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NTANGI CHAPTER 12 I B LE ASSETS LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 5 6 7 8 9 10 Describe the characteristics of intangible assets. Identify the costs to include in the initial valuation of intangible assets. Explain the procedure for amortizing intangible assets. Describe the types of intangible assets. Explain the conceptual issues related to goodwill. Describe the accounting procedures for recording goodwill. Explain the accounting issues related to intangible-asset impairments. Identify the conceptual issues related to research and development costs. Describe the accounting for research and development and similar costs. Indicate the presentation of intangible assets and related items. Measuring the Intangible Since 2000, the intangibility indexthe ratio of research and development (R&D) to capital spending (multiplied by 100) has risen for nine of the ten biggest companies that report R&D. For example, in the following table, Procter & Gamble shows a 41% increase in its intangibility index. Intangibility Index Company Exxonmobil GE Microsoft Procter & Gamble Pfizer Johnson & Johnson Altria Chevrontexaco Intel IBM All 10 Overall R&D Spending Capital Spending 2000 5.1 73.6 429.1 62.9 211.0 183.8 32.0 2.2 58.4 95.6 56.8 2005/2006 4.4 100.7 761.6 89.0 295.4 239.2 42.3 2.9 88.4 129.9 79.1 Change 2000Latest 42.1% 2.1 588 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark However, as shown in the following graph, the metrics used by the government to track the economy do not adequately capture investments in intangibles. That is, the gap between the official government economic measures, based on capital expenditures and the same measures adjusted for intangible investments, has been increasing in recent decades. The Growing Importance of Intangibles 26% 24% 22% 20% Official data 18% 0% 5059 Gap Investment including intangibles* 6069 7079 8089 9099 '00'09 *Includes research, product development, brand equity, employee training, and organizational change. As a result, a panel of economists and business leaders recently proposed changing how economic inputs and outputs are measured. If adopted, these new measures will put more emphasis on R&D, product innovation, and other intangibles that increasingly drive growth in the 21st-century economy. The proposal supports the old axiom, You manage what you measure, and has the potential to influence government policies to support economic growth. While the specific innovation measures are still in the development stage, accounting information on R&D and intangible assets will be an important input into these innovation metrics. Source: Adapted from M. Mandel, A Better Way to Track the Economy, BusinessWeek (January 28, 2008), p. 29; and M. Mandel, S. Hamm, and C. Farrell, Why the Economy Is a Lot Stronger Than You Think, BusinessWeek Online (February 13, 2006), cover story. PREVIEW OF CHAPTER 12 As our opening story indicates, the accounting and reporting of intangible assets is taking on increasing importance in this information age, especially for companies like Microsoft Corp., Pfizer Inc., and IBM. In this chapter we explain the basic conceptual and reporting issues related to intangible assets. The content and organization of the chapter are as follows. I N TA N G I B L E A S S E T S I N TA N G I B L E ASSET ISSUES Characteristics Valuation Amortization TYPES OF I N TA N G I B L E S Marketing-related Customer-related Artistic-related Contract-related Technology-related Goodwill I M PA I R M E N T O F I N TA N G I B L E S Limited-life intangibles Indefinite-life intangibles other than goodwill Goodwill Summary RESEARCH AND DEVELOPMENT COSTS Identifying R&D Accounting for R&D Similar costs Conceptual questions P R E S E N TAT I O N O F I N TA N G I B L E S A N D R E L AT E D I T E M S Intangible assets R&D costs 589 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 590 Chapter 12 Intangible Assets INTANGIBLE ASSET ISSUES Characteristics Objective1 Describe the characteristics of intangible assets. See the FASB Codification section (page 617). Gap Inc.s most important asset is its brand image, not its store fixtures. The CocaCola Companys success comes from its secret formula for making Coca-Cola, not its plant facilities. America Onlines subscriber base, not its Internet connection equipment, provides its most important asset. The U.S. economy is dominated by information and service providers. For these companies, their major assets are often intangible in nature. What exactly are intangible assets? Intangible assets have two main characteristics. [1] 1. They lack physical existence. Tangible assets such as property, plant, and equipment have physical form. Intangible assets, in contrast, derive their value from the rights and privileges granted to the company using them. 2. They are not financial instruments. Assets such as bank deposits, accounts receivable, and long-term investments in bonds and stocks also lack physical substance. However, financial instruments derive their value from the right (claim) to receive cash or cash equivalents in the future. Financial instruments are not classified as intangibles. In most cases, intangible assets provide benefits over a period of years. Therefore, companies normally classify them as long-term assets. Following a discussion of the general valuation and accounting provisions for intangible assets, we present a more extensive discussion of the types of intangible assets and their accounting. Valuation Purchased Intangibles Objective2 Identify the costs to include in the initial valuation of intangible assets. Companies record at cost intangibles purchased from another party. Cost includes all acquisition costs plus expenditures to make the intangible asset ready for its intended use. Typical costs include purchase price, legal fees, and other incidental expenses. Sometimes companies acquire intangibles in exchange for stock or other assets. In such cases, 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. What if a company buys several intangibles, or a combination of intangibles and tangibles? In such a basket purchase, the company should allocate the cost on the basis of fair values. Essentially, the accounting treatment for purchased intangibles closely parallels that for purchased tangible assets.1 Internally Created Intangibles Sometimes a company may incur substantial research and development costs to create an intangible. For example, Google expensed the R&D costs incurred to develop its valuable search engine. Costs incurred internally to create intangibles are generally expensed. How do companies justify this approach? Some argue that the costs incurred internally to create intangibles bear no relationship to their real value. Therefore, they reason, expensing these costs is appropriate. Others note that it is difficult to associate internal costs with a specific intangible. Still others contend that due to the underlying subjectivity related to intangibles, companies should follow a conservative approach that is, expense as incurred. As a result, companies capitalize only direct costs incurred in developing the intangible, such as legal costs, and expense the rest. The accounting in this section relates to the acquisition of a single asset or group of assets. The accounting for intangible assets acquired in a business combination (transaction in which the purchaser obtains control of one or more businesses) is discussed later in this chapter. 1 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Intangible Asset Issues 591 Amortization of Intangibles The allocation of the cost of intangible assets in a systematic way is called amortization. Intangibles have either a limited (finite) useful life or an indefinite useful life. For example, a company like Walt Disney has both types of intangibles. Walt Disney amortizes its limited-life intangible assets (e.g., copyrights on its movies and licenses related to its branded products). It does not amortize indefinite-life intangible assets (e.g., the Disney trade name or its Internet domain name). Objective3 Explain the procedure for amortizing intangible assets. Limited-Life Intangibles Companies amortize their limited-life intangibles by systematic charges to expense over their useful life. The useful life should reflect the periods over which these assets will contribute to cash flows. Walt Disney, for example, considers these factors in determining useful life: 1. The expected use of the asset by the company. 2. The expected useful life of another asset or a group of assets to which the useful life of the intangible asset may relate (such as lease rights to a studio lot). 3. Any legal, regulatory, or contractual provisions that may limit the useful life. 4. Any provisions (legal, regulatory, or contractual) that enable renewal or extension of the assets legal or contractual life without substantial cost. This factor assumes that there is evidence to support renewal or extension. Disney also must be able to accomplish renewal or extension without material modifications of the existing terms and conditions. 5. The effects of obsolescence, demand, competition, and other economic factors. Examples include the stability of the industry, known technological advances, legislative action that results in an uncertain or changing regulatory environment, and expected changes in distribution channels. 6. The level of maintenance expenditure required to obtain the expected future cash flows from the asset. For example, a material level of required maintenance in relation to the carrying amount of the asset may suggest a very limited useful life. [2] The amount of amortization expense for a limited-life intangible asset should reflect the pattern in which the company consumes or uses up the asset, if the company can reliably determine that pattern. For example, assume that Second Wave, Inc. purchases a license to provide a specified quantity of a gene product, called Mega. Second Wave should amortize the cost of the license following the pattern of use of Mega. If Second Waves license calls for it to provide 30 percent of the total the first year, 20 percent the second year, and 10 percent per year until the license expires, it would amortize the license cost using that pattern. If it cannot determine the pattern of production or consumption, Second Wave should use the straight-line method of amortization. (For homework problems, assume the use of the straight-line method unless stated otherwise.) When Second Wave amortizes these licenses, it should show the charges as expenses. It should credit either the appropriate asset accounts or separate accumulated amortization accounts. The amount of an intangible asset to be amortized should be its cost less residual value. The residual value is assumed to be zero unless at the end of its useful life the intangible asset has value to another company. For example, if Hardy Co. commits to purchasing an intangible asset from U2D Co. at the end of the assets useful life, U2D Co. should reduce the cost of its intangible asset by the residual value. Similarly, U2D Co. should consider fair values, if reliably determined, for residual values. What happens if the life of a limited-life intangible asset changes? In that case the remaining carrying amount should be amortized over the revised remaining useful life. Companies should, on a regular basis, evaluate the limited-life intangibles for impairment. Similar to the accounting for property, plant, and equipment, an impairment loss should be recognized if the carrying amount of the intangible is not recoverable and its carrying amount exceeds its fair value. (We will cover impairment of intangibles in more detail later in the chapter.) PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 592 Chapter 12 Intangible Assets Indefinite-Life Intangibles If no factors (legal, regulatory, contractual, competitive, or other) limit the useful life of an intangible asset, a company considers its useful life indefinite. An indefinite life means that there is no foreseeable limit on the period of time over which the intangible asset is expected to provide cash flows. A company does not amortize an intangible asset with an indefinite life. To illustrate, assume that Double Clik Inc. acquired a trademark that it uses to distinguish a leading consumer product. It renews the trademark every 10 years. All evidence indicates that this trademark product will generate cash flows for an indefinite period of time. In this case, the trademark has an indefinite life; Double Clik does not record any amortization. Companies should test indefinite-life intangibles for impairment at least annually. As we will discuss in more detail later in the chapter, the impairment test for indefinite-life intangibles differs from the one for limited-life intangibles. Only the fair value test is performed for indefinite-life intangibles; there is no recoverability test for these intangibles. The reason: Indefinite-life intangible assets might never fail the undiscounted cash flows recoverability test because cash flows could extend indefinitely into the future. Illustration 12-1 summarizes the accounting treatment for intangible assets. Manner Acquired Type of Intangible Limited-life intangibles Indefinite-life intangibles Purchased Capitalize Internally Created Expense* Amortization Over useful life Impairment Test Recoverability test and then fair value test Fair value test only I NTERNATIONAL I NSIGHT iGAAP requires capitalization of some development costs. ILLUSTRATION 12-1 Accounting Treatment for Intangibles Capitalize Expense* Do not amortize *Except for direct costs, such as legal costs. DEFINITELY INDEFINITE The importance of intangible asset classification as either limited-life or indefinite-life is illustrated in the experience of Outdoor Channel Holdings. Heres what happened: In 2004, Outdoor Channel recorded an intangible asset related to the value of an important distributor relationship, purchased from another company. At that time, it classified the relationship as indefinite-life. Thus, in 2004 and 2005 Outdoor Channel recorded no amortization expense on this asset. In 2006 investors were surprised to find that Outdoor Channel changed the classification of the distributor relationship to limited-life, with an expected life of 21.33 years (a fairly definite useful life) and, shortly after, wrote off this intangible completely. Apparently, the company was overly optimistic about the expected future cash flows arising from the distributor relationship. As a result of that optimism, 2005 income was overstated by $9.5 million, or 14 percent, and the impairment recorded in 2006 amounted to 7 percent of 2005 year-end assets. From indefinite-life to limited-life to worthless in two short yearsinvestors were surely hurt by Outdoors aggressive intangible asset classification. Source: Jack Ciesielski, The AAO Weblog, www.accountingobserver.com/blog/ (January 12, 2007). What do the numbers mean? TYPES OF INTANGIBLE ASSETS Objective4 Describe the types of intangible assets. As indicated, the accounting for intangible assets depends on whether the intangible has a limited or an indefinite life. There are many different types of intangibles, often classified into the following six major categories. [3] 1. Marketing-related intangible assets. 2. Customer-related intangible assets. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Types of Intangible Assets 593 3. 4. 5. 6. Artistic-related intangible assets. Contract-related intangible assets. Technology-related intangible assets. Goodwill. Marketing-Related Intangible Assets Companies primarily use marketing-related intangible assets in the marketing or promotion of products or services. Examples are trademarks or trade names, newspaper mastheads, 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. Trade names like Kleenex, Pepsi-Cola, Buick, Excedrin, Wheaties, and Sunkist create immediate product identification in our minds, thereby enhancing marketability. Under common law, the right to use a trademark or trade name, whether 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 periods of 10 years each. Therefore a company that uses an established trademark or trade name may properly consider it to have an indefinite life and do not amortize its cost. If a company buys a trademark or trade name, it capitalizes the cost at the purchase price. If a company develops a trademark or trade name, it capitalizes costs related to securing it, such as attorney fees, registration fees, design costs, consulting fees, and successful legal defense costs. However, it excludes research and development costs. When the total cost of a trademark or trade name is insignificant, a company simply expenses it. The value of a marketing-related intangible can be substantial. Consider Internet domain names. The name Drugs.com at one time sold for $800,000. The bidding for the name Loans.com approached $500,000. Company names themselves identify qualities and characteristics that companies work hard and spend much to develop. In a recent year an estimated 1,230 companies took on new names in an attempt to forge new identities and paid over $250 million to corporate-identity consultants. Among these were Primerica (formerly American Can), Navistar (formerly International Harvester), and Nissan (formerly Datsun).2 Or consider the use of the iPhone trade name. Cisco Systems sued Apple for using the iPhone trade name when Apple introduced its hot new phone in 2007. Not so fast, said Cisco, which had held the iPhone trade name since 2000 and was using it on its own voice-over-Internet products. The two companies came to an agreement for joint use of the name. It was not disclosed what Apple paid for this arrangement, but it is not surprising why Apple would want to settleto avoid a costly delay to the launch of its highly anticipated iPhone.3 Customer-Related Intangible Assets Customer-related intangible assets result from interactions with outside parties. Examples include customer lists, order or production backlogs, and both contractual and noncontractual customer relationships. To illustrate, assume that Green Market Inc. acquires the customer list of a large newspaper for $6,000,000 on January 1, 2010. This customer database includes name, contact information, order history, and demographic information. Green Market expects to 2 To illustrate how various intangibles arise from a given product, consider how the creators of the highly successful game Trivial Pursuit protected their creation. First, they copyrighted the 6,000 questions that are at the heart of the game. Then they shielded the Trivial Pursuit name by applying for a registered trademark. As a third mode of protection, they obtained a design patent on the playing boards design as a unique graphic creation. Nick Wingfield, Apple, Cisco Reach Accord Over iPhone, Wall Street Journal Online (February 22, 2007). 3 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 594 Chapter 12 Intangible Assets benefit from the information evenly over a three-year period. In this case, the customer list is a limited-life intangible that Green Market should amortize on a straight-line basis. Green Market records the purchase of the customer list and the amortization of the customer list at the end of each year as follows. January 1, 2010 Customer List Cash (To record purchase of customer list) December 31, 2010, 2011, 2012 Customer List Amortization Expense Customer List (or Accumulated Customer List Amortization) (To record amortization expense) 2,000,000 2,000,000 6,000,000 6,000,000 The preceding example assumed no residual value for the customer list. But what if Green Market determines that it can sell the list for $60,000 to another company at the end of three years? In that case, Green Market should subtract this residual value from the cost in order to determine the amortization expense for each year. Amortization expense would be $1,980,000, as shown in Illustration 12-2. ILLUSTRATION 12-2 Calculation of Amortization Expense with Residual Value Cost Residual value Amortization base Amortization expense per period: $1,980,000 ($5,940,000 3) $6,000,000 60,000 $5,940,000 Companies should assume a zero residual value unless the assets useful life is less than the economic life and reliable evidence is available concerning the residual value. [4] Artistic-Related Intangible Assets Artistic-related intangible assets involve ownership rights to plays, literary works, musical works, pictures, photographs, and video and audiovisual material. Copyrights protect these ownership rights. 