””What is it about intangible assets that What is it about intangible assets that create value -- value that is more create value -- value that is more

significant than that of tangible assets?significant than that of tangible assets?““One big difference is that when you’re One big difference is that when you’re

dealing with tangible assets, your ability dealing with tangible assets, your ability to leverage them - to get additional to leverage them - to get additional business or value out of them -- is business or value out of them -- is limited. … But the only limit to the limited. … But the only limit to the

number of people who can use a number of people who can use a knowledge asset is the size of the knowledge asset is the size of the

market.”market.”

New Math for New Math for a New a New

EconomyEconomy Baruch Lev on Baruch Lev on

GoodwillGoodwill

• PatentsPatents

• CopyrightsCopyrights

• TrademarksTrademarks

• LeaseholdsLeaseholds

• FranchisesFranchises

• GoodwillGoodwill

Intangible AssetsIntangible Assets

SpecificallyIdentifiable

non-non-identifiableidentifiable

• lack physical lack physical substancesubstance

• have a high degree of have a high degree of uncertainty about uncertainty about future benefits to be future benefits to be derivedderived

• Future benefits may Future benefits may or may not be long-or may not be long-lived.lived.

• value estimation may value estimation may pose a problem.pose a problem.

• Exclusive right to use, manufacture & sell a product Exclusive right to use, manufacture & sell a product or process.or process.

• Purchased externallyPurchased externally the cost is equal to: the cost is equal to:– Initial acquisition cost.Initial acquisition cost.

– Legal fees.Legal fees.

– Successful legal defense of patent costs.Successful legal defense of patent costs.

– Unsuccessful legal defense costs are expenses of the period.Unsuccessful legal defense costs are expenses of the period.

• Developed internallyDeveloped internally the cost is equal to: the cost is equal to:– Legal fees.Legal fees.

– Successful defense efforts. Successful defense efforts. (Unsuccessful are expenses.)(Unsuccessful are expenses.)

– NOT R&D (R&D is generally expensed when incurred.)NOT R&D (R&D is generally expensed when incurred.)

Patents--17 year legal lifePatents--17 year legal life

• Exclusive right to Exclusive right to ownership, use of artistic, ownership, use of artistic, creative expressions.creative expressions.

• Right to reproduce and sell Right to reproduce and sell artistic work.artistic work.

• May be quite valuable, non-May be quite valuable, non-renewable.renewable.

CopyrightsCopyrights life of author + 50 (now 70) Yearslife of author + 50 (now 70) Years

Trademarks and Trade Names--Trademarks and Trade Names--word, phrase, symbolword, phrase, symbol

20-year renewable terms20-year renewable terms

• If intangible acquired the cost should If intangible acquired the cost should be capitalized.be capitalized.

• Intangible internally developed Intangible internally developed should include as cost legal fees, should include as cost legal fees, design fees, etc.design fees, etc. TM

Leaseholds Leaseholds (contractual)(contractual)

• Right to use specific property (Lessee) for Right to use specific property (Lessee) for a period of time in return for a period of time in return for consideration.consideration.

• To capitalize a lease or not ? To capitalize a lease or not ? Series of Series of criteria must be met to determine if the criteria must be met to determine if the lease itself is an asset or a rental expense lease itself is an asset or a rental expense (covered in chapter 22).(covered in chapter 22).

Leasehold ImprovementsLeasehold Improvements

– Improvements which revert to the lessor at Improvements which revert to the lessor at

the end of the lease.the end of the lease.

– Should be amortized to income over the life Should be amortized to income over the life

of the asset or the lease, whichever is shorter.of the asset or the lease, whichever is shorter.

– Generally shown as tangible assets under Generally shown as tangible assets under

property, plant and equipment.property, plant and equipment.

– Contractual agreement that conveys the right to Contractual agreement that conveys the right to sell certain goods; exclusive use of trade names sell certain goods; exclusive use of trade names usually within a geographical area.usually within a geographical area.

– Capitalize the cost of the franchise.Capitalize the cost of the franchise.– Franchise operating expenses are expenses of Franchise operating expenses are expenses of

the period.the period.

