Chapter 12: Intangible Assets

Intangible assets: lack physical substance, are subject to a high degree of uncertainty concerning future benefits.

Examples: patents, copyrights, franchises, goodwill, organization costs, trademarks.

The same accounting issues relating to plant assets also apply to intangibles. However, by their nature intangibles are often more difficult to identify, value, and estimate a useful life.

Intangibles can be categorized according to:

- whether they are separately identifiable (examples included patents, trademarks, etc), or inseparable from the firm's other assets (goodwill).

- whether they are externally purchased, or developed internally.

Accounting for costs related to intangible is governed by APB 17 and FAS 2. In general:

- all costs related to external purchases of intangibles are capitalized and amortized as expense over the periods benefitted.

- the maximum amortization period is 40 years.

- the straight-line method must be used unless some other method can be shown to be more appropriate.

- costs related to intangibles that are internally developed are expensed as incurred. Exceptions (which are capitalized) are: external legal fees for successfully defending rights to patents, etc., organizational costs, and R&D expenditures for long-lived assets that have alternative future uses (these assets are capitalized and depreciated, with the depreciation allocated to R&D).

Specifically Identifiable Intangible Assets

1. Patents.

A patent is the exclusive right to use, manufacture and sell a product or process. Patents are granted by the U.S. Patent Office for a period of 17 years.

R&D costs incurred to develop products or processes that become patented must be expensed as incurred. Thus, companies only capitalize patents purchased from other companies. The amount capitalized includes the purchase price, attorney fees, and any legal costs involved in defending the patent. (These last fees are capitalized to patents even if the product was internally developed.)

Capitalized costs are amortized over the patent's legal life or useful life, whichever is shorter.

Example: At the beginning of 1994, Kurt Company purchased a patent on a product for $800,000. The remaining legal life of the patent is 14 years. The estimated useful life of the patent, however, is 10 years. In January 1995, Kurt incurs legal fees of $50,000 in connection with a successful defense of a patent infringement suit. At the beginning of 1996, Kurt withdraws the product from the market because of a potential health hazard.

Journal entries:

1994 Patent 800,000 Cash 800,000

To record the purchase of the patent.

Amortization expense 80,000 Patent 80,000

To record amortization of the patent for 1994 (800,000/10).

1995 Patent 50,000 Cash 50,000

To capitalize legal fees involved in defending the patent.

Amortization expense 85,555 Patent 85,555

To record amortization of the patent for 1995 (800,000 - 80,000 + 50,000)/9)).

1996 Loss related to product withdraw 684,445 Patent 684,445

(800,000 + 50,000 - 80,000 - 85,555 = 684,445)

2. Copyrights.

A copyright is a grant by the federal government giving the owner the right to reproduce and sell artistic or literary work. Copyrights are granted for the life of the creator plus 50 years.

The costs of the copyright, such as acquisition and legal costs of defending ownership, are capitalized and amortized over a useful life not exceeding 40 years.

3. Trademarks and tradenames.

These are words, symbols or other devices that identify particular products. The right to exclusive use of a trademark exists as long as it is continually used by the originator.

Companies can register their trademarks with the U.S. Patent Office for a period of 20 years, and can continuously renew the registration for additional 20 year increments as long as the trademark is continuously used.

Although the maximum allowable amortization period is 40 years, most trademarks are amortized over a much shorter period due to the uncertainty of future benefits.

4. Organization Costs.

These are costs incurred in the process of organizing the company. Examples are legal fees, accounting fees, state fees and taxes, underwriting fees and promotional costs.

Most companies amortize organization costs over a short period. (For tax purposes, the minimum period is 5 years and a 5 year life is often chosen for financial reporting purposes too.)

Example: Cheon Company was organized in 1994 and began operations on January 1, 1995. Cheon is engaged in conducting market research studies on behalf of manufacturers. Before the start of operations, the following costs were incurred:

Attorneys' fees in connection with the organization of Cheon...........$16,000 Improvements to leased offices prior to occupancy.............................28,000 Meetings of incorporators, state filing fees, and other organization expenses....................................................................22,000 $66,000

The entry to record organization costs is:

Organization costs 38,000 Cash 38,000

Note: the leasehold improvements are capitalized separately to "leasehold improvements" and depreciated over the lease term, or the life of the improvements, whichever is shorter. Leasehold improvements are usually shown in the property, plant and equipment section of the balance sheet.

