business combinations, goodwill and intangibles fasb 141 and 142

Business Combinations, Goodwill and Intangibles

FASB 141 and 142

U.S. Patent

Holder: P. Bye

Process: no-fade, brake fluid

Copyright

Artist: B. Joel

Song: Uptown Girl

Intangible assets generally result from legal or contractual rights which do not have a physical substance.

Intangibles may be purchased from others or developed internally.

The costs of internally developed unidentifiable intangible assets, such as employee training, are expensed as incurred.

U.S. Patent

Holder: P. Bye

Process: no-fade, brake fluid

When a company internally develops an intangible asset, only certain costs can be capitalized such as legal and related costs.

Tangible and intangible assets have the following common characteristics:• Held for use and not for investment• Expected life greater than one year• Derive their value from their ability to

generate revenue (future cash inflows)• Can have an indefinite life (not

depreciated or amortized)• Can have a limited life (depreciated or

amortized)

Intangible assets have four unique characteristics that distinguish them from tangible assets:

• More uncertainty about future benefits

• Value subject to wider fluctuations• Value may be applicable to only one

particular company.• Indeterminate lives.

XYZ Co.Balance She 12/31/9

CashEquipment 54Goodwill 32,010Patents 1,430

But . . .

Only if purchased!

For financial reporting purposes, identifiable and unidentifiable intangible assets are treated the same - they are both capitalized.

Identifiable vs. Unidentifiable

• Identifiable:– Patents– Copyrights– Trade names, trade

marks– Secret formulas– Franchise– License

• Unidentifiable:– Goodwill

Many new types of intangible assets are discussed in FASB 141

Acquisition of an Entire Company--Business Combination

There is one way to account for a business combination--

pooling of interest and purchase.

There is one way to account for a business combination--

pooling of interest and purchase.

The purchase method raises a problem in how to allocate

the purchase price to the various assets acquired.

The purchase method raises a problem in how to allocate

the purchase price to the various assets acquired.

Page 149

Acquisition of an Entire Company--Business Combination

Compared to pooling of interest, the purchase method records assets at their fair market value, which results in lower

earnings in subsequent years due to higher amortization and depreciation charges.

Compared to pooling of interest, the purchase method records assets at their fair market value, which results in lower

earnings in subsequent years due to higher amortization and depreciation charges.

Despite opposition from the business community, the FASB has eliminated the pooling of interest method in FASB 141.

Despite opposition from the business community, the FASB has eliminated the pooling of interest method in FASB 141.

Page 149

Acquiring an entire company

• When we acquire an entire company, the specific assets may be worth LESS than we paid

• This difference is called GOODWILL -- an intangible asset

Goodwill

• Defined: “The excess amount paid for a company in a business combination over the fair market value of the company’s identifiable assets.”

• Recording Goodwill1. Write identifiable assets up to FMV.

2. Record excess purchase price over net assets at FMV as goodwill.

OK

Purchase Agreement

Price $100,000

Appraisal

Land $10,000

Bldg. 40,000

FMV $50,000

Purchased goodwill arises when a company is acquired and is the difference between the purchase price of a company and the fair market value of its identifiable net assets.

9

Sources of Goodwill

• Going concern goodwill

• Combination goodwill

FASB ended up not using this terminology in the actual standards that they issued. There is no requirement that we distinguish between the different sources of goodwill.

Goodwill

• Defined in FASB 142:– The excess of the cost of an acquired

entity over the net of the amounts assigned to assets acquired and liabilities assumed.

• The amounts assigned are fair values• Goodwill includes all intangible assets that do

not meet the criteria for recognition as an asset apart from goodwill.

– You only have goodwill if you've purchased another entire company.

The “Plug” Figure

• Goodwill is what it takes to balance the journal entry when you record the purchase of another company.

• ProceduresValue all identifiable assets and liabilities.Difference between cost and fair value of net

assets = Goodwill.Usually positive but occasionally the fair value is

GREATER than purchase price. This is sometimes called "Negative Goodwill."

