CHAPTER Intangible Assetsharmon/password1/Kieso14E...related to intangibles, companies should follow...

50–59 60–69 70–79 80–89 90–99 '00–'09

26%

24%

22%

20%

18%

0%

Investment includingintangibles*

Official data

Gap

The Growing Importance of Intangibles

*Includes research, product development, brand equity, employee training, and organizational change.

Percent

Data: Bureau of Economic Analysis, Bureau of Labor Statistics.

IVIIIII IIIIII'08

I'09

IV'07

0

2

–2

–4

–6

–8

4

Reported GDP jumps ahead of jobs...

AnnualGrowth Rate

Real GDPPrivate Jobs

Are We There Yet?As shown in the graph below on the left, 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.

Intangible Assets12C

HA

PTER

1 Describe the characteristics of intangible assets.

2 Identify the costs to include in the initial valuation of intangible assets.

3 Explain the procedure for amortizing intangible assets.

4 Describe the types of intangible assets.

5 Explain the conceptual issues related to goodwill.

6 Describe the accounting procedures for recording goodwill.

7 Explain the accounting issues related to intangible-asset impairments.

8 Identify the conceptual issues related to research and development costs.

9 Describe the accounting for research and development and similar costs.

10 Indicate the presentation of intangible assets and related items.

LEARNING OBJECTIVESAfter studying this chapter, you should be able to:

This growing gap appears to also be behind the recent debate on whether we are digging out of the economic recession or not. As shown in the chart above on the right, based on an official measure—gross domestic product (GDP)—it appears that we are climbing out of the recession nicely. At the same time, job growth is still in negative territory. That is, we are not there yet, as we are experiencing a “jobless recovery.” Why the disconnect between these measures? As indicated above, a big driver is that GDP does not pick up cutbacks in “intangible investments,” such as business spending on research and development, product design, and worker training.

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For example, as shown in the chart on the right, many companies have taken a deep ax to their R&D spending, which also does show up in GDP (that is, cuts in R&D increase corporate incomes and GDP). Alcoa, in an effort to preserve cash, reduced its R&D spending by 36 percent from the year before. And Johnson & Johnson has reduced its R&D by 13 percent. Even though the recently passed stimulus package included extra government funds for research and development, this recent data indicate that total real spending on R&D is falling for the second straight year. These cutbacks in R&D spending appear to be directly related to sluggish job growth. Nonproduction jobs—which include engineers, scientists, and other knowledge workers—declined 7.6 percent during the period that R&D spending was being cut. Thus, the GDP statistics are sending too rosy a message about the economy, making it difficult to know if the United States is really on the road to recovery. In effect, government statisticians are trying to track the 21st-century economic recovery with 20th-century tools. The Bureau of Economic Analysis (BEA), the government agency that compiles the GDP figures, is taking steps to address this. Software has been treated as investment since 1999, and the BEA plans to include R&D in the official GDP statistics in 2013. But the agency acknowledges that other areas of intangible investment still need to be worked into the numbers. And 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), and Michael Mandel, “The GDP Mirage: By Overlooking Cuts in Research and Develop-ment, Product Design, and Worker Training, GDP Is Greatly Overstating the Economy’s Strength,” BusinessWeek (November 9, 2009).

IN THIS CHAPTER

C See the International Perspectives on pages 668 and 681.

C Read the IFRS Insights on pages 712–719 for a discussion of:

— Development costs

— Impairments of intangibles

IFRS

As our opening story indicates, the account-ing and reporting of intangible assets is taking on increasing importance in this information

age, especially for companies like Texas Instruments and Johnson & Johnson. 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.

