Intermediate Accounting IFRS Kieso Weygandt Warfield 2020 PDF

CHAPTER 12 Intangible Assets LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Discuss the characteristics, valuation, and amortization of intangible assets. 2. Describe the accounting for various types of intangible assets. 3. Explain the accounting...

CHAPTER 12 Intangible Assets LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Discuss the characteristics, valuation, and amortization of intangible assets. 2. Describe the accounting for various types of intangible assets. 3. Explain the accounting issues for recording goodwill. 4. Identify impairment procedures and presentation requirements for intangible assets. 5. Describe the accounting and presentation for research and development and similar costs.  This chapter also includes numerous conceptual discussions that are integral to the topics presented here. PREVIEW OF CHAPTER 12 As the following opening story indicates, sustainability strategies are taking on increased importance for companies like SAP (DEU) and Alcatel Lucent Enterprise (FRA). Reporting challenges for effective sustainability investments are similar to those for intangible assets. 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. Is This Sustainable? Companies are increasing their focus on sustainability issues. Companies like Alcatel Lucent Enterprise (FRA), China Southern Power Grid Co. (CHN), and Clorox (USA) are implementing strategic initiatives such as fuel-spill control, use of recycled materials, and water conservation in efforts to support long- term objectives related to responsible management of resource use. Why the growing importance of sustainability? One important reason is that market participants are increasingly looking to invest in companies that are pursuing sustainability strategies. For example, as indicated in the adjacent graph, global sustainability investments have increased from below $10 trillion in 2006 to over $70 trillion in 2017. In response, companies are now providing more useful “non- financial” information about the future cash flow consequences of sustainability strategies. Many companies are exploring ways to combine this non-financial information with mandated disclosures in what is called an integrated report. In such a report, a company discloses data on numerous metrics beyond conventional financial statements, whether the data are “integrated” or released in a separate format. Practitioners collectively refer to sustainability reporting as ESG, for the three major categories of data: environmental, social, and company governance. While a growing number of companies are issuing sustainability reports, there is significant variation in the content and format. Only a handful, like those prepared by Clorox (USA), SAP (DEU), and Polymer Group Inc. (USA), integrate a sustainability report with the financial statements. Standards to ensure useful information on ESG issues are being developed by the International Integrated Reporting Council and the Sustainability Accounting Standards Board. And with the emergence of sustainability and integrated reporting standards, companies are voluntarily seeking assurance that their sustainability reports are meeting these standards. For example, over half of the world’s largest companies recently reporting on sustainability also invested in external assurance for their reports. With standards and assurance, it is hoped that sustainability reports will gain the same credibility as the financial statements. Review and Practice Go to the Review and Practice section at the end of the chapter for a targeted summary review and practice problem with solution. Multiple-choice questions with annotated solutions, as well as additional exercises and practice problem with solutions, are also available online. Intangible Asset Issues LEARNING OBJECTIVE 1 Discuss the characteristics, valuation, and amortization of intangible assets. Characteristics Christian Dior’s (FRA) most important asset is its brand image, not its store fixtures. The Coca-Cola Company’s (USA) success comes from its secret formula for making Coca-Cola, not its plant facilities. The world 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 three main characteristics. (See the Authoritative Literature References section near the end of the chapter.) 1. They are identifiable. To be identifiable, an intangible asset must either be separable from the company (can be sold or transferred), or it arises from a contractual or legal right from which economic benefits will flow to the company.  2. 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. 3. They are not monetary assets. Assets such as bank deposits, accounts receivable, and long-term investments in bonds and shares also lack physical substance. However, monetary assets derive their value from the right (claim) to receive cash or cash equivalents in the future. Monetary assets are not classified as intangibles. In most cases, intangible assets provide benefits over a period of years. Therefore, companies normally classify them as non-current assets. Valuation Purchased Intangibles Companies 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 shares 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 relative fair values. Essentially, the accounting treatment for purchased intangibles closely parallels that for purchased tangible assets.1 Internally Created Intangibles Businesses frequently incur costs on a variety of intangible resources, such as scientific or technological knowledge, market research, intellectual property, and brand names. These costs are commonly referred to as research and development (R&D) costs. Intangible assets that might arise from these expenditures include patents, computer software, copyrights, and trademarks. For example, Nokia (FIN) incurred R&D costs to develop its communications equipment, resulting in patents related to its technology. In determining the accounting for these costs, Nokia must determine whether its R&D project is at a sufficiently advanced stage to be considered economically viable. To perform this assessment, Nokia evaluates costs incurred during the research phase and the development phase. Illustration 12.1 indicates the two stages of research and development activities, along with the accounting treatment for costs incurred during these phases. ILLUSTRATION 12.1 Research and Development Stages As indicated, all costs incurred in the research phase are expensed as incurred. Once a project moves to the development phase, certain development costs are capitalized. Specifically, development costs are capitalized when certain criteria are met, indicating that an economically viable intangible asset will result from the R&D project. In essence, economic viability indicates that the project is far enough along in the process such that the economic benefits of the R&D project will flow to the company. Therefore, development costs incurred from that point forward meet the recognition criteria and should be recorded as an intangible asset (see Underlying Concepts).  Underlying Concepts The controversy surrounding the accounting for R&D expenditures reflects a debate about whether such expenditures meet the definition of an asset. If so, then an “expense all research and some development costs” policy results in overstated expenses and understated assets. In summary, companies expense all research phase costs and some development phase costs. Certain development costs are capitalized once economic viability criteria are met. IFRS identifies several specific criteria that must be met before development costs are capitalized (which we discuss in more detail later in the chapter).2 Amortization of Intangibles The allocation of the cost of intangible assets in a systematic way is called amortization. Intangibles have either a limited (finite) useful life or an indefinite useful life. For example, a company like Disney (USA) has both types of intangibles. 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 Intangibles Companies 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. Disney, for example, considers these factors in determining useful lives: 1. The expected use of the asset by the company. 2. The effects of obsolescence, demand, competition, and other economic factors. Examples include the stability of the industry,  known technological advances, legislative action that results in an uncertain or changing regulatory environment, and expected changes in distribution channels. 3. 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 modifications of the existing terms and conditions. 4. The level of maintenance expenditure required to obtain the expected future cash flows from the asset. For example, a material level of required maintenance in relation to the carrying amount of the asset may suggest a very limited useful life. 5. Any legal, regulatory, or contractual provisions that may limit the useful life. 6. 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). 