property for a period of time in exchange for money.
- Terms are more favorable than the market terms, so it’s an intangible asset to one of the parties.
Technology-Based Intangible Assets
- Relate to innovations or technological advances.
- E.g. Technological patents or trade secrets.
- Patent – Gives the holder the right to exclude others from making, selling, or using a product or process for a period of 20 years from the date filed.
- If purchased from an inventor/owner – purchase price is cost.
- Other costs incurred in connection with the patent are capitalized as part of the patent cost.
- If internally generated, R&D costs are expensed after the 6 criteria are met. (So they are typically expensed as a result)
- Cost of a patent is amortized over the shorter of its legal life or useful life to the entity.
- Legal fees and other costs associated with a defense of a patent are capitalized as part of the asset’s cost.
Objective 6 – Explain and Account for Impairment of Limited-Life and Indefinite-life Intangible Assets
Impairment and Derecognition
- Impairment – Carrying amount is written down and the impairment loss is recognized.
Impairment of Limited-Life Intangibles
- Same as long-lived tangible assets –
- ASPE - Assess for potential impairment whenever events indicate the carrying value may not be recoverable.
- IFRS - Assess at the end of the period.
- Refer to Illustration 11-14 in Chapter 11 for the sources of info that indicate impairment.
- ASPE - Cost Recovery Impairment Model
- IFRS - Rational Entity Impairment Model
Impairment of Indefinite-Life Intangibles
- Fair Value Test – Compares the fair value of the intangible asset with its carrying amount.
- If fair value < carrying amount, the impairment loss = difference.
- Don’t use the separate recoverability test because undiscounted cash flows have a lower value today.
- Test for impairment by comparing carrying amount and recoverable value on an annual basis whether or not there is indication of impairment.
- Derecognize the intangible asset when it is disposed of or when its continuing use or disposal is not expected to generate any further economic benefits.
- Recognize a gain/loss equal to difference between carrying amount and proceeds on disposal.
Objective 7 – Explain how goodwill is measured and accounted for after acquisition.
Recognition and Measurement of Goodwill
Recognition of Internally generated Goodwill
- Goodwill generated internally is not capitalized in the accounts.
- Future benefits of goodwill may have nothing to do with the costs of development – and goodwill may exist even when no expenditures have been spent to develop it.
- Goodwill is recognized when a business combination occurs – It can’t be separated.
- At purchase:
- The purchaser entity initiates a detailed investigation of the underlying assets of the purchasee entity to find fair values.
- Differences between current fair value and carrying amount are common among long-term assets due to variations of interest rates.
- The difference between the fair value of consideration paid and the identified fair value is the goodwill.
- A “negative goodwill” that occurs when the total fair value of identifiable net assets acquired > fair value of the consideration transferred.
- Market imperfection – Seller is better off not selling at this price.
- Excess is recognized as a gain in net income in the same period – reassess the variables, values, and measurement procedures before doing so.
Valuation After Acquisition
- Three Approaches
- Charge goodwill immediately to expense. – Immediate write-off for consistency with how the asset was obtained.
- Amortize goodwill over its useful life – Value of the asset disappears with time.
- Retain goodwill indefinitely unless a reduction in value occurs. – Goodwill has an indefinite life and is an asset until a decline in value occurs.
- Goodwill acquired in a business combination is considered to have an indefinite life and is no longer amortized.
- Income statements are not charged with any amounts paid for goodwill until the asset is considered impaired.
Objective 8 – Explain and account for impairment of goodwill.
Impairment of Goodwill
- Goodwill is not an identifiable asset and cannot generate cash flows independently of other assets.
- Assigned to a reporting unit or Cash generating Unit (CGU) to be tested for impairment.
- Calculate impairment loss:
- IFRS - Carrying amount of unit (including goodwill) – Fair value of unit.
- ASPE - Carrying amount of unit (including goodwill) – Recoverable amount of unit (higher of value in use and fair value less costs to sell).
- Recording Impairment
- Debit Loss on Impairment
- Credit Accumulated Impairment Losses – Goodwill
- Impairment Tests
Limited Life Intangible
Recoverability Test; if failed write down to fair value.
Compare carrying amount with recoverable Amount.
Compare carrying amount with fair value.
Compare carrying amount with recoverable amount.
Compare carrying amount of reporting unit with fair value.
Compare carrying amount of CGU with recoverable amount.
Objective 9 – Identify the types of disclosure requirements for intangible assets and goodwill and explain the issues in analysis of assets.
