SFAS Nos. 141 and 142
SFAS Nos. 141 and 142
Intangible Assets
Intangible assets are defined as those assets (not including financial assets) that lack physical substance.
Many intangible assets arise from contractual or governmental rights. A well-known example of this type
of intangible asset is the right to operate a taxicab in a metropolitan area, such as New York City. Although
this right is evidenced by a physical object, the taxicab medallion, it is the legal right itself that is valuable.
Other intangibles assets are not created by a specific contract or legal right. The existence of these
intangibles is evidenced by the fact that they are bought, sold, or licensed, either separately or in
conjunction with a broader assortment of assets. A good example of this type of intangible is a customer
list. Magazine subscription companies, Web travel services, and real estate listing services all generate
substantial revenues by selling or “leasing” their customer lists. In addition, a purchaser must pay a
premium when buying an existing business location because of the value of the customer list (and customer
relationships) that is tied to the business; the value of this premium should be reported as a separate
intangible asset.
The most important distinction in intangible assets for accounting purposes is between those intangible
assets that are internally generated and those that are externally purchased. This distinction is important
because the transfer of externally-purchased intangible assets in an arms’-length market transaction
provides reliable evidence that the intangibles have probable future economic benefit. Such reliable
evidence does not exist for most internally-generated intangibles. Accordingly, most costs associated with
generating and maintaining internally-generated intangibles are expensed as incurred. [Footnote: Statement
of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” Norwalk, CT:
Financial Accounting Standards Board, 2001, par. 10; this standard references APB Opinion No. 17, par.
24.] Only the actual legal and filing costs are included as part of the intangible asset cost for these
internally-developed items. Any costs to defend the rights in court are added to the intangible asset cost if
successful. If not successful, all asset costs related to the rights would be written off as expenses.
Most externally-obtained intangible assets arise in transactions involving other assets. For example, the
purchase of the tangible assets of a factory building and its associated machinery also might involve the
acquisition of the intangible assets of the operating permit for the factory, the water rights tied to the
property, and the customer relationships developed by the prior factory owner. Accounting for this kind of
“basket purchase” of assets will be discussed later in the chapter. A short description of some of the
common types of intangible assets is given below.
TRADEMARK A trademark is a distinctive name, symbol, or slogan that distinguishes a product or
service from similar products or services. Well-known examples include Coke, Windows, Yahoo!, and the
Nike Swoosh. As shown in Exhibit 12-10 later in the chapter, it was estimated in 2001 that the value of the
Coca-Cola trademark was in excess of $68 billion. Because the Coca-Cola trademark is an internallygenerated intangible asset, it is not reported in The Coca-Cola Company’s balance sheet. However, the
company has purchased other trademarks (such as Minute Maid), with a total cost of $2.6 billion; these are
reported in The Coca-Cola Company’s balance sheet, as shown in Chapter 3.
FRANCHISES Franchise operations have become so common in everyday life that we often don’t realize
we are dealing with them. In fact, these days it is difficult to find a nonfranchise business in a typical
shopping mall. When a business obtains a franchise, the recorded cost of the franchise includes any sum
paid specifically for the franchise right as well as legal fees and other costs incurred in obtaining it.
Although the value of a franchise at the time of its acquisition may be substantially in excess of its cost, the
amount recorded should be limited to actual outlays. For example, approximately 70 percent of
McDonald’s locations are operated under franchise agreements. A McDonald’s franchisor must contribute
an initial cash amount of $175,000 which is used to buy some of the equipment and signs and also to pay
the initial franchise fee. The value of a McDonald’s franchise alone is much more than $175,000, but the
1
SFAS Nos. 141 and 142
franchisor would only record a franchise asset in his or her financial statements equal to the cost (not value)
of the franchise. However, if a franchise right is included when one company purchases another company,
presumably the entire value is included in the purchase price, and the fair value attributable to the franchise
right is recorded as an intangible asset in the acquirer’s books.