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 reliably determine that pattern. For example, assume that Second Wave Ltd. purchases a license 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, Second 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 amortizes this license, 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 intangible asset has value to another company. For example, if Hardy Co. purchases an intangible asset from U2D Co., U2D Co. should reduce the cost of its intangible asset by the residual value (when computing amortization). Similarly, U2D Co. should consider fair values, if reliably determinable, for the residual. IFRS requires companies to assess the estimated residual values and useful lives of intangible assets at least annually. 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 (see Underlying Concepts). Companies must also evaluate the limited-life intangibles annually to determine if there is an indication of impairment. If there is indication of impairment, an impairment test is performed. Underlying Concepts The terms “carrying amount,” “carrying value,” and “book value” are all used to refer to the cost less accumulated amortization of an intangible asset. An impairment loss should be recognized for the amount that the carrying amount of the intangible is greater than the recoverable amount. Recall that the recoverable amount is the greater of the fair value less costs to sell or value-in-use. (We will cover impairment of intangibles in more detail later in the chapter.) Indefinite-Life Intangibles If 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 asset with an indefinite life. To illustrate, assume that Double Clik Group acquired a trademark 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 also must test indefinite-life intangibles for impairment at least annually. The impairment test for indefinite-life intangibles is similar to the one for limited-life intangibles. That is, an impairment loss should be recognized for the amount that the carrying amount of the indefinite-life intangible asset is greater than the recoverable amount.3 Illustration 12.2 summarizes the accounting treatment for intangible assets.4 Manner Acquired Type of Internally Impairment Intangible Purchased Created Amortization Test Limited- Capitalize Expense* Over useful Compare life life recoverable intangibles amount to carrying value. Indefinite- Capitalize Expense* Do not Compare life amortize recoverable intangibles amount to carrying value. *Except for certain limited costs that meet recognition criteria. ILLUSTRATION 12.2 Accounting Treatment for Intangibles Types of Intangible Assets LEARNING OBJECTIVE 2 Describe the accounting for various types of intangible assets. There are many different types of intangibles, often classified into the following six major categories. 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 Assets Companies primarily use marketing-related intangible assets in the marketing or promotion of their products or services. Examples are trademarks or trade names, newspaper mastheads, Internet domain names, and non-competition agreements. A trademark or trade name is a word, phrase, or symbol that distinguishes or identifies a particular company or product. Trade names like Mercedes-Benz, Pepsi-Cola, Honda, Cadbury Eggs, Wheaties, and Ikea create immediate product identification in our minds, thereby enhancing marketability. A recent expansion of Internet domain names will allow industries to use terms like.cars or even Web slang like.lol. This expansion has led to a new wave of domain-name activity. For a substantial fee, companies can register their own domain names; applications received include company names such as Sony (JPN) (which would have the name.sony) and for city-based domains such as.NYC and.Berlin. Under common law, the right to use a trademark or trade name, whether registered or not, rests exclusively with the original user as long as the original user continues to use it. For example, in the United States, registration with the U.S. Patent and Trademark Office provides legal protection for an indefinite number of renewals for periods of 10 years each.5 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 securing it, such as attorney fees, registration fees, design costs, and consulting fees. However, it excludes research costs and development costs that do not meet recognition criteria. When the total cost of a trademark or trade name is insignificant, a company simply expenses it. It is not uncommon for companies to incur legal fees and other costs to protect their valuable trade names and other intangible assets (e.g., copyrights and patents, discussed in the next two sections) (see “Patent Battles” in the “What Do the Numbers Mean?” box). In general, IFRS does not allow capitalization of these subsequent expenditures. The reason? The IASB indicates that subsequent expenditures likely only maintain the expected future economic benefits of the existing intangible asset, rather than enhancing its value or creating a new intangible asset. Customer-Related Intangible Assets Customer-related intangible assets result from interactions with outside parties. Examples include customer lists, order or production backlogs, and both contractual and non-contractual customer relationships. To illustrate, assume that Green Market AG acquires the customer list of a large newspaper for €6,000,000 on January 1, 2022. This customer database includes names, contact details, order history, and demographic information. Green Market expects to benefit 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. 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 per year, as shown in Illustration 12.3. Cost €6,000,000 Residual value (60,000) Amortization base €5,940,000 Amortization expense per period: €1,980,000 (€5,940,000 ÷ 3) ILLUSTRATION 12.3 Calculation of Amortization Expense with Residual Value 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. Artistic-Related Intangible Assets Artistic-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 government-granted right that all authors, painters, musicians, sculptors, and other artists have in their creations and expressions. A copyright is granted for the life of the creator plus 70 years.6 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, Disney (USA) faced the loss of its copyright on Mickey Mouse, which could have affected sales of billions of 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 U.S. Supreme Court—and won an extension of copyright lives from 50 to 70 years. As another example, Really Useful Group (USA) owns copyrights on the musicals of Andrew Lloyd Webber—Cats, Phantom of the Opera, Jesus Christ Superstar, and others. Really Useful Group has little in the way of tangible assets, yet analysts value the company at over $300 million. Companies capitalize the costs of acquiring a copyright. They amortize 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 encourages a company like Really Useful Group to write off these costs over a fairly short period of time. Companies must expense all research costs and any development costs not meeting recognition criteria that lead to a copyright as those costs are incurred. Contract-Related Intangible Assets Contract-related intangible assets represent the value of rights that arise from contractual 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. When you purchase a Prius from a Toyota (JPN) dealer, fill up your tank at the corner Shell (NLD) station, or eat lunch at a McDonald’s (USA) restaurant, you are most likely dealing with 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. Another type of franchise arrangement, granted by a governmental body, permits a business to use public property in performing its services. Examples are the use of city streets for a bus line or taxi service; the use of public land for telephone, electric, or cable television lines; and the use of airwaves for radio or TV broadcasting. Such operating rights are 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 intangible asset account (entitled Franchises or Licenses) 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 franchise. 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 operating 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 Assets Technology-related intangible assets relate to innovations or technological advances. Examples are patented technology and trade secrets granted by a governmental body. In many countries, 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.7 Companies such as Merck (USA) and Canon (JPN) were founded on patents and built on the exclusive rights thus granted.8 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 Samsung (KOR) purchases a patent from an inventor, the purchase price represents its cost. Samsung can capitalize other costs incurred in connection with securing a patent, such as registration and attorneys’ fees. However, it must expense all research costs and any development costs incurred before achieving economic viability related to the development of the product, process, or idea that it subsequently patents. 