PREVIEW OF CHAPTER 12

665

INTANG IBLE ASSETS

RESEARCH AND DEVELOPMENT COSTS

INTANG IBLE ASSET ISSUES

• Characteristics

• Valuation

• Amortization

TYPES OF INTANG IBLES

IMPA IRMENT OF INTANG IBLES

PRESENTAT ION OF INTANG IBLES AND

RELATED I TEMS

• Marketing-related

• Customer-related

• Artistic-related

• Contract-related

• Technology-related

• Goodwill

• Limited-life intangibles

• Indefinite-life intangibles other than goodwill

• Goodwill

• Summary

• Identifying R&D

• Accounting for R&D

• Similar costs

• Conceptual questions

• Intangible assets

• R&D costs

0–10–20

Selected Companies that Have Cut R&DSpending over the Past YearPercent Change in R&D Spending*

...but the GDP stats don’t count R&D cuts...

HasbroJohnson & JohnsonEatonLexmark InternationalMicron TechnologyAdobe SystemsAnalog DevicesUnited TechnologiesCaterpillarTexas InstrumentsAlcoa

–30–40“Latest quarter compared to a year earlier.”Data: Company reports.


666 Chapter 12 Intangible Assets

INTANGIBLE ASSET ISSUESCharacteristics

Gap Inc.’s most important asset is its brand image, not its store fixtures. The Coca-Cola Company’s success comes from its secret formula for making Coca-Cola, not its plant facilities. America Online’s 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 character-istics. [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 fi nancial instruments. Assets such as bank deposits, accounts receivable, and long-term investments in bonds and stocks also lack physical substance. How-ever, fi nancial instruments derive their value from the right (claim) to receive cash or cash equivalents in the future. Financial instruments are not classifi ed 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 IntangiblesCompanies 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 val-ues. Essentially, the accounting treatment for purchased intangibles closely parallels that for purchased tangible assets.1

Internally Created IntangiblesSometimes 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 inter-nally 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

LEARNING OBJECTIVE 1Describe the characteristics of intangible assets.

See the FASB Codification section (page 694).

LEARNING OBJECTIVE 2Identify the costs to include in the initial valuation of intangible assets.

1The 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.

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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.

Amortization of IntangiblesThe allocation of the cost of intangible assets in a systematic way is called amorti-zation. Intangibles have either a limited (finite) useful life or an indefinite useful life. For example, a company like Walt Disney has both types of intangi-bles. 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).

Limited-Life IntangiblesCompanies 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 asset’s 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 modifi cations 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, legis-lative 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 fl ows from the asset. For example, a material level of required maintenance in rela-tion 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 reli-ably determine that pattern. For example, assume that Second Wave, Inc. purchases a li-cense 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 Wave’s 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, Sec-ond 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 amor-tizes 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 in-tangible 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 asset’s 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.

Intangible Asset Issues 667

3 LEARNING OBJECTIVEExplain the procedure for amortizing intangible assets.


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 impair-ment. 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.)

Indefi nite-Life IntangiblesIf 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 as-set with an indefinite life. To illustrate, assume that Double Clik Inc. acquired a trade-mark 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 intangi-bles. 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.

INTERNATIONAL PERSPECTIVE

IFRS requires capitalization of some development costs.

The importance of intangible asset classifi cation as either limited-life or indefi nite-life is illus-trated in the experience of Outdoor Channel Holdings. Here’s 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 classifi ed the relationship as indefi nite-life. Thus, in 2004 and 2005 Outdoor Channel recorded no amortization expense on this asset. In 2006 investors were surprised to fi nd that Outdoor Channel changed the classifi cation of the distributor relationship to limited-life, with an expected life of 21.33 years (a fairly defi nite useful life) and, shortly after, wrote off this intangible completely.

Apparently, the company was overly optimistic about the expected future cash fl ows 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 indefi nite-life to limited-life to worthless in two short years—investors were surely hurt by Outdoor’s aggressive intangible asset classifi cation.

Source: Jack Ciesielski, The AAO Weblog, www.accountingobserver.com/blog/ (January 12, 2007).

DEFINITELY INDEFINITE

What do the numbers mean?