The entry to record amortization of organization costs for 1995, assuming a 5 year life:

Amortization expense - organization costs 7,600 Organization costs 7,600

5. Franchises.

A franchise is an agreement whereby one party (the franchisor) provides to another party (the franchisee) the exclusive right to market a product or service within a designated area.

Examples include utilities, fast food restaurants and professional sports teams.

The original franchise fee is recorded as an intangible asset and amortized over an estimated useful life not to exceed 40 years. Any periodic payments required under the franchise agreement are expensed as incurred.

Goodwill

Goodwill consists of the favorable characteristics of a business enterprise that cannot be separately identified and valued.

Examples: superior management team; effective advertising; good labor relations; strategic location; favorable image in the community.

We only record goodwill as an asset when we can identify part of a company's acquisition cost with goodwill.

Thus, recording goodwill requires a market transaction. Only by acquiring another entity may a company record goodwill.

Goodwill = the purchase price of the company - the fair value of its net assets.

Example: Abbott Brothers acquired the Benedictine Sisters for $1,000,000 cash. The book value of Benedictine's net assets (assets - liabilities) is $600,000, comprised of assets with a book value of $1,100,000 less liabilities with a book value of $500,000. However, the fair value of Benedictine's assets is $1,300,000. Fair value and book value are the same for Benedictine's liabilities.

Abbot Brothers will record goodwill of $200,000 as a result of the acquisition:

Cash purchase price $1,000,000 Fair value of net assets: Assets $1,300,000 Liabilities (500,000) (800,000)

Goodwill $ 200,000

Note: the book value of the assets has no relevance in the calculation of goodwill.

Benedictine's accounts (at fair value) consist of:

Cash $200,000 Receivables 400,000 Property, plant and equipment (net) 700,000 Liabilities (500,000)

The entry by Abbott to record the acquisition of Benedictine is:

Cash 200,000 Receivables 400,000 Property, plant and equipment (net) 700,000 Goodwill 200,000 Liabilities 500,000 Cash 1,000,000

The goodwill account is amortized over an estimated useful life not to exceed 40 years. The straight-line method is used.

The entry to record annual amortization of goodwill for Benedictine, assuming a 40 year life:

Amortization of goodwill 5,000 Goodwill 5,000

Amortization of goodwill is shown as an operating expense on the income statement. However, it is not a deductible expense for tax purposes. Notice that a contra-asset account (accumulated amortization) is not used; instead, goodwill is credited directly.

What if the purchase price of the business is less than the fair market value of its net assets?

This is an unusual case; the owners of the business would have been better off selling the assets individually.

The excess of fair value over purchase price is used to reduce proportionately the fair values of the noncurrent assets. If these are reduced to zero, then a deferred credit "badwill" is created. Badwill is amortized to revenue over a period not to exceed 40 years.

Research and Development Costs

FASB Statement 2 requires that all research and development costs must be expensed as incurred.

Reason: there is often considerable uncertainty concerning the profitability of individual R&D projects.

The FASB's definition of R&D includes activities related to pre-production efforts, and excludes activities related to existing and ongoing production and products.

The amount of R&D costs charged to expense must be disclosed for each period that an income statement is prepared. This is useful information for assessing the company's future cash flows.

Example: Jolson Corporation incurred the following costs in connection with the indicated activities during 1995:

a. Searching for applications of new research findings..............................$120,000
b. Consulting fees paid to outsiders in connection with R&D activities........30,000
c. Quality control during commercial production..........................................16,000
d. Design changes to existing products..........................................................80,000
e. Laboratory research aimed at discovering new knowledge.......................70,000
f. Adaptation of existing capability to meet a customer's need.....................13,000
g. Engineering activity required to advance the design of a product to the manufacturing stage...................................................................30,000
h. Design of tools involving new technology................................................25,000

What amount should Jolson expense as R&D for 1995?

Answer: Items a, b, e, g and h are included as R&D activities. (Items c, d and f are not.)