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 Samsung 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 several years knocked off its 20-year legal life. Why? Because, in the United States, a drugmaker spends one to four years on animal tests, four to six years on human tests, and two to three years for the U.S. Food and Drug Administration to review the tests. All this time occurs after issuing the patent but before the product goes on pharmacists’ shelves. What Do the Numbers Mean? Patent Battles The smartphone industry has been a patent battleground. For example, Nokia (FIN) filed patent lawsuits against Apple (USA), and Apple countersued, over such cell phone features as swiping gestures on touch screens and the “app store” for downloading software. Apple also targeted HTC (TWN) for infringing on Apple’s patented feature that allows screens to detect more than one finger touch at a time. This facilitates the popular zoom-in and zoom-out capability. HTC, in turn, sued Apple for infringing on patented technology that helps extend battery life. With respect to popular apps used on smartphones, BlackBerry (CAN) sued Facebook (USA), alleging that the Facebook apps WhatsApp and Instagram co-opted BlackBerry’s intellectual property. This property includes the very features that users demand in these apps, explaining why BlackBerry would go to these legal lengths to protect its patents. The activity-tracker product space is another patent battleground. Competition in that market heated up when Under Armour (USA) paid $150 million to acquire MapMyFitness (USA), which had 20 million people registered to use its websites and mobile applications to map, record, and share their workouts. To protect the value of the patent related to its miCoach (USA) fitness tracking system, adidas AG (DEU) sued Under Armour to protect its 10 patents, underscoring the growing importance of gadgetry and personal technology for sportswear makers that traditionally focused on shoes and apparel. Sources: J. Mintz, “Smart Phone Makers in Legal Fights over Patents,” Wisconsin State Journal (December 19, 2010), p. F4; S. Germano, “adidas Sues Under Armour Over Patents: Company Alleges Under Armour Infringes on 10 miCoach Patents,” Wall Street Journal (February 4, 2014); and D. George-Cosh, “BlackBerry Brings Patent Case Against Facebook, WhatsApp and Instagram,” Wall Street Journal (March 6, 2018). Amortization expense should reflect the pattern, if reliably determined, in which a company uses up the patent.9 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, 2022, to secure a patent. The patent’s useful life is 10 years, amortized on a straight-line basis. Harcott records the legal fees and the amortization at the end of 2022 as follows. 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, AstraZeneca plc (GBR) filed for additional patents on minor modifications 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, AstraZeneca can apply the unamortized costs of the old patent to the new patent. Alternatively, if a patent becomes impaired because demand drops for the product, the asset should be written down or written off immediately to expense. What Do the Numbers Mean? Patents—Strategic Lifeblood Are patents valuable assets, even though they are intangible? Let’s take a look at BASF (DEU), a leading international chemical company. Here is the BASF strategy statement regarding innovation: “Innovations based on effective and efficient research and development are an important growth engine for BASF…. This is how we ensure our long-term business success with chemistry- based solutions for almost all sectors of industry.” And BASF acts on this strategy through expenditures on research and development, which many times lead to valuable patents. For example in a recent year, BASF spent €1,426 million on research and development (that’s 30 percent of net income), and product innovation alone (from products on the market since 2013) generated €9 billion in sales. In that year alone, BASF filed 900 new patents worldwide. Because patented technology is so important to BASF’s success, it is not surprising that it provides expansive disclosure of patent- related information in its financial statements. Adjacent is an excerpt, from the note disclosure. This development schedule for know-how intangible assets (sometimes referred to as a “roll-forward”) provides reconciliation of the changes in the intangible asset account. This information is important for understanding the magnitude of this important intangible asset and how it changed during the period. Note that BASF’s total intangible assets decreased during the year and that there was a net decrease in its patent balance. This would be something to watch, given the importance of patented innovations in the BASF strategy. Assets 2018 2017 Intangible assets €16,554 €17,755  (000,000) 11—INTANGIBLE ASSETS (in part) Know-how, patents and production Acquisition costs technology Balance as of January 1, €1,879 2018 Additions, net 2,761 Disposals/Transfers (117) Exchange differences, 52 other Balance as of December 4,575 31, 2018 Accumulated amortization (1,046) Net carrying value €3,529 Goodwill LEARNING OBJECTIVE 3 Explain the accounting issues for recording goodwill. Although companies may capitalize certain costs incurred in developing specifically 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 Company. In this situation, Portofino measures the assets acquired and the liabilities assumed 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.10 In many business combinations, the purchasing company records goodwill. Goodwill is measured as the excess of the cost of the purchase over the fair value of the identifiable 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 Goodwill Internally Created Goodwill Goodwill generated internally should not be capitalized in the accounts. The reason? Measuring the components of goodwill is simply 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 (see Underlying Concepts).  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 representation (and verifiability) winning out over relevance. 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 (cost) 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, Feng, Inc. decides that it needs a parts division to supplement its existing tractor distributorship. The president of Feng is interested in buying Tractorling SA, a small concern in São Paulo, Brazil. Illustration 12.4 presents Tractorling’s statement of financial position. Tractorling SA Statement of Financial Position As of December 31, 2022 Assets Equity and Liabilities Property, plant, and equipment, net $153,000 Share capital $100,000 Inventory 42,000 Retained earnings 100,000 Accounts receivable 35,000 Current liabilities 55,000 Cash 25,000 Total equity and Total assets $255,000 liabilities $255,000 ILLUSTRATION 12.4 Tractorling Statement of Financial Position After considerable negotiation, Tractorling decides to accept Feng’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 statement of financial position does not disclose the fair values of its identifiable assets. Suppose, though, that as the negotiations progress, Feng investigates Tractorling’s underlying assets to determine their fair values. Such an investigation may be accomplished either through a purchase audit undertaken by Feng or by an independent appraisal from some other source. The investigation determines the valuations shown in Illustration 12.5. Fair Values Property, plant, and equipment, net $205,000 Patents 18,000 Inventory 122,000 Accounts receivable 35,000 Cash 25,000 Liabilities (55,000) Fair value of net assets $350,000 ILLUSTRATION 12.5 Fair Value of Tractorling’s Net Assets Normally, differences between fair value and book value are more common among non-current 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. Liabilities 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 – $42,000) could result from a number of factors. The most likely is that the company uses the average-cost method. Recall that during periods of inflation, average-cost will result in lower inventory valuations than FIFO. In many cases, the values of non-current assets such as property, plant, and equipment and intangibles may have increased substantially over the years. This difference could be due to inaccurate estimates of useful lives, continual expensing of small expenditures (say, less than $300), inaccurate estimates of residual 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 Feng pay $400,000? Undoubtedly, Tractorling points to its established reputation, good credit rating, top management team, and well-trained employees, as well as synergies and cost savings in the combined entity. These factors make the value of the business greater than $350,000. Feng places a premium on the future earning power of these attributes as well as on the basic asset structure of the company today. Feng 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 unidentifiable 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.”11 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 12.6 shows this approach.  