ORDER BACKLOG To some companies, especially capital equipment manufacturers, the order backlog
is a key economic asset. The order backlog is the amount of orders the company has received for equipment
that has not yet been produced or delivered. Note that these orders do not constitute sales because they do
not satisfy the revenue recognition requirement that the product be completed and shipped. However, this
order backlog does represent future valuable economic activity, and the contractual right to these
backlogged orders constitutes an important intangible asset. In its 2001 10-K filing, Boeing reported the
following about its order backlog:
The Company's backlog of firm contractual orders (in billions) at
December 31 follows:
Commercial Airplanes
Military Aircraft and Missile Systems
Space and Communications
Total contractual backlog
2001
======
$ 75.9
17.6
13.1
-----$106.6
======
2000
======
$ 89.8
17.1
13.7
----$120.6
======
As with other intangible assets, this internally-generated order backlog would not be recognized as an
intangible asset on Boeing’s balance sheet. However, if another company were to buy Boeing, part of the
purchase price would be identified with the economic value of the order backlog, and a corresponding
intangible asset would be recognized in the books of the acquiring company.
GOODWILL Goodwill is the business contacts, reputation, functioning systems, staff camaraderie, and
industry experience that make a business much more than just a collection of assets. As mentioned above, if
these factors are the result of a contractual right or are associated with intangibles that can be bought and
sold separately, then the value of the factor should be reported as a separate intangible asset. In essence,
goodwill is a residual number, the value of all of the synergies of a functioning business that cannot be
specifically identified with any other intangible factor. Goodwill is recognized only when it is purchased as
part of the acquisition of another company. In other words, a company’s own goodwill, its homegrown
goodwill, is not recognized. Goodwill will be discussed more in depth later in the chapter.
=========
FYI: The most important recent development in accounting for intangibles is the FASB’s emphasis on
companies reporting separate amounts for all of the individual intangible assets that can be identified.
Previously, these assets were typically tossed in with goodwill.
=========
Exhibit 12-4 Acquisition Costs of Goodwill and Other Intangible Assets
Patent
Trademark
An exclusive right granted by a national
government that enables an inventor to
control the manufacture, sale, or use of an
invention. In the U.S., legal life is 17
years.
An exclusive right granted by a national
government that permits the use of
COST: Purchase price, filing and
registry fees, cost of subsequent litigation
to protect right. Does not include internal
research and development costs.
COST: Same as Patent.
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SFAS Nos. 141 and 142
Copyright
Franchise agreement
Acquired customer list
Goodwill
distinctive symbols, labels, and designs,
e.g., McDonald’s golden arches, Nike’s
swoosh, Apple computer name and logo.
Legal life is virtually unlimited.
An exclusive right granted by a national
government that permits an author to sell,
license, or control his/her work. In the
U.S., copyrights expire 50 years after the
death of the author.
An exclusive right or privilege received
by a business or individual to perform
certain functions or sell certain products
or services.
A list or database containing customer
information such as name, address, past
purchases, and so forth. Companies that
originally develop such a list often sell or
lease it to other companies, unless
prohibited by customer confidentiality
agreements.
Miscellaneous intangible resources,
factors, and conditions that allow a
company to earn above-normal income
with its identifiable net assets. Goodwill is
recorded only when a business entity is
acquired by a purchase.
COST: Same as Patent.
COST: Expenditures made to purchase
the franchise. Legal fees and other costs
incurred in obtaining the franchise.
COST: Purchase price when acquired
from another company. Costs to internally
develop a customer list are expensed as
incurred.
COST: Portion of purchase price that
exceeds the sum of the current market
value for all identifiable net assets, both
tangible and intangible.
Some of these illustrations are taken from SFAS No. 141, “Business Combinations,” Appendix A.
ACCOUNTING FOR THE ACQUISITION OF
INTANGIBLE ASSETS
One of the most striking trends in business in the past 20 years is the increasing importance of intangible
assets. This trend has proved to be a difficult challenge for financial reporting. The classic financial
reporting model is based on manufacturing and retail companies with a focus on inventory, accounts
receivable, buildings, equipment, and so forth. In a world driven by information technology, global brand
names, and human capital, this accounting model often excludes the most important economic assets of a
business. For example, in 1999 it was estimated that an average of 250 megabytes of digital information
were generated for each man, woman, and child on the earth, with the amount doubling every
year.[Footnote: Eric Woodman, “Information Generation,” EMC Corporation, November 22, 2000.] In
2001, Federal Reserve economist Leonard Nakamura estimated that U.S. companies invest approximately
$1 trillion per year in intangible assets, and that the value of the existing stock of intangibles is $5 trillion.