Value all identifiable assets and liabilities

• Fixed assets--may be undervalued

• Patent--might not be on books if internally developed.

• Trade names will probably not be recorded

• Estimate for doubtful accounts could be off.

• Unrecorded liabilities, particularly contingencies. See new FASB 141 guidance on

valuing assets and liabilities on page 156

Impairment Losses - Goodwill

At same time each year, the goodwill of a reporting unit is subjected to a two step impairment test

New GAAP - FASB 141 & 142

2-step impairment test

• 1. Determine fair values of all identifiable tangible and intangible assets (other than goodwill) and the fair values of all liabilities– If fair value is greater than carrying value,

no impairment loss is recorded– If fair value is LESS than carrying value,

perform step two


Page 186


• Implied goodwill is the difference between the fair values as determined in step 1 and the carrying value without goodwill

• 2. If implied goodwill is less than the carrying value of goodwill, recognize an impairment loss for the difference



• Detailed evaluation can be carried forward to the next year without change if– No significant changes in assets and liabilities in

the reporting unit– Most recent evaluation indicated substantial

margin of implied goodwill over the carrying value of goodwill

– The likelihood that a current fair value determination would be less than the current carrying value is considered remote


Page 187

Interim impairment tests

• If events and circumstances indicate that impairment is more likely than not, an interim impairment test must be conducted:– Adverse change in business climate– Unanticipated competition– Loss of key personnel– Adverse action or assessment by a

regulator


Income Statement Presentation

• Impairment losses on goodwill– Presented in aggregate on income

statement as separate line item– Presented before income from continuing

operations


Goodwill Example“Target Company”Net Accounts Receivable $ 60,000Inventory 90,000Plant & Equipment (net) 190,000Marketable Securities 30,000Patent 10,000Current liabilities $20,000LT debt 80,000 - 100,000Owners’ equity $280,000

Page 151

On Jan. 1, 1998, Diversified Inc. purchased all the assets and assumed all the liabilities of Target Company for $290,000

• A/R were estimated to be worth $50,000• Inventories were worth $95,000• PP&E were worth $200,000• Marketable securities were worth $30,000• The patent is worth $50,000• The liabilities were correctly stated

At what amount, if any, should goodwill be recorded?

• Steps to work the problem:Estimate fair value of the identifiable

assetsCompare fair value of identifiable

assets to purchase priceGoodwill is the difference

Fair values of identifiable assets

• A/R (overvalued by $10,000) $ 50,000

• Inventory (under by $5,000) 95,000

• PP&E (under by $10,000) 200,000

• Intangible assets (under by 40,000) 50,000

• Marketable securities (ok) 30,000

• Less liabilities (ok) -100,000

= Fair value of net assets $325,000

Difference between purchase price and fair value

• Fair value of net assets $325,000

• Purchase price 400,000

• Goodwill $ 75,000

Journal entry to record purchase

• A/R $50,000Inventory 95,000PP&E 200,000Patent 50,000Investments 30,000Goodwill 75,000

Liabilities $100,000Cash 400,000

• Total $500,000 $500,000

Page 152

Compute amortization of goodwill expense for 1998:

• $75,000 / 40 years =

• $1,875 per year

Dr Cr

Amortization Expense $1,875

Goodwill $1,875

Under FASB 142:

• Goodwill is not amortized because it has an indefinite life.– Instead, a two-stage impairment test is performed

at least annually– If goodwill appears to have declined in value, an

impairment loss is recognized in net income.– We’ll talk more about this in conjunction with rules

on other impairment tests in Chapter 13

New Rules

What if purchase price is LESS than fair value of net assets?