ILLUSTRATION 12.6 Determination of Goodwill—Master Valuation Approach Feng records this transaction as follows. Property, Plant, and Equipment 205,000 Patents 18,000 Inventory 122,000 Accounts receivable 35,000 Cash 25,000 Goodwill 50,000 Liabilities 55,000 Cash 400,000 Companies often identify goodwill on the statement of financial position as the excess of cost over the fair value of the net assets acquired. Goodwill Write-Off Companies 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 statement of financial position. 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 companies immediately expense goodwill created internally and should follow the same treatment for purchased goodwill. Though these arguments may have some merit, non-amortization 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 Purchase In 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 bargain 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 IASB notes that an economic gain is inherent in a bargain purchase. The purchaser is better off by the amount by which the fair value of what is acquired exceeds the amount paid. As an example, the recently proposed merger between Deutsche Bank (DEU) and Commerzbank (DEU) was asserted to depend on the ability of the merged bank to realize a “badwill” gain of over €16 billion.12 Some expressed concern that some companies may attempt inappropriate gain recognition by making an intentional error in measurement of the assets or liabilities. As a result, the IASB requires companies to disclose the nature of this gain transaction. Such disclosure will help users to better evaluate the quality of the earnings reported. Impairment and Presentation of Intangible Assets LEARNING OBJECTIVE 4 Identify impairment procedures and presentation requirements for intangible assets. An intangible asset is impaired when a company is not able to recover the asset’s carrying amount either through using it or by selling it. As discussed in Chapter 11, to determine whether a long- lived asset (property, plant, and equipment or intangible assets) is impaired, a review is made of the asset’s cash-generating ability through use or sale. If the carrying amount is higher than the recoverable amount, the difference is an impairment loss. If the recoverable amount is greater than the carrying amount, no impairment is recorded. The specific procedures for recording impairments depend on the type of intangible asset—limited-life or indefinite-life (including goodwill). Impairment of Limited-Life Intangibles The rules that apply to impairments of property, plant, and equipment also apply to limited-life intangibles. At each statement of financial position date, a company should review limited- life intangibles for impairment. Information indicating that an impairment test should be performed might be internal (e.g., adverse changes in performance) or external (e.g., adverse changes in the business or regulatory environment, or technological or competitive developments). If there is an indication that an intangible asset is impaired, the company performs an impairment test: compare the carrying value of the intangible asset to the recoverable amount. Recall that the recoverable amount is defined as the higher of fair value less costs to sell or value-in-use. Fair value less costs to sell means what the asset could be sold for after deducting costs of disposal. Value-in-use is the present value of cash flows expected from the future use and eventual sale of the asset at the end of its useful life. The impairment loss is the carrying amount of the asset less the recoverable amount of the impaired asset. As with other impairments, the loss is reported in profit or loss. Companies generally report the loss in the “Other income and expense” section. Illustration 12.7 presents an impairment loss situation. Impairment Loss on Patent Facts: Lerch SE has a patent on how to extract oil from shale rock, with a carrying value of €5,000,000 at the end of 2021. Unfortunately, several recent non-shale-oil discoveries adversely affected the demand for shale-oil technology, indicating that the patent is impaired. Lerch determines the recoverable amount for the patent, based on value-in-use (because there is no active market for the patent). Lerch estimates the patent’s value-in-use at €2,000,000, based on the discounted expected net future cash flows at its market rate of interest. Questions: (a) What is the amount of the impairment? (b) What is the journal entry to record the impairment? Solution: a. The impairment loss is computed as follows (based on value-in use). Carrying value of patent €5,000,000 Recoverable amount (based on value-in-use) (2,000,000) Loss on impairment €3,000,000 b. Lerch records this loss as follows. Loss on Impairment 3,000,000 Patents 3,000,000 After recognizing the impairment, the recoverable amount of €2,000,000 is the new carrying amount or book value of the patent. Lerch should amortize the patent’s recoverable amount (new carrying amount) over its remaining useful life or legal life, whichever is shorter.  ILLUSTRATION 12.7 Computation of Loss on Impairment of Patent Reversal of Impairment Loss What happens if a review in a future year indicates that an intangible asset is no longer impaired because the recoverable amount of the asset is higher than the carrying amount? In that case, the impairment loss may be reversed. To illustrate, continuing the Lerch patent example, assume that the remaining life of the patent is five years with zero residual value. Recall the carrying value of the patent after impairment is €2,000,000 (€5,000,000 – €3,000,000). Thus, Lerch’s amortization is €400,000 (€2,000,000 ÷ 5) over the remaining five years of the patent’s life. The amortization expense and related carrying amount after the impairment are shown in Illustration 12.8. Year Amortization Carrying Expense Amount 2022 €400,000 €1,600,000 (€2,000,000 − €400,000) 2023 400,000 1,200,000 (€1,600,000 − €400,000) 2024 400,000 800,000 (€1,200,000 − €400,000) 2025 400,000 400,000 (€800,000 − €400,000) 2026 400,000 0 (€400,000 − €400,000) ILLUSTRATION 12.8 Post-Impairment Carrying Value of Patent Early in 2023, based on improving conditions in the market for shale- oil technology, Lerch remeasures the recoverable amount of the patent to be €1,750,000. In this case, Lerch reverses a portion of the recognized impairment loss with the following entry. Patents (€1,750,000 – €1,600,000) 150,000  Recovery of Impairment Loss 150,000 The recovery of the impairment loss is reported in the “Other income and expense” section of the income statement. The carrying amount of the patent is now €1,750,000 (€1,600,000 + €150,000).13 Assuming the remaining life of the patent is four years, Lerch records €437,500 (€1,750,000 ÷ 4) of amortization expense in 2023. Impairment of Indefinite-Life Intangibles Other Than Goodwill Companies test indefinite-life intangibles (including goodwill) for impairment annually.14 The impairment test for indefinite-life assets other than goodwill is the same as that for limited-life intangibles. That is, compare the recoverable amount of the intangible asset with the asset’s carrying value. If the recoverable amount is less than the carrying amount, the company recognizes an impairment. Illustration 12.9 presents an impairment situation for an indefinite- life intangible. Impairment Loss on License Facts: 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 Government Communications Commission (GCC) rules. Arcon Radio has renewed the license with the GCC 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 GCC decided to auction these licenses to the highest bidder instead of renewing them. Based on recent auctions of similar licenses, Arcon Radio estimates the fair value less costs to sell (the recoverable amount) of its license to be €1,500,000. Question: What is the impairment loss, if any, to be reported by Arcon? Solution: Arcon reports an impairment loss of €500,000, computed as follows. Carrying value of broadcast license €2,000,000 Recoverable amount (based on fair value less costs to (1,500,000) sell) Loss on impairment € 500,000 ILLUSTRATION 12.9 Computation of Loss on Impairment of Broadcast License Guidelines for reversal of impairments similar to those applied to limited-life intangible assets are applied to indefinite-life intangible assets other than goodwill. Impairment of Goodwill The timing of the impairment test for goodwill is the same as that for other indefinite-life intangibles. That is, companies must test goodwill at least annually. However, because goodwill generates cash flows only in combination with other assets, the impairment test is conducted based on the cash-generating unit to which the goodwill is assigned. Recall from our discussion in Chapter 11 that companies identify a cash-generating unit based on the smallest identifiable group of assets that generate cash flows independently of the cash flows from other assets. Under IFRS, when a company records goodwill in a business combination, it must assign the goodwill to the cash-generating unit that is expected to benefit from the synergies and other benefits arising from the business combination. To illustrate, assume that Kohlbuy AG has three divisions. It purchased one division, Pritt Products, four years ago for €2 million. Unfortunately, Pritt experienced operating losses over the last three quarters. Kohlbuy