[Footnote: Leonard I. Nakamura, “What is the U.S. Gross Investment in Intangibles? (At Least) One
Trillion Dollars a Year!” Federal Reserve Bank of Philadelphia, Working Paper No. 01-15, October 2001.]
Finally, in 2001 Professor Erik Brynjolfsson of MIT’s Sloan School estimated that U.S. companies had
invested $1.3 trillion over the preceding 10 years in their “organization capital,” or their processes and
ways of doing things effectively and efficiently; this is comparable to the amount those same companies
had invested in new equipment and factories over the same period. [Footnote: Mark Kindley, “Hidden
Assets,” CIO Insight, October 1, 2001.]
There are many signs of a growing dissatisfaction with the traditional accounting model. For example, the
Stern School of Business at New York University has established an “Intangibles Research Center” to
promote research into improving the accounting for intangibles. In addition, in August 1996 the FASB
began a project on the accounting for intangibles. The FASB noted: “Intangible assets make up an
increasing proportion of the assets of many (if not most) entities, but despite their importance, those assets
often are not recognized as such.” The FASB’s project culminated in the release of two standards – SFAS
No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets.”[Footnote:
Statement of Financial Accounting Standards No. 141, “Business Combinations,” Norwalk, CT: Financial
Accounting Standards Board, 2001; and Statement of Financial Accounting Standards No. 142, “Goodwill
3
SFAS Nos. 141 and 142
and Other Intangible Assets,” Norwalk, CT: Financial Accounting Standards Board, 2001.] The general
thrust of these two Statements is a requirement that companies make greater efforts to identify and
separately recognize more intangible assets. Theoretically, this requirement has existed since 1970; APB
Opinion No. 17 (paragraphs 24 through 26) stipulated that the cost of identifiable intangible assets should
be separately recognized in the financial statements. However, in practice most companies have reported
intangibles as an ill-defined conglomeration, with little detail about separate intangibles. Statement No. 141
and Statement No. 142 are an attempt to increase the efforts of companies to identify intangibles with
different economic characteristics, and to improve the financial reporting detail provided with respect to
these intangibles.
Statements No. 141 and 142 also substantially change the practice of amortizing the cost of intangibles
assets. Under these standards, many intangible assets are assumed to have indefinite useful lives and thus
are not systematically amortized. The amortization (and nonamortization) of intangible assets is discussed
in Chapter 13. The different types of intangible assets, and the process through which they are recognized,
are discussed below.
Internally-Generated Intangibles
One thing that Statements No. 141 and 142 do NOT attempt is to require companies to identify and value
internally-generated, or homegrown, intangibles. In most cases, these are the most valuable intangible
assets that a company has. As an illustration, consider Exhibit 12-10 which lists the ten most valuable
brands in the world in 2001. Each of these brands represents a valuable economic asset that has been
internally-generated. For example, the $68.9 billion Coca-Cola brand name has been created over the years
by The Coca-Cola Company through successful business operations and relentless marketing. But because
the valuation of this asset is not deemed sufficiently reliable to meet the standard for financial statement
recognition, it is not included in The Coca-Cola Company’s balance sheet. However, as explained below, if
another company were to buy The Coca-Cola Company, an important part of recording the transaction
would be allocating the total purchase price to the various economic assets acquired, including previouslyunrecorded intangible assets.
============================================
E X H I B I T 1 2 – 1 0 Ten Most Valuable Brands in the World for 2001
Ten Most Valuable Brands in the World for 2001
Brand Value
Brand
(in billions)
1 Coca-Cola
$68.9
2 Microsoft
65.1
3 IBM
52.8
4 General Electric
42.4
5 Nokia
35.0
6 Intel
34.7
7 Disney
32.6
8 Ford
30.1
9 McDonald's
25.3
10 AT&T
22.8
Source: Interbrand at www.interbrand.com.