“negative goodwill” situation

Assume purchase price was $300,000

A/R $ 50,000

Inventory 95,000

PP&E 200,000

Intangible asset 50,000

Marketable securities 30,000– Less liabilities -100,000= Net fair value $325,000

• Purchase price $300,000

• NEGATIVE Goodwill = ($ 25,000)

Page 153

“Negative Goodwill”

• If the fair value of the acquired net assets exceeds the purchase price, the excess is allocated as a pro rata reduction of the amounts that would otherwise have been assigned to noncurrent assets– EXCEPTIONS:

• Marketable securities carried at fair value• See notes for other exceptions

• You can go all the way to ZERO if necessary to eliminate the “negative goodwill”

New Rules

“Negative Goodwill”

• If the acquisition is a really, really great bargain, it is possible to write down all the noncurrent (non-financial) assets to zero and still need a credit to balance the journal entry.

• Under FASB 141, this amount would be recognized immediately (at acquisition) as an extraordinary gain.

Reduce noncurrent assets to eliminate negative goodwill

Fair values - Noncurrent assets:PP&E $200,000 80%

Patent 50,000 20%Total $250,000 100%

Page 153

$20,000$ 5,000$25,000

Record

PP&E = $200,000 – 20,000 = $180,000

Patent = $50,000 – 5,000 = $ 45,000

Goodwill = $ 0

Journal entry to record purchase

• A/R $50,000Inventory 95,000PP&E 180,000Patent 45,000Investments 30,000

Liabilities $100,000Cash 300,000

• Total $400,000 $400,000

Tax Issues

• Amortization of Goodwill may or may not be tax deductible

• Amortization of goodwill acquired BEFORE 8-11-93 is NOT tax deductible– It is a permanent difference between book

income and taxable income

Page 154

Tax Issues

• Amortization of goodwill acquired AFTER 8-10-93 is tax deductible over a 15 year period– It will be a temporary difference between

book income & taxable income

ExpenseResearch &Development

Intangible Assetswith Finite Life

PatentLicense agreement

Intangible Assetswith Indefinite Life

TradenameGoodwill

Cost ofIntangibles

Amo rt ize ov e r u s e fu l l ife

ImpairmentLoss

Expense immediately

Annual impairment test

What can be capitalized?

• The rules governing classification as an (purchased) intangible asset are in the chart on page 155:– Arises from contractual or other legal rights

even if those rights are not transferable, or– It is capable of being separated or divided

from the acquired entity and sold, transferred, licensed, or exchanged even if there is no intention to do so.

• Refer back to examples on page 130

Intangibles capitalized

• The rules governing classification as an (purchased) intangible asset are in the chart on page 155:– Valued at acquisition cost if acquired

individually– When acquired in a group of other

assets, acquisition cost is allocated to each item based on relative fair value

Amortization Expense =

Cost Economic life

Current accounting principles require that an intangible asset be amortized over its economic life, but not to exceed 40 years.

Page 183

Amortization of Intangibles

• Apparently "unlimited" life is really just indefinite--use maximum period 40 years.

• Before APB Opinion #17, unlimited life intangibles were not amortized.– "Grandfather Clause" for intangible assets

acquired before 11/1/70 - they do not have to be amortized.

Amortization of Intangibles

Finite Useful Life

Indefinite Useful Life

Goodwill N/A Not amortized. Subject to impairment test annually. Any goodwill impairment is recognized as an expense.Other

intangible assets

Amortized over expected useful life.

Not amortized. Subject to impairment test at least annually. If useful life becomes finite, the carrying value is amortized over useful life.

Page 183 – NEW MATERIAL – FASB 142

Determining useful life

Expected use by the organizationExpected useful life of similar or related

assetsLegal, regulatory or contract provisions

and provisions for renewal/extension.– Patents max, 17 years– Copyrights max 50 years after death of

author.

Renewal or extension provisions under laws, regulations or contracts

Effects of obsolescence, demand, competition, technological change.