management is now reviewing the division (the cash-generating unit) for purposes of its annual impairment testing. Illustration 12.10 lists the Pritt Division’s net assets, including the associated goodwill of €900,000 from the purchase. Property, plant, and equipment net € 800,000 Goodwill 900,000 Inventory 700,000 Receivables 300,000 Cash 200,000 Accounts and notes payable (500,000) Net assets €2,400,000 ILLUSTRATION 12.10 Net Assets of Pritt Division, Including Goodwill Kohlbuy determines the recoverable amount for the Pritt Division to be €2,800,000, based on a value-in-use estimate.15 Because the fair value of the division exceeds the carrying amount of the net assets, Kohlbuy does not recognize any impairment. However, if the recoverable amount for the Pritt Division were less than the carrying amount of the net assets, then Kohlbuy must record an impairment. Illustration 12.11 presents the goodwill impairment evalation for Kohlbuy. Evaluating Goodwill Impairment Facts: The carrying value of Kohlbuy’s Pritt Division is €2,400,000 (including Goodwill of €900,000). The recoverable amount of the Pritt Division is €1,900,000. Questions: (a) What the impairment loss, if any, should be recorded? (b) What journal entry does Kohlbuy make to record the impairment loss, if any? Solution: a. The amount of the impairment loss to be recorded is as follows. Recoverable amount of Pritt Division € 1,900,000 Net identifiable assets (2,400,000) Loss on impairment € 500,000 b. Kohlbuy makes the following entry to record the impairment. Loss on Impairment 500,000 Goodwill 500,000 Following this entry, the carrying value of the goodwill is €400,000. ILLUSTRATION 12.11 Evaluation of Goodwill Impairment If conditions change in subsequent periods, such that the recoverable amount of the Pritt Division’s assets other than goodwill exceeds their carrying value, Kohlbuy may reverse an impairment loss on the Pritt Division assets other than goodwill. Goodwill impairment loss reversals are not permitted. 16 Presentation of Intangible Assets The reporting of intangible assets is similar to the reporting of property, plant, and equipment. However, contra accounts may not be shown for intangibles on the statement of financial position. As indicated, on the statement of financial position, companies should report as a separate item all intangible assets other than goodwill. If goodwill is present, companies should report it separately. The IASB concluded that since goodwill and other intangible assets differ significantly from other types of assets, such disclosure benefits users of the statement of financial position. On the income statement, companies should present amortization expense and impairment losses and reversals for intangible assets other than goodwill separately in net income (usually in the operating section), as a separate line item. The notes to the financial statements should include information about acquired intangible assets, including the amortization expense for each type of asset. The notes should include information about changes in the carrying amount of each type of intangible asset during the period. Illustration 12.12 shows an excerpt of the intangible asset reporting for Nestlé (CHE). Note that Nestlé uses the label “Balance Sheet” for its statement of financial position. ILLUSTRATION 12.12 Nestlé’s Intangible Asset Disclosures Research and Development Costs LEARNING OBJECTIVE 5 Describe the accounting and presentation for research and development and similar costs. Research 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 product, 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 12.13 shows the outlays for R&D made by selected companies in a recent year. Sales Company (in millions) R&D/Sales Volkswagen (DEU) $291.1 5.26 % Samsung (KOR) 195.9 7.20 Intel (USA) 55.9 20.57 Microsoft (USA) 86.8 13.13 Roche (CHE) 51.9 20.81 Google (USA) 66.0 14.85 Amazon (USA) 89.0 10.45 Toyota (JPN) 249.0 3.69 Novartis (CHE) 52.4 17.37 Johnson & Johnson (USA) 74.3 11.44 ILLUSTRATION 12.13 R&D Outlays, as a Percentage of Sales As discussed earlier, IFRS requires that all research costs be expensed as incurred. Development costs are generally expensed as incurred. However, once a project moves to the development phase, certain development costs are capitalized. Capitalization begins when the project is far enough along in the process such that the economic benefits of the R&D project will probably flow to the company (the project is economically viable).17 For purposes of homework, assume that all R&D costs are expensed as incurred unless stated otherwise. What Do the Numbers Mean? Global R&D Incentives Research and development investments are the lifeblood of product and process developments that lead to future cash flows and growth. Countries around the world understand this and as a result provide significant incentives in the form of tax credits, “super deductions” (deductions greater than 100 percent), and company tax rate reductions, including “patent box” rates for companies that own and use patents registered in that country. The following table provides a summary for seven major economies. Statutory Country Tax Rate R&D Incentives China 25.0% Offers a 150% super deduction and favorable tax rates for qualifying companies. France 31.0% Offers a variety of R&D incentives including refundable tax credits (30% of first €100 million of R&D expenditure), grants, special innovation tax credits, and a patent box (income from licensing/sale of patent taxed at reduced rate of 17%). Ireland 12.5% Offers a 25% incremental credit for all expenditure exceeding the “base amount” (total qualified expenditure incurred). A 25% volume-based credit is applied to all qualifying research expenses. Japan 23.2% Offers volume-based credits, as well as incremental credits for companies that have increased their research spending. The tax credit ranges from 6–10% of total R&D expenditure for large companies. Singapore 17.0% Offers super deductions under a complex  multi-tiered system for R&D carried out both in Singapore and outside Singapore. Super deductions can be as high as 250%. United 19.0% Offers a 130% super deduction or a taxable Kingdom credit of 11% thereafter. Also offers a full deduction for capital costs incurred for R&D that may be claimed in the year the expenditure is incurred rather than depreciated. United 21.0% Offers choice to report Alternative Simplified States Credit (14% of excess of qualified research expenses) or Traditional Research Tax Credit (20% of amount of qualified research expenses exceeding a base amount). As indicated, there are wide variations in both statutory tax rates and R&D incentives. However, tax credits, government incentives, and company tax rates may constitute only a fraction of the relevant factors a company considers when evaluating development centers. In addition, depending on the politics of tax provisions, there can be year-to-year uncertainty in company tax planning, thereby weakening the effectiveness of such incentives. Sources: L. Cutler, D. Sayuk, and Camille Shoff, “Global R&D Incentives Compared,” Journal of Accountancy (June 2013); and www2.deloitte.com/content/dam/Deloitte/us/Documents/Tax/us-tax-surveyof- global-investment-and-innovation-incentives.pdf. Identifying R&D Activities Illustration 12.14 shows the definitions for research activities and development activities. These definitions differentiate research and development costs from other similar costs.  ILLUSTRATION 12.14 Research 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. Accounting for R&D Activities The 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 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 recognition, account for in accordance with their nature (as either limited-life or indefinite-life intangibles).18 4. Contract services. Expense the costs of services performed by others in connection with R&D as incurred. 5. Indirect costs. Include a reasonable allocation of indirect costs in R&D costs, except for general and administrative costs, which must be clearly related in order to be included in R&D. 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 depreciation and other costs related to such research facilities as R&D expenses. To illustrate, assume that Next Century Incorporated develops, produces, and markets laser machines for medical, industrial, and defense uses. Illustration 12.15 lists the types of expenditures related to its laser-machine activities, along with the recommended accounting treatment.  Next Century Incorporated Accounting Type of Expenditure Treatment Rationale 1. Construction of long-range Capitalize and Has research facility for use in depreciate as R&D alternative current and future projects expense. future use. (three-story, 400,000- square-foot building). 2. Acquisition of R&D Expense Research cost. equipment for use on immediately as current project only. R&D. 3. Acquisition of machinery Capitalize and Has for use on current and depreciate as R&D alternative future R&D projects. expense. future use. 4. Purchase of materials for Record as Inventory Has use on current and future and allocate to R&D alternative R&D projects. projects; expense as future use. consumed. 