================================
4
SFAS Nos. 141 and 142
In the future, financial reporting will move toward providing more information about internally-generated
intangibles. Whether this will involve actual valuation and recognition of these intangibles in the financial
statements, or simply more extensive note disclosure, remains to be seen.
Intangibles Acquired in a Basket Purchase
A common method of acquiring intangible assets is in conjunction with a collection of associated assets.
For example, a company might pay $700,000 to purchase a patent along with a functioning factory and
special equipment used in producing the patented product. Useful information is lost if the entire $700,000
purchase price is merely recorded as a generic “asset.” Accordingly, just as demonstrated earlier in the
chapter with a basket purchase involving only tangible assets, the total purchase price of $700,000 is
allocated among all of the assets, tangible and intangible, according to the relative fair values of the assets.
If the fair values of the patent, factory, and equipment are estimated to be $200,000, $450,000, and
$100,000, respectively, the $700,000 cost would be allocated as follows:
Estimated
Cost Allocation According to
Cost Assigned to
Fair Values
Relative Estimated Values
Individual Assets
Patent .............................................. $ 200,000
Factory ............................................
450,000
Equipment .....................................
100,000
....................................... $750,000
200,000/750,000 × $700,000
450,000/750,000 × $700,000
100,000/750,000 × $700,000
$186,667
420,000
93,333
$700,000
===================
Caution: Of course, an intangible can be acquired all by itself. If a company buys a single intangible asset,
the purchase price allocation is simple – all of the purchase price is recorded as the cost of the single
intangible asset.
======================
FIVE GENERAL CATEGORIES OF INTANGIBLE ASSETS To aid companies in identifying
different types of intangible assets that should be recognized separately, in SFAS No. 141 (Appendix A)
the FASB included a description of five general categories of intangible assets. Those five general
categories are:
i. Marketing-related intangible assets such as trademarks, brand names, and Internet domain names.
ii. Customer-related intangible assets such as customer lists, order backlogs, and customer relationships.
iii. Artistic-related intangible assets such as items protected by copyright.
iv. Contract-based intangible assets such as licenses, franchises, and broadcast rights.
v. Technology-based intangible assets including both patented and unpatented technologies as well as
trade secrets.
These five categories do not comprise a comprehensive catalogue of all possible intangible assets. In
addition, the identification of intangibles should not be viewed as merely matching up an acquired basket of
assets with items from the FASB’s list. As with all other assets, intangible assets must meet specific criteria
in order to be recognized. The conceptual background for those criteria is laid out in Concepts Statement
No. 5 (paragraph 63) which indicates that in order to be recognized as an asset, an item must have probable
future economic benefit, must be relevant to decision-makers, and must be reliably measurable. Those
criteria are presumed to be satisfied with intangibles that are based on contracts or that are separately
traded.
CONTRACT-BASED INTANGIBLES Most of the intangible assets briefly described at the beginning of
this chapter arise from contracts or other legal rights. Examples, are trademarks, patents, copyrights, and
franchise agreements. An intangible asset that is based on contractual or legal rights should be recognized
as a separate asset, even if the right is inseparably connected with another asset. For example, the legal
right to operate a specific nuclear power plant would often be sold together with the nuclear power plant
5
SFAS Nos. 141 and 142
itself. Although these assets are not practically separable, the right to operate the factory is established by a
specific legal permit and should be valued and reported separately in the books of the company that
acquires the plant.
SEPARATELY-TRADABLE INTANGIBLES Some intangible assets arise as companies establish and
maintain relationships of trust with their customers. These relationships are not imposed by legal right or
contract but are voluntary and are based on past positive experiences. Companies are increasingly
recognizing the value in these relationships, and are even learning how to sell or rent these relationships.
One example is the sale (exclusive use) or rental (nonexclusive use) of a customer database to another
company. The fact that there is a market for these databases is taken as evidence that intangibles of this sort
are reliably-measurable assets that should be recognized as a separate asset when acquired by a company.