Franchises Franchises (contractual)(contractual)

Increasing Short-Run Cash FlowsIncreasing Short-Run Cash Flows

Production EconomiesProduction Economies

Raise more fundsRaise more funds

Cash reservesCash reserves

Low cost of fundsLow cost of funds

Reduce inventory holding costsReduce inventory holding costs

Avoiding transaction costAvoiding transaction cost

Tax BenefitTax Benefit

ExclusivityExclusivity

Access to TechnologyAccess to Technology

Brand nameBrand name

Goodwill… Goodwill… leads to above average earningsleads to above average earnings

Human FactorHuman Factor

Management TalentManagement Talent

Good labor relationsGood labor relations

Good training programsGood training programs

Organizational structureOrganizational structure

Good public relationsGood public relations

StabilityStability

Assurance of supplyAssurance of supply

Reducing fluctuationsReducing fluctuations

Good government relationsGood government relations

• Valuation of purchased intangiblesValuation of purchased intangibles..– Record at Record at historical costhistorical cost. . Costs of acquisition plus Costs of acquisition plus

normal, routine costs to get the asset in place and fit for normal, routine costs to get the asset in place and fit for use are part of the cost of the intangible.use are part of the cost of the intangible.

– Intangibles acquired for shares should use the fair Intangibles acquired for shares should use the fair market value of what was given up or what was market value of what was given up or what was acquired whichever is more clearly evident.acquired whichever is more clearly evident.

• Valuation of internally-created intangiblesValuation of internally-created intangibles..– Costs incurred (such as Costs incurred (such as research and developmentresearch and development) are ) are

generally generally expensedexpensed as they occur. This is because of as they occur. This is because of uncertainty about future benefits to be derived from uncertainty about future benefits to be derived from such costs.such costs.

– Generally Generally only direct costsonly direct costs such as legal fees are such as legal fees are capitalizedcapitalized..

Intangible Asset Valuation

Intangible Amortization (uses SL) Intangible Amortization (uses SL) DrDr Amortization Expense Amortization Expense $$$$$$

CrCr Intangible Asset Intangible Asset ** $$$$$$ Generally contra account (Accumulated Amortization Patent) is Generally contra account (Accumulated Amortization Patent) is not not used. The asset is reduced directly. While this violates historical used. The asset is reduced directly. While this violates historical cost and disclosure, it is the current practice.cost and disclosure, it is the current practice.• use a rational and systematic method (APB #17)use a rational and systematic method (APB #17)• Use a “sensible” basis for selecting economic lifeUse a “sensible” basis for selecting economic life

– Legal lives, contracts, renewalsLegal lives, contracts, renewals– Economic lives, obsolescenceEconomic lives, obsolescence– Apparently unlimited lives must be quantifiedApparently unlimited lives must be quantified– Several factors may affect how life is measuredSeveral factors may affect how life is measured– Use shortest of the lives above (not more than 40 yrs)Use shortest of the lives above (not more than 40 yrs)– Can be expressed in units of activityCan be expressed in units of activity– Useful life should be at least 5 yearsUseful life should be at least 5 years

Intangible AmortizationIntangible Amortization

– straight-linestraight-line (generally)(generally) with a life not less than 5 nor with a life not less than 5 nor greater than 40 years. greater than 40 years.

• Because of uncertainty, consumption is assumed to be Because of uncertainty, consumption is assumed to be even.even.

• 40 years is considered the longest period for which 40 years is considered the longest period for which accounting estimates may be considered reliable. accounting estimates may be considered reliable.

• Matching should be followed. Intangibles Matching should be followed. Intangibles acquired acquired by firm must be amortized and not immediately by firm must be amortized and not immediately expensed unless value is impaired.expensed unless value is impaired.