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. It gives the owner or heirs the exclusive right to reproduce and sell an artistic or published work. Copyrights are not renewable. Copyrights can be valuable. In the late 1990s, Walt Disney Company faced the loss of its copyright on Mickey Mouse, which could have affected sales of billions of dollars of Mickey-related goods and services (including theme parks). This copyright was so important that Disney and many other big entertainment companies fought all the way to the Supreme Courtand won an extension of copyright lives from 50 to 70 years. As another example, Really Useful Group owns copyrights on the musicals of Andrew Lloyd WebberCats, Phantom of the Opera, Jesus Christ-Superstar, and others. The company has little in the way of tangible assets, yet analysts value it at over $300 million. Companies capitalize the costs of acquiring and defending a copyright. They amortize any capitalized costs over the useful life of the copyright if less than its legal life (life of the creator plus 70 years). For example, Really Useful Group should allocate the costs of its copyrights to the years in which it expects to receive the benefits. The difficulty of determining the number of years over which it will receive benefits typically encourages a company like Really Useful Group to write off these costs over a fairly short period of time. Companies must expense the research and development costs that lead to a copyright as those costs are incurred. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Types of Intangible Assets 595 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. A franchise is a contractual 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. We deal with franchises everyday: A Toyota dealer, a McDonalds restaurant, a Century 21 real estate broker, and a Marriott resort are all examples of franchises. The franchisor, having developed a unique concept or product, protects its concept or product through a patent, copyright, or trademark or trade name. The franchisee acquires the right to exploit the franchisors idea or product by signing a franchise agreement. In another type of franchise arrangement, a municipality (or other governmental body) allows a privately owned company to use public property in performing its services. Examples are the use of public waterways for a ferry service, use of public land for telephone or electric lines, use of phone lines for cable TV, use of city streets for a bus line, or use of the airwaves for radio or TV broadcasting. Such operating rights, obtained through agreements with governmental units or agencies, are frequently referred to as licenses or permits. Franchises and licenses may be for a definite period of time, for an indefinite period of time, or perpetual. The company securing the franchise or license carries an intangible asset account (entitled Franchise or License) on its books, only when it can identify costs with the acquisition of the operating right. (Such costs might be legal fees or an advance lump-sum payment, for example.) A company should amortize the cost of a franchise (or license) with a limited life as operating expense over the life of the franchise. It should not amortize a franchise with an indefinite life nor a perpetual franchise; the company should instead carry such franchises at cost. Annual payments made under a franchise agreement should be entered as operating expenses in the period in which they are incurred. These payments do not represent an asset since they do not relate to future rights to use the property. Technology-Related Intangible Assets Technology-related intangible assets relate to innovations or technological advances. Examples are patented technology and trade secrets granted by the U.S. Patent and Trademark Office. A patent gives the holder exclusive right to use, manufacture, and sell a product or process for a period of 20 years without interference or infringement by others. Companies such as Merck, Polaroid, and Xerox were founded on patents and built on the exclusive rights thus granted.4 The two principal kinds of patents are product patents, which cover actual physical products, and process patents, which govern the process of making products. If a company like Qualcomm purchases a patent from an inventor, the purchase price represents its cost. Qualcomm can capitalize other costs incurred in connection with securing a patent, as well as attorneys fees and other unrecovered costs of a successful legal suit to protect the patent, as part of the patent cost. However, it must expense as incurred any research and development costs related to the development of the product, process, or idea that it subsequently patents. (We discuss accounting for research and development costs in more detail on pages 605606.) 4 Consider the opposite result: Sir Alexander Fleming, who discovered penicillin, decided not to use a patent to protect his discovery. He hoped that companies would produce it more quickly to help save sufferers. Companies, however, refused to develop it because they did not have the patent shield and, therefore, were afraid to make the investment. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 596 Chapter 12 Intangible Assets Companies should amortize the cost of a patent over its legal life or its useful life (the period in which benefits are received), whichever is shorter. If Qualcomm owns a patent from the date it is granted, and expects the patent to be useful during its entire legal life, the company should amortize it over 20 years. If it appears that the patent will be useful for a shorter period of time, say, for five years, it should amortize its cost over five years. Changing demand, new inventions superseding old ones, inadequacy, and other factors often limit the useful life of a patent to less than the legal life. For example, the useful life of pharmaceutical patents is frequently less than the legal life because of the testing and approval period that follows their issuance. A typical drug patent has several years knocked off its 20-year legal life. Why? Because a drug-maker spends one to four years on animal tests, four to six years on human tests, and two to three years for the Food and Drug Administration to review the tests. All this time occurs after issuing the patent but before the product goes on pharmacists shelves. PATENT BATTLES From bioengineering to software design to Wall Street, global competition is bringing to the boiling point battles over patents. For example, to protect its patented one-click shopping technology that saves your shipping and credit card information when you shop online, Amazon.com filed a complaint against Barnesandnoble.com, its rival in the Web-retailing wars. Amazon alleged infringement on its patent for one-click shopping. Similar patent skirmishes have sprung up on Wall Street. For example, eSpeed settled a dispute with several of the stock exchanges concerning the use of its patented computerized process for matching bids and offers on securities. Also, the Reuters Group sued Bloomberg over use of its automated trading technology. Although these companies have settled their disputes, patent battles continue amid ongoing debate over whether process patents held by companies like Amazon.com, eSpeed, and Reuters create an unfair competitive advantage. Source: Adapted from L. Rohde, Amazon, Barnes and Noble Settle Patent Dispute, CNN.com (March 8, 2002); and J. Creswell, A Wall Street Rush to Patent Profit-Making Methods, New York Times, www.nytimes.com (August 11, 2006). What do the numbers mean? As mentioned earlier, companies capitalize the costs of defending copyrights. The accounting treatment for a patent defense is similar. A company charges all legal fees and other costs incurred in successfully defending a patent suit to Patents, an asset account. Such costs should be amortized along with acquisition cost over the remaining useful life of the patent. Amortization expense should reflect the pattern, if reliably determined, in which a company uses up the patent.5 A company may credit amortization of patents directly to the Patents account or to an Accumulated Patent Amortization account. To illustrate, assume that Harcott Co. incurs $180,000 in legal costs on January 1, 2010, to successfully defend a patent. The patents useful life is 20 years, amortized on a straight-line basis. Harcott records the legal fees and the amortization at the end of 2010 as follows. January 1, 2010 Patents Cash (To record legal fees related to patent) December 31, 2010 Patent Amortization Expense Patents (or Accumulated Patent Amortization) (To record amortization of patent) 5 180,000 180,000 9,000 9,000 Companies may compute amortization on a units-of-production basis in a manner similar to that described for depreciation on property, plant, and equipment. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Types of Intangible Assets 597 Weve indicated that a patents useful life should not extend beyond its legal life of 20 years. However, companies often make small modifications or additions that lead to a new patent. For example, Astra Zeneca Plc filed for additional patents on minor modifications to its heartburn drug, Prilosec. The effect may be to extend the life of the old patent. If the new patent provides essentially the same benefits, Astra Zeneca can apply the unamortized costs of the old patent to the new patent.6 Alternatively, if a patent becomes impaired because demand drops for the product, the asset should be written down or written off immediately to expense. THE VALUE OF A SECRET FORMULA After several espionage cases were uncovered, the secrets contained within the Los Alamos nuclear lab seemed easier to check out than a library book. But The Coca-Cola Company has managed to keep the recipe for the worlds best-selling soft drink under wraps for more than 100 years. The company offers almost no information about its lifeblood, and the only written copy of the formula resides in a bank vault in Atlanta. This handwritten sheet is available to no one except by vote of Coca-Colas board of directors. Cant science offer some clues? Coke purportedly contains 17 to 18 ingredients. That includes the usual caramel color and corn syrup, as well as a blend of oils known as 7X (rumored to be a mix of orange, lemon, cinnamon, and others). Distilling natural products like these is complicated, since they are made of thousands of compounds. One ingredient you will not find, by the way, is cocaine. Although the original formula did contain trace amounts, todays Coke doesnt. When was it removed? That too is a secret. Some experts indicate that the power of the Coca-Cola formula and related brand image account for almost $63 billion, or roughly 12 percent, of Cokes $538 billion stock value. Source: Adapted from Reed Tucker, How Has Cokes Formula Stayed a Secret? Fortune (July 24, 2000), p. 42; and David Kiley, Best Global Brands, BusinessWeek (August 6, 2007), p. 59. What do the numbers mean? Goodwill Although companies may capitalize certain costs incurred in developing specifiObjective5 cally identifiable assets such as patents and copyrights, the amounts capitalized Explain the conceptual issues are generally insignificant. But companies do record material amounts of intangirelated to goodwill. ble assets when purchasing intangible assets, particularly in situations involving a business combination (the purchase of another business). To illustrate, assume that Portofino Company decides to purchase Aquinas Company. In this situation, Portofino measures the assets acquired and the liabilities assumed at fair value. In measuring these assets and liabilities, Portofino must identify all the assets and liabilities of Aquinas. As a result, Portofino may recognize some assets or liabilities not previously recognized by Aquinas. For example, Portofino may recognize intangible assets such as a brand name, patent, or customer list that were not recorded by Aquinas. In this case, Aquinas may not have recognized these assets because they were developed internally and charged to expense.7 6 Another classic example is Eli Lillys drug Prozac (prescribed to treat depression). In 1998 this product accounted for 43 percent of Eli Lillys sales. The patent on Prozac expired in 2001, and the company was unable to extend its protection with a second-use patent for the use of Prozac to treat appetite disorders. Sales of the product slipped substantially as generic equivalents entered the market. GAAP [5] provides detailed guidance regarding the recognition of identifiable intangible assets in a business combination. With this guidance, the FASB expected that companies would recognize more identifiable intangible assets, and less goodwill, in the financial statements as a result of business combinations. 7 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 598 Chapter 12 Intangible Assets In many business combinations, the purchasing company records goodwill. Goodwill is measured as the excess of the cost of the purchase over the fair value of the identifiable net assets (assets less liabilities) purchased. For example, if Portofino paid $2,000,000 to purchase Aquinass identifiable net assets (with a fair value of $1,500,000), Portofino records goodwill of $500,000. Goodwill is therefore measured as a residual rather than measured directly. That is why goodwill is sometimes referred to as a plug, a gap filler, or a master valuation account. Conceptually, goodwill represents the future economic benefits arising from the other assets acquired in a business combination that are not individually identified and separately recognized. It is often called the most intangible of the intangible assets, because it is identified only with the business as a whole. The only way to sell goodwill is to sell the business. Recording Goodwill Objective6 Describe the accounting procedures for recording goodwill. Internally Created Goodwill. Goodwill generated internally should not be capitalized in the accounts. The reason? Measuring the components of goodwill is simply too complex, and associating any costs with future benefits is too difficult. The future benefits of goodwill may have no relationship to the costs incurred in the development of that goodwill. To add to the mystery, goodwill may even exist in the absence of specific costs to develop it. Finally, because no objective transaction with outside parties takes place, a great deal of subjectivityeven misrepresentation may occur. Purchased Goodwill. As indicated earlier, goodwill is recorded only when an entire business is purchased. To record goodwill, a company compares the fair value of the net tangible and identifiable intangible assets with the purchase price of the acquired business. The difference is considered goodwill. Goodwill is the residualthe excess of cost over fair value of the identifiable net assets acquired. To illustrate, Multi-Diversified, Inc. decides that it needs a parts division to supplement its existing tractor distributorship. The president of Multi-Diversified is interested in buying Tractorling Company, a small concern in Chicago. Illustration 12-3 presents the balance sheet of Tractorling Company. Underlying Concepts Capitalizing goodwill only when it is purchased in an arms-length transaction, and not capitalizing any goodwill generated internally, is another example of reliability winning out over relevance. ILLUSTRATION 12-3 Tractorling Co. Balance Sheet Assets TRACTORLING CO. BALANCE SHEET AS OF DECEMBER 31, 2010 Equities $ 25,000 35,000 42,000 153,000 $255,000 Current liabilities Capital stock Retained earnings Total equities $ 55,000 100,000 100,000 $255,000 Cash Receivables Inventories Property, plant, and equipment, net Total assets co llege/k i es o Expanded Discussion Valuing Goodwill After considerable negotiation, Tractorling Company decides to accept MultiDiversifieds offer of $400,000. What, then, is the value of the goodwill, if any? The answer is not obvious. Tractorlings historical cost-based balance sheet does not disclose the fair values of its identifiable assets. Suppose, though, that as the negotiations progress, Multi-Diversified investigates Tractorlings underlying assets to determine their fair values. Such an investigation may be accomplished either through a purchase audit undertaken by Multi-Diversified or by an independent appraisal w PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile y. c o m / Types of Intangible Assets 599 from some other source. The investigation determines the valuations shown in Illustration 12-4. Fair Values Cash Receivables Inventories Property, plant, and equipment, net Patents Liabilities Fair value of net assets $ 25,000 35,000 122,000 205,000 18,000 (55,000) $350,000 ILLUSTRATION 12-4 Fair Value of Tractorlings Net Assets Normally, differences between current fair value and book value are more common among long-term assets than among current assets. Cash obviously poses no problems as to value. Receivables normally are fairly close to current valuation, although they may at times need certain adjustments due to inadequate bad debt provisions. Liabilities usually are stated at book value. However, if interest rates have changed since the company incurred the liabilities, a different valuation (such as present value based on expected cash flows) is appropriate. Careful analysis must be made to determine that no unrecorded liabilities are present. The $80,000 difference in Tractorlings inventories ($122,000 $42,000) could result from a number of factors. The most likely is that the company uses LIFO. Recall that during periods of inflation, LIFO better matches expenses against revenues. However, it also creates a balance sheet distortion. Ending inventory consists of older layers costed at lower valuations. In many cases, the values of long-term assets such as property, plant, and equipment, and intangibles may have increased substantially over the years. This difference could be due to inaccurate estimates of useful lives, continual expensing of small expenditures (say, less than $300), inaccurate estimates of salvage values, and the discovery of some unrecorded assets. (For example, in Tractorlings case, analysis determines Patents have a fair value of $18,000.) Or, fair values may have substantially increased. Since the investigation now determines the fair value of net assets to be $350,000, why would Multi-Diversified pay $400,000? Undoubtedly, Tractorling points to its established reputation, good credit rating, top management team, well-trained employees, and so on. These factors make the value of the business greater than $350,000. Multi-Diversified places a premium on the future earning power of these attributes as well as on the basic asset structure of the company today. Multi-Diversified labels the difference between the purchase price of $400,000 and the fair value of $350,000 as goodwill. Goodwill is viewed as one or a group of unidentifiable values (intangible assets), the cost of which is measured by the difference between the cost of the group of assets or enterprise acquired and the sum of the assigned costs of individual tangible and identifiable intangible assets acquired less liabilities assumed.8 This procedure for valuation is called a master valuation approach. It assumes goodwill covers all the values that cannot be specifically identified with any identifiable tangible or intangible asset. Illustration 12-5 (on the next page) shows this approach. 