Another example is the relationship a bank has with its depositors. Although these relationships themselves
are not typically traded in separate transactions, they are inherent in the trading of portfolios of customer
deposits. When a bank acquires a set of depositor liabilities from another bank, included in that transaction
is the transfer of the depositor relationships to the acquiring bank. In such a transaction, a fair value should
be estimated for the depositor relationships and a separate intangible asset recognized.
===========================
FYI: One of the dangers in these tradable intangibles is that the very relationship of trust that created the
valuable intangible in the first place may be impaired when it is sold. For example, subscribers to a
magazine may cancel their subscription when they learn that the magazine publisher has sold their
subscriber database to a telemarketing firm or a political fund-raising organization.
============================
OTHER INTANGIBLES THAT ARE RELIABLY-MEASURABLE ASSETS Not all recognizable
intangibles are either contract-based or separately-tradable intangibles. In some cases, intangibles not
falling into either of these two categories can still be relevant and have reliably-measurable probable future
economic benefit. One example specifically mentioned by the FASB is the value of an existing group of
trained employees associated with, say, a manufacturing facility or a computer software development firm.
Such employees cannot be forced by law to continue to work for the new owners of the facility;
accordingly, the intangible value of the group of employees is not contract based. In addition, it is not
possible for employees to be bought and sold in groups like commodities. [Footnote: This discussion treats
so-called “at-will” employees who are not under exclusive, long-term contracts to work for a specific
employer. The accounting issues associated with purchasing a trained group of employees under long-term
contracts are discussed in a Chapter 13 boxed item about accounting for professional baseball teams.] In
summary, most , but not all, intangible assets recorded in conjunction with a basket purchase will be
contract based or separately tradable. For other intangibles, the burden is on the acquiring company to
demonstrate that the intangible has reliably-measurable probable future economic benefit.
=============================
FYI: In forming a corporation, certain organization costs are incurred, including legal fees, promotional
costs, stock certificate costs, underwriting costs, and state incorporation fees. It can be argued that the
benefits to be derived from these expenditures extend beyond the first fiscal period. However, the AICPA,
with the approval of the FASB, has decided that organization costs (and the costs associated with other
types of start-up activities) should be expensed as they are incurred. This pronouncement, which differs
from prior practice, was released in 1998. See AICPA SOP 98-5.
========================================
ESTIMATING THE FAIR VALUE OF AN INTANGIBLE The most difficult part of recording an
amount for an intangible asset is not in identifying the asset but instead is in estimating a fair value of the
asset. The objective in estimating the fair value is to duplicate the price at which the intangible asset would
change hands in an arms’-length market transaction. If there is a market for similar intangibles assets, then
the best estimate of fair value is made with reference to these observable market prices. In the absence of
such a market, present value techniques should be used to estimate the fair value. As described in Concepts
6
SFAS Nos. 141 and 142
Statement No. 7, and as illustrated in Appendix B of this textbook, the present value of future cash flows
can be used to estimate fair value in one of two ways. In the traditional approach, which is often used in
situations in which the amount and timing of the future cash flows is determined by contract, the present
value is computed using a risk-adjusted interest rate that incorporates expectations about the uncertainty of
receipt of the future contractual cash flows. In the expected cash flow approach, a range of possible
outcomes is identified, the present value of the cash flows in each possible outcome is computed (using the
risk-free interest rate), and a weighted-average present value is computed by summing the present value of
the cash flows in each outcome, multiplied by the estimated probability of that outcome. To illustrate the
traditional and the expected cash flow approaches, consider the following two examples.
Traditional approach: Intangible Asset A is the right to receive royalty payments in the future. The future
royalty cash flows are $1,000 at the end of each year for the next five years. The risk-free interest rate is
5%; the receipt of these royalty cash flows is not certain, so a risk-adjusted interest rate of 12% is used in
computing their present value. The fair value of Intangible Asset A is estimated as follows:
Business Calculator Keystrokes:
N = 5 years
I = 12 %
PMT = $1,000
FV = $0 (there is no additional payment at the end of five years)
PV = $3,605
If this Intangible Asset A is acquired as part of a basket purchase with other assets, this $3,605 amount
would be used as the estimated fair value of the intangible asset in the allocation of the total purchase price.
