Business Combinations, Goodwill and Intangibles

FASB 141 and 142

Intangible assets generally result from legal or contractual rights which do not have a physical substance.
U.S. Patent Holder: P. Bye Process: no-fade, brake fluid Copyright Artist: B. Joel Song: Uptown Girl

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.

When a company internally develops an intangible asset, only certain costs can be capitalized such as legal and related costs.
U.S. Patent
Holder: P. Bye Process: no-fade, brake fluid

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.

For financial reporting purposes, identifiable and unidentifiable intangible assets are treated the same - they are both capitalized.
XYZ Co. Balance She 12/31/9 Cash Equipment 54 Goodwill 32,010 Patents 1,430

But . . . Only if purchased!

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.

Page 149

The purchase method raises a problem in how to allocate the purchase price to the various assets acquired.

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.
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 O companys identifiable assets. K Recording Goodwill
1. Write identifiable assets up to FMV. 2. Record excess purchase price over net assets at FMV as goodwill.

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.
Purchase Agreement Page 149 Price $100,000 Appraisal Land Bldg. $10,000 40,000

FMV $50,000

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. Procedures
Value 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

Page 186

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
New GAAP - FASB 141 & 142

2-step impairment test

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
New GAAP - FASB 141 & 142

Page 187

2-step impairment test

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 New GAAP - FASB 141 & 142

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
New GAAP - FASB 141 & 142

Income Statement Presentation

Impairment losses on goodwill
Presented in aggregate on income statement as separate line item Presented before income from continuing operations

New GAAP - FASB 141 & 142

Goodwill Example
Target Company
Net Accounts Receivable $ 60,000 Inventory 90,000 Plant & Equipment (net) 190,000 Marketable Securities 30,000 Patent 10,000 Current liabilities $20,000 LT debt 80,000 - 100,000 Owners 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 assets Compare fair value of identifiable assets to purchase price Goodwill is the difference

Fair values of identifiable assets

A/R (overvalued by $10,000) Inventory (under by $5,000) PP&E (under by $10,000) Intangible assets (under by 40,000) Marketable securities (ok) Less liabilities (ok) = Fair value of net assets $ 50,000 95,000 200,000 50,000 30,000 -100,000 $325,000

Difference between purchase price and fair value

Fair value of net assets Purchase price Goodwill $325,000 400,000 $ 75,000

Journal entry to record purchase

A/R Inventory PP&E Patent Investments Goodwill Liabilities Cash Total $50,000 95,000 200,000 50,000 30,000 75,000
Page 152

$500,000

$100,000 400,000 $500,000

Compute amortization of goodwill expense for 1998:

$75,000 / 40 years = $1,875 per year
Dr Cr

Amortization Expense $1,875

Goodwill $1,875

New Rules

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. Well talk more about this in conjunction with rules on other impairment tests in Chapter 13

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

negative goodwill situation

Page 153

Assume purchase price was $300,000

A/R Inventory PP&E Intangible asset Marketable securities Less liabilities = Net fair value $ 50,000 95,000 200,000 50,000 30,000 -100,000 $325,000 $300,000

Purchase price NEGATIVE Goodwill =

($ 25,000)

Negative Goodwill

Page 152

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

Negative Goodwill

New Rules

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 Patent Total $200,000 80% 50,000 20% $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 Inventory PP&E Patent Investments Liabilities Cash Total $50,000 95,000 180,000 45,000 30,000 $100,000 300,000 $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

Research & Development

Expense immediately

Expense
Amortize over useful life

Cost of Intangibles

Intangible Assets with Finite Life

Patent License agreement

Intangible Assets with Indefinite Life

Tradename Goodwill

Annual impairment test

Impairment Loss

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

Current accounting principles require that an intangible asset be amortized over its economic life, but not to exceed 40 years.
Page 183

Amortization Expense =

Cost Economic life

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.

Page 183 NEW MATERIAL FASB 142

Amortization of Intangibles
Finite Useful Life Goodwill
N/A

Indefinite Useful Life

Not amortized. Subject to impairment test annually. Any goodwill impairment is recognized as an expense. Not amortized. Subject to impairment test at least annually. If useful life becomes finite, the carrying value is amortized over useful life.

Other intangible assets

Amortized over expected useful life.

Determining useful life

Expected use by the organization Expected useful life of similar or related assets Legal, regulatory or contract provisions and provisions for renewal/extension.
Patents max, 17 years Copyrights max 50 years after death of author.
Page 183

Determining useful life

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

Determining 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

New Materials - FASB 142

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:

Amortization Expense =
Page 185

Cost - Residual Value Economic life

New GAAP - FASB 142

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 assets useful life to current owner Amortization Expense = 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

Page 188

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?

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. Managements 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
New GAAP - FASB 141 & 142

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

New GAAP - FASB 141 & 142

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 New GAAP - FASB 141 & 142

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
New GAAP - FASB 141 & 142

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
New GAAP - FASB 141 & 142