5. Salaries of research staff Expense Research cost. designing new laser bone immediately as scanner. R&D. 6. Research costs incurred Record as a Not R&D cost under contract with New receivable. (reimbursable Horizon, Inc., and billable expense). monthly.  Next Century Incorporated 7. Material, labor, and Expense Does not meet overhead costs of prototype immediately as recognition laser scanner (economic R&D. criteria. viability not achieved). 8. Costs of testing prototype Expense Does not meet and design modifications immediately as recognition (economic viability not R&D. criteria. achieved). 9. Legal fees to obtain patent Capitalize as patent Direct cost of on new laser scanner. and amortize to patent. overhead as part of cost of goods manufactured. 10. Executive salaries. Expense as Not R&D cost operating expense. (general and administrative expense). 11. Cost of marketing research Expense as Not R&D cost to promote new laser operating expense. (selling scanner. expense). Capitalize as R&D. Meets 12. Engineering costs incurred recognition to advance the laser criteria. scanner to full production stage (economic viability achieved).  Next Century Incorporated 13. Costs of successfully Expense as legal Such defending patent on laser fees. expenditures scanner. only maintain expected benefits. 14. Commissions to sales staff Expense as Not R&D cost marketing new laser operating expense. (selling scanner. expense). ILLUSTRATION 12.15 Sample R&D Expenditures and Their Accounting Treatment Evolving Issue Recognition of R&D and Internally Generated Intangibles The requirement that companies expense immediately all research and most development costs (as well as start-up costs) incurred internally is a 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. Proponents of immediate expensing contend that from an income statement standpoint, long-run application of this standard frequently makes little difference. They argue that because of the ongoing nature of most companies’ R&D activities, the amount of R&D cost charged to expense each accounting period is about the same, whether there is immediate expensing or capitalization and subsequent amortization. Others criticize this practice. They believe that the statement of financial position should report an intangible asset related to expenditures that have future benefit. To preclude capitalization of most R&D expenditures removes from the statement of financial position what may be a company’s most valuable asset. Indeed, research 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. 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. The current accounting for R&D and other internally generated intangible assets represents one of the many trade-offs made among relevance, faithful representation, and cost-benefit  considerations. The FASB and IASB have completed some limited- scope projects on the accounting for intangible assets, and the Boards have contemplated a joint project on the accounting for identifiable intangible assets (i.e., excluding goodwill). Such a project would address concerns that the current accounting requirements lead to inconsistent treatments for some types of intangible assets depending on how they arise. At present, that project is on hold. The IASB has an active project on goodwill and impairment (see www.ifrs.org/projects/work-plan/goodwill-and- impairment). Sources for research studies: Baruch Lev and Theodore Sougiannis, “The Capitalization, Amortization, and Value-Relevance of R&D,” Journal of Accounting and Economics (February 1996); and Martha L. Loudder and Bruce K. Behn, “Alternative Income Determination Rules and Earnings Usefulness: The Case of R&D Costs,” Contemporary Accounting Research (Fall 1995). See also the recent critique of the accounting for intangible assets in Baruch Lev and Feng Gu, The End of Accounting (Hoboken, NJ: John Wiley & Sons, 2016). Costs Similar to R&D Costs Many costs have characteristics similar to research and development costs.19 Examples are: 1. Start-up costs for a new operation. 2. Initial operating losses. 3. Advertising costs. For the most part, these costs are expensed as incurred, similar to the accounting for research costs. We briefly explain these costs in the following sections. Start-Up Costs Start-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 business in a new territory. Start-up costs include organizational costs, such as legal and governmental 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 expectation of future revenues or increased efficiencies. However, determining the amount and timing of future benefits is so difficult that a conservative approach— expensing these costs as incurred—is required. To illustrate examples of start-up costs, assume that U.S.-based Hilo Beverage Company 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. 2. Training of local employees related to product, maintenance, computer systems, finance, 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 statement of financial position using appropriate IFRS reporting guidelines. Initial Operating Losses Some 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 considered an asset. IFRS requires that operating losses during the early years should not be capitalized. 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 enterprises. 20 Advertising Costs Over the years, PepsiCo (USA) 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? PepsiCo could expense the costs in various ways: 1. When the pop stars have completed their singing assignments. 2. The first time the advertising runs. 3. Over the estimated useful life of the advertising. 4. In an appropriate fashion to each of the three periods identified above. 5. Over the period revenues are expected to result. PepsiCo must expense these advertising costs as incurred. The IASB acknowledges that advertising and promotional activities may enhance or create customer relationships, which in turn generate revenues. However, those expenditures are no different than other internally generated intangible assets (e.g., brands, mastheads, and customer lists), which primarily contribute to the development of the business as a whole. Therefore, they do not meet the separately identifiable criterion and should be expensed as incurred. What Do the Numbers Mean? Branded For many companies, developing a strong brand image is as important as developing the products they sell. Now more than ever, companies see the power of a strong brand, enhanced by significant and effective advertising investments. As the following chart indicates, the value of brand investments is substantial. Apple (USA) heads the list with an estimated brand value of about $184.2 billion. Companies from around the globe are represented in the top 20 brands. Valuable Global Brands (in billions) 1. Apple (USA) $184.2 2. Google (USA) 141.7 3. Microsoft (USA) 80.0 4. Coca-Cola (USA) 69.7 5. Amazon (USA) 64.8 6. Samsung (KOR) 56.2 7. Toyota (JPN) 50.3 8. Facebook (USA) 48.2 9. Mercedes-Benz (DEU) 47.8 10. IBM (USA) 46.0 Source: Interbrand Corp. Companies may include the value of a brand in the financial statements under goodwill. But, generally you will not find the estimated values of brands recorded in companies’ statements of financial position. 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 advertising spending. For example, in estimating the brand values  shown in the table, Interbrand Corp. (USA) estimates the percentage of the overall future revenues the brand will generate and then discounts the net cash flows 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: Interbrand Corp., Best Global Brands Report (2017). Presentation of Research and Development Costs Companies 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 statement. GlaxoSmithKline (GBR), a global research pharmaceutical company, reported research and development in its recent income statement, with related accounting policy discussion in the notes as shown in Illustration 12.16. GlaxoSmithKline (in millions) 31 December 2018 Turnover £30,821 Cost of Sales (10,241) Gross Profit 20,580 Selling, General, and Administrative (9,915) Research and Development (3,893) Royalty Income 299 Other Operating Income (1,588) Operating Profit £ 5,483 Note 2 (in part) Research and development Research and development expenditure is charged to the income statement in the period in which it is incurred. Development expenditure is capitalised when the criteria for recognising an asset are met, usually when a regulatory filing has been made in a major market and approval is considered highly probable. Property, plant and equipment used for research and development is capitalised and depreciated in accordance with the Group’s policy. ILLUSTRATION 12.16 R&D Reporting Review and Practice Key Terms Review amortization bargain purchase business combination cash-generating unit copyright development activities development phase economic viability franchise goodwill impaired impairment loss indefinite useful life (intangibles) intangible assets license (permit) limited useful life (intangibles) master valuation approach organizational costs patent