1. Intangible Assets To understand issues with intangibles, it is important to recognize that: Most assets (excluding land) are simply “Delayed Expenses” eg: You pay $100,000 to own and use a machine for 10 yrs. Option 1 (not GAAP): Expense $100,000 in current year Option 2 (GAAP): Record asset and expense ratably over its useful life (depreciation) Option 2 delays the expenses to better match revenues

2. Intangible Assets Intangible Assets are assets that: Lack Physical Substance Are not Financial Instruments - Bank Deposits, Bonds, Stocks, etc. Examples include Patents, Goodwill, and Trademarks

3. Internally-generated intangibles (like Research & Development Costs) get expensed in the current period Intangible Assets Valuation However, legal fees and other processing costs can be capitalized into the value of the asset. In other words, internally generated intangibles may not actually generate an asset account

4. Intangible Assets Valuation Example: Mendez Corp. incurred $210,000 of R&D costs to develop a product for which a patent was granted on Jan 1, 2000. Legal fees and other costs associated with registration of the patent totaled $60,000. On March 31, 2002, Mendez paid $90,000 for legal fees in a successful defense of the patent. The total amount that should be capitalized (included as cost) for the patent (as of March 31, 2002) is: $60,000 + $90,000 = $150,000 The R&D Costs would be expensed entirely in 2000.

5. Intangible Assets Valuation Generally, purchased intangibles get recorded as assets Intangibles purchased through exchange of asset or stock are recorded at: FMV of intangible received or asset/stock given up, whichever is more evident and measurable. Purchased Intangibles are recorded at cost, where: Cost = expenses to acquire and prepare asset for use Cost includes legal fees to process or defend the asset

6. Intangible Assets Valuation Example: Paterno Corp. purchases a trademark for $400,000. Legal and registration fees to process the trademark were $8,000. The Trademark is recorded on Paterno’s balance sheet at: $400,000 + $8,000 = $408,000

7. Intangible Assets Valuation Example: On May 5, 2001, Pitts Corp. exchanged 4,000 shares of its $10 par Common Stock for a patent owned by Gore Co. Pitts also paid $2,000 to register the patent. Gore carries the patent on its books at $110,000. Pitts’ Common Stock traded at $32 a share on the NYSE on May 5 th, 2001. Pitts should record the patent on its books at the FMV of the patent received or stock given up, whichever is more evident and measurable. In this case, FMV of stock given up = $32 x 4,000 = $128,000 But Pitts should also include the $2,000 to register the patent. So the asset account would hold $128,000 + $2,000 = $130,000

8. Intangible Assets Types Trademark: A word, phrase or symbol that identifies a company, product or brand. Carried at cost (if purchased) plus costs for: Legal Fees Registration Fees Design Costs Consulting Fees Other expenses directly related to securing the trademark Considered to have an indefinite life, so not amortized. Exception: If it clearly has a limited life then it may be amortized.

9. Intangible Assets Types Copyright: Exclusive right to reproduce and sell an artistic or published item. Carried at cost (if purchased) plus costs for: Legal Fees Registration Fees Consulting Fees Other expenses directly related to securing the copyright Granted for life of the creator + 50 years. Usually the useful life is much less than this. Amortize over the best estimate of useful life.

10. Intangible Assets Types Franchise: Contractual right to sell certain products or services, use a trademark, and use a trade name within a certain geographical area. Carried at cost (if purchased) plus costs for: Legal Fees Registration Fees Consulting Fees Other expenses directly related to securing the franchise May be indefinite life or limited life, depending on the contract terms. If limited life, amortize costs over limited life. If indefinite life, do not amortize.

11. Intangible Assets Types Patent: Exclusive right to use, manufacture, and sell a product. Carried at cost (if purchased) plus costs for: Legal Fees (including patent defense) Registration Fees Consulting Fees Other expenses directly related to securing the patent Granted by the government for 20 years. Amortize patent over 20 years or useful life, whichever is less. Does not include R&D expenses to “discover” the product

12. Intangible Assets Types Goodwill: Very fuzzy concept of intangible value. The amount a company is worth above it’s assets’ Fair Market Value. However, there is one situation where we can effectively capture some sense of this “true” or “intrinsic” value and we can, therefore, establish a Goodwill account… Every company has its Goodwill. But, it is impossible to measure internally, so no Goodwill account is created. Conceptually, it would include things like value of employee knowledge, customer loyalty, and other nebulous “assets” that cannot be valued on the balance sheet.

