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Chapter 8, Part II: Intangible Assets

CharacteristicsRecognition, Valuation

Purchased / Internally-created intangibles

Patents, copyrights, trademarksGoodwill

Research and development costs

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Characteristics of intangible assets

Intangible assetsdo not physically exist,are long-term in nature, andare non-monetary assets.

Common types of intangiblespatents, copyrights, trademarks or trade namesfranchises, licensesquality of managementknowledge of workforcecustomer loyalty

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(1) Intangible assets that relate to customers or market factors of the business:lists (advertising, customers, mailing etc.) strategic position of the businesscustomer relations brand names, image

(2) Intangible assets that have a fixed or definite life:rights (broadcasting, drilling, landing etc.) agreements (consulting, co-operation)permits (construction) covenants not to compete

(3) Intangible assets that relate to innovation within the businesssecret formulas and processes (e.g. "Coke/CocaCola recipe")computer software internet domains

(4) Intangible assets with statutorily established useful lives:patents franchisescopyrights licenses

(5) Intangible assets relating to employees:exceptional expertise ongoing training programhigh motivation strong labor relations

(6) Intangible assets relating to organizational structure of the business:favorable financial arrangements easy access to capital marketexceptional credit rating

(adapted from Kieso/Weygandt/Warfield, p.607)

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Recognition and ValuationRecognition debate

Asset definition (IASB Framework for the Preparation of FinSt §49a)1. expected to provide future benefits to the reporting entity2. owned or controlled by the reporting entity3. result of a past transaction or event

Recognition test1. see 1. above2. cost or value can be measured reliably

Examples where application of criteria is under debate:Coca-Cola spends millions of dollars, euros, pesos etc. on advertising every year to promote new and existing products.Hewlett-Packard possibly spends large sums training its customerservice personnel in copier maintenance.Pfizer spends billions on research to find new drugs.

Traditional opinion: no asset because future benefit as opposed to current effect cannot be assessed: expense as incurred!Alternative opinion: Imagine effect on future performance whenthese strategic investments would be abandoned!

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Is it identifiable?

no

Costs incurred to acquire/create intangible

assets

Was itinternallycreated?

yesnoIs it identifiable?

no

yes

definite life? nodefinite life?

yes

expense as incurred

capitalize as intangible asset /

amortize over asset‘suseful life

capitalize as goodwill orother intangible asset / annual impairment test

no yes yes

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Valuation of Purchased Intangibles

if acquired for cash or on creditrecord at cost

if acquired for stock or other assetsfair market valueof the compensation given orof the intangible received

whichever is more evident

Valuation of purchased intangibles similar to thatfor tangible assets.

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Valuation of Internally-Created Intangibles

accountingalternative

Expense as incurred

follow accounting approach for self-created tangible assets

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Patentsexclusive right granted by the government for a certain periodof time to make a particular product or use a specific process

patent protection usually for up to 20 yearsusually a yearly fee has to be paid to maintain patent protection

Expensing: amortize over useful lifeuseful life sometimes shorter than legal life impairment of asset

Self-invented products/processesresearch cost must be expensed as incurreddevelopment cost are• capitalized under certain restrictions [IAS] or• expensed as incurred [HGB]

to record purchase of a patent:

Patent 18.000 Cash 18.000

to record amortization expense:

Patent amortization expense 3.000 Patent 3.000

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Copyrights, Trademarks and Trade Names

Copyrightan exclusive right granted by the government to publish and sell literary, musical, or other artistic materials for a periodof the author‘s life plus fifty yearsnot renewablerecord at acquisition cost and amortize over useful life

Trademarks and Trade Namesregistered symbol or name that can be used only by itsowner to identify a product, service, or enterpriseindefinite number of renewals for periods of 20 yearsdebit trademark or brand name for the acquisition cost and amortize over a reasonable periodindefinite-life intangible under US-GAAP and IAS

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Goodwillsome intangible assets are not specifically identifiable

subsumed under „goodwill“only purchased goodwill is recorded

arises in mergers and acquisitionsidentifiable only with the business as a whole

Origin: price to be paid for a business has to compensate theseller for the future earnings given up

earnings value usually higher than book value of the equityNote: Not all intangible assets that are acquired are „goodwill“!

Goodwill = cost of identifiable net assets – fair value of identifiable netassets

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Goodwill – an example

The balance sheet of CityCable, an imaginary local cableprovider, looks as follows

CountyCable wants to acquire CityCable. The offer of € 120.000 goes to the owners of CityCable. How much goodwill is involved, if any?

Assets Equities

Cash 15.000 Current liabilities 80.000Receivables 8.000 Owners' capital 45.000Office equipment, net 35.000 Retained earnings 25.000Property 90.000Licenses 2.000

150.000 150.000

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Accounting for goodwill

The following alternative treatments are reasonable:1. writing-off goodwill against reserves

very conservativedoes an asset exist at all?arguments in favor of this view:• quite a number of M & As faced serious problems when

they tried to unite different corporate cultures• useful life is difficult to determine

2. amortize goodwill over its useful life3. retain goodwill infinitely but test for impairment and

charge it to expense, if necessary

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2. Amortize goodwill over its useful life

goodwill clearly has potential future benefitsvalue of goodwill, however, eventually disappearsarguments to support this view:

expected synergies do materialize (even if not to the full extent)matching cost and revenuescurrent earnings opportunities disappear; they have to be replacedby new ones in order to maintain earnings power

argument against this view:difficult determination of useful life

Note: Amortization of goodwill over its useful life – with therebuttable presumption of a limit of 20 (40) years – used to bethe standard under IAS (US-GAAP). Now both IFRS and US-GAAP prescribe an annual impairmenttest, i.e. goodwill is assumed to have an indefinite life.