ILLUSTRATION 12-1Accounting Treatment for Intangibles

Manner Acquired

Type of Internally Impairment Intangible Purchased Created Amortization Test

Limited-life Capitalize Expense* Over useful life Recoverability intangibles test and then fair value test

Indefinite-life Capitalize Expense* Do not Fair value test intangibles amortize only

*Except for direct costs, such as legal costs.


TYPES OF INTANGIBLE ASSETSAs 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. 3. Artistic-related intangible assets. 4. Contract-related intangible assets. 5. Technology-related intangible assets. 6. Goodwill.

Marketing-Related Intangible AssetsCompanies primarily use marketing-related intangible assets in the marketing or pro-motion 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 trade-mark 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 does 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 se-curing it, such as attorney fees, registration fees, design costs, consulting fees, and success-ful 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

4 LEARNING OBJECTIVEDescribe the types of intangible assets.

Types of Intangible Assets 669

2To 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 board’s design as a unique graphic creation.


surprising why Apple would want to settle—to avoid a costly delay to the launch of its highly anticipated iPhone.3

Customer-Related Intangible AssetsCustomer-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 news-paper for $6,000,000 on January 1, 2012. This customer database includes name, contact information, order history, and demographic information. Green Market expects to bene-fit 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, 2012

Customer List 6,000,000

Cash 6,000,000

(To record purchase of customer list)

December 31, 2012, 2013, 2014

Amortization Expense 2,000,000

Customer List (or Accumulated Customer

List Amortization) 2,000,000

(To record amortization expense)

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 12-2Calculation of Amortization Expense with Residual Value

Cost $6,000,000Less: Residual value 60,000

Amortization base $5,940,000

Amortization expense per period: $1,980,000 ($5,940,000 4 3)

Companies should assume a zero residual value unless the asset’s useful life is less than the economic life and reliable evidence is available concerning the residual value. [4]

Artistic-Related Intangible AssetsArtistic-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, sculp-tors, 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


3Nick Wingfield, “Apple, Cisco Reach Accord Over iPhone,” Wall Street Journal Online (February 22, 2007).


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 Court—and 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 Webber—Cats, 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 amor-tize 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 encour-ages 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.

Contract-Related Intangible AssetsContract-related intangible assets represent the value of rights that arise from contrac-tual 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 McDonald’s 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 franchisor’s 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 ser-vices. 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 intangi-ble 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 fran-chise. 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 operat-ing 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 AssetsTechnology-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. Compa-nies such as Merck, Polaroid, and Xerox were founded on patents and built on the ex-clusive 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 suc-cessful legal suit to protect the patent, as part of the patent cost. However, it must ex-pense 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 682–683.)

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 sev-eral 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.

4Consider 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.

From bioengineering to software design to Wall Street, global competition is bringing to the boil-ing point battles over patents. For example, to protect its patented “one-click” shopping technol-ogy that saves your shipping and credit card information when you shop online, Amazon.com fi led 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 com-petitive 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).

PATENT BATTLES



As mentioned earlier, companies capitalize the costs of defending copyrights. The accounting treatment for a patent defense is similar. A company charges all unrecov-ered 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, 2012, to successfully defend a patent. The patent’s useful life is 20 years, amortized on a straight-line basis. Harcott records the legal fees and the amortization at the end of 2012 as follows.

5Companies may compute amortization on a units-of-production basis in a manner similar to that described for depreciation on property, plant, and equipment.6Another classic example is Eli Lilly’s drug Prozac (prescribed to treat depression). In 1998, this product accounted for 43 percent of Eli Lilly’s 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.

January 1, 2012

Patents 180,000

Cash 180,000

(To record legal fees related to patent)

December 31, 2012

Amortization Expense 9,000

Patents (or Accumulated Patent Amortization) 9,000

(To record amortization of patent)

We’ve indicated that a patent’s 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 mod-ifications 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.



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 world’s 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-Cola’s board of directors.