=======================
FYI: In the traditional approach to computing present values, all of the “art” goes into determining the
appropriate risk-adjusted interest rate.
=======================
Expected cash flow approach: Intangible Asset B is a secret formula to produce a fast-food cheeseburger
that contains 25 essential vitamins and minerals, reduces cholesterol levels, and replenishes the ozone layer.
Future cash flows from the secret formula are uncertain; the following estimates have been generated, with
the associated probabilities:
Outcome 1
10% probability of cash flows of $5,000 at the end of each year for 10 years.
Outcome 2
30% probability of cash flows of $1,000 at the end of each year for 4 years.
Outcome 3
60% probability of cash flows of $100 at the end of each year for 3 years.
In the expected cash flow approach, the uncertainty of the future cash flows is not reflected in a riskadjusted interest rate but is instead incorporated through the assessment of the various possible outcomes
and the probabilities of each. Thus, the risk-free interest rate (5% in this case) is used in computing the
present value of the cash flows in each outcome:
Present
Probability-Weighted
Value
Probability
Present Value
Outcome 1
$38,609
0.10
$3,861
Outcome 2
3,546
0.30
1,064
Outcome 3
272
0.60
163
Total estimated fair value
$5,088
To summarize, the fair value of an intangible can be determined by reference to market prices, by
computing present value using the traditional approach, or by computing present value using the expected
cash flow approach. Again, these present value computation procedures are reviewed in Appendix B of this
text.
ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT One valuable intangible sometimes
involved when one company purchases a collection of assets from another is existing research and
7
SFAS Nos. 141 and 142
development projects, often called “acquired in-process R&D.” For example, on October 1, 2001, Bristol,
Myers, Squibb, a large pharmaceuticals company, acquired the pharmaceuticals division of DuPont for $7.8
billion. Of this amount, $2.009 billion was associated with five ongoing research projects, as described in
the financial statement note below:
“The [$2.009 billion] charge was associated with five research projects in the
Cardiovascular, Central Nervous System, Oncology, and Anti-Infective therapeutic areas
ranging from the preclinical to the phase II development stage. The amount was
determined by identifying research projects for which technological feasibility has not
been established and for which there is no alternative future use. The projected FDA
approval dates are years 2005 through 2008, at which time the Company expects these
projects to begin to generate cash flows. The cost to complete these research projects is
estimated at $1.2 billion.”
Acquired in-process R&D creates a somewhat embarrassing situation for financial accountants. As
mentioned earlier in the chapter, normal R&D costs are expensed as incurred in accordance with FASB
Statement No. 2. The rationale behind this treatment is that there is too much uncertainty over the future
economic value of research and development. However, as demonstrated in the Bristol, Myers, Squibb
case, the value of ongoing R&D can be verified in a market transaction. On this issue, the FASB decided to
adhere to the rule of expensing all R&D costs and to defer broader consideration of the accounting for
research and development. Thus, when a group of assets is acquired, the portion of the cost allocated to inprocess R&D, based on relative fair values, is not recognized as an intangible asset but is instead
recognized as an immediate expense.
FYI: In late 1998, the chairman of the SEC criticized acquiring companies for allocating too much of the
acquisition cost to acquired in-process research and development, which is then written off immediately as an
expense. This practice is discussed in a boxed item later in the chapter.
To summarize this section on the acquisition of intangibles as part of a basket purchase, the key point is
that it is important to itemize and recognize intangible assets separately as much as possible. The total
purchase price is allocated to the intangible assets according to their relative fair values. As discussed in
Chapter 13, some of these intangibles will be amortized and some will not. Acquired in-process R&D is
recognized as an expense immediately in order to ensure consistent treatment of research and development
expenditures.
Intangibles Acquired in the Acquisition of a Business
In the previous section we discussed the acquisition of intangible assets as part of a basket purchase. In
this section we cover the acquisition of an entire company. When one company acquires another, the
acquiring company pays for an assorted collection of tangible assets, liabilities, identifiable intangible
assets, and usually an additional intangible asset, goodwill, that is essentially the synergistic value of the
acquired business that can’t be associated with any specific tangible or intangible asset.