8 The FASB expressed concern about measuring goodwill as a residual, but noted that there is no real measurement alternative since goodwill is not separable from the company as a whole. [6] PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 600 Chapter 12 Intangible Assets ILLUSTRATION 12-5 Determination of GoodwillMaster Valuation Approach Assigned to purchase price of $400,000 Cash Receivables Inventories Property, plant, and equipment, net Patents Liabilities Fair maket value of net identifiable assets Purchase price Value assigned to goodwill $ 25,000 35,000 122,000 205,000 18,000 (55,000) $350,000 400,000 $ 50,000 Multi-Diversified records this transaction as follows. Cash Receivables Inventories Property, Plant, and Equipment Patents Goodwill Liabilities Cash 25,000 35,000 122,000 205,000 18,000 50,000 55,000 400,000 Companies often identify goodwill on the balance sheet as the excess of cost over the fair value of the net assets acquired. Goodwill Write-off Companies that recognize goodwill in a business combination consider it to have an indefinite life and therefore should not amortize it. Although goodwill may decrease in value over time, predicting the actual life of goodwill and an appropriate pattern of amortization is extremely difficult. In addition, investors find the amortization charge of little use in evaluating financial performance. Furthermore, the investment community wants to know the amount invested in goodwill, which often is the largest intangible asset on a companys balance sheet. Therefore, companies adjust its carrying value only when goodwill is impaired. This approach significantly impacts the income statements of some companies. Some believe that goodwills value eventually disappears. Therefore, they argue, companies should charge goodwill to expense over the periods affected, to better match expense with revenues. Others note that the accounting treatment for purchased goodwill and goodwill created internally should be consistent. They point out that companies immediately expense goodwill created internally and should follow the same treatment for purchased goodwill. Though these arguments may have some merit, nonamortization of goodwill combined with an adequate impairment test should provide the most useful financial information to the investment community. We discuss the accounting for goodwill impairments later in the chapter. Bargain Purchase In a few cases, the purchaser in a business combination pays less than the fair value of the identifiable net assets. Such a situation is referred to as a bargain purchase. A bargain purchase results from a market imperfection: That is, the seller would have been better off to sell the assets individually than in total. However, situations do occur (e.g., a forced liquidation or distressed sale due to the death of a company founder) in which the purchase price is less than the value of the net identifiable assets. This excess amount is recorded as a gain by the purchaser. The FASB notes that an economic gain is inherent in a bargain purchase. The purchaser is better off by the amount by which the fair value of what is acquired exceeds the amount paid. Some expressed concern that some companies may attempt inappropriate gain recognition by making an intentional error in measurement of the assets or PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Impairment of Intangible Assets 601 liabilities. As a result, the FASB requires companies to disclose the nature of this gain transaction. Such disclosure will help users to better evaluate the quality of the earnings reported.9 IMPAIRMENT OF INTANGIBLE ASSETS In some cases, the carrying amount of a long-lived asset (property, plant, and equipment or intangible assets) is not recoverable. Therefore, a company needs a write-off. As discussed in Chapter 11, this write-off is referred to as an impairment. Objective7 Explain the accounting issues related to intangible-asset impairments. Impairment of Limited-Life Intangibles The rules that apply to impairments of property, plant, and equipment also apply to limited-life intangibles. As discussed in Chapter 11, a company should review property, plant, and equipment for impairment at certain pointswhenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. In performing this recoverability test, the company estimates the future cash flows expected from use of the assets and its eventual disposal. If the sum of the expected future net cash flows (undiscounted) is less than the carrying amount of the asset, the company would measure and recognize an impairment loss. [8] The company then uses the fair value test. This test measures the impairment loss by comparing the assets fair value with its carrying amount. The impairment loss is the carrying amount of the asset less the fair value of the impaired asset. As with other impairments, the loss on the limited-life intangible is reported as part of income from continuing operations. The entry generally appears in the Other expenses and losses section. To illustrate, assume that Lerch, Inc. has a patent on how to extract oil from shale rock. Unfortunately, several recent non-shale oil discoveries adversely affected the demand for shale-oil technology. Thus, the patent has provided little income to date. As a result, Lerch performs a recoverability test. It finds that the expected net future cash flows from this patent are $35 million. Lerchs patent has a carrying amount of $60 million. Because the expected future net cash flows of $35 million are less than the carrying amount of $60 million, Lerch must determine an impairment loss. Discounting the expected net future cash flows at its market rate of interest, Lerch determines the fair value of its patent to be $20 million. Illustration 12-6 shows the impairment loss computation (based on fair value). Carrying amount of patent Fair value (based on present value computation) Loss on impairment $60,000,000 20,000,000 $40,000,000 ILLUSTRATION 12-6 Computation of Loss on Impairment of Patent Lerch records this loss as follows: Loss on Impairment Patents 40,000,000 40,000,000 After recognizing the impairment, the reduced carrying amount of the patents is its new cost basis. Lerch should amortize the patents new cost over its remaining useful life or legal life, whichever is shorter. Even if shale-oil prices increase in subsequent periods and the value of the patent increases, Lerch may not recognize restoration of the previously recognized impairment loss. 9 Underlying Concepts The basic attributes of intangibles, their uncertainty as to future benefits, and their uniqueness have discouraged valuation in excess of cost. A recent standard dropped the requirement that this gain be reported as an extraordinary item. [7] This change is consistent with convergence in international accounting standards. Note that IASB standards do not permit extraordinary item reporting. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 602 Chapter 12 Intangible Assets Impairment of Indefinite-Life Intangibles Other Than Goodwill Companies should test indefinite-life intangibles other than goodwill for impairment at least annually. The impairment test for an indefinite-life asset other than goodwill is a fair value test. This test compares the fair value of the intangible asset with the assets carrying amount. If the fair value is less than the carrying amount, the company recognizes an impairment. Companies use this one-step test because many indefinitelife assets easily meet the recoverability test (because cash flows may extend many years into the future). Thus, companies do not use the recoverability test. To illustrate, assume that Arcon Radio purchased a broadcast license for $2,000,000. The license is renewable every 10 years if the company provides appropriate service and does not violate Federal Communications Commission (FCC) rules. Arcon Radio has renewed the license with the FCC twice, at a minimal cost. Because it expects cash flows to last indefinitely, Arcon reports the license as an indefinite-life intangible asset. Recently the FCC decided to auction these licenses to the highest bidder instead of renewing them. Arcon Radio expects cash flows for the remaining two years of its existing license. It performs an impairment test and determines that the fair value of the intangible asset is $1,500,000. Arcon therefore reports an impairment loss of $500,000, computed as follows. ILLUSTRATION 12-7 Computation of Loss on Impairment of Broadcast License Carrying amount of broadcast license Fair value of broadcast license Loss on impairment $2,000,000 1,500,000 $ 500,000 Arcon Radio now reports the license at $1,500,000, its fair value. Even if the value of the license increases in the remaining two years, Arcon may not restore the previously recognized impairment loss. Impairment of Goodwill The impairment rule for goodwill is a two-step process. First, a company compares the fair value of the reporting unit to its carrying amount, including goodwill. If the fair value of the reporting unit exceeds the carrying amount, goodwill is not impaired. The company does not have to do anything else. To illustrate, assume that Kohlbuy Corporation has three divisions. It purchased one division, Pritt Products, four years ago for $2 million. Unfortunately, Pritt experienced operating losses over the last three quarters. Kohlbuy management is now reviewing the division for purposes of recognizing an impairment. Illustration 12-8 lists the Pritt Divisions net assets, including the associated goodwill of $900,000 from the purchase. ILLUSTRATION 12-8 Net Assets of Pritt Division, Including Goodwill Cash Receivables Inventory Property, plant, and equipment (net) Goodwill Less: Accounts and notes payable Net assets $ 200,000 300,000 700,000 800,000 900,000 (500,000) $2,400,000 Kohlbuy determines that the fair value of Pritt Division is $2,800,000. Because the fair value of the division exceeds the carrying amount of the net assets, Kohlbuy does not recognize any impairment. However, if the fair value of Pritt Division were less than the carrying amount of the net assets, then Kohlbuy would perform a second step to determine possible PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Impairment of Intangible Assets 603 impairment. In the second step, Kohlbuy determines the fair value of the goodwill (implied value of goodwill) and compares it to its carrying amount. To illustrate, assume that the fair value of the Pritt Division is $1,900,000 instead of $2,800,000. Illustration 12-9 computes the implied value of the goodwill in this case.10 Fair value of Pritt Division Net identifiable assets (excluding goodwill) ($2,400,000 Implied value of goodwill $1,900,000 1,500,000 $ 400,000 $900,000) ILLUSTRATION 12-9 Determination of Implied Value of Goodwill Kohlbuy then compares the implied value of the goodwill to the recorded goodwill to measure the impairment, as shown in Illustration 12-10. Carrying amount of goodwill Implied value of goodwill Loss on impairment $900,000 400,000 $500,000 ILLUSTRATION 12-10 Measurement of Goodwill Impairment Impairment Summary Illustration 12-11 summarizes the impairment tests for various intangible assets. Type of Intangible Asset Limited life Indefinite life other than goodwill Goodwill Impairment Test Recoverability test, then fair value test Fair value test Fair value test on reporting unit, then fair value test on implied goodwill ILLUSTRATION 12-11 Summary of Intangible Asset Impairment Tests WHAT? ME IMPAIRED? Goodwill impairment issues have grabbed their share of business headlines. For example, HewlettPackard (H-P) received a fair amount of criticism for its failure to take impairment charges on goodwill arising from its merger with Compaq. H-Ps chief financial officer acknowledged the issue, but played down its significance: Theres no question that if profitability doesnt improve, there will be an impairment charge. Another example is Lee Enterprises Inc., owner of several major newspapers. Upon its acquisition of Pulitzer Inc. for $1.46 billion, Lee recorded additional goodwill; at the end of fiscal year 2007, it showed $1.6 billion of goodwill and other intangible assets. With things not going well in the newspaper business, some are waiting for the other shoe to drop. The intangibles make up nearly 75 percent of Lees total assets and Lees book value (assets minus liabilities) and are about twice the companys current market value. Although no impairment had been recorded, the market seems to expect one is coming. Lees CFO indicates they will continue to evaluate these assets, and H-Ps CFO makes the case that a goodwill impairment is no big deal. What do you think? Is an impairment charge just a bookkeeping entry, or can it provide some new information about the merits of H-Ps merger with Compaq or Lees acquisition of Pulitzer? Source: Carol J. Loomis, Why Carlys Big Bet Is Failing, Fortune (February 7, 2005), p. 50; and J. Weil, Pulitzers Owner Takes Prize of Frothy Numbers, www.bloomberg.com (January 9, 2008). What do the numbers mean? 10 Illustration 12-9 assumes that the carrying amount equals the fair value of net identifiable assets (excluding goodwill). If different, companies use the fair value of the net identifiable assets (excluding goodwill) to determine the implied goodwill. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 604 Chapter 12 Intangible Assets RESEARCH AND DEVELOPMENT COSTS Objective8 Identify the conceptual issues related to research and development costs. Research and development (R&D) costs are not in themselves intangible assets. However, we present the accounting for R&D costs here because R&D activities frequently result in the development of patents or copyrights (such as a new product, process, idea, formula, composition, or literary work) that may provide future value. As indicated in the opening story, many companies spend considerable sums on research and development. Illustration 12-12 shows the outlays for R&D made by selected U.S. companies. ILLUSTRATION 12-12 R&D Outlays, as a Percentage of Sales and Profits Company Caterpillar Deere Dell General Mills Hewlett-Packard Johnson & Johnson Kellogg Merck Procter & Gamble R&D Expense ($ million) $1,347.0 816.8 498.0 191.0 3,611.0 7,125.0 190.6 4,782.9 2,112.0 R&D/Sales 3.24% 3.39 0.87 1.54 3.46 13.36 1.75 21.13 2.76 R&D/Net Income 38.08% 44.84 19.28 16.70 49.71 64.46 18.98 107.87 20.43 I NTERNATIONAL I NSIGHT International accounting standards require the capitalization of appropriate development expenditures. This conflicts with U.S. GAAP. Two difficulties arise in accounting for R&D expenditures: (1) identifying the costs associated with particular activities, projects, or achievements, and (2) determining the magnitude of the future benefits and length of time over which such benefits may be realized. Because of these latter uncertainties, the FASB has simplified the accounting practice in this area. Companies must expense all research and development costs when incurred. [9] Identifying R&D Activities Illustration 12-13 shows the definitions for research activities and development activities. These definitions differentiate research and development costs from other similar costs. [10] ILLUSTRATION 12-13 Research Activities versus Development Activities Research Activities Idea Development Activities Prototy pe Planned search or critical investigation aimed at discovery of new knowledge. 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. Examples Conceptual formulation and design of possible product or process alternatives; construction of prototypes and operation of pilot plants. Examples Laboratory research aimed at discovery of new knowledge; searching for applications of new research findings. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Research and Development Costs 605 R&D activities do not include routine or periodic alterations to existing products, production lines, manufacturing processes, and other ongoing operations, even though these alterations may represent improvements. For example, routine ongoing efforts to refine, enrich, or improve the qualities of an existing product are not considered R&D activities. Accounting for R&D Activities The costs associated with R&D activities and the accounting treatments accorded them are as follows. Objective9 Describe the accounting for research and development and similar costs. 1. Materials, Equipment, and Facilities. Expense the entire costs, unless the items have alternative future uses (in other R&D projects or otherwise). If there are alternative future uses, carry the items as inventory and allocate as consumed, or capitalize and depreciate as used. 2. Personnel. Expense as incurred salaries, wages, and other related costs of personnel engaged in R&D. 3. Purchased Intangibles. Recognize and measure at fair value. After initial recognition, account for in accordance with their nature (as either limited-life or indefinitelife intangibles).11 4. Contract Services. Expense the costs of services performed by others in connection with the R&D as incurred. 5. Indirect Costs. Include a reasonable allocation of indirect costs in R&D costs, except for general and administrative cost, which must be clearly related in order to be included in R&D. [12] Consistent with item 1 above, if a company owns a research facility that conducts R&D activities and that has alternative future uses (in other R&D projects or otherwise), it should capitalize the facility as an operational asset. The company accounts for depreciation and other costs related to such research facilities as R&D expenses.12 To illustrate, assume that Next Century Incorporated develops, produces, and markets laser machines for medical, industrial, and defense uses.13 Illustration 12-14 (on the next page) lists the types of expenditures related to its laser-machine activities, along with the recommended accounting treatment. 11 If R&Drelated intangibles (often referred to as in-process R&D) are also acquired in a business combination, they are also recognized and measured at fair value. After initial recognition, these intangible assets are accounted for in accordance with their nature (as either limited-life or indefinite-life intangibles.) [11] 12 Companies in the extractive industries can use the following accounting treatment for the unique costs of research, exploration, and development activities and for those costs that are similar to but not classified as R&D costs: (1) expense as incurred, (2) capitalize and either depreciate or amortize over an appropriate period of time, or (3) accumulate as part of inventoriable costs. Choice of the appropriate accounting treatment for such costs is based on the degree of certainty of future benefits and the principle of matching revenues and expenses. 13 Sometimes companies conduct R&D activities for other companies under a contractual arrangement. In this case, the contract usually specifies that the company performing the R&D work be reimbursed for all direct costs and certain specific indirect costs, plus a profit element. Because reimbursement is expected, the company doing the R&D work records the R&D costs as a receivable. The company for whom the work has been performed reports these costs as R&D and expenses them as incurred. For a more complete discussion of how an enterprise should account for funding of its R&D by others, see [13]. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 606 Chapter 12 Intangible Assets ILLUSTRATION 12-14 Sample R&D Expenditures and Their Accounting Treatment Next Century Incorporated Type of Expenditure 1. Construction of long-range research facility for use in current and future projects (three-story, 400,000-square-foot building). 2. Acquisition of R&D equipment for use on current project only. 3. Acquisition of machinery for use on current and future R&D projects. 4. Purchase of materials for use on current and future R&D projects. 5. Salaries of research staff designing new laser bone scanner. 6. Research costs incurred under contract with New Horizon, Inc., and billable monthly. 7. Material, labor, and overhead costs of prototype laser scanner. 8. Costs of testing prototype and design modifications. 9. Legal fees to obtain patent on new laser scanner. 10. Executive salaries. 