Can’t 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 compli-cated, since they are made of thousands of compounds. One ingredient you will not fi nd, by the way, is cocaine. Although the original formula did contain trace amounts, today’s Coke doesn’t. When was it removed? That too is a secret.

Some experts indicate that the power of the Coca-Cola formula and related brand image ac-count for almost $63 billion, or roughly 12 percent, of Coke’s $538 billion stock value.

Source: Adapted from Reed Tucker, “How Has Coke’s Formula Stayed a Secret?” Fortune (July 24, 2000), p. 42; and David Kiley, “Best Global Brands,” BusinessWeek (August 6, 2007), p. 59.

THE VALUE OF A SECRET FORMULA


GoodwillAlthough companies may capitalize certain costs incurred in developing specifi-cally identifiable assets such as patents and copyrights, the amounts capitalized are generally insignificant. But companies do record material amounts of intangible 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 Com-pany. In this situation, Portofino measures the assets acquired and the liabilities as-sumed 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

In many business combinations, the purchasing company records goodwill. Good-will is measured as the excess of the cost of the purchase over the fair value of the iden-tifiable net assets (assets less liabilities) purchased. For example, if Portofino paid $2,000,000 to purchase Aquinas’s 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 GoodwillInternally Created Goodwill. Goodwill generated internally should not be capi-talized in the accounts. The reason? Measuring the components of goodwill is sim-ply 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 subjectivity—even 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 residual—the 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. Illustra-tion 12-3 presents the balance sheet of Tractorling Company.

LEARNING OBJECTIVE 5Explain the conceptual issues related to goodwill.

7GAAP [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.


Underlying Concepts

Capitalizing goodwill only when it is purchased in an arm’s-length transaction, and not capitalizing any goodwill generated internally, is another example of faithful represen-tation winning out over relevance.

LEARNING OBJECTIVE 6Describe the accounting procedures for recording goodwill.



ILLUSTRATION 12-3Tractorling Co. Balance Sheet

TRACTORLING CO.BALANCE SHEET

AS OF DECEMBER 31, 2012

Assets Equities

Cash $ 25,000 Current liabilities $ 55,000 Accounts receivable 35,000 Capital stock 100,000 Inventory 42,000 Retained earnings 100,000 Property, plant, and equipment, net 153,000

Total assets $255,000 Total equities $255,000

After considerable negotiation, Tractorling Company decides to accept Multi-Diversified’s offer of $400,000. What, then, is the value of the goodwill, if any?

The answer is not obvious. Tractorling’s 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 Tractorling’s 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 from some other source. The investigation determines the valuations shown in Illustration 12-4.

ILLUSTRATION 12-4Fair Value of Tractorling’s Net Assets

Fair Values

Cash $ 25,000Accounts receivable 35,000Inventory 122,000Property, plant, and equipment, net 205,000Patents 18,000Liabilities (55,000)

Fair value of net assets $350,000

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. Liabili-ties 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 Tractorling’s inventories ($122,000 2 $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 equip-ment, and intangibles may have increased substantially over the years. This difference could be due to inaccurate estimates of useful lives, continual expensing of small expen-ditures (say, less than $300), inaccurate estimates of salvage values, and the discovery of some unrecorded assets. (For example, in Tractorling’s 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 em-ployees, and so on. These factors make the value of the business greater than $350,000.

Gateway to the Profession

Expanded Discussion—

Valuing Goodwill



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 unidenti-fiable 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 shows this approach.

8The 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]

ILLUSTRATION 12-5Determination of Goodwill—Master Valuation Approach

Multi-Diversified records this transaction as follows.