recoverable amount research activities research and development (R&D) costs research phase start-up costs trademark, trade name Learning Objectives Review  1 Discuss the characteristics, valuation, and amortization of intangible assets. Intangible assets have three main characteristics: (1) they are identifiable, (2) they lack physical existence, and (3) they are not monetary assets. In most cases, intangible assets provide services over a period of years and so are normally classified as non-current assets. Intangibles are recorded at cost. Cost includes all acquisition costs and expenditures needed to make the intangible asset ready for its intended use. If intangibles are acquired in exchange for shares or other assets, 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. When a company makes a “basket purchase” of several intangibles or a combination of intangibles and tangibles, it should allocate the cost on the basis of relative fair values. Intangibles have either a limited useful life or an indefinite useful life. Companies amortize limited-life intangibles. They do not amortize indefinite-life intangibles. Limited-life intangibles should be amortized by systematic charges to expense over their useful lives. The useful lives should reflect the period over which these assets will contribute to cash flows. The amount to report for amortization expense should reflect the pattern in which a company consumes or uses up the asset, if it can reliably determine that pattern. Otherwise, use a straight-line approach. 2 Describe the accounting for various types of intangible assets. Major types of intangibles are (1) marketing-related intangibles, used in the marketing or promotion of products or services; (2) customer- related intangibles, resulting from interactions with outside parties; (3) artistic-related intangibles, giving ownership rights to such items as plays and literary works; (4) contract-related intangibles, representing the value of rights that arise from contractual arrangements; (5) technology-related intangibles, relating to innovations or technological advances; and (6) goodwill, arising from business combinations. 3 Explain the accounting issues for recording goodwill. Unlike receivables, inventories, and patents that a company can sell or exchange individually in the marketplace, goodwill can be identified only with the company as a whole. Goodwill is a “going concern” valuation and is recorded only when an entire business is purchased. A company should not capitalize goodwill generated internally. The future benefits of goodwill may have no relationship to the costs incurred in the development of that goodwill. Goodwill may exist even in the absence of specific costs to develop it. 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. Goodwill is often identified on the statement of financial position as the excess of cost over the fair value of the net assets acquired. 4 Identify impairment procedures and presentation requirements for intangible assets. An intangible asset is impaired when a company is not able to recover the asset’s carrying amount either through using it or by selling it. Limited-life intangibles are reviewed annually to determine if there are impairment indicators; if so, the impairment test is performed. Indefinite-life intangibles, including goodwill, must be tested for impairment every year. An impairment loss is recorded in net income if the recoverable amount (the greater of fair value less costs to sell and value-in-use) of an intangible asset is less than the carrying value. Impairment losses on intangible assets (other than goodwill) may be reversed but only up to the carrying amount that would have been recorded in the absence of the impairment. With respect to presentation, on the statement of financial position, companies should report all intangible assets other than goodwill as a separate item. Contra accounts are not normally shown. If goodwill is present, it too should be reported as a separate item. On the income statement, companies should report amortization expense and impairment losses in operating income. The notes to the financial statements have additional detailed information. 5 Describe the accounting and presentation for research and development and similar costs. R&D costs are not in themselves intangible assets, but R&D activities frequently result in the development of something a company patents or copyrights. The difficulties in accounting for R&D expenditures are (1) identifying the costs associated with particular activities, projects, or achievements; and (2) determining the magnitude of the future benefits and length of time over which a company may realize such benefits. Because of these latter uncertainties, companies are required to expense all research costs when incurred. Certain costs incurred during the development phase of an R&D project are capitalized when an R&D project achieves economic viability. Illustration 12.15 shows the costs associated with R&D activities and the accounting treatment accorded them. Many costs have characteristics similar to R&D costs. Examples are start-up costs, initial operating losses, and advertising costs. For the most part, these costs are expensed as incurred, similar to the accounting for all research and many development costs. Financial statements must disclose the total R&D costs charged to expense each period for which an income statement is presented. Enhanced Review and Practice Go online for multiple-choice questions with solutions, review exercises with solutions, and a full glossary of all key terms. Practice Problem Sky ASA, organized in 2022, provided you with the following information. 1. Purchased a license for €20,000 on July 1, 2022. The license gives Sky exclusive rights to sell its services in the provincial region and will expire on July 1, 2030. 2. Purchased a patent on January 2, 2023, for €40,000. It is estimated to have a 5-year life. 3. Costs incurred to develop an exclusive Internet connection process as of June 1, 2023, were €45,000. The process has an indefinite life. 4. On April 1, 2023, Sky purchased a small circuit board manufacturer for €350,000. Goodwill recorded in the transaction was €90,000. 5. On July 1, 2023, legal fees of €11,400 were incurred for application and filing of a new patent, which will expire at the same time as the patent purchased on January 2, 2023. 6. Research and development costs incurred as of September 1, 2023, were €75,000. None of the related projects involved had achieved economic viability. Instructions a. Prepare the journal entries to record all the entries related to the patent during 2023. b. At December 31, 2023, an impairment test is performed on the license purchased in 2022. It is estimated that the net cash flows to be received from the license will be €13,000, and its recoverable amount is €7,000. Compute the amount of impairment, if any, to be recorded on December 31, 2023. c. What is the amount to be reported for intangible assets on the statement of financial position at December 31, 2022? At December 31, 2023? Solution a. January 2, 2023 Patents 40,000 Cash 40,000 July 1, 2023 Patents 11,400 Cash 11,400 December 31, 2023 Patent Amortization Expense 9,267 Patents 9,267 Computation of Patent Amortization Expense: €40,000 × 12/60 = €8,000 €11,400 × 6/54 = 1,267 Total €9,267 b. Computation of impairment loss: Cost €20,000 Less: Accumulated amortization [€20,000 × (18 ÷ 96)] 3,750 Book value €16,250 Book value of €16,250 is greater than the recoverable amount. Therefore, the license is impaired. The impairment loss is computed as follows. Book value €16,250 Recoverable amount 7,000 Loss on impairment € 9,250 c. Intangible assets as of December 31, 2022:  Licenses €18,750* *Cost € 20,000 Less: Accumulated amortization [€20,000 1,250 × (6 ÷ 96)] Total € 18,750 Intangible assets as of December 31, 2023: Licenses € 7,000 Patents (€40,000 + €11,400 − €9,267) 42,133 Goodwill 90,000 Total €139,133 All the costs to develop the Internet connection process and the research and development costs are expensed as incurred. Exercises, Problems, Problem Solution Walkthrough Videos, Data Analytics Activities, and many more assessment tools and resources are available for practice in Wiley’s online courseware. Questions 1. What are the three main characteristics of intangible assets? 2. If intangibles are acquired for shares, how is the cost of the intangible determined? 3. Intangibles have either a limited useful life or an indefinite useful life. How should these two different types of intangibles be amortized? 4. Why does IFRS make a distinction between internally created intangibles and purchased intangibles? 5. In 2022, Ghostbusters SA spent €420,000 for “goodwill” visits by sales personnel to key customers. The purpose of these visits was to build a solid, friendly relationship for the future and to gain insight into the problems and needs of the companies served. How should this expenditure be reported? 6. What are factors to be considered in estimating the useful life of an intangible asset? 7. What should be the pattern of amortization for a limited-life intangible? 