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

Copyright

Holder: P. Bye
Process: no-fade,
brake fluid

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
There is
is one
one way
way to
to account
account
for
for aa business
business combination-combination-pooling
pooling of
of interest
interest and
and
purchase.
purchase.
The
The purchase
purchase method
method raises
raises
aa problem
problem in
in how
how to
to allocate
allocate
the
the purchase
purchase price
price to
to the
the
various
various assets
assets acquired.
acquired.

Page 149

Acquisition of an Entire Company

--Business Combination
Compared
Compared to
to pooling
pooling of
of interest,
interest, the
the
purchase
purchase method
method records
records assets
assets at
at their
their
fair
fair market
market value,
value, which
which results
results in
in lower
lower
earnings
earnings in
in subsequent
subsequent years
years due
due to
to higher
higher
amortization
amortization and
and depreciation
depreciation charges.
charges.
Page 149

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

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.
Page
149

Purchase
Agreement

Appraisal
Land

$10,000

Price $100,000

Bldg.

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)
$ 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
Goodwill

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

$500,000

Page
152

$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

Under FASB 142:

New Rules

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

Assume purchase price was $300,000

Page 153

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

Purchase price
NEGATIVE Goodwill =

$300,000

($ 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
Page 153

Fair values - Noncurrent assets:

PP&E
Patent
Total

$200,000 80%
50,000 20%
$250,000 100%

$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
$50,000
Inventory
95,000
PP&E 180,000
Patent
45,000
Investments 30,000
Liabilities $100,000
Cash
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

Research &
Development

Expense immediately

Intangible Assets
with Finite Life

Cost of
Intangibles

Intangible Assets
with Indefinite Life
Tradename
Goodwill

Expense

Patent
License agreement

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
Page 183
exceed 40 years.
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

Other
intangible
assets

Amortized over
expected useful
life.

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

Example 1

Page 188

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 &