Cash 25,000Accounts Receivable 35,000Inventory 122,000Property, Plant, and Equipment 205,000Patents 18,000Goodwill 50,000

Liabilities 55,000

Cash 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-OffCompanies 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 company’s 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 goodwill’s 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 com-panies immediately expense goodwill created internally and should follow the same treatment for purchased goodwill. Though these arguments may have some merit,

Assigned to purchase priceof $400,000

CashAccounts receivableInventory Property, plant, and equipment, netPatents Liabilities

Fair value of net identifiable assetsPurchase price

Value assigned to goodwill

$ 25,000 35,000 122,000 205,000 18,000

(55,000)

$350,000 400,000

$ 50,000


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 PurchaseIn 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 bar-gain 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 pur-chaser 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 liabili-ties. As a result, the FASB requires companies to disclose the nature of this gain transac-tion. Such disclosure will help users to better evaluate the quality of the earnings reported.9

IMPAIRMENT OF INTANGIBLE ASSETSIn 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.

Impairment of Limited-Life IntangiblesThe 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 prop-erty, plant, and equipment for impairment at certain points—whenever 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 asset’s 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 de-mand 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. Lerch’s patent has a carrying amount of $60 mil-lion. 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.

7 LEARNING OBJECTIVEExplain the accounting issues related to intangible-asset impairments.

9This gain is not reported as an extraordinary item, [7] which is consistent with convergence in international accounting standards. Note that IFRS does not permit extraordinary item reporting.

Impairment of Intangible Assets 677



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 im-pairment loss computation (based on fair value).

ILLUSTRATION 12-6Computation of Loss on Impairment of Patent

Carrying amount of patent $60,000,000Less: Fair value (based on present value computation) 20,000,000

Loss on impairment $40,000,000

Lerch records this loss as follows:

Loss on Impairment 40,000,000

Patents 40,000,000

After recognizing the impairment, the reduced carrying amount of the patents is its new cost basis. Lerch should amortize the patent’s new cost over its remain-ing 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.

Impairment of Indefi nite-Life Intangibles Other Than GoodwillCompanies 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 asset’s carrying amount. If the fair value is less than the carrying amount, the company recog-nizes an impairment. Companies use this one-step test because many indefinite-life 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 re-newed 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 per-forms 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.

Underlying Concepts

The basic attributes of intangibles, their uncertainty as to future benefits, and their uniqueness have discouraged valuation in excess of cost.

ILLUSTRATION 12-7Computation of Loss on Impairment of Broadcast License

Carrying amount of broadcast license $2,000,000Less: Fair value of broadcast license 1,500,000

Loss on impairment $ 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 GoodwillThe 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.

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To illustrate, assume that Kohlbuy Corporation has three divisions. It purchased one division, Pritt Products, four years ago for $2 million. Unfortunately, Pritt experi-enced 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 Division’s net assets, including the associated goodwill of $900,000 from the purchase.

ILLUSTRATION 12-8Net Assets of Pritt Division, Including Goodwill

Cash $ 200,000Accounts receivable 300,000Inventory 700,000Property, plant, and equipment (net) 800,000Goodwill 900,000Accounts and notes payable (500,000)

Net assets $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 impair-ment. 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 com-putes the implied value of the goodwill in this case.10

10Illustration 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.

ILLUSTRATION 12-9Determination of Implied Value of Goodwill

Fair value of Pritt Division $1,900,000Less: Net identifiable assets (excluding goodwill) ($2,400,000 2 $900,000) 1,500,000

Implied value of goodwill $ 400,000

Impairment of Intangible Assets 679

Kohlbuy then compares the implied value of the goodwill to the recorded goodwill to measure the impairment, as shown in Illustration 12-10.

ILLUSTRATION 12-10Measurement of Goodwill Impairment

Carrying amount of goodwill $900,000Less: Implied value of goodwill 400,000

Loss on impairment $500,000

Impairment SummaryIllustration 12-11 summarizes the impairment tests for various intangible assets.

ILLUSTRATION 12-11Summary of Intangible Asset Impairment Tests

Type of Intangible Asset Impairment Test

Limited life Recoverability test, then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit, then fair value test

on implied goodwill.



RESEARCH AND DEVELOPMENT COSTSResearch 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 prod-uct, 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 global companies.