11. Cost of marketing research to promote new laser scanner. 12. Engineering costs incurred to advance the laser scanner to full production stage. 13. Costs of successfully defending patent on laser scanner. 14. Commissions to sales staff marketing new laser scanner. Accounting Treatment Capitalize and depreciate as R&D expense. Expense immediately as R&D. Capitalize and depreciate as R&D expense. Inventory and allocate to R&D projects; expense as consumed. Expense immediately as R&D. Record as a receivable (reimbursable expenses). Expense immediately as R&D. Expense immediately as R&D. Capitalize as patent and amortize to overhead as part of cost of goods manufactured. Expense as operating expense (general and administrative). Expense as operating expense (selling). Expense immediately as R&D. Capitalize as patent and amortize to overhead as part of cost of goods manufactured. Expense as operating expense (selling). Costs Similar to R&D Costs Many costs have characteristics similar to research and development costs. Examples are: 1. 2. 3. 4. Start-up costs for a new operation. Initial operating losses. Advertising costs. Computer software costs. For the most part, these costs are expensed as incurred, similar to the accounting for R&D costs. We briefly explain these costs in the following sections. Start-Up Costs Start-up costs are incurred for one-time activities to start a new operation. Examples include opening a new plant, introducing a new product or service, or conducting business in a new territory. Start-up costs include organizational costs, such as legal and state fees incurred to organize a new business entity. The accounting for start-up costs is straightforward: Expense start-up costs as incurred. The profession recognizes that companies incur start-up costs with the expectation of future revenues or increased efficiencies. However, to determine the amount and timing of future benefits is so difficult that a conservative approachexpensing these costs as incurredis required. [14] PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Research and Development Costs 607 To illustrate examples of start-up costs, assume that U.S.-based Hilo Beverage Company decides to construct a new plant in Brazil. This represents Hilos first entry into the Brazilian market. Hilo plans to introduce the companys major U.S. brands into Brazil, on a locally produced basis. The following costs might be involved: 1. Travel-related costs; costs related to employee salaries; and costs related to feasibility studies, accounting, tax, and government affairs. 2. Training of local employees related to product, maintenance, computer systems, finance, and operations. 3. Recruiting, organizing, and training related to establishing a distribution network. Hilo Beverage should expense all these start-up costs as incurred. Start-up activities commonly occur at the same time as activities involving the acquisition of assets. For example, as it is incurring start-up costs for the new plant, Hilo probably is also buying or building property, plant, equipment, and inventory. Hilo should not immediately expense the costs of these tangible assets. Instead, it should report them on the balance sheet using appropriate GAAP reporting guidelines. Initial Operating Losses Some contend that companies should be allowed to capitalize initial operating losses incurred in the start-up of a business. They argue that such operating losses are an unavoidable cost of starting a business. For example, assume that Hilo lost money in its first year of operations and wishes to capitalize this loss. Hilos CEO argues that as the company becomes profitable, it will offset these losses in future periods. What do you think? We believe that this approach is unsound, since losses have no future service potential and therefore cannot be considered an asset. GAAP requires that operating losses during the early years should not be capitalized. In short, the accounting and reporting standards should be no different for an enterprise trying to establish a new business than they are for other enterprises. [15]14 Advertising Costs Over the years, PepsiCo has hired various pop stars, such as Justin Timberlake and Beyonc, to advertise its products. How should it report such advertising costs related to its star spokespeople? Pepsi could expense the costs in various ways: 1. 2. 3. 4. 5. When they have completed their singing assignments. The first time the advertising runs. Over the estimated useful life of the advertising. In an appropriate fashion to each of the three periods identified above. Over the period revenues are expected to result. For the most part, Pepsi must expense advertising costs as incurred or the first time the advertising takes place. Whichever of these two approaches is followed, the results are essentially the same. On the other hand, companies record as assets any tangible assets used in advertising, such as billboards or blimps. The rationale is that such assets do have alternative future uses. Again the profession has taken a conservative 14 A company is considered to be in the developing stages when it is directing its efforts toward establishing a new business and either the company has not started the principal operations or it has earned no significant revenue. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 608 Chapter 12 Intangible Assets BRANDED For many companies, developing a strong brand image is as important as developing the products they sell. Now more than ever, companies see the power of a strong brand, enhanced by significant and effective advertising investments. As the following chart indicates, the value of brand investments is substantial. Coca-Cola heads the list with an estimated brand value of about $65 billion. The Worlds 10 Most Valuable Brands (in billions) 1 2 3 4 5 Coca-Cola Microsoft IBM GE Nokia $65.3 58.7 57.0 51.6 33.7 6 7 8 9 10 Toyota Intel McDonalds Disney Mercedes-Benz $32.0 31.0 29.4 29.2 23.6 What do the numbers mean? Source: 2007 data, from Interbrand Corp., J. P. Morgan Chase, Citigroup, and Morgan Stanley. Occasionally you may find the value of a brand included in a companys financial statements under goodwill. But generally you will not find the estimated values of brands recorded in companies balance sheets. The reason? The subjectivity that goes into estimating a brands value. In some cases, analysts base an estimate of brand value on opinion polls or on some multiple of ad spending. For example, in estimating the brand values shown above, Interbrand Corp. estimates the percentage of the overall future revenues the brand will generate and then discounts the net cash flows, to arrive at a present value. Some analysts believe that information on brand values is relevant. Others voice valid concerns about the reliability of brand value estimates due to subjectivity in the estimates for revenues, costs, and the risk component of the discount rate. Source: Adapted from David Kiley, Best Global Brands, BusinessWeek (August 6, 2007), p. 59. approach to recording advertising costs because defining and measuring the future benefits can be so difficult. [16]15 Computer Software Costs A special problem arises in distinguishing R&D costs from selling and administrative activities. The FASBs intent was that companies exclude from the definition of R&D activities the acquisition, development, or improvement of a product or process for use in their selling or administrative activities. For example, the costs of software incurred by an airline in improving its computerized reservation system, or the costs incurred in developing a companys management information system are not research and development costs. Accounting for computer software costs is a specialized and complex accounting topic that we discuss and illustrate in Appendix 12A (pages 614617). Conceptual Questions The requirement that companies expense immediately all R&D costs (as well as startup costs) incurred internally is a conservative, practical solution. It ensures consistency in practice and uniformity among companies. But the practice of immediately writing off expenditures made in the expectation of benefiting future periods is conceptually incorrect. 15 There are some exceptions for immediate expensing of advertising costs when they relate to direct-response advertising, but that subject is beyond the scope of this book. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Presentation of Intangibles and Related Items 609 Proponents of immediate expensing contend that from an income statement standpoint, long-run application of this standard frequently makes little difference. They argue that because of the ongoing nature of most companies R&D activities, the amount of R&D cost charged to expense each accounting period is about the same, whether there is immediate expensing or capitalization and subsequent amortization. Others criticize this practice. They believe that the balance sheet should report an intangible asset related to expenditures that have future benefit. To preclude capitalization of all R&D expenditures removes from the balance sheet what may be a companys most valuable asset. This standard represents one of the many trade-offs made among relevance, reliability, and cost-benefit considerations.16 Underlying Concepts The requirement that companies expense all R&D costs as incurred is an example of the conflict between relevance and reliability. Here, this requirement leans strongly in support of reliability, as well as conservatism, consistency, and comparability. No attempt is made to match costs and revenues. PRESENTATION OF INTANGIBLES AND RELATED ITEMS Presentation of Intangible Assets Objective10 Indicate the presentation of intanThe reporting of intangible assets is similar to the reporting of property, plant, and gible assets and related items. equipment. However, contra accounts are not normally shown for intangibles on the balance sheet. As Illustration 12-15 (on page 610) shows, on the balance sheet companies should report as a separate item all intangible assets other than goodwill. If goodwill is present, companies should report it separately. The FASB concluded that since goodwill and other intangible assets differ significantly from other types of assets, such disclosure benefits users of the balance sheet. On the income statement, companies should present amortization expense and impairment losses for intangible assets other than goodwill separately and as part of continuing operations. Again, see Illustration 12-15. 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. The notes to the financial statements should include information about acquired intangible assets, including the aggregate amortization expense for each of the succeeding five years. If separate accumulated amortization accounts are not used, accumulated amortization should be disclosed in the notes. The notes should include information about changes in the carrying amount of goodwill during the period. Presentation of Research and Development Costs Companies should disclose in the financial statements (generally in the notes) the total R&D costs charged to expense each period for which they present an income statement. Merck & Co., Inc., a global research pharmaceutical company, reported both co llege/k i es o w Additional Disclosures of Intangibles and R&D Costs Research findings indicate that capitalizing R&D costs may be helpful to investors. For example, one study showed a significant relationship between R&D outlays and subsequent benefits in the form of increased productivity, earnings, and shareholder value for R&Dintensive companies. Baruch Lev and Theodore Sougiannis, The Capitalization, Amortization, and Value-Relevance of R&D, Journal of Accounting and Economics (February 1996). Another study found that there was a significant decline in earnings usefulness for companies that were forced to switch from capitalizing to expensing R&D costs, and that the decline appears to persist over time. Martha L. Loudder and Bruce K. Behn, Alternative Income Determination Rules and Earnings Usefulness: The Case of R&D Costs, Contemporary Accounting Research (Fall 1995). 16 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile y. c o m / 610 Chapter 12 Intangible Assets ILLUSTRATION 12-15 Intangible Asset Disclosures HARBAUGH COMPANY Balance Sheet (partial) (in thousands) Intangible assets (Note C) Goodwill (Note D) Income Statement (partial) (in thousands) as part of Continuing operations Amortization expense Impairment losses (goodwill) Notes to the Financial Statements Note C: Acquired Intangible Assets As of December 31, 2010 Gross Carrying Amount Amortized intangible assets Trademark Customer list Other Total Unamortized intangible assets Licenses Trademark Total Aggregate Amortization Expense For year ended 12/31/10 Estimated Amortization Expense For year ended 12/31/11 For year ended 12/31/12 For year ended 12/31/13 For year ended 12/31/14 For year ended 12/31/15 $2,000 500 60 $2,560 Accumulated Amortization $(100) (310) (10) $(420) $380 46 $3,840 2,575 $1,300 400 $1,700 $380 $200 90 70 60 50 Note D: Goodwill The changes in the carrying amount of goodwill for the year ended December 31, 2010, are as follows: Technology Segment $1,413 189 $1,602 Communications Segment $904 115 (46) $973 ($000s) Balance as of January 1, 2010 Goodwill acquired during year Impairment losses Balance as of December 31, 2010 Total $2,317 304 (46) $2,575 The Communications segment is tested for impairment in the third quarter, after the annual forecasting process. Due to an increase in competition in the Texas and Louisiana cable industry, operating profits and cash flows were lower than expected in the fourth quarter of 2009 and the first and second quarters of 2010. Based on that trend, the earnings forecast for the next 5 years was revised. In September 2010, a goodwill impairment loss of $46 was recognized in the Communications reporting unit. The fair value of that reporting unit was estimated using the expected present value of future cash flows. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Presentation of Intangibles and Related Items 611 internal and acquired research and development in its recent income statement, as shown in Illustration 12-16. Merck & Co., Inc. (in millions) Years Ended December 31 2006 Sales Costs, expenses, and other Materials and production Marketing and administrative Research and development Equity income from affiliates Other (income) expense, net $22,636.0 6,001.1 8,165.4 4,782.9 142.3 (2,294.4) (382.7) $16,414.6 2005 $22,011.9 5,149.6 7,155.5 3,848.0 322.2 (1,717.1) (110.2) $14,648.0 2004 $22,972.8 4,965.7 7,238.7 4,010.2 107.6 (1,008.2) (344.0) $14,970.0 ILLUSTRATION 12-16 Income Statement Disclosure of R&D Costs In addition, Merck provides a discussion about R&D expenditures in its annual report, as shown in Illustration 12-17. Merck & Co., Inc. Research and development in the pharmaceutical industry is inherently a long-term process. The following data show the trend of the Companys research and development spending. For the period 1996 to 2006, the compounded annual growth rate in research and development was 11%. ILLUSTRATION 12-17 Mercks R&D Disclosure R&D Expenditures $4,800 4,200 3,150 millions 2,100 1,050 0 96 97 98 99 00 01 02 03 04 05 06 You will want to read the CONVERGENCE CORNER on page 612 For discussion of how international convergence efforts relate to the accounting for intangible assets. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark CONVERGENCE CORNER INTANGIBLE ASSETS There are some significant differences between iGAAP and U.S. GAAP in the accounting for both intangible assets and impairments. iGAAP related to intangible assets is presented in IAS 38 (Intangible Assets). iGAAP related to impairments is found in IAS 36 (Impairment of Assets). R E L E VA N T FA C T S As in U.S. GAAP, under iGAAP the costs associated with research and development are segregated into the two components. Costs in the research phase are always expensed under both iGAAP and U.S. GAAP. Under iGAAP, however, costs in the development phase are capitalized once technological feasibility is achieved. ABOUT THE NUMBERS To illustrate the effect of differences in the accounting for brands, consider the following disclosure by GlaxoSmithKline plc in a recent annual report. Notes to the Financial Statements Intangible assets (in part): The following table sets out the iGAAP to U.S. GAAP adjustments required to the iGAAP income statement for amortisation of brands: Income Statement ( million) Amortisation charge under iGAAP Amortisation charge under US GAAP iGAAP to U.S. GAAP adjustment 139 1,454 1,315 iGAAP permits some capitalization of internally generated intangible assets (e.g., brand value), if it is probable there will be a future benefit and the amount can be reliably measured. U.S. GAAP requires expensing of all costs associated with internally generated intangibles. iGAAP requires an impairment test at each reporting date for long-lived assets and intangibles and records an impairment if the assets carrying amount exceeds Thus, GlaxoSmithKline would report lower-income by 1.3 billion if it its recoverable amount. The recoverable amount is the accounted for its brands under U.S. GAAP. higher of the assets fair value less costs to sell and its value in use. Value in use is the future cash flows to be derived from the particular assets, discounted to present value. Under U.S. GAAP, impairment loss is measured as the excess of the carrying amount over the assets fair value. iGAAP allows reversal of impairment losses when there has been a change in economic conditions or in the expected use of the asset. Under U.S. GAAP, impairment losses cannot be reversed for assets to be held and used; the impairment loss results in a new cost basis for the asset. iGAAP and U.S. GAAP are similar in the accounting for impairments of assets held for disposal. With issuance of a recent converged statement on business combinations (IFRS 3 and SFAS No. 141Revised ), iGAAP and U.S. GAAP are very similar for intangibles acquired in a business combination. That is, companies recognize an intangible asset separately from goodwill if the intangible represents contractual or legal rights or is capable of being separated or divided and sold, transferred, licensed, rented, or exchanged. In addition, under both U.S. GAAP and iGAAP, companies recognize acquired in-process research and development (IPR&D) as a separate intangible asset if it meets the definition of an intangible asset and its fair value can be measured reliably. ON TH E HORIZON The IASB and FASB have identified a project that would consider expanded recognition of internally generated intangible assets. As indicated, iGAAP permits more recognition of intangibles compared to U.S. GAAP. Thus, it will be challenging to develop converged standards for intangible assets, given the long-standing prohibition on capitalizing internally generated intangible assets and research and development in U.S. GAAP. Learn more about the timeline for the intangible asset project at the IASB website: http://www.iasb.org/current Projects/IASB Projects/ IASB Work Plan.htm. 612 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Summary of Learning Objectives 613 SUMMARY OF LEARNING OBJECTIVES 1 Describe the characteristics of intangible assets. Intangible assets have two main characteristics: (1) They lack physical existence, and (2) they are not financial instruments. In most cases, intangible assets provide services a over period of years and so are normally classified as long-term assets. 2 Identify the costs to include in the initial valuation of intangible assets. Intangibles are recorded at cost. Cost includes all acquisition costs and expenditures needed to make the intangible asset ready for its intended use. If 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. When a company makes a basket purchase of several intangibles or a combination of intangibles and tangibles, it should allocate the cost on the basis of fair values. 