13. Intangible Assets Types These assets are recorded at book value, which is clearly not a good indication of their true value. The target firm of a merger has assets on its balance sheet. Mergers and Acquisitions So, to price this target, a buying firm must assess the Fair Market Value of all the target’s assets. Almost always, however, the buying firm pays more than the sum total of the Fair Market Value for all the target firm’s assets. Why does the buyer overpay for these assets? Because the buyer has some sense of the “intrinsic” or “true” value of the “assets” that are impossible to record on the balance sheet.

14. Intangible Assets Types In a Merger or Acquisition, we record an intangible asset called Goodwill when: Mergers and Acquisitions A buyer pays more than the total FMV for all assets on the target’s balance sheet. Therefore, Goodwill = Amount Paid for target – FMV of target’s assets. Why record Goodwill now when we can’t do it otherwise? Because, by overpaying for the target, the buyer has shown us the “intrinsic” or “true” value of the “assets” that are impossible to record on the balance sheet.

15. Intangible Assets Types Goodwill Goodwill = Amount Paid for target – FMV of target’s assets. Goodwill is only recorded when an entire business is purchased. Considered to have an indefinite life. Not amortized. (Note: this is a new rule based on SFAS 121, which is why we are using the textbook supplement to Chapter 12.)

16. Intangible Assets Amortization or Impairment? FASB now considers some Intangibles to have indefinite life (similar to land) Indefinite Life Intangibles are no longer amortized. They will only be written down if they become impaired. Limited Life Intangibles are amortized over useful life. Limited Life Intangibles may also be written down if they become impaired. e.g. Goodwill e.g. Patents offer 20 year protection

17. Intangible Assets Amortization Limited LifeIndefinite Life Amortize over: 1) Identifiable use pattern or 2) Straight-line over useful life Don’t Amortize at all

18. Intangible Assets Impairment (Different rules for Limited Life vs. Indefinite Life assets vs. Goodwill) Then, we need to determine if we need to record impairment. (i.e., we need to run the impairment test) Then, we need to determine how much impairment to record. (i.e., we need to record the impairment loss) (Same rules for Limited Life and Indefinite Life assets but different rules for Goodwill) First, we need to determine when we need to test for impairment. (Different rules for Limited Life vs. Indefinite Life assets)

19. Intangible Assets Impairment Review for Impairment when any event or circumstance indicates that the carrying or book value of the assets may no longer be recoverable. When do we need to run the Impairment Test? Limited Life Assets: In other words, run the test when something happens that makes you think an intangible asset may have lost some value. Example: Paterno Pharmaceutical Corp. should review for impairment the value of its patent for the drug HormoneRep, after learning of a study that links hormone replacement therapy drugs to cancer.

20. Intangible Assets Impairment Review for Impairment annually. When do we need to run the Impairment Test? Indefinite Life Assets:

21. Intangible Assets Impairment (The Recoverability Test) Run the Impairment Test: Do we need to record an impairment loss? Limited Life Assets: If Book Value > Undiscounted expected future cash flows from use and disposition of asset …then record impairment loss. or… If Book Value > Fair Market Value (The FMV Test)

22. Intangible Assets Impairment Indefinite Life Assets (not including Goodwill): …then record impairment loss. If Fair Market Value < Book Value (The FMV Test) Run the Impairment Test: Do we need to record an impairment loss?

23. Intangible Assets Impairment Goodwill: …then record impairment loss. If Fair Market Value of the Subsidiary < Book Value of the Subsidiary’s assets including Goodwill (The Subsidiary Value Test) Run the Impairment Test: Do we need to record an impairment loss?