As shown in the chart below, goodwill impairments spiked in 2007 and 2008, coinciding with the stock market downturn in the wake of the fi nancial crisis.

IMPAIRMENT RISK

A spike in impairments when the market declines is understandable because declines in stock price are indicators that the fair values of acquired assets have declined below the carrying value. A good example is Time Warner; it recorded a $25 billion write-off of intangible assets, including goodwill, in 2008. As one analyst noted, “Anybody looking at the plunge in the Time Warner’s stock price could see the company was placing a much higher value on its assets than the market thought they were worth.”

While goodwill impairments declined in 2009, they are still higher than pre-fi nancial crisis levels. Investors need to keep watch. Asset write-downs of this sort—brand names, franchise rights, and other intangible assets (including goodwill)—are important because they tell investors that management has concluded their companies’ future cash fl ows will not achieve previous estimates.

Source: J. Weil, “Time Warner Kicks Off Writedown Season with Bang,” Bloomberg.com (January 8, 2009).


Annual Goodwill Impairment Trend

Years

Total number impaired Percentage impaired

0%

2%

4%

6%

8%

10%

Perc

enta

ge o

f tot

al p

opul

atio

n

Num

ber

impa

ired 12%

14%

16%

18%

0

50

100

2005 2006 2007 2008 2009

150

200

250

300

Source: “Evaluating Impairment Risk: Goodwill Impairment Charges Decline in 2009” (KPMG LLP), 2009.

LEARNING OBJECTIVE 8Identify the conceptual issues related to research and development costs.


ILLUSTRATION 12-12R&D Outlays, as a Percentage of Sales

Sales Company (millions) R&D/Sales

Canon ¥4,094,000 2.74%Daimler €958,730 3.19%GlaxoSmithKline £24,352.0 15.12%Johnson & Johnson $53,324.0 13.36%Nokia €50,710.0 11.77%Roche CHF45,617.0 19.39%Procter & Gamble $76,476.0 2.76%Samsung W121,294.0 5.82%

Two difficulties arise in accounting for R&D expenditures: (1) identifying the costs associated with particular activities, projects, or achievements, and (2) deter-mining 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 simpli-fied the accounting practice in this area. Companies must expense all research and development costs when incurred. [9]

Identifying R&D ActivitiesIllustration 12-13 shows the definitions for research activities and development activities. These definitions differentiate research and development costs from other similar costs. [10]

INTERNATIONAL PERSPECTIVE

IFRS require the capitalization of appropriate development expenditures. This conflicts with GAAP.

Prototype

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.

Planned search or critical investigation aimed at discovery of new knowledge.

Laboratory research aimed at discovery of new knowledge; searching for applications of new research findings.

Development ActivitiesResearch Activities

ExamplesExamples

Idea

Conceptual formulation and design of possible product or process alternatives; construction of prototypes and operation of pilot plants.

ILLUSTRATION 12-13Research Activities versus Development Activities

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.

Research and Development Costs 681



Accounting for R&D ActivitiesThe costs associated with R&D activities and the accounting treatments accorded them are as follows.

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 recogni-tion, account for in accordance with their nature (as either limited-life or indefi nite-life 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 depre-ciation and other costs related to such research facilities as R&D expenses.12

To illustrate, assume that Next Century Incorporated develops, produces, and mar-kets 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.

Costs Similar to R&D CostsMany costs have characteristics similar to research and development costs. Examples are:

1. Start-up costs for a new operation. 2. Initial operating losses. 3. Advertising costs. 4. Computer software costs.

11If R&D–related 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]12Companies 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 invento-riable 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.13Sometimes 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].

LEARNING OBJECTIVE 9Describe the accounting for research and development and similar costs.