3 Explain the procedure for amortizing intangible assets. Intangibles have either a limited useful life or an indefinite useful life. Companies amortize limited-life intangibles. They do not amortize indefinite-life intangibles. Limited-life intangibles should be amortized by systematic charges to expense over their useful life. The useful life should reflect the period over which these assets will contribute to cash flows. The amount to report for amortization expense should reflect the pattern in which a company consumes or uses up the asset, if it can reliably determine that pattern. Otherwise, use a straight-line approach. 4 Describe the types of intangible assets. Major types of intangibles are: (1) marketingrelated intangibles, used in the marketing or promotion of products or services; (2) customerrelated intangibles, resulting from interactions with outside parties; (3) artistic-related intangibles, giving ownership rights to such items as plays and literary works; (4) contractrelated intangibles, representing the value of rights that arise from contractual arrangements; (5) technology-related intangibles, relating to innovations or technological advances; and (6) goodwill, arising from business combinations. 5 Explain the conceptual issues related to goodwill. Unlike receivables, inventories, and patents that a company can sell or exchange individually in the marketplace, goodwill can be identified only with the company as a whole. Goodwill is a going concern valuation and is recorded only when an entire business is purchased. A company should not capitalize goodwill generated internally. The future benefits of goodwill may have no relationship to the costs incurred in the development of that goodwill. Goodwill may exist even in the absence of specific costs to develop it. 6 Describe the accounting procedures for recording goodwill. To record goodwill, a company compares the fair value of the net tangible and identifiable intangible assets with the purchase price of the acquired business. The difference is considered goodwill. Goodwill is the residual. Goodwill is often identified on the balance sheet as the excess of cost over the fair value of the net assets acquired. 7 Explain the accounting issues related to intangible-asset impairments. Impairment occurs when the carrying amount of the intangible asset is not recoverable. Companies use a recoverability test and a fair value test to determine impairments for limited-life intangibles. They use only a fair value test for indefinite-life intangibles. Goodwill impairments require a two-step process: First, test the fair value of the reporting unit, then do the fair value test on implied goodwill. 8 Identify the conceptual issues related to research and development costs. R&D costs are not in themselves intangible assets, but R&D activities frequently result in the development of something a company patents or copyrights. The difficulties in accounting KEY TERMS amortization, 591 bargain purchase, 600 business combination, 590 copyright, 594 development activities, 604 fair value test, 601 franchise, 595 goodwill, 598 impairment, 601 indefinite-life intangibles, 591 intangible assets, 590 license (permit), 595 limited-life intangibles, 591 master valuation approach, 599 organizational costs, 606 patent, 595 recoverability test, 601 research activities, 604 research and development (R&D) costs, 604 start-up costs, 606 trademark, trade name, 593 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 614 Chapter 12 Intangible Assets for R&D expenditures are: (1) identifying the costs associated with particular activities, projects, or achievements, and (2) determining the magnitude of the future benefits and length of time over which a company may realize such benefits. Because of these latter uncertainties, companies are required to expense all research and development costs when incurred. 9 Describe the accounting for research and development and similar costs. Illustration 12-14 shows the costs associated with R&D activities and the accounting treatment accorded them. Many costs have characteristics similar to R&D costs. Examples are startup costs, initial operating losses, and advertising costs. For the most part, these costs are expensed as incurred, similar to the accounting for R&D costs. 10 Indicate the presentation of intangible assets and related items. On the balance sheet, companies should report all intangible assets other than goodwill as a separate item. Contra accounts are not normally shown. If goodwill is present, it too should be reported as a separate item. On the income statement, companies should report amortization expense and impairment losses in Continuing operations. The notes to the financial statements have additional detailed information. Financial statements must disclose the total R&D costs charged to expense each period for which an income statement is presented. APPENDIX 12A ACCOUNTING FOR COMPUTER SOFTWARE COSTS Our economy is changing from a focus on manufacturing processes (tangible outputs) to a focus on information flow (intangible outputs). As a result, the accounting for computer software products becomes increasingly important.17 This appendix discusses the basic issues involved in accounting for computer software. Objective11 Understand the accounting treatment for computer software costs. DIVERSITY IN PRACTICE Companies can either purchase computer software or create it. They may purchase or create software for external use (such as spreadsheet applications like Excel or Lotus 1-2-3) or for internal use (e.g., to establish a better internal accounting system). How should companies account for the costs of developing software? Should they expense such costs immediately, or capitalize and amortize them in the future? At one time, some companies expensed all software costs, and others capitalized such costs. Still others differentiated such costs on the basis of whether the software was purchased or created, or whether it was used for external or internal purposes. Another major question is whether the costs involved in developing software are research and development costs. If they are actually R&D costs, then companies should expense them as incurred. If they are not R&D costs, then a strong case can be made for capitalization. As one financial executive of a software company, who argues for capitalization, noted, The key distinction between our spending and R&D is recoverability. We know we are developing something we can sell. 17 A major contributing factor was IBMs decision in 1969 to unbundle its hardware and softwareto state the cost of the hardware and software separately. Previously, computer companies provided most application software free with the hardware. This unbundling led to the creation of a whole new industry, the software industry, whose members began selling software to hardware users. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Appendix: Accounting for Computer Software Costs 615 THE PROFESSIONS POSITION In an attempt to resolve the issue of how to account for software (at least for companies that sell computer software), the FASB issued the following rules. [17] 1. Until a company has established technological feasibility for a software product, it should charge to R&D expense the costs incurred in creating the product. 2. Technological feasibility is established when the company has completed a detailed program design or a working model. In short, the FASB has taken a conservative position in regard to computer software costs. For example, a company like Microsoft must expense all costs until it has completed the activities (planning, designing, coding, and testing) necessary to establish that it can produce the product to meet its design specifications. From that point on, Microsoft should capitalize subsequently incurred costs and amortize them to current and future periods. Two additional points: First, if Microsoft purchases software and it has alternative future uses, then it may be capitalized. Second, this standard applies only to the development of software that is to be sold, leased, or otherwise marketed to third parties (i.e., for external use). The profession has also indicated how to account for software to be used internally. Activities performed during the preliminary project stage of development (e.g., conceptual formulation and evaluation of alternatives) are similar to R&D costs. Companies should expense such costs immediately. Once the software is at the application development stage (e.g., at the coding or installation stages), its future economic benefits become probable. At that point, companies must capitalize the software costs. Finally, subsequent to the application development stage, costs related to training and application maintenance should be expensed as incurred. [18] ACCOUNTING FOR CAPITALIZED SOFTWARE COSTS If companies are to capitalize software costs, then they must establish a proper amortization pattern for such costs. As a basis for amortization, one of two amounts is used: (1) the ratio of current revenues to current and anticipated revenues (the percent-ofrevenue approach), or (2) the straight-line method over the remaining useful life of the asset (straight-line approach). A company must use whichever of these amounts is greater. This rule can result in the use of the percent-of-revenue method one year and the straight-line method in another.18 To illustrate, assume that AT&T has capitalized software costs of $10 million, and current (first-year) revenues from sales of this product of $4 million. AT&T anticipates earning $16 million in additional future revenues from this product; it estimates that the product has an economic life of four years. Under the two approaches, the calculations are as follows for the first years amortization: Percent-of-revenue approach: $4,000 $20,000,000 Straight-line approach: $10,000,000 4 years $2,500,000 $10,000,000 $2,000,000 Thus AT&T uses the straight-line approach because it results in the greater amortization charge. 18 Because there are no revenues associated with software developed for internal use, amortization of these internal use capitalized costs is based on the straight-line approach. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 616 Chapter 12 Intangible Assets REPORTING SOFTWARE COSTS How reliable is software as an asset? Because of this concern, the FASB indicated that companies should value capitalized software costs at the lower of unamortized cost (book value) or net realizable value. If net realizable value is lower, then companies should write down the capitalized software costs to this value. Once companies have written down the costs, they may not write them back up. In addition to the regular disclosures for R&D costs, companies should report in the financial statements the following information relating to software. 1. Unamortized software costs. 2. The total amount charged to expense and the amounts, if any, written down to net realizable value. Again, these accounting and reporting requirements apply only to software developed for external purposes. Illustration 12A-1 presents an example of software development cost disclosure, taken from the annual report of Analogic Corporation. ILLUSTRATION 12A-1 Disclosure of Software Development Costs Analogic Corporation (in thousands) 2007 Total current assets Property, plant, and equipment, net Investments in and advances to affiliated companies Capitalized software, net Intangible assets, net Other assets Total assets Significant accounting policies (in part): Note (f) Research and development and capitalized software development costs: Research and product development costs are expensed as incurred and include primarily engineering salaries, stock based compensation, overhead and materials used in connection with research and product development projects. Software development costs incurred subsequent to establishing technological feasibility through general release of the software products are capitalized in accordance with GAAP. Technological feasibility is demonstrated by the completion of a detailed program design. Capitalized costs are amortized on a straight-line basis over the economic lives of the related products, generally three years. Amortization expense was $739, $1,157 and $857 in fiscal years 2007, 2006 and 2005 respectively and is included in product cost of sales. The unamortized balance of capitalized software was $2,319 and $2,670 at July 31, 2007 and 2006 respectively. $365,442 80,482 35 2,319 413 10,450 $459,141 2006 $390,835 81,853 917 2,670 2,068 10,302 $488,645 SETTING STANDARDS FOR SOFTWARE ACCOUNTING Its unreasonable to expense all software costs, and its unreasonable to capitalize all software costs, said IBMs director of financial reporting. If you subscribe to those two statements, then it follows that there is somewhere in between where development ends and capitalization begins. Now you have to define that point.19 The FASB defined that point as technological feasibility, which is established upon completion of a detailed program design or a working model. The difficulty of applying this criterion to software is that there is no such thing as a real, specific, baseline design. But you could make it look like you have one as early or as late as you like, says Osman Eralp of Hambrecht & Quist.20 That is, if a 19 20 When Does Life Begin? Forbes (June 16, 1986), pp. 7274. Ibid. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark FASB Codification 617 company wishes to capitalize, it draws up a detailed program design quickly. If it wants to expense lots of development costs, it simply holds off writing a detailed program design. And, once capitalized, the costs are amortized over the useful life specified by the developer. Because of either constant redesign or supersession, softwares useful life is generally quite short (two to four years). As another example, some companies manage by the numbers. That is, they are very careful to identify projects that are worthwhile and capitalize the computer software costs associated with them. They believe that good projects must be capitalized and amortized in the future; otherwise, the concept of properly matching expense and revenues is abused. In contrast, other companies choose not to manage by the numbers. They simply expense all development costs. Companies that expense all these costs have no use for a standard that requires capitalization. In their view, it would mean only that they would need a more complex, more expensive cost accounting system, which would provide little if any benefit. Financial analysts have reacted almost uniformly against any capitalization of software costs. They believe such costs should be expensed because of the rapid obsolescence of software and the potential for abuse that may result from capitalizing costs inappropriately. As Donald Kirk, a former chairman of the FASB, stated, The Board is now faced with the problem of balancing what it thought was good theory with the costs for some companies of implementing a new accounting system with the concerns of users about the potential for abuse of the standard.21 The accounting for software development costs has been addressed in the authoritative literature. However, some of the issues debated may arise again, if accounting standard-setters propose expanded capitalization of development costs beyond those related to software. Such a debate is likely if the FASB converges to iGAAP, which permits expanded capitalization of development costs compared to U.S. GAAP. SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 12A 11 Understand the accounting treatment for computer software costs. Costs incurred in creating a software product should be charged to R&D expense when incurred until technological feasibility has been established for the product. Subsequent costs should be capitalized and amortized to current and future periods. Software that a company purchases for sale or lease to third parties and has alternative future uses may be capitalized and amortized using the greater of the percent-of-revenue approach or the straight-line approach. KEY TERMS technological feasibility, 615 FASB CODIFICATION FASB Codification References [1] FASB ASC 350-10-05. [Predecessor literature: Goodwill and Other Intangible Assets, Statement of Financial Accounting Standards No. 142 (Norwalk, Conn.: FASB, 2001).] [2] FASB ASC 350-30-35. [Predecessor literature: Goodwill and Other Intangible Assets, Statement of Financial Accounting Standards No. 142 (Norwalk, Conn.: FASB, 2001) par. 11.] [3] FASB ASC 805-10. [Predecessor literature: Business Combinations, Statement of Financial Accounting Standards No. 141R (Norwalk, Conn.: FASB, 2007).] [4] FASB ASC 350-30-35. [Predecessor literature: Goodwill and Other Intangible Assets, Statement of Financial Accounting Standards No. 142 (Norwalk, Conn.: FASB, 2001), par. B55.] 21 Donald J. Kirk, Growing Temptation & Rising Expectation FASB Viewpoints (June 12, 1985), p. 7. Accelerating Regulation, PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 618 Chapter 12 Intangible Assets [5] FASB ASC 805-10-20. [Predecessor literature: Business Combinations, Statement of Financial Accounting Standards No. 141R (Norwalk, Conn.: FASB, 2007).] [6] FASB ASC 805-10-30. [Predecessor literature: Business Combinations, Statement of Financial Accounting Standards No. 141R (Norwalk, Conn.: FASB, 2007).] [7] FASB ASC 805-10-30. [Predecessor literature: Business Combinations, Statement of Financial Accounting Standards No. 141R (Norwalk, Conn.: FASB, 2007).] [8] FASB ASC 360-10-05. [Predecessor literature: Accounting for the Impairment or Disposal of Long-lived Assets, Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: 2001).] [9] FASB ASC 735-10-25-1. [Predecessor literature: Accounting for Research and Development Costs, Statement of Financial Accounting Standards No. 2 (Stamford, Conn.: FASB, 1974), par. 12.] [10] FASB ASC Master Glossary. [Predecessor literature: Accounting for Research and Development Costs, Statement of Financial Accounting Standards No. 2 (Stamford, Conn.: FASB, 1974), par. 8.] [11] FASB ASC 805-10. [Predecessor literature: Business Combinations, Statement of Financial Accounting Standards No. 141Revised (Norwalk, Conn.: FASB, 2007), par. E11.] [12] FASB ASC 730-10-25-2. [Predecessor literature: Accounting for Research and Development Costs, Statement of Financial Accounting Standards No. 2 (Stamford, Conn.: FASB, 1974), par. 11.] [13] FASB ASC 730-20-05. [Predecessor literature: Research and Development Arrangements, Statement of Financial Accounting Standards No. 68 (Stamford, Conn.: FASB, 1982).] [14] FASB ASC 720-15-25. [Predecessor literature: Reporting on the Costs of Start-up Activities, Statement of Position 98-5 (New York: AICPA, 1998).] [15] FASB ASC 915-205-45-1. [Predecessor literature: Accounting and Reporting by Development Stage Enterprises, Statement of Financial Accounting Standards No. 7 (Stamford, Conn.: FASB, 1975), par. 10.] [16] FASB ASC 720-35-05-3. [Predecessor literature: Reporting on Advertising Costs, Statement of Position 93-7 (New York: AICPA, 1993).] [17] FASB ASC 985-20-05 [Predecessor literature: Accounting for the Cost of Computer Software to Be Sold, Leased, or Otherwise Marketed, Statement of Financial Accounting Standards No. 86 (Stamford, Conn.: FASB, 1985).] [18] FASB ASC 350-10-05. [Predecessor literature: Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, Statement of Position 98-1 (New York: AICPA, 1998).] Exercises Access the FASB Codification at http://asc.fasb.org/home to prepare responses to the following exercises. Provide Codification references for your responses. CE12-1 Access the Codification glossary (Master Glossary) to answer the following. (a) (b) (c) (d) What What What What is is is is the definition provided for an intangible asset? the definition of goodwill? the definition of research and development (R&D)? a development stage entity? CE12-2 Your friend Harry does not understand the concept of an indefinite-life intangible asset. He wonders, Does this mean the life is infinite? What does the authoritative literature say about indefinite-life intangible assets? CE12-3 What guidance does the Codification provide concerning the disclosure of research and development (R&D) costs? CE12-4 What is the nature of the authoritative guidance for advertising costs for entertainment companies? An additional Codification case can be found in the Using Your Judgment section, on page 634. es o llege/k i Be sure to check the companion website for a Review and Analysis Exercise, with solution. w co PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile y. c o m / Questions 619 Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter. QUESTIONS 1. What are the two main characteristics of intangible assets? 