24. Intangible Assets Impairment If we need to record an impairment loss, how much should it be? Limited or Indefinite Life Assets (not including Goodwill): Impairment Loss = Carrying Amount - FMV

25. Intangible Assets Impairment If we need to record an impairment loss, how much should it be? Goodwill: The impairment loss will readjust the current Goodwill balance to a new ending balance. The new ending balance approximates what a buyer would record as Goodwill if they bought the Subsidiary today. New ending balance = FMV of subsidiary – BV of subsidiary’s assets excluding goodwill Think of this as FMV subsidiary – BV of subsidiary’s “real” assets Impairment Loss = GW Beg. Bal. – GW End Bal. (The loss readjusts the GW account balance)

26. Intangible Assets Impairment Summary Limited Life Intangibles Indef. Life Intangibles (Not Goodwill) Goodwill Test When?Event indicates possible impairment Annually Impairment Test1) Recoverability 1 2) FMV 2 FMVSubsidiary Value 3 Compute Impairment Loss Carrying Value – FMV GW Beg. Bal. – GW End Bal 4 1 Recoverability Test: BV > Net Future Cash Flows (Not Discounted) 2 FMV Test: BV > FMV 3 Subsidiary Value: Subsidiary BV of assets including GW > FMV of subsidiary 4 GW End. Bal: FMV of subsidiary – Carrying Value of Subsidiary assets excluding Goodwill

27. Intangible Assets Impairment Example—Limited Life Asset Patent to extract oil recorded at $60,000,000 Can obtain $20,000,000 from selling patent (FMV of Patent) Expected future cash flows from patent are $15,000,000 Recoverability Test: Carrying Value > Expected future cash flows (undiscounted) $60,000,000 > $20,000,000 + $15,000,000 Must record impairment loss = Carrying Value - FMV = $60,000,000 - $20,000,000 Impairment Loss $40,000,000 Oil Patent$40,000,000

28. Intangible Assets Impairment Example—Indefinite Life Asset Trademark recorded at $15,000,000 Can obtain $12,000,000 from selling trademark (FMV) Expected future cash flows from patent are $900,000,000 FMV Test: Carrying Value > FMV $15,000,000 > $12,000,000 Must record impairment loss = Carrying Value - FMV = $15,000,000 - $12,000,000 Impairment Loss $3,000,000 Trademark$3,000,000 Note: This is why the Recoverability Test does not apply. Indefinite assets may have incredibly large (even infinite) future cash flows.

29. Intangible Assets Impairment Example—Goodwill Paterno Inc. acquired Linebacker Co. 3 years ago: FMV of Linebacker Assets:1,200,000 FMV of Linebacker Liabilities:(300,000) Cash Paid by Paterno:$1,100,000 After this transaction. Linebacker shows up on Paterno’s balance sheet as a subsidiary as follows: Linebacker Net Assets: Assets1,200,000 Goodwill200,000 Liabilities(300,000) Net Assets1,100,000 Paterno paid $1,100,000 for $900,000 worth of net assets. $900,000 FMV of net assets

30. Intangible Assets Impairment Example—Goodwill Linebacker Net Assets: Assets1,200,000 Goodwill200,000 Liabilities(300,000) Net Assets1,100,000 During annual impairment review, the FMV of Linebacker is determined to be $980,000 Subsidiary Value Test: FMV < BV of subsidiary assets including GW $980,000 < $1,100,000. Need to impair. Ending Goodwill Balance = FMV – BV of subsidiary assets excluding GW Ending GW = $980,000 – (1,100,000 – 200,000) = $80,000 Impairment Loss = Adjustment to Goodwill Account = Beg Bal – End Bal Impairment Loss = $200,000 - $80,000 = $120,000

31. Homework Hint (Preview of Ch. 23) Any changes in amortization or depreciation are applied to remaining book value in future years. Example 1: Patent bought 2 years ago cost $400,000. Useful life at purchase date 10 years. Revised useful life estimate is 6 years. Accumulated Depreciation (based on original estimates): 2 years x $40,000 per year = $80,000 Note: this includes the 2 you’ve already had. Remaining BV = $400,000 - $80,000 = $320,000 Amortize this over the remaining useful life = 4 years. $320,000 / 4 years = $80,000 per year from now forward.

32. Homework Hint (Preview of Ch. 23) Any changes in amortization or depreciation are applied to remaining book value in future years. Example 2: Patent bought in 2000 cost $400,000. Useful life of 10 years. On Dec 31, 2002, paid $16,000 legal fees to defend patent rights. Dec 31, 2002 Accumulated Depreciation (based on original estimates): 2 years x $40,000 per year = $80,000 Remaining BV = $320,000 + new legal fees = $336,000 Amortize this over the remaining useful life = 8 years. $336,000 / 8 years = $42,000 per year from now forward.