Presentation and Disclosure
- Significant amount of info is required in the nots to the financial statements, particularly for IFRS.
- Following info is required for each class of intangible asset and separately for internally generated intangibles and other intangibles:
- Whether their lives are indefinite or finite, useful life, methods and rates of amortization, line where amortization is included on statement of comprehensive income.
- Carrying amount of indefinitely life of assets with reason of assessment.
- Reconciliation of opening/ending balances of carrying amounts and accumulated amortization and impairment losses with reasons.
- Impairment losses and reversals of impairment losses and where they are reported.
- For material impairment loss recognized/reversed:
- Circumstances that led to recognition, amount recognized, nature of asset or cash generating unit, and info about how recoverable amount was determined.
- For cash generating units or groups of units that have a significant amount of goodwill or intangible assets with indefinite life:
- How the recoverable amount was determined with assumptions underlying calculation of recoverable amount.
- For revaluation model assets:
- Carrying amount, carrying amount if there is no revaluation model applied, date of revaluation, amount of associated revaluation surplus and changes in account, and methods/assumptions to estimate fair value.
- Financial accounting does not capture and report many contributing assets due to the presence of missing values.
- Unrecognized, internally developed intangible assets: Knowledge Assets or Intellectual Capital.
- Includes value of key personnel, investment in products from R&D and potential, organizational adaptability, customer retention, strategic direction, brands, flexible and innovative management, customer service capability, and effective advertising programs.
- Because they are not capitalized, they are excluded from the statement of financial position.
- Difficult to measure the assets and often cannot be controlled by the enterprise (i.e. train employees but they walk out the door).
- When comparing operating results, pay close attention to deferred charges, intangible assets, and goodwill.
Objective 10 – Identify differences in accounting between IFRS and ASPE.
A Comparison of IFRS and ASPE
- With few specific exceptions, they share similar rules and regulations.
- Accounting treatment for costs incurred in development phase of internally generated intangibles:
- ASPE - Entities choose whether to capitalize or expense costs associated with internally generated intangibles.
- IFRS - Costs are capitalized.
- Impairment Models:
- ASPE - Cost Recovery Model
- IFRS - Rational Entity Model
<<Refer to illustration 12-15 on Page 746-747 for specific changes>>
Objective 11 (APPENDIX 12A) – Explain and apply basic approaches to valuing goodwill.
- Determine the fair value of consideration transferred and fair value of assets/liabilities acquired.
Excess Earnings Approach
- Calculate average annual “normalized” earnings a company is expected to earn in the future.
- Normalize earnings by analyzing the past earnings of the company for need for adjustments to estimate expected future earnings.
- Base future earnings on net assets’ current fair values.
- Amounts not expected to recur should be adjusted out.
2. Calculate the annual average earnings that the company would be expected to earn if it generated the same return on investment as the average firm in the same industry.
- Return on investment is % that results when income / net assets or shareholders’ equity invested.
3. Calculate excess annual earnings: specific company’s expected revenue – average firm’s expected revenue.
- Generating a higher income means the business has an unidentifiable value that provides greater earning power.
4. Estimate the value of goodwill based on future stream of excess earnings.
- Choose a discount rate and length of discount period as excess earnings continue for several years and must be discounted to present value.
- Relatively subjective – Lower discount rate = higher goodwill value.
- Discount Rate = Excess Earnings / Capitalization Rate (Chosen)
- A conservative or risk-adjusted rate (higher than normal) tends to be used due to uncertainty.
- Excess earnings are assumed to last a limited number of years, discounted over a shorter period.
Total earnings Approach
- Value of the company as a whole is determined, based on expected earnings rather than just excess earnings.
- Deduct fair value of identifiable net assets from the value of the company as a whole to get Goodwill.
Other Valuation Methods
- Number of Years Method – Multiply excess earnings by number of years that the excess earnings are expected to continue.
- Provides a rough estimate of goodwill and is simple (no time value of money).
- Average Yearly Earnings Method – Acquire a company for n times its average yearly earnings – therefore other similar companies are worth n times their own average yearly earnings.
- Discounted Free Cash Flow –Project the company’s free cash flow over a long period, typically 10 or 20 years.
- Project the important financial variables (e.g. production, prices, non-cash expenses, taxes, capital outlays) into the future to determine the amount of operating cash flow generated beyond the amount needed to maintain capacity.
- Calculate present value of free cash flow.
- Amount represents value of the business.