Level of maintenance expenditures necessary– High future costs suggests short useful life



• If the precise length of the useful life is not known, use the best estimate of the useful life

• If no known factors limit the useful life, the useful life is considered to be indefinite.– Indefinite infinite

Page 184

Amortization Methods:

• Method should reflect the pattern in which the economic benefits are consumed or used up

• If pattern is unknown - use straight-line method:


Cost - Residual Value Economic life

New Materials - FASB 142

Page 185

Amortization Methods

• Residual value is presumed to be zero unless– Another entity which has committed to

purchase it for a certain price at a future date– A market for intangible exists and is expected

to exist at end of asset’s useful life to current owner

New GAAP - FASB 142


Cost - Residual Value Economic life

Accounting for Amortization

• "Accumulated amortization" account not generally used -- amortize by crediting asset account directly.– Note that under FASB 142, historical cost

and accumulated amortization WILL BE DISCLOSED

• Write-off Intangibles when it becomes evident that their value has been impaired (FASB 121). FASB 144

Page 185

Annual evaluation (other than goodwill)

• Evaluate estimated remaining useful life and adjust current and future amortization if needed

• Apply impairment test per FASB 144 and write-down if expected future cash inflows are less than carrying value

New GAAP - FASB 142 & FASB 144

Impairment test for intangibles not amortized

• At least annually:– Compare fair value to carrying amount– If carrying amount > fair value, recognize

impairment loss – In other words, write intangible down to its fair

value

• If an impairment is recognized, the fair value at that date becomes the new carrying value– If fair value later increases, there is no restoration

-- no upward adjustments are permitted!

New GAAP - FASB 142 & FASB 144

Example 1• A company acquires a broadcast license that

expires in 5 years. The license is renewable every 10 years if the license holder provides at least an average level of service and complies with Federal Communication Commission (FCC) rules and policies. The previous owner renewed the license twice. The new owner intends to renew the license in the foreseeable future.– What is the useful life? Should the cost be amortized

or subject only to an annual impairment test?

Page 188

Example 2

• The company in example 1 operates the television station for 10 years (easily obtaining a renewal license as expected). The FCC decides that it will no longer renew licenses. Instead, broadcast rights will be put up for bid. The current license has five years before it expires.– What is the useful life? Should the cost be

amortized or subject only to an annual impairment test?

Example 3

• A direct mail marketing company acquires a customer list and expects to be to derive benefit from the information for at least one year but no more than three years. The acquiring company intends to add customer names and other information to the list in the future. Management’s best estimate of the useful life of the names on the list at acquisition (given the pattern in which the expected benefits will be consumed) is about 18 months. – What is the useful life? Should the cost be amortized or

subject only to an annual impairment test?

Specific Types of Intangible Assets

Page 188

Intangible assets acquired in a business combination are recognized separately from goodwill if they arise from contractual or legal rights -- or because the asset is separable

Marketing-related intangibles

• Trademarks, tradenames

• Trade dress (unique color, shape, package design)

• Newspaper mastheads

• Internet domain names

• Noncompetition agreements


Customer related

• Legal or contractual rights– Order or production

backlog– Customer contracts

and related customer relationships

• Separable– Customer lists– Noncontractual

customer relationships such as bank depositors


Technology-based

• Legal or contractual rights– Patented technology– Computer software

and mask works– Trade secrets such

as secret formulas, processes, recipes

• Separable– Unpatented

technology– Databases, including

title plants– Trade secrets not

protected by law


Artistic-related

• Plays, operas, ballets• Books, magazines, newspapers and

other literary works• Muscial works such as compositions,

song lyrics, advertising jingles• Video and audiovisual material including

motion pictures, music videos, television programs


Contract-based

• Licensing, royalty and standstill agreements• Advertising, construction, management,

service or supply contracts• Lease agreements• Construction permits• Operating and broadcast rights• Use rights such as drilling, water, air, mineral,

timber cutting, and route authorities


business combinations, goodwill and intangibles fasb 141 and 142

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