8. Novartis (CHE) acquired a trademark that is helpful in distinguishing one of its new products. The trademark is renewable every 10 years at minimal cost. All evidence indicates that this trademarked product will generate cash flows for an indefinite period of time. How should this trademark be amortized? 9. McNabb Company spent $190,000 developing a new process prior to achieving economic viability, $45,000 in legal fees to obtain a patent, and $91,000 to market the process that was patented, all in the year 2022. How should these costs be accounted for in 2022? 10. Izzy Ltd. purchased a patent for £350,000 which has an estimated useful life of 10 years. Its pattern of use or consumption cannot be reliably determined. Prepare the entry to record the amortization of the patent in its first year of use. 11. Explain the difference between artistic-related intangible assets and contract-related intangible assets. 12. What is goodwill? What is a bargain purchase? 13. Under what circumstances is it appropriate to record goodwill in the accounts? How should goodwill, properly recorded on the books, be written off in order to conform with IFRS? 14. In examining financial statements, financial analysts often write off goodwill immediately. Comment on this procedure. 15. Braxton Inc. is considering the write-off of a limited-life intangible because of its lack of profitability. Explain to the management of Braxton how to determine whether a write-off is permitted. 16. Last year, Zeno Company recorded an impairment on an intangible asset. Recent appraisals indicate that the asset has increased in value. Should Zeno record this recovery in value? 17. Explain how losses on impaired intangible assets should be reported in income. 18. Shi Ltd. determines that its goodwill is impaired. It finds that its recoverable amount is HK$3,600,000 and its recorded goodwill is HK$4,000,000. The fair value of its identifiable assets is HK$14,500,000. What is the amount of goodwill impaired? 19. What is the nature of research and development costs? Can development costs be capitalized? Explain. 20. Research and development activities may include (a) personnel costs, (b) materials and equipment costs, and (c) indirect costs. What is the recommended accounting treatment for these three types of R&D costs? 21. Which of the following activities should be expensed currently as R&D costs? a. Testing in search for or evaluation of product or process alternatives. b. Engineering follow-through in an early phase of commercial production. c. Legal work in connection with patent applications or litigation, and the sale or licensing of patents. 22. Indicate the proper accounting for the following items. a. Organization costs. b. Advertising costs. c. Operating losses. 23. In 2021, Jackie Chan Ltd. developed a new product that will be marketed in 2023. In connection with the development of this product, the following costs were incurred in 2022: research and development costs ¥40,000,000, materials and supplies consumed ¥6,000,000, and compensation paid to research consultants ¥12,500,000. (¥23,000,000 of the development phase costs were incurred after the product became economically viable.) It is anticipated that these costs will be recovered in 2025. What is the amount of research and development costs that Chan should record in 2022 as a charge to expense? 24. Recently, a group of university students decided to form a company for the purposes of selling a process to recycle the waste product from manufacturing cheese. Some of the initial costs involved were legal fees and office expenses incurred in starting the business, governmental fees, and stamp taxes. One student wants to charge these costs against revenue in the current period. Another wishes to defer these costs and amortize them in the future. Which student is correct? 25. An intangible asset with an estimated useful life of 30 years was acquired on January 1, 2012, for $540,000. On January 1, 2022, a review was made of intangible assets and their expected service lives, and it was determined that this asset had an estimated useful life of 30 more years from the date of the review. What is the amount of amortization for this intangible in 2022? Brief Exercises BE12.1 (LO 2) Celine Dion Corporation purchases a patent from Salmon Company on January 1, 2022, for $54,000. The patent has a remaining legal life of 16 years. Celine Dion feels the patent will be useful for 10 years. Prepare Celine Dion’s journal entries to record the purchase of the patent and 2022 amortization. BE12.2 (LO 2) Use the information provided in BE12.1. Assume that at January 1, 2024, the carrying amount of the patent on Celine Dion’s books is $43,200. In January, Celine Dion spends $24,000 successfully defending a patent suit. Celine Dion still feels the patent will be useful until the end of 2031. Prepare the journal entries to record the $24,000 expenditure and 2024 amortization. BE12.3 (LO 2) Larry Lyon SA spent €68,000 in attorney fees while developing the trade name of its new product, the Mean Bean Machine. Prepare the journal entries to record the €68,000 expenditure and the first year’s amortization, using an 8-year life. BE12.4 (LO 2) Gershwin plc obtained a franchise from Sonic Hedgehog Inc. for a cash payment of £120,000 on April 1, 2022. The franchise grants Gershwin the right to sell certain products and services for a period of 8 years. Prepare Gershwin’s April 1 journal entry and December 31 adjusting entry. BE12.5 (LO 3) On September 1, 2022, Winans Ltd. acquired Aumont Enterprises for a cash payment of £700,000. At the time of purchase, Aumont’s statement of financial position showed assets of £620,000, liabilities of £200,000, and equity of £420,000. The fair value of Aumont’s assets is estimated to be £800,000. Compute the amount of goodwill acquired by Winans. BE12.6 (LO 4) Kenoly Corporation owns a patent that has a carrying amount of $300,000. Kenoly expects future net cash flows from this patent to total $210,000 over its remaining life of 10 years. The recoverable amount of the patent is $110,000. Prepare Kenoly’s journal entry, if necessary, to record the loss on impairment. BE12.7 (LO 4) Use the information in BE12.6. Assume that at the end of the year following the impairment (after recording amortization expense), the estimated recoverable amount for the patent is $130,000. Prepare Kenoly’s journal entry, if needed. BE12.8 (LO 4) Waters Ltd. purchased Jang Group 3 years ago and at that time recorded goodwill of HK$400,000. The Jang Division’s net assets, including the goodwill, have a carrying amount of HK$800,000. The fair value of the division is estimated to be HK$1,000,000. Prepare Waters’ journal entry, if necessary, to record impairment of the goodwill. BE12.9 (LO 4) Use the information provided in BE12.8. Assume that the recoverable amount of the division is estimated to be HK$750,000. Prepare Waters’ journal entry, if necessary, to record impairment of the goodwill. BE12.10 (LO 5) Sujo Ltd. commenced operations in early 2022. The company incurred HK$60,000,000 of costs such as fees to underwriters, legal fees, governmental fees, and promotional expenditures during its formation. Prepare journal entries to record the HK$60,000,000 expenditure and 2022 amortization, if any. BE12.11 (LO 5) Treasure Land plc incurred the following costs in 2022. Cost of laboratory research aimed at discovery of new knowledge £120,000 Cost of testing in search for product alternatives 100,000 Cost of engineering activity required to advance the design of a product to the manufacturing stage 210,000 Prototype testing subsequent to meeting economic viability 75,000 £505,000 Prepare the necessary 2022 journal entry or entries for Treasure Land. BE12.12 (LO 5) Indicate whether the following items are capitalized or expensed in the current year. a. Purchase cost of a patent from a competitor. b. Research costs. c. Development costs (after achieving economic viability). d. Organizational costs. e. Costs incurred internally to create goodwill. BE12.13 (LO 4) Nieland Industries had one patent recorded on its books as of January 1, 2022. This patent had a book value of $288,000 and a remaining useful life of 8 years. During 2022, Nieland incurred research costs of $96,000 and brought a patent infringement suit against a competitor. On December 1, 2022, Nieland received the good news that its patent was valid and that its competitor could not use the process Nieland had patented. The company incurred $85,000 to defend this patent. At what amount should the patent(s) be reported on the December 31, 2022, statement of financial position, assuming monthly amortization of patents? BE12.14 (LO 4) Sinise Industries acquired two copyrights during 2022. One copyright related to a textbook that was developed internally at a cost of €9,900. This textbook is estimated to have a useful life of 3 years from September 1, 2022, the date it was published. The second copyright (a history research textbook) was purchased from University Press on December 1, 2022, for €24,000. This textbook has an indefinite useful life. How should these two copyrights be reported on Sinise’s statement of financial position as of