Amortization expense = Cost - salvage value

Useful Life

• IdentifiabilityIdentifiability -- separately identifiable or lacking -- separately identifiable or lacking specific identificationspecific identification

• Manner of acquisitionManner of acquisition -- acquired singly, in groups, -- acquired singly, in groups, in a business combination -- or developed internallyin a business combination -- or developed internally

• Period of benefitPeriod of benefit -- limited by law or contract, related -- limited by law or contract, related to human or economic factors, or indefinite or to human or economic factors, or indefinite or indetermined duration indetermined duration

• Separability from enterpriseSeparability from enterprise -- rights transferable -- rights transferable with title, salable, or inseparable from the entire enterprisewith title, salable, or inseparable from the entire enterprise

Describing Intangible Assets by their Describing Intangible Assets by their Characteristics:Characteristics:

Record only Externally- Record only Externally-

generated Goodwill generated Goodwill

… calculation of the Excess Purchase Price:

Purchase price of net assets

- FMV of net assets

Goodwill

Value:Value:(a) based on the Excess Purchase Price, or(a) based on the Excess Purchase Price, or(b) based on the Excess Earnings Power(b) based on the Excess Earnings Power

• Excess earnings are the difference between: Excess earnings are the difference between:

(a) what a firm with goodwill earns … and… (a) what a firm with goodwill earns … and…

(b) what a “normal” firm without it earns (b) what a “normal” firm without it earns

… … the excess is goodwillthe excess is goodwill

• Calculate the “normal” rate of return on asset book Calculate the “normal” rate of return on asset book values based on a rate from industry sources, F/S, etc.values based on a rate from industry sources, F/S, etc.

Goodwill Valuation:Goodwill Valuation: Excess Earnings Power Excess Earnings Power

PV of the firm’s future earnings

- PV of “normal” (industry) earnings

PV excess earnings = Goodwill

Estimating Future Earnings:Estimating Future Earnings: Excess Earnings Power Excess Earnings Power

(1) Take average of past 5- 6 years earnings & (1) Take average of past 5- 6 years earnings & calculate rate of return based on assets usedcalculate rate of return based on assets used

(*) You may need to adjust assets to FMV or write (*) You may need to adjust assets to FMV or write them off. You may need to normalize earnings them off. You may need to normalize earnings stream, i.e., check for the effects of extraordinary stream, i.e., check for the effects of extraordinary items, prior period adjustments, etc.items, prior period adjustments, etc.

(2) You then take average earnings less normal (2) You then take average earnings less normal earnings = excess earningsearnings = excess earnings

(3) Select a discount rate to take the present value (3) Select a discount rate to take the present value of earningsof earnings– Determination of the rate is subjectiveDetermination of the rate is subjective– Determination of the discounting period subjectiveDetermination of the discounting period subjective

Goodwill Impairment TestGoodwill Impairment Test

Step One:Step One:Fair Value of Reporting UnitFair Value of Reporting Unit

< Book Value< Book Value

No ImpairmentNo Impairment

ImpairmentImpairment

Step Two:Step Two:1. Impairment loss = the 1. Impairment loss = the excess of Carrying Valueexcess of Carrying Value over “implied fair valueover “implied fair value of goodwill”of goodwill”

2. Restoration of impairment2. Restoration of impairment loss is loss is notnot permitted permitted

nono

yesyes

SFAS # 142SFAS # 142• Goodwill is no longer amortizedGoodwill is no longer amortized• negative goodwill is considered an extraordinary gainnegative goodwill is considered an extraordinary gain• goodwill is annually test for impairmentgoodwill is annually test for impairment• goodwill is also tested for impairment more frequently goodwill is also tested for impairment more frequently

if events or circumstances warrant it:if events or circumstances warrant it:– a significant adverse change in legal factors or the a significant adverse change in legal factors or the

business climatebusiness climate– an adverse action or assessment by a regulatoran adverse action or assessment by a regulator– unanticipated competitionunanticipated competition– a loss of key personnela loss of key personnel– a more likely-than-not expectation that a reporting a more likely-than-not expectation that a reporting

unit will be sold or otherwise disposed ofunit will be sold or otherwise disposed of– the testing for recoverability under SFAS 121 of a the testing for recoverability under SFAS 121 of a

significant “asset group” within a reporting unitsignificant “asset group” within a reporting unit– recording a goodwill impairment loss by a subsidiary recording a goodwill impairment loss by a subsidiary

that is a component of a reporting unitthat is a component of a reporting unit