Historically there have been two ways to account for a business combination. The easy way is called a
pooling of interests. Conceptually, a pooling of interests is the joining of two equals. From an accounting
standpoint, the ledgers of the two combining companies are merely added together. The other way to
account for a business combination is using the purchase method. Conceptually, the purchase method
involves one company buying the other. The purchase method raises a number of accounting issues. The
first, previously discussed, is how to allocate the purchase price to the various assets acquired. In general,
when the purchase method is used, all acquired assets are recorded on the books of the acquiring company
at their fair values as of the acquisition date.
The question of purchase vs. pooling has been a major controversy in accounting. The dispute arises
over the fact that in a purchase transaction, assets are recorded at their fair values at the time of the
transaction. Because this fair value is typically greater than book value, the “step up” in recorded cost
8
SFAS Nos. 141 and 142
(including the cost of goodwill) historically resulted in higher depreciation and amortization charges. Thus,
a purchase transaction would result in lower reported earnings in subsequent years than would a pooling
transaction. In 2001, the FASB issued Statement No. 141 that eliminated the pooling method. Because of
the feared impact on reported earnings in subsequent years, the business community overwhelmingly
opposed this proposal. However, the FASB was able to push the standard forward, primarily by
compromising and not requiring the amortization of goodwill. The FASB’s alternative to goodwill
amortization (an interesting method of annually computing goodwill impairment) is discussed in Chapter
13.
=============================
FYI: It is interesting to note that, as of May 2002, the IASB still allowed pooling accounting under the
provisions of IFRS 22 (which was last revised in 1998). It is likely that the IASB will revise this standard to
eliminate pooling.
===========================
Another objective of Statement No. 141 is to curtail the use of the goodwill asset account as a “kitchen
sink” containing a hodge-podge of costs that would more appropriately be allocated to individual intangible
assets. Goodwill is best thought of as a residual amount, the amount of the purchase price of a business that
is left over after all other tangible and intangible assets have been identified. As such, goodwill is that
intangible something that makes the whole company worth more than its individual parts. In general,
goodwill represents all the special advantages, not otherwise separately identifiable, enjoyed by an
enterprise, such as a high credit standing, reputation for superior products and services, experience with
development and distribution processes, favorable government relations, and so forth. These factors allow a
business to earn above-normal income with the identifiable assets, tangible and intangible, employed in the
business.
The accounting for the acquisition of an entire company is very similar to the accounting for a basket
purchase – the total purchase price is allocated to all of the acquired items in accordance with their
estimated fair values. Two differences in the accounting for acquisition of a basket of assets and acquisition
of an entire business are as follows:
 No intangible assets that are not either contract based or separately tradable are to be recognized in
recording a business acquisition. The FASB decided that in a business acquisition, the uncertainty
associated with estimating the fair value of these intangibles outweighs any benefit that might be
obtained by reporting these intangibles apart from goodwill. Thus, in a business acquisition, these
intangibles are essentially included as part of recorded goodwill.
 The acquisition cost is not allocated in proportion to the fair values of the identifiable assets.
Instead, each identifiable asset is recorded at an amount equal to its estimated fair value; any
residual is reported as goodwill.
In determining fair values of assets and liabilities for the purpose of allocating the overall acquisition
price, current market values should be sought rather than the values reported in the accounts of the acquired
company. Receivables should be stated at amounts expected to be realized. Inventories and securities
should be restated in terms of current market values. Land, buildings, and equipment may require special
appraisals in arriving at their present replacement or reproduction values. Intangible assets, such as patents
and franchises, should be included at their estimated fair values whether or not they were recorded as assets
on the books of the acquired company. Care should be taken to determine that liabilities are fully
recognized.
To the extent possible, the amount paid for any existing company should be related to identifiable
assets. If an excess does exist, it is recognized as an asset and called goodwill or “cost in excess of fair
value of net assets acquired.”
To illustrate the recording of the purchase of an ongoing business, assume that Airnational Corporation
purchases the net assets of Speedy Freight Airlines for $1,500,000 in cash. A schedule of net assets for
Speedy Freight, as recorded on Speedy Freight’s books at the time of acquisition, is presented below.