Start-Up CostsStart-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 busi-ness 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 expec-tation of future revenues or increased efficiencies. However, to determine the amount and timing of future benefits is so difficult that a conservative approach—expensing these costs as incurred—is required. [14]

To illustrate examples of start-up costs, assume that U.S.-based Hilo Beverage Com-pany decides to construct a new plant in Brazil. This represents Hilo’s first entry into the Brazilian market. Hilo plans to introduce the company’s 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.


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.

ILLUSTRATION 12-14Sample R&D Expenditures and Their Accounting Treatment

Next Century Incorporated

Type of Expenditure Accounting Treatment Rationale

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.

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.


Record as a receivable.



Capitalize as patent and amortize to over-head as part of cost of goods manufactured.

Expense as operating expense.



Capitalize as patent and amortize to over-head as part of cost of goods manufactured.


Has alternative future use.

Research cost.



Research cost.

Not R&D cost (reimbursable expense).

Development cost.

Development cost.

Direct cost of patent.

Not R&D cost (general and administrative expense).

Not R&D cost (selling expense).

Development cost.

Direct cost of patent.

Not R&D cost (selling expense).



2. Training of local employees related to product, maintenance, computer systems, fi nance, 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 LossesSome 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. Hilo’s 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 consid-ered an asset.

GAAP requires that operating losses during the early years should not be capi-talized. 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 en-terprises. [15]14

Advertising CostsOver the years, PepsiCo has hired various pop stars, such as Justin Timberlake and Beyoncé, 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. When they have completed their singing assignments. 2. The fi rst time the advertising runs. 3. Over the estimated useful life of the advertising. 4. In an appropriate fashion to each of the three periods identifi ed above. 5. 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 tan-gible 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 approach to recording advertising costs because defining and measuring the future benefits can be so difficult. [16]15

14A 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.15There 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.


Computer Software CostsA special problem arises in distinguishing R&D costs from selling and administrative activities. The FASB’s 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 company’s management information system are not research and devel-opment costs.

Accounting for computer software costs is a specialized and complex accounting topic that we discuss and illustrate in Appendix 12A (pages 690–693).

Conceptual QuestionsThe requirement that companies expense immediately all R&D costs (as well as start-up 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.

For many companies, developing a strong brand image is as important as developing the prod-ucts they sell. Now more than ever, companies see the power of a strong brand, enhanced by signifi cant 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 $69 billion.


BRANDED

The World’s 10 Most Valuable Brands(in billions)

1 Coca-Cola $68.7 6 McDonald’s $32.32 IBM 60.2 7 Google 32.03 Microsoft 55.6 8 Toyota 31.34 GE 47.8 9 Intel 30.65 Nokia 34.9 10 Disney 28.4

Source: 2009 data, from Interbrand Corp., J. P. Morgan Chase, Citigroup, and Morgan Stanley.

Occasionally you may find the value of a brand included in a company’s financial state-ments under goodwill. But generally you will not fi nd the estimated values of brands recorded in companies’ balance sheets. The reason? The subjectivity that goes into estimating a brand’s 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 fl ows, 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 Burt Helm, “100 Best Global Brands,” BusinessWeek (September 28, 2009), p. 46.




Proponents of immediate expensing contend that from an income statement standpoint, long-run application of this standard frequently makes little differ-ence. They argue that because of the ongoing nature of most companies’ R&D ac-tivities, the amount of R&D cost charged to expense each accounting period is about the same, whether there is immediate expensing or capitalization and sub-sequent 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 company’s most valuable asset. This standard represents one of the many trade-offs made among relevance, faithful representation, and cost-benefit considerations.16

PRESENTATION OF INTANGIBLES AND RELATED ITEMSPresentation of Intangible Assets

The reporting of intangible assets is similar to the reporting of property, plant, and equipment. However, contra accounts are not normally shown for intangibles on the balance sheet. As Illustration 12-15 shows, on the balance sheet companies should report as a separate item all intangible assets other than goodwill. If good-will 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 im-pairment losses for intangible assets other than goodwill separately and as part of con-tinuing 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 succeed-ing 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 CostsCompanies 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 state-ment. Merck & Co., Inc., a global research pharmaceutical company, reported both

16Research 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&D–intensive 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 Account-ing Research (Fall 1995).