2. If intangibles are acquired for stock, how is the cost of the intangible determined? the management of Braxton how to determine whether a write-off is permitted. 16. Last year Zeno Company recorded an impairment on an intangible asset held for use. Recent appraisals indicate that the asset has increased in value. Should Zeno record this recovery in value? 3. Intangibles have either a limited useful life or an indefinite useful life. How should these two different types of intangibles be amortized? 4. Why does the accounting profession make a distinction between internally created intangibles and purchased intangibles? 17. Explain how losses on impaired intangible assets should be reported in income. 18. Simon Company determines that its goodwill is impaired. It finds that its implied goodwill is $360,000 and its recorded goodwill is $400,000. The fair value of its identifiable assets is $1,450,000. What is the amount of goodwill impaired? 5. In 2010 Ghostbusters Corp. spent $420,000 for goodwill visits by sales personnel to key customers. The purpose of these visits was to build a solid, friendly relationship for the future and to gain insight into the problems and needs of the companies served. How should this expenditure be reported? 19. What is the nature of research and development costs? 20. Research and development activities may include (a) personnel costs, (b) materials and equipment costs, and (c) indirect costs. What is the recommended accounting treatment for these three types of R&D costs? 6. What are factors to be considered in estimating the useful life of an intangible asset? 7. What should be the pattern of amortization for a limitedlife intangible? 21. Which of the following activities should be expensed currently as R&D costs? (a) Testing in search for or evaluation of product or process alternatives. (b) Engineering follow-through in an early phase of commercial production. (c) Legal work in connection with patent applications or litigation, and the sale or licensing of patents. 8. Columbia Sportswear Company acquired a trademark that is helpful in distinguishing one of its new products. The trademark is renewable every 10 years at minimal cost. All evidence indicates that this trademark product will generate cash flows for an indefinite period of time. How should this trademark be amortized? 9. McNabb Company spent $190,000 developing a new process, $45,000 in legal fees to obtain a patent, and $91,000 to market the process that was patented, all in the year 2010. How should these costs be accounted for in 2010? 22. Indicate the proper accounting for the following items. (a) Organization costs. (b) Advertising costs. (c) Operating losses. 10. Izzy Inc. purchased a patent for $350,000 which has an estimated useful life of 10 years. Its pattern of use or consumption cannot be reliably determined. Prepare the entry to record the amortization of the patent in its first year of use. 23. In 2009, Austin Powers Corporation developed a new product that will be marketed in 2010. In connection with the development of this product, the following costs were incurred in 2009: research and development costs $400,000; materials and supplies consumed $60,000; and compensation paid to research consultants $125,000. It is anticipated that these costs will be recovered in 2012. What is the amount of research and development costs that Austin Powers should record in 2009 as a charge to expense? 11. Explain the difference between artistic-related intangible assets and contract-related intangible assets. 12. What is goodwill? What is negative goodwill? 13. Under what circumstances is it appropriate to record goodwill in the accounts? How should goodwill, properly recorded on the books, be written off in order to conform with generally accepted accounting principles? 14. In examining financial statements, financial analysts often write off goodwill immediately. Comment on this procedure. 24. Recently, a group of university students decided to incorporate for the purposes of selling a process to recycle the waste product from manufacturing cheese. Some of the initial costs involved were legal fees and office expenses 15. Braxton Inc. is considering the write-off of a limited life intangible because of its lack of profitability. Explain to PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 620 Chapter 12 Intangible Assets incurred in starting the business, state incorporation fees, 29. and stamp taxes. One student wishes to charge these costs against revenue in the current period. Another wishes to *30. defer these costs and amortize them in the future. Which student is correct? Briefly discuss the convergence efforts that are underway in the area of intangible assets. An article in the financial press stated, More than half of software maker Comserves net worth is in a pile of tapes and ring-bound books. That raises some accountants eyebrows. What is the professions position regarding the incurrence of costs for computer software that will be sold? 25. An intangible asset with an estimated useful life of 30 years was acquired on January 1, 2000, for $540,000. On January 1, 2010, a review was made of intangible assets and their expected service lives, and it was determined that this *31. Garfunkel, Inc. has incurred $6 million in developing a asset had an estimated useful life of 30 more years from computer software product for sale to third parties. Of the the date of the review. What is the amount of amortiza$6 million costs incurred, $4.5 million is capitalized. The tion for this intangible in 2010? product produced from this development work has gen26. Where can authoritative iGAAP guidance related to intanerated $2 million of revenue in 2010 and is anticipated to gible assets be found? generate another $8 million in future years. The estimated useful life of the project is 4 years. How much of the cap27. Briefly describe some of the similarities and differences italized costs should be amortized in 2010? between U.S. GAAP and iGAAP with respect to the accounting for intangible assets. *32. In 2010, EZ-Learn Software developed a software package for assisting calculus instruction in business colleges, at a cost of $2,000,000. Although there are tens of thousands of calculus students in the market, college instructors seem to change their minds frequently on the use of teaching aids. Not one package has yet been ordered or delivered. Prepare an argument to advocate expensing the development cost in the current year. Offer an argument for capitalizing the development cost over its estimated useful life. Which stakeholders are harmed or benefited by either approach? 28. Sophia Co., a cellular phone company based in Italy, prepares its financial statements in accordance with iGAAP. In 2010, it reported average assets of 12,500 and net income 1,125. Included in net income is amortization expense of 120. Under U.S. GAAP, Sophias amortization expense would have been 325. Briefly discuss how analysis of Sophias 2010 return on total assets (and comparisons to a company using U.S. GAAP) would be affected by differences in intangible asset amortization between iGAAP and U.S. GAAP. BRIEF EXERCISES 2 3 BE12-1 Celine Dion Corporation purchases a patent from Salmon Company on January 1, 2010, for $54,000. The patent has a remaining legal life of 16 years. Celine Dion feels the patent will be useful for 10 years. Prepare Celine Dions journal entries to record the purchase of the patent and 2010 amortization. BE12-2 Use the information provided in BE12-1. Assume that at January 1, 2012, the carrying amount of the patent on Celine Dions books is $43,200. In January, Celine Dion spends $24,000 successfully defending a patent suit. Celine Dion still feels the patent will be useful until the end of 2019. Prepare the journal entries to record the $24,000 expenditure and 2012 amortization. BE12-3 Larry Byrd, Inc., spent $68,000 in attorney fees while developing the trade name of its new product, the Mean Bean Machine. Prepare the journal entries to record the $68,000 expenditure and the first years amortization, using an 8-year life. BE12-4 Gershwin Corporation obtained a franchise from Sonic Hedgehog Inc. for a cash payment of $120,000 on April 1, 2010. The franchise grants Gershwin the right to sell certain products and services for a period of 8 years. Prepare Gershwins April 1 journal entry and December 31 adjusting entry. BE12-5 On September 1, 2010, Winans Corporation acquired Aumont Enterprises for a cash payment of $700,000. At the time of purchase, Aumonts balance sheet showed assets of $620,000, liabilities of $200,000, and owners equity of $420,000. The fair value of Aumonts assets is estimated to be $800,000. Compute the amount of goodwill acquired by Winans. BE12-6 Kenoly Corporation owns a patent that has a carrying amount of $300,000. Kenoly expects future net cash flows from this patent to total $210,000. The fair value of the patent is $110,000. Prepare Kenolys journal entry, if necessary, to record the loss on impairment. 2 3 2 3 2 3 6 7 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Exercises 621 7 BE12-7 Waters Corporation purchased Johnson Company 3 years ago and at that time recorded goodwill of $400,000. The Johnson Divisions net assets, including the goodwill, have a carrying amount of $800,000. The fair value of the division is estimated to be $1,000,000. Prepare Waterss journal entry, if necessary, to record impairment of the goodwill. BE12-8 Use the information provided in BE12-7. Assume that the fair value of the division is estimated to be $750,000 and the implied goodwill is $350,000. Prepare Waterss journal entry, if necessary, to record impairment of the goodwill. BE12-9 Capriati Corporation commenced operations in early 2010. The corporation incurred $60,000 of costs such as fees to underwriters, legal fees, state fees, and promotional expenditures during its formation. Prepare journal entries to record the $60,000 expenditure and 2010 amortization, if any. BE12-10 Treasure Land Corporation incurred the following costs in 2010. Cost of laboratory research aimed at discovery of new knowledge Cost of testing in search for product alternatives Cost of engineering activity required to advance the design of a product to the manufacturing stage $120,000 100,000 210,000 $430,000 7 9 9 Prepare the necessary 2010 journal entry or entries for Treasure Land. 9 BE12-11 (a) (b) (c) (d) Indicate whether the following items are capitalized or expensed in the current year. Purchase cost of a patent from a competitor. Research and development costs. Organizational costs. Costs incurred internally to create goodwill. 3 9 BE12-12 Nieland Industries had one patent recorded on its books as of January 1, 2010. This patent had a book value of $288,000 and a remaining useful life of 8 years. During 2010, Nieland incurred research and development costs of $96,000 and brought a patent infringement suit against a competitor. On December 1, 2010, Nieland received the good news that its patent was valid and that its competitor could not use the process Nieland had patented. The company incurred $85,000 to defend this patent. At what amount should patent(s) be reported on the December 31, 2010, balance sheet, assuming monthly amortization of patents? BE12-13 Sinise Industries acquired two copyrights during 2010. One copyright related to a textbook that was developed internally at a cost of $9,900. This textbook is estimated to have a useful life of 3 years from September 1, 2010, the date it was published. The second copyright (a history research textbook) was purchased from University Press on December 1, 2010, for $24,000. This textbook has an indefinite useful life. How should these two copyrights be reported on Sinises balance sheet as of December 31, 2010? *BE12-14 Karen Austin Corporation has capitalized software costs of $800,000, and sales of this product the first year totaled $420,000. Karen Austin anticipates earning $980,000 in additional future revenues from this product, which is estimated to have an economic life of 4 years. Compute the amount of software cost amortization for the first year. 3 10 11 EXERCISES 1 4 E12-1 (Classification IssuesIntangibles) Presented below and on the next page is a list of items that could be included in the intangible assets section of the balance sheet. 1. 2. 3. 4. 5. 6. 7. Investment in a subsidiary company. Timberland. Cost of engineering activity required to advance the design of a product to the manufacturing stage. Lease prepayment (6 months rent paid in advance). Cost of equipment obtained. Cost of searching for applications of new research findings. Costs incurred in the formation of a corporation. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 622 Chapter 12 Intangible Assets 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. Operating losses incurred in the start-up of a business. Training costs incurred in start-up of new operation. Purchase cost of a franchise. Goodwill generated internally. Cost of testing in search for product alternatives. Goodwill acquired in the purchase of a business. Cost of developing a patent. Cost of purchasing a patent from an inventor. Legal costs incurred in securing a patent. Unrecovered costs of a successful legal suit to protect the patent. Cost of conceptual formulation of possible product alternatives. Cost of purchasing a copyright. Research and development costs. Long-term receivables. Cost of developing a trademark. Cost of purchasing a trademark. Instructions (a) Indicate which items on the list above would generally be reported as intangible assets in the balance sheet. (b) Indicate how, if at all, the items not reportable as intangible assets would be reported in the financial statements. 1 4 E12-2 (Classification IssuesIntangibles) Presented below is selected account information related to Matt Perry Inc. as of December 21, 2010. All these accounts have debit balances. Cable television franchises Music copyrights Research and development costs Goodwill Cash Discount on notes payable Accounts receivable Property, plant, and equipment Internet domain name Film contract rights Customer lists Prepaid expenses Covenants not to compete Brand names Notes receivable Investments in affiliated companies Organization costs Land Instructions Identify which items should be classified as an intangible asset. For those items not classified as an intangible asset, indicate where they would be reported in the financial statements. 1 4 E12-3 (Classification IssuesIntangible Asset) Langrova Inc. has the following amounts included in its general ledger at December 31, 2010. Organization costs Trademarks Discount on bonds payable Deposits with advertising agency for ads to promote goodwill of company Excess of cost over fair value of net identifiable assets of acquired subsidiary Cost of equipment acquired for research and development projects; the equipment has an alternative future use Costs of developing a secret formula for a product that is expected to be marketed for at least 20 years $24,000 20,000 35,000 10,000 75,000 90,000 70,000 Instructions (a) On the basis of the information above, compute the total amount to be reported by Langrova for intangible assets on its balance sheet at December 31, 2010. Equipment has alternative future use. (b) If an item is not to be included in intangible assets, explain its proper treatment for reporting purposes. 3 9 E12-4 1. (Intangible Amortization) Presented below is selected information for Palmiero Company. Palmiero purchased a patent from Vania Co. for $1,500,000 on January 1, 2008. The patent is being amortized over its remaining legal life of 10 years, expiring on January 1, 2018. During 2010, Palmiero determined that the economic benefits of the patent would not last longer than 6 years PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Exercises 623 from the date of acquisition. What amount should be reported in the balance sheet for the patent, net of accumulated amortization, at December 31, 2010? Palmiero bought a franchise from Dougherty Co. on January 1, 2009, for $350,000. The carrying amount of the franchise on Doughertys books on January 1, 2009, was $500,000. The franchise agreement had an estimated useful life of 30 years. Because Palmiero must enter a competitive bidding at the end of 2018, it is unlikely that the franchise will be retained beyond 2018. What amount should be amortized for the year ended December 31, 2010? On January 1, 2008, Palmiero incurred organization costs of $275,000. What amount of organization expense should be reported in 2010? Palmiero purchased the license for distribution of a popular consumer product on January 1, 2010, for $150,000. It is expected that this product will generate cash flows for an indefinite period of time. The license has an initial term of 5 years but by paying a nominal fee, Palmiero can renew the license indefinitely for successive 5-year terms. What amount should be amortized for the year ended December 31, 2010? 2. 3. 4. Instructions Answer the questions asked about each of the factual situations. 2 3 8 E12-5 (Correct Intangible Asset Account) As the recently appointed auditor for Hillary Corporation, you have been asked to examine selected accounts before the 6-month financial statements of June 30, 2010, are prepared. The controller for Hillary Corporation mentions that only one account is kept for Intangible Assets. Intangible Assets Debit Jan. 4 Jan. 5 Jan. 31 Feb. 11 March 31 April 30 June 30 Research and development costs Legal costs to obtain patent Payment of 7 months rent on property leased by Hillary Premium on common stock Unamortized bond discount on bonds due March 31, 2030 Promotional expenses related to start-up of business Operating losses for first 6 months 940,000 75,000 91,000 250,000 84,000 207,000 141,000 Credit Balance 940,000 1,015,000 1,106,000 856,000 940,000 1,147,000 1,288,000 Instructions Prepare the entry or entries necessary to correct this account. Assume that the patent has a useful life of 12 years. 3 9 E12-6 (Recording and Amortization of Intangibles) Powerglide Company, organized in 2009, has set up a single account for all intangible assets. The following summary discloses the debit entries that have been recorded during 2010. 1/2/10 4/1/10 7/1/10 8/1/10 9/1/10 Purchased patent (8-year life) Goodwill (indefinite life) Purchased franchise with 10-year life; expiration date 7/1/20 Payment of copyright (5-year life) Research and development costs $ 380,000 360,000 450,000 156,000 215,000 $1,561,000 Instructions Prepare the necessary entries to clear the Intangible Assets account and to set up separate accounts for distinct types of intangibles. Make the entries as of December 31, 2010, recording any necessary amortization and reflecting all balances accurately as of that date. (Use straight-line amortization.) 2 3 E12-7 (Accounting for Trade Name) In early January 2009, Reymont Corporation applied for a trade name, incurring legal costs of $18,000. In January of 2010, Reymont incurred $7,800 of legal fees in a successful defense of its trade name. Instructions (a) Compute 2009 amortization, 12/31/09 book value, 2010 amortization, and 12/31/10 book value if the company amortizes the trade name over 10 years. (b) Compute the 2010 amortization and the 12/31/10 book value, assuming that at the beginning of 2010, Reymont determines that the trade name will provide no future benefits beyond December 31, 2013. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 624 Chapter 12 Intangible Assets (c) Ignoring the response for part (b), compute the 2011 amortization and the 12/31/11 book value, assuming that at the beginning of 2011, based on new market research, Reymont determines that the fair value of the trade name is $16,000. Estimated total future cash flows from the trade name is $17,000 on January 3, 2011. 9 E12-8 (Accounting for Organization Costs) Fontenot Corporation was organized in 2009 and began operations at the beginning of 2010. The company is involved in interior design consulting services. The following costs were incurred prior to the start of operations. Attorneys fees in connection with organization of the company Purchase of drafting and design equipment Costs of meetings of incorporators to discuss organizational activities State filing fees to incorporate $17,000 10,000 7,000 1,000 $35,000 Instructions (a) Compute the total amount of organization costs incurred by Fontenot. (b) Prepare the journal entry to record organization costs for 2010. 2 3 8 E12-9 (Accounting for Patents, Franchises, and R&D) Devon Harris Company has provided information on intangible assets as follows. A patent was purchased from Bradtke Company for $2,500,000 on January 1, 2009. Harris estimated the remaining useful life of the patent to be 10 years. The patent was carried in Bradtkes accounting records at a net book value of $2,000,000 when Bradtke sold it to Harris. During 2010, a franchise was purchased from Greene Company for $580,000. In addition, 5% of revenue from the franchise must be paid to Greene. Revenue from the franchise for 2010 was $2,500,000. Harris estimates the useful life of the franchise to be 10 years and takes a full years amortization in the year of purchase. Harris incurred research and development costs in 2010 as follows. Materials and equipment Personnel Indirect costs $142,000 189,000 102,000 $433,000 Harris estimates that these costs will be recouped by December 31, 2013. The materials and equipment purchased have no alternative uses. On January 1, 2010, because of recent events in the field, Harris estimates that the remaining life of the patent purchased on January 1, 2009, is only 5 years from January 1, 2010. Instructions (a) Prepare a schedule showing the intangibles section of Harriss balance sheet at December 31, 2010. Show supporting computations in good form. (b) Prepare a schedule showing the income statement effect for the year ended December 31, 2010, as a result of the facts above. Show supporting computations in good form. (AICPA adapted) 2 3 E12-10 (Accounting for Patents) During 2007, Thompson Corporation spent $170,000 in research and development costs. As a result, a new product called the New Age Piano was patented. The patent was obtained on October 1, 2007, and had a legal life of 20 years and a useful life of 10 years. Legal costs of $24,000 related to the patent were incurred as of October 1, 2007. Instructions (a) Prepare all journal entries required in 2007 and 2008 as a result of the transactions above. (b) On June 1, 2009, Thompson spent $12,400 to successfully prosecute a patent infringement suit. As a result, the estimate of useful life was extended to 12 years from June 1, 2009. Prepare all journal entries required in 2009 and 2010. (c) In 2011, Thompson determined that a competitors product would make the New Age Piano obsolete and the patent worthless by December 31, 2012. Prepare all journal entries required in 2011 and 2012. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Exercises 625 2 3 E12-11 (Accounting for Patents) Reddy Industries has the following patents on its December 31, 2009, balance sheet. Patent Item Patent A Patent B Patent C Initial Cost $40,800 $15,000 $14,400 Date Acquired 3/1/06 7/1/07 9/1/08 Useful Life at Date Acquired 17 years 10 years 4 years The following events occurred during the year ended December 31, 2010. 1. 2. 3. Research and development costs of $245,700 were incurred during the year. Patent D was purchased on July 1 for $28,500. This patent has a useful life of 912 years. As a result of reduced demands for certain products protected by Patent B, a possible impairment of Patent Bs value may have occurred at December 31, 2010. The controller for Reddy estimates the expected future cash flows from Patent B will be as follows. Year 2011 2012 2013 Expected Future Cash Flows $2,000 2,000 2,000 The proper discount rate to be used for these flows is 8%. (Assume that the cash flows occur at the end of the year.) Instructions (a) Compute the total carrying amount of Reddys patents on its December 31, 2009, balance sheet. (b) Compute the total carrying amount of Reddys patents on its December 31, 2010, balance sheet. 5 6 E12-12 (Accounting for Goodwill) Fred Graf, owner of Graf Interiors, is negotiating for the purchase of Terrell Galleries. The balance sheet of Terrell is given in an abbreviated form below. TERRELL GALLERIES BALANCE SHEET AS OF DECEMBER 31, 2010 Assets Cash Land Building (net) Equipment (net) Copyright (net) Total assets $100,000 70,000 200,000 175,000 30,000 $575,000 Liabilities and Stockholders Equity Accounts payable Long-term notes payable Total liabilities Common stock Retained earnings Total liabilities and stockholders equity $200,000 25,000 $ 50,000 300,000 350,000 225,000 $575,000 Graf and Terrell agree that: 1. 2. Land is undervalued by $50,000. Equipment is overvalued by $5,000. Terrell agrees to sell the gallery to Graf for $380,000. Instructions Prepare the entry to record the purchase of Terrell Galleries on Grafs books. 3 5 6 E12-13 (Accounting for Goodwill) On July 1, 2010, Brandon Corporation purchased Mills Company by paying $250,000 cash and issuing a $150,000 note payable. At July 1, 2010, the balance sheet of Mills Company was as follows. Cash Receivables Inventory Land Buildings (net) Equipment (net) Trademarks $ 50,000 90,000 100,000 40,000 75,000 70,000 10,000 $435,000 Accounts payable Stockholders equity $200,000 235,000 $435,000 The recorded amounts all approximate current values except for land (fair value of $80,000), inventory (fair value of $125,000), and trademarks (fair value of $15,000). PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 626 Chapter 12 Intangible Assets Instructions (a) Prepare the July 1 entry for Brandon Corporation to record the purchase. (b) Prepare the December 31 entry for Brandon Corporation to record amortization of intangibles. The trademark has an estimated useful life of 4 years with a residual value of $3,000. 7 E12-14 (Copyright Impairment) Presented below is information related to copyrights owned by Botticelli Company at December 31, 2010. Cost Carrying amount Expected future net cash flows Fair value $8,600,000 4,300,000 4,000,000 3,400,000 Assume that Botticelli Company will continue to use this copyright in the future. As of December 31, 2010, the copyright is estimated to have a remaining useful life of 10 years. Instructions (a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2010. The company does not use accumulated amortization accounts. (b) Prepare the journal entry to record amortization expense for 2011 related to the copyrights. (c) The fair value of the copyright at December 31, 2011, is $3,400,000. Prepare the journal entry (if any) necessary to record the increase in fair value. 6 7 E12-15 (Goodwill Impairment) sion of Santana, Inc. Presented below is net asset information related to the Mischa Divi- MISCHA DIVISION NET ASSETS AS OF DECEMBER 31, 2010 (IN MILLIONS) Cash Receivables Property, plant, and equipment (net) Goodwill Less: Notes payable Net assets $ 60 200 2,600 200 (2,700) 360 $ The purpose of the Mischa division is to develop a nuclear-powered aircraft. If successful, traveling delays associated with refueling could be substantially reduced. Many other benefits would also occur. To date, management has not had much success and is deciding whether a write-down at this time is appropriate. Management estimated its future net cash flows from the project to be $400 million. Management has also received an offer to purchase the division for $335 million. All identifiable assets and liabilities book and fair value amounts are the same. Instructions (a) Prepare the journal entry (if any) to record the impairment at December 31, 2010. (b) At December 31, 2011, it is estimated that the divisions fair value increased to $345 million. Prepare the journal entry (if any) to record this increase in fair value. 9 E12-16 (Accounting for R&D Costs) Margaret Avery Company from time to time embarks on a research program when a special project seems to offer possibilities. In 2009 the company expends $325,000 on a research project, but by the end of 2009 it is impossible to determine whether any benefit will be derived from it. Instructions (a) What account should be charged for the $325,000, and how should it be shown in the financial statements? (b) The project is completed in 2010, and a successful patent is obtained. The R&D costs to complete the project are $130,000. The administrative and legal expenses incurred in obtaining patent number 472-1001-84 in 2010 total $24,000. The patent has an expected useful life of 5 years. Record these costs in journal entry form. Also, record patent amortization (full year) in 2010. (c) In 2011, the company successfully defends the patent in extended litigation at a cost of $47,200, thereby extending the patent life to December 31, 2018. What is the proper way to account for this cost? Also, record patent amortization (full year) in 2011. (d) Additional engineering and consulting costs incurred in 2011 required to advance the design of a product to the manufacturing stage total $60,000. These costs enhance the design of the product considerably. Discuss the proper accounting treatment for this cost. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Problems 627 9 E12-17 (Accounting for R&D Costs) Martinez Company incurred the following costs during 2010 in connection with its research and development activities. Cost of equipment acquired that will have alternative uses in future R&D projects over the next 5 years (uses straight-line depreciation) Materials consumed in R&D projects Consulting fees paid to outsiders for R&D projects Personnel costs of persons involved in R&D projects Indirect costs reasonably allocable to R&D projects Materials purchased for future R&D projects $330,000 59,000 100,000 128,000 50,000 34,000 Instructions Compute the amount to be reported as research and development expense by Martinez on its income statement for 2010. Assume equipment is purchased at the beginning of the year. 11 *E12-18 (Accounting for Computer Software Costs) Majoli Inc. has capitalized computer software costs of $3,900,000 on its new Trenton software package. Revenues from 2010 (first year) sales are $2,000,000. Additional future revenues from Trenton for the remainder of its economic life, through 2014, are estimated to be $10,000,000. Instructions (a) What method or methods of amortization are to be applied in the write-off of capitalized computer software costs? (b) Compute the amount of amortization for 2010 for Trenton. 11 *E12-19 (Accounting for Computer Software Costs) During 2010, Botosan Enterprises Inc. spent $5,000,000 developing its new Dover software package. Of this amount, $2,600,000 was spent before technological feasibility was established for the product, which is to be marketed to third parties. The package was completed at December 31, 2010. Botosan expects a useful life of 8 years for this product with total revenues of $16,000,000. During the first year (2011), Botosan realizes revenues of $3,200,000. Instructions (a) Prepare journal entries required in 2010 for the foregoing facts. (b) Prepare the entry to record amortization at December 31, 2011. (c) At what amount should the computer software costs be reported in the December 31, 2011, balance sheet? Could the net realizable value of this asset affect your answer? (d) What disclosures are required in the December 31, 2011, financial statements for the computer software costs? (e) How would your answers for (a), (b), and (c) be different if the computer software was developed for internal use? es o co See the books companion website, www.wiley.com/college/kieso, for a set of B Exercises. llege/k i w PROBLEMS 2 3 P12-1 (Correct Intangible Asset Account) Reichenbach Co., organized in 2009, has set up a single account for all intangible assets. The following summary discloses the debit entries that have been recorded during 2009 and 2010. Intangible Assets 7/1/09 10/1/09 12/31/09 8-year franchise; expiration date 6/30/17 Advance payment on laboratory space (2-year lease) Net loss for 2009 including state incorporation fee, $1,000, and related legal fees of organizing, $5,000 (all fees incurred in 2009) Patent purchased (10-year life) Cost of developing a secret formula (indefinite life) Goodwill purchased (indefinite life) Legal fee for successful defense of patent purchased above Research and development costs $ 48,000 24,000 1/2/10 3/1/10 4/1/10 6/1/10 9/1/10 16,000 84,000 75,000 278,400 12,650 160,000 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile y. c o m / 628 Chapter 12 Intangible Assets Instructions Prepare the necessary entries to clear the Intangible Assets account and to set up separate accounts for distinct types of intangibles. Make the entries as of December 31, 2010, recording any necessary amortization and reflecting all balances accurately as of that date. (Ignore income tax effects.) 2 3 P12-2 (Accounting for Patents) Fields Laboratories holds a valuable patent (No. 758-6002-1A) on a precipitator that prevents certain types of air pollution. Fields does not manufacture or sell the products and processes it develops. Instead, it conducts research and develops products and processes which it patents, and then assigns the patents to manufacturers on a royalty basis. Occasionally it sells a patent. The history of Fields patent number 758-6002-1A is as follows. Date 20012002 Jan. 2003 March 2003 Jan. 2004 Nov. 2005 Dec. 2006 April 2007 July 2011 Activity Research conducted to develop precipitator Design and construction of a prototype Testing of models Fees paid engineers and lawyers to prepare patent application; patent granted June 30, 2004 Engineering activity necessary to advance the design of the precipitator to the manufacturing stage Legal fees paid to successfully defend precipitator patent Research aimed at modifying the design of the patented precipitator Legal fees paid in unsuccessful patent infringement suit against a competitor Cost $384,000 87,600 42,000 59,500 81,500 42,000 43,000 34,000 Fields assumed a useful life of 17 years when it received the initial precipitator patent. On January 1, 2009, it revised its useful life estimate downward to 5 remaining years. Amortization is computed for a full year if the cost is incurred prior to July 1, and no amortization for the year if the cost is incurred after June 30. The companys year ends December 31. Instructions Compute the carrying value of patent No. 758-6002-1A on each of the following dates: (a) December 31, 2004. (b) December 31, 2008. (c) December 31, 2011. 2 3 P12-3 (Accounting for Franchise, Patents, and Trade Name) rations intangible assets is as follows. Information concerning Sandro Corpo- 1. On January 1, 2010, Sandro signed an agreement to operate as a franchisee of Hsian Copy Service, Inc. for an initial franchise fee of $75,000. Of this amount, $15,000 was paid when the agreement was signed, and the balance is payable in 4 annual payments of $15,000 each, beginning January 1, 2011. The agreement provides that the down payment is not refundable and no future services are required of the franchisor. The present value at January 1, 2010, of the 4 annual payments discounted at 14% (the implicit rate for a loan of this type) is $43,700. The agreement also provides that 5% of the revenue from the franchise must be paid to the franchisor annually. Sandros revenue from the franchise for 2010 was $900,000. Sandro estimates the useful life of the franchise to be 10 years. (Hint: You may want to refer to Appendix 18A to determine the proper accounting treatment for the franchise fee and payments.) 2. Sandro incurred $65,000 of experimental and development costs in its laboratory to develop a patent that was granted on January 2, 2010. Legal fees and other costs associated with registration of the patent totaled $17,600. Sandro estimates that the useful life of the patent will be 8 years. 3. A trademark was purchased from Shanghai Company for $36,000 on July 1, 2007. Expenditures for successful litigation in defense of the trademark totaling $10,200 were paid on July 1, 2010. Sandro estimates that the useful life of the trademark will be 20 years from the date of acquisition. Instructions (a) Prepare a schedule showing the intangible assets section of Sandros balance sheet at December 31, 2010. Show supporting computations in good form. (b) Prepare a schedule showing all expenses resulting from the transactions that would appear on Sandros income statement for the year ended December 31, 2010. Show supporting computations in good form. (AICPA adapted) PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Problems 629 9 10 P12-4 (Accounting for R&D Costs) During 2008, Robin Wright Tool Company purchased a building site for its proposed research and development laboratory at a cost of $60,000. Construction of the building was started in 2008. The building was completed on December 31, 2009, at a cost of $320,000 and was placed in service on January 2, 2010. The estimated useful life of the building for depreciation purposes was 20 years. The straight-line method of depreciation was to be employed, and there was no estimated salvage value. Management estimates that about 50% of the projects of the research and development group will result in long-term benefits (i.e., at least 10 years) to the corporation. The remaining projects either benefit the current period or are abandoned before completion. A summary of the number of projects and the direct costs incurred in conjunction with the research and development activities for 2010 appears below. Number of Projects Completed projects with long-term benefits Abandoned projects or projects that benefit the current period Projects in processresults indeterminate Total 15 10 5 30 Salaries and Employee Benefits $ 90,000 65,000 40,000 $195,000 Other Expenses (excluding Building Depreciation Charges) $50,000 15,000 12,000 $77,000 Upon recommendation of the research and development group, Robin Wright Tool Company acquired a patent for manufacturing rights at a cost of $88,000. The patent was acquired on April 1, 2009, and has an economic life of 10 years. Instructions If generally accepted accounting principles were followed, how would the items above relating to research and development activities be reported on the following financial statements? (a) The companys income statement for 2010. (b) The companys balance sheet as of December 31, 2010. Be sure to give account titles and amounts, and briefly justify your presentation. (CMA adapted) 6 7 P12-5 (Goodwill, Impairment) On July 31, 2010, Mexico Company paid $3,000,000 to acquire all of the common stock of Conchita Incorporated, which became a division of Mexico. Conchita reported the following balance sheet at the time of the acquisition. Current assets Noncurrent assets Total assets $ 800,000 2,700,000 $3,500,000 Current liabilities Long-term liabilities Stockholders equity Total liabilities and stockholders equity $ 600,000 500,000 2,400,000 $3,500,000 It was determined at the date of the purchase that the fair value of the identifiable net assets of Conchita was $2,750,000. Over the next 6 months of operations, the newly purchased division experienced operating losses. In addition, it now appears that it will generate substantial losses for the foreseeable future. At December 31, 2010, Conchita reports the following balance sheet information. Current assets Noncurrent assets (including goodwill recognized in purchase) Current liabilities Long-term liabilities Net assets $ 450,000 2,400,000 (700,000) (500,000) $1,650,000 It is determined that the fair value of the Conchita Division is $1,850,000. The recorded amount for Conchitas net assets (excluding goodwill) is the same as fair value, except for property, plant, and equipment, which has a fair value $150,000 above the carrying value. Instructions (a) Compute the amount of goodwill recognized, if any, on July 31, 2010. (b) Determine the impairment loss, if any, to be recorded on December 31, 2010. (c) Assume that fair value of the Conchita Division is $1,600,000 instead of $1,850,000. Determine the impairment loss, if any, to be recorded on December 31, 2010. (d) Prepare the journal entry to record the impairment loss, if any, and indicate where the loss would be reported in the income statement. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 630 Chapter 12 Intangible Assets 2 3 6 7 10 P12-6 (Comprehensive Intangible Assets) Montana Matts Golf Inc. was formed on July 1, 2009, when Matt Magilke purchased the Old Master Golf Company. Old Master provides video golf instruction at kiosks in shopping malls. Magilke plans to integrate the instruction business into his golf equipment and accessory stores. Magilke paid $770,000 cash for Old Master. At the time Old Masters balance sheet reported assets of $650,000 and liabilities of $200,000 (thus owners equity was $450,000). The fair value of Old Masters assets is estimated to be $800,000. Included in the assets is the Old Master trade name with a fair value of $10,000 and a copyright on some instructional books with a fair value of $24,000. The trade name has a remaining life of 5 years and can be renewed at nominal cost indefinitely. The copyright has a remaining life of 40 years. Instructions (a) Prepare the intangible assets section of Montana Matts Golf Inc. at December 31, 2009. How much amortization expense is included in Montana Matts income for the year ended December 31, 2009? Show all supporting computations. (b) Prepare the journal entry to record amortization expense for 2010. Prepare the intangible assets section of Montana Matts Golf Inc. at December 31, 2010. (No impairments are required to be recorded in 2010.) (c) At the end of 2011, is evaluating the results of the instructional business. Due to fierce competition from online and television (e.g., the Golf Channel), the Old Master reporting unit has been losing money. Its book value is now $500,000. The fair value of the Old Master reporting unit is $420,000. The implied value of goodwill is $90,000. Magilke has collected the following information related to the companys intangible assets. Intangible Asset Trade name Copyright Expected Cash Flows (undiscounted) $ 9,000 30,000 Fair Values $ 3,000 25,000 Prepare the journal entries required, if any, to record impairments on Montana Matts intangible assets. (Assume that any amortization for 2011 has been recorded.) Show supporting computations. CONCEPTS FOR ANALYSIS CA12-1 (Accounting for Pollution Expenditure) Counting Crows Company operates several plants at which limestone is processed into quicklime and hydrated lime. The Eagle Ridge plant, where most of the equipment was installed many years ago, continually deposits a dusty white substance over the surrounding countryside. Citing the unsanitary condition of the neighboring community of Scales Mound, the pollution of the Galena River, and the high incidence of lung disease among workers at Eagle Ridge, the states Pollution Control Agency has ordered the installation of air pollution control equipment. Also, the Agency has assessed a substantial penalty, which will be used to clean up Scales Mound. After considering the costs involved (which could not have been reasonably estimated prior to the Agencys action), Counting Crows Company decides to comply with the Agencys orders, the alternative being to cease operations at Eagle Ridge at the end of the current fiscal year. The officers of Counting Crows agree that the air pollution control equipment should be capitalized and depreciated over its useful life, but they disagree over the period(s) to which the penalty should be charged. Instructions Discuss the conceptual merits and reporting requirements of accounting for the penalty in each of the following ways. (a) As a charge to the current period. (b) As a correction of prior periods. (c) As a capitalizable item to be amortized over future periods. (AICPA adapted) CA12-2 (Accounting for Pre-Opening Costs) After securing lease commitments from several major stores, Auer Shopping Center, Inc. was organized and built a shopping center in a growing suburb. The shopping center would have opened on schedule on January 1, 2010, if it had not been struck by a severe tornado in December. Instead, it opened for business on October 1, 2010. All of the additional construction costs that were incurred as a result of the tornado were covered by insurance. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Concepts for Analysis 631 In July 2009, in anticipation of the scheduled January opening, a permanent staff had been hired to promote the shopping center, obtain tenants for the uncommitted space, and manage the property. A summary of some of the costs incurred in 2009 and the first nine months of 2010 follows. January 1, 2010 through September 30, 2010 $540,000 360,000 557,000 2009 Interest on mortgage bonds Cost of obtaining tenants Promotional advertising $720,000 300,000 540,000 The promotional advertising campaign was designed to familiarize shoppers with the center. Had it been known in time that the center would not open until October 2010, the 2009 expenditure for promotional advertising would not have been made. The advertising had to be repeated in 2010. All of the tenants who had leased space in the shopping center at the time of the tornado accepted the October occupancy date on condition that the monthly rental charges for the first 9 months of 2010 be canceled. Instructions Explain how each of the costs for 2009 and the first 9 months of 2010 should be treated in the accounts of the shopping center corporation. Give the reasons for each treatment. (AICPA adapted) CA12-3 (Accounting for Patents) On June 30, 2010, your client, Ferry Company, was granted two patents covering plastic cartons that it had been producing and marketing profitably for the past 3 years. One patent covers the manufacturing process, and the other covers the related products. Ferry executives tell you that these patents represent the most significant breakthrough in the industry in the past 30 years. The products have been marketed under the registered trademarks Evertight, Duratainer, and Sealrite. Licenses under the patents have already been granted by your client to other manufacturers in the United States and abroad and are producing substantial royalties. On July 1, Ferry commenced patent infringement actions against several companies whose names you recognize as those of substantial and prominent competitors. Ferrys management is optimistic that these suits will result in a permanent injunction against the manufacture and sale of the infringing products as well as collection of damages for loss of profits caused by the alleged infringement. The financial vice-president has suggested that the patents be recorded at the discounted value of expected net royalty receipts. Instructions (a) What is the meaning of discounted value of expected net receipts? Explain. (b) How would such a value be calculated for net royalty receipts? (c) What basis of valuation for Ferrys patents would be generally accepted in accounting? Give supporting reasons for this basis. (d) Assuming no practical problems of implementation, and ignoring generally accepted accounting principles, what is the preferable basis of valuation for patents? Explain. (e) What would be the preferable theoretical basis of amortization? Explain. (f) What recognition, if any, should be made of the infringement litigation in the financial statements for the year ending September 30, 2010? Discuss. (AICPA adapted) CA12-4 (Accounting for Research and Development Costs) Cuevas Co. is in the process of developing a revolutionary new product. A new division of the company was formed to develop, manufacture, and market this new product. As of year-end (December 31, 2010), the new product has not been manufactured for resale. However, a prototype unit was built and is in operation. Throughout 2010 the new division incurred certain costs. These costs include design and engineering studies, prototype manufacturing costs, administrative expenses (including salaries of administrative personnel), and market research costs. In addition, approximately $900,000 in equipment (with an estimated useful life of 10 years) was purchased for use in developing and manufacturing the new product. Approximately $315,000 of this equipment was built specifically for the design development of the new product. The remaining $585,000 of equipment was used to manufacture the pre-production prototype and will be used to manufacture the new product once it is in commercial production. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 632 Chapter 12 Intangible Assets Instructions (a) How are research and development defined in the authoritative literature (GAAP)? (b) Briefly indicate the practical and conceptual reasons for the conclusion reached by the Financial Accounting Standards Board on accounting and reporting practices for research and development costs. (c) In accordance with GAAP, how should the various costs of Cuevas described above be recorded on the financial statements for the year ended December 31, 2010? (AICPA adapted) CA12-5 (Accounting for Research and Development Costs) Czeslaw Corporations research and development department has an idea for a project it believes will culminate in a new product that would be very profitable for the company. Because the project will be very expensive, the department requests approval from the companys controller, Jeff Reid. Reid recognizes that corporate profits have been down lately and is hesitant to approve a project that will incur significant expenses that cannot be capitalized due to the requirements of the authoritative literature. He knows that if they hire an outside firm that does the work and obtains a patent for the process, Czeslaw Corporation can purchase the patent from the outside firm and record the expenditure as an asset. Reid knows that the companys own R&D department is first-rate, and he is confident they can do the work well. Instructions Answer the following questions. (a) Who are the stakeholders in this situation? (b) What are the ethical issues involved? (c) What should Reid do? USING YOUR JUDGMENT FI NANCIAL REPORTI NG Financial Reporting Problem The Procter & Gamble Company (P&G) llege/k i es o The financial statements of P&G are presented in Appendix 5B or can be accessed at the books companion website, www.wiley.com/college/kieso. Instructions w co Refer to P&Gs financial statements and the accompanying notes to answer the following questions. (a) Does P&G report any intangible assets, especially goodwill, in its 2007 financial statements and accompanying notes? (b) How much research and development (R&D) cost was expensed by P&G in 2007 and 2006? What percentage of sales revenue and net income did P&G spend on R&D in 2007 and 2006? llege/k i es o co PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile ile y. c o m / y. c o m / Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. Instructions Go to the books companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) (1) What amounts for intangible assets were reported in their respective balance sheets by Coca-Cola and PepsiCo? (2) What percentage of total assets is each of these reported amounts? (3) What was the change in the amount of intangibles from 2006 to 2007 for Coca-Cola and PepsiCo? w Using Your Judgment 633 (b) (1) On what basis and over what periods of time did Coca-Cola and PepsiCo amortize their intangible assets? (2) What were the amounts of accumulated amortization reported by Coca-Cola and PepsiCo at the end of 2007 and 2006? (3) What was the composition of the identifiable and unidentifiable intangible assets reported by Coca-Cola and PepsiCo at the end of 2007? Financial Statement Analysis Cases Case 1: Merck and Johnson & Johnson Merck & Co., Inc. and Johnson & Johnson are two leading producers of health care products. Each has considerable assets, and each expends considerable funds each year toward the development of new products. The development of a new health care product is often very expensive, and risky. New products frequently must undergo considerable testing before approval for distribution to the public. For example, it took Johnson & Johnson 4 years and $200 million to develop its 1-DAY ACUVUE contact lenses. Below are some basic data compiled from the financial statements of these two companies. (all dollars in millions) Total assets Total revenue Net income Research and development expense Intangible assets Johnson & Johnson $53,317 47,348 8,509 5,203 11,842 Merck $42,573 22,939 5,813 4,010 2,765 Instructions (a) What kinds of intangible assets might a health care products company have? Does the composition of these intangibles matter to investorsthat is, would it be perceived differently if all of Mercks intangibles were goodwill, than if all of its intangibles were patents? (b) Suppose the president of Merck has come to you for advice. He has noted that by eliminating research and development expenditures the company could have reported $1.3 billion more in net income. He is frustrated because much of the research never results in a product, or the products take years to develop. He says shareholders are eager for higher returns, so he is considering eliminating research and development expenditures for at least a couple of years. What would you advise? (c) The notes to Mercks financial statements note that Merck has goodwill of $1.1 billion. Where does recorded goodwill come from? Is it necessarily a good thing to have a lot of goodwill on your books? Case 2: Analysis of Goodwill As a new intern for the local branch office of a national brokerage firm, you are excited to get an assignment that allows you to use your accounting expertise. Your supervisor provides you the spreadsheet below, which contains data for the most recent quarter for three companies that the firm has been recommending to it clients as buys. Each of the companies returns on assets has outperformed their industry cohorts in the past, but given recent challenges in their markets, there is concern that the companies may experience operating challenges and lower earnings. (All numbers in millions, except return on assets.) Company Sprint Nextel Washington Mutual E* Trade Financial Market Value of Company $36,361 11,742 1,639 Book Value (Net Assets) $51,271 23,941 4,104 Carrying Value of Goodwill $30,718 9,062 2,035 Return on Assets 3.5% 2.4% 5.6% Instructions (a) The market value for each of these companies is lower than the corresponding book value. What implications does this have for each companys future prospects? PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 634 Chapter 12 Intangible Assets (b) To date, none of these companies has recorded goodwill impairments. Your supervisor suspects that they will need to record impairments in the near future, but he is unsure about the goodwill impairment rules. Is it likely that these companies will recognize impairments? Explain. (c) Using the data on the previous page, estimate the amount of goodwill impairment for each company and prepare the journal entry to record the impairment. For each company, you may assume that the book value less the carrying value of the goodwill approximates the fair value of the companies net assets. (d) Discuss the effects of your entries in part (c) on your evaluation of these companies based on the return on assets ratio. International Reporting Case Bayer, Glaxo SmithKline, and Merck Presented below are data and accounting policy notes for the goodwill of three international drug companies. Bayer, a German company, prepares its statements in accordance with International Financial Reporting Standards (iGAAP); Glaxo SmithKline follows United Kingdom (U.K.) rules; and Merck, a U.S. company, prepares its financial statements in accordance with U.S. GAAP. Related Information Research and development expense Amortization expense Net income Accumulated goodwill amortization Stockholders equity Bayer ( millions) 2,107 0 603 0 12,268 Glaxo SmithKline ( millions) 2,839 12 4,302 84 10,091 Merck ($ millions) 4,010 0 5,813 0 17,288 Both U.S. GAAP and iGAAP do not allow amortization of goodwill. Under U.K. standards, goodwill is amortized over useful lives not to exceed 20 years. Instructions (a) Compute the return on equity for each of these companies, and use this analysis to briefly discuss the relative profitability of the three companies. (b) Assume that each of the companies uses the maximum allowable amortization period for goodwill (if any). Discuss how these companies goodwill amortization policies affect your ability to compare their amortization expense and income. (c) Some analysts believe that the only valid way to compare companies that follow different goodwill accounting practices is to treat all goodwill as an asset and record expense only if the goodwill is impaired.22 Using the data above, make these adjustments as appropriate, and compare the profitability of the three drug companies, comparing this information to your analysis in (a). (d) iGAAP requires that development costs must be capitalized if technical and commercial feasibility of the resulting product has been established. Assume that Bayer recorded 1 million of development costs in the year reported above. Discuss briefly how this accounting affects your ability to compare the financial results of Bayer and Merck. BRI DGE TO TH E PROFESSION Professional Research: FASB Codification King Company is contemplating the purchase of a smaller company, which is a distributor of Kings products. Top management of King is convinced that the acquisition will result in significant synergies in its selling and distribution functions. The financial management group (of which you are a part) has been asked to prepare some analysis of the effects of the acquisition on the combined companys financial statements. This is the first acquisition for King, and some of the senior staff insist that based on their recollection of goodwill accounting, any goodwill recorded on the acquisition will result in a drag on future earnings for goodwill amortization. Other younger members on the staff argue that goodwill accounting has changed. Your supervisor asks you to research this issue. 22 Trevor Harris, Apples to Apples: Accounting for Value in World Markets (New York: Morgan Stanley Dean Witter, February 1998). PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Using Your Judgment 635 Instructions Access the FASB Codification at http://asc.fasb.org/home to conduct research using the Codification Research System to prepare responses to the following items. Provide Codification references for your responses. (a) Identify the accounting literature that addresses goodwill and other intangible assets. (b) Define goodwill. (c) Is goodwill subject to amortization? Explain. (d) When goodwill is recognized by a subsidiary, should it be tested for impairment at the consolidated level or the subsidiary level? Discuss. Professional Simulation Go to the books companion website, at www.wiley.com/college/kieso, to find an interactive problem that simulates the computerized CPA exam. The professional simulation for this chapter asks you to address questions related to the accounting for intangible assets. KWW_Professional _Simulation Intangible Assets Time Remaining 0 hours 40 minutes copy paste calculator sheet standards help ? spliter done co Remember to check the books companion website to find additional resources for this chapter. llege/k i es o w PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile y. c o m / ... View Full Document

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