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SFAS Nos. 141 and 142
Assets
Cash ..........................................................................................................................................
Receivables ............................................................................................................................
Inventory ..................................................................................................................................
Land, buildings, and equipment (net) .........................................................................
$ 37,500
246,000
392,000
361,200
$1,036,700
Liabilities
Current liabilities ...................................................................................................................
Long-term debt......................................................................................................................
$ 86,000
183,500
Book value of net assets ..................................................................................................
269,500
$ 767,200
Analysis of the $732,800 difference between the purchase price of $1,500,000 and the net asset book
value of $767,200 ($1,036,700 - $269,500) reveals the following differences between the recorded costs
and market values of the assets.
Cost
Market
Inventory ....................................................................................
Land, buildings, and equipment .................................................
Patents .......................................................................................
Purchased in-process R&D ........................................................
Existing work force .....................................................................
$392,000
361,200
0
0
0
$427,000
389,500
50,000
400,000
100,000
Totals .........................................................................................
$753,200
$1,366,500
The identifiable portion of the $732,800 difference amounts to $613,300 ($1,366,500 – $753,200) and
is allocated to the respective items. The remaining difference of $119,500 ($732,800 - $613,300) is
recorded as part of goodwill. The total recorded amount of goodwill is $219,500 ($119,500 + $100,000)
because, as mentioned above, in a business acquisition the estimated fair values of intangibles such as the
value of existing work force that are not contract based or separately tradable are included in goodwill. In
fact, rather than estimate the fair value of such assets for accounting purposes, a company might just ignore
them in the purchase price allocation process because they will end up in the residual goodwill amount
anyway.
The entry to record the purchase is as follows:
Cash ...................................................................................................................................................
Receivables ........................................................................................................................................
Inventory .............................................................................................................................................
Land, Buildings, and Equipment .........................................................................................................
Patents ................................................................................................................................................
R&D Expense .....................................................................................................................................
Goodwill ..............................................................................................................................................
Current Liabilities .........................................................................................................................
Long-Term Debt ...........................................................................................................................
Cash ............................................................................................................................................
37,500
246,000
427,000
389,500
50,000
400,000
219,500
86,000
183,500
1,500,000
The estimated fair value associated with purchased in-process research and development projects is
recognized as an expense in the period of the acquisition, consistent with the treatment of other research
and development expenditures.
After it is recognized, goodwill is left on the books at its originally-recorded amount unless there is
evidence that its value has been impaired. As mentioned earlier, this treatment is viewed by some as a
compromise by the FASB. The primary business objection to the purchase method (as compared to the
pooling-of-interest method) was that the purchase method results in the recognition of goodwill which,
historically, was then amortized and resulted in reduced reported earnings in subsequent years. Whether or
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SFAS Nos. 141 and 142
not goodwill should be amortized is an interesting theoretical discussion, but the existing standard says that
goodwill is not to be amortized. Goodwill impairment is discussed in Chapter 13.
Notice that the patent asset was not recorded on the books of Speedy Freight before the acquisition.
This could be because the patent cost had been fully amortized or because the patent had been developed
through in-house research and development and all of those costs had been immediately expensed.
However, when Speedy Freight is acquired, the patent is recognized as an identifiable economic asset.
Because goodwill is recorded on the books only when another company is acquired, one must be
careful in interpreting a company’s reported goodwill balance. The reported goodwill balance does not
reflect the company’s own goodwill but the goodwill of other companies it has acquired. So, MICROSOFT
goodwill is not recognized on Microsoft’s balance sheet, nor is PEPSICO’s goodwill shown on the balance
sheet of PepsiCo. There is substantial goodwill on Pepsi’s balance sheet, but that has arisen from the
acquisitions of other companies such as, for example, FRITO LAY. Thus, companies with sizeable
economic goodwill may have no recorded goodwill at all, and the goodwill that a company does report was
developed by someone else. Current accounting principles may result in misleading users of financial
statements as far as goodwill is concerned. On the other hand, to allow companies to