Underlying Concepts

The requirement that companies expense all R&D costs as incurred is an example of the conflict between relevance and faithful representation. Here, this requirement leans strongly in support of faithful representation, as well as consistency and compara-bility. No attempt is made to match costs and revenues.

LEARNING OBJECTIVE 10Indicate the presentation of intangible assets and related items.

c12IntangibleAssets.indd Page 686 12/30/10 12:18:11 PM user-s146c12IntangibleAssets.indd Page 686 12/30/10 12:18:11 PM user-s146 /Users/user-s146/Desktop/Merry_X-Mas/New/Users/user-s146/Desktop/Merry_X-Mas/New

HARBAUGH COMPANY

Balance Sheet (partial)(in thousands)

Intangible assets (Note C) $3,840Goodwill (Note D) 2,575

Income Statement (partial)(in thousands)

as part of Continuing operations

Amortization expense $380Impairment losses (goodwill) 46

Notes to the Financial Statements

Note C: Acquired Intangible Assets

As of December 31, 2012

Gross Carrying Accumulated Amount Amortization

Amortized intangible assets Trademark $2,000 $(100) Customer list 500 (310) Other 60 (10)

Total $2,560 $(420)

Unamortized intangible assets Licenses $1,300 Trademark 400

Total $1,700

Aggregate Amortization ExpenseFor year ended 12/31/12 $380

Estimated Amortization ExpenseFor year ended 12/31/13 $200For year ended 12/31/14 90For year ended 12/31/15 70For year ended 12/31/16 60For year ended 12/31/17 50

Note D: GoodwillThe changes in the carrying amount of goodwill for the year ended December 31, 2012, are as follows:

Technology Communications($000s) Segment Segment Total

Balance as of January 1, 2012 $1,413 $904 $2,317Goodwill acquired during year 189 115 304Impairment losses — (46) (46)

Balance as of December 31, 2012 $1,602 $973 $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 2011 and the first and second quarters of 2012. Based on that trend, the earnings forecast for the next 5 years was revised. In September 2012, 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.

ILLUSTRATION 12-15Intangible Asset Disclosures

Presentation of Intangibles and Related Items 687

Types of intangibles and carrying values

Current and future expense

Goodwill by segment and carrying values

Impairment methodology



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

2009 2008 2007

Sales $ 27,428.3 $23,850.3 $24,197.7

Costs, expenses and other Materials and production 9,018.9 5,582.5 6,140.7 Marketing and administrative 8,543.2 7,377.0 7,556.7 Research and development 5,845.0 4,805.3 4,882.8 Restructuring costs 1,633.9 1,032.5 327.1 Equity income from affiliates (2,235.0) (2,560.6) (2,976.5) Other (income) expense, net (10,669.5) (2,318.1) 4,774.8

$ 12,136.5 $13,918.6 $20,705.6

ILLUSTRATION 12-16Income 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 follow-ing data show the trend of the Company’s research and development spending. For the period 1996 to 2009, the compounded annual growth rate in research and development was approximately 11%.

ILLUSTRATION 12-17Merck’s R&D Disclosure

96 97 98 99 00 01 02 03 04 05 06 07 08 09

4,200

5,000

$6,000R&D Expenditures

3,150

2,100

mill

ions

1,050

0

You will want to read the IFRS INSIGHTS on pages 712–719

for discussion of IFRSrelated to intangible assets.


KEY TERMS

amortization, 667bargain purchase, 677business combination,

666(n)copyright, 670development activities, 681fair value test, 677franchise, 671goodwill, 674impairment, 677indefinite-life intangibles,

667intangible assets, 666license (permit), 671limited-life intangibles,

667master valuation

approach, 676organizational costs, 683patent, 672recoverability test, 677research activities, 681research and

development (R&D)

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