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3. Retain goodwill indefinitely unlessreduction in value occurs

goodwill is not considered an asset subject to wearoutat least annual tests for impairmentarguments to support this view

some form of goodwill will always be an assetavoids (questionable) determination of useful life

arguments against this viewreduced usefulness of financial statements because of extraordinary write-offsaccounting manipulation

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The impairment model (under FASB Statement 142, Goodwill and other intangible assets)

Step 1 – the fair value of the reporting unit as a whole is compared to the book value of the reportingunit (including goodwill) and, if a deficiency exists, impairment would need to be calculated.

Fair value is an ambiguous term:• replacement cost (current cost)• market value (what could be recovered from disposing the

asset today)• discounted value of future cash flows from the asset

Step 2 – the impairment is measured as thedifference between the implied fair value of goodwilland its carrying amount

The implied fair value of goodwill is the difference betweenthe fair value of the reporting unit as a whole less the fair value of the reporting unit‘s individual assets and liabilities, including any unrecognized intangible assets.

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Discounted value of cash flows

Basis: a discount rate r (the cost of capital)the discount rate is an implied interest rate that makes cash flows of different due dates comparableone € today is worth € (1 + r) one year aheadr difficult to determine

Let ct be the sequence of cash flows expected fromthe asset; the asset‘s present value is then:

( )∑∞

= +=

1 1tt

t

rcPV

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CityCable Example cont‘d

... Fair value of CityCable Division now assumed to be€ 100.000Step 1

Step 2

Cash € 15.000Receivables 5.000Office equipment (net) 23.000Property 120.000Licenses 2.000Goodwill 35.000Less: Liabilities 80.000

Net assets 120.000

Fair value of reporting unitlower than book valueincluding goodwill:

€ 100.000 < € 120.000

Fair value of CityCable Division € 100.000Net identifiable assets (exluding goodwill) 85.000

Implied value of goodwill 15.000

Impairment becauseimplied value less thancarrying amount of goodwill.

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Where does all the equity come from to absorb such a loss?

consider two corporations, GIANT and DWARF. GIANT intends to acquire DWARF by issuingadditional shares.Situation before the acquisition:

GIANT has 200.000 shares, € 1 par value, outstanding. These shares were issued at par. GIANT also has bank debt of €800.000.

DWARF has 10.000 shares, € 10 par value, outstanding. These shares were issued at par. DWARF also has bank debt of €200.000.

GIANT

A = 1.000.000 L = 800.000OE = 200.000

DWARF

A = 300.000 L = 200.000OE = 100.000

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DWARF‘s research department seems to have found a drug that fosters rapid growth and that‘s why GIANT is eager to acquire DWARF. DWARF‘s stock price is up to € 40, whileGIANT‘s stock price is noted at € 8. The acquisiton price forDWARF is € 400.000 and to finance the acquisition GIANT issues 50.000 new shares, € 1 par value, at € 7 over par.

Assuming, for simplicity, that the book value of DWARF‘s assets is equal to their market value we note that GIANT acquires net assets of € 100.000 for a price of € 400.000, i.e. goodwill of € 300.000 is involved here (assuming that no otherintangible asset is identifiable).

"NEW" GIANT

A = 1.000.000 L = 800.000 300.000 200.000

300.000 OE = 200.000 50.000 350.000

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A year passes. Assume „NEW“ GIANT‘s revenues just wereequal to expenses from transactions with customers.An impairment test for DWARF Division of GIANT at year-endrevealed the following, assuming the book value of net assetsremained unchanged but the fair value of the division droppedto € 250.000

Fair value of DWARF Division: € 250.000Less assumed FV of individual net assets 100.000Implied fair value of goodwill 150.000

Book value of goodwill 300.000

Goodwill impairment 150.000

Goodwill impairment loss will be reported as a separate line on the income statement, and „NEW“ GIANT reports goodwilltotaling € 150.000 on the balance sheet.The corresponding reduction on the equities side goes to additional paid-in capital (share premium) no cash effects

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Research and Development Costs

R&D creates intangible assets patents, copyrights

Research is defined as activities aimed at the discovery of new knowledge.Development is the translation of research findings into a plan or design for a new product or process, or for a significant improvement to an existing product or process.

Accounting treatmentresearch and development costs are expensed as incurred (HGB)research costs are expensed as incurred; development cost must be capitalized (IAS)

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Notes on R&D accountingresearch and development is an ongoing task for businesses

if effort levels over time are comparable, difference betweencapitalizing and charging to expense is not substantial for theincome statementmost research projects fail

research costs do not represent future benefitsFASB cites studies that 30-90% of all new products fail and thatthree-fourths of new product expenses got unsuccessful products

development costs often do not represent future benefitseitherhard to trace specific costs to specific profitable projectsdifficulty to separate research from development activities

gives companies a de-facto choice under IAS differences between IAS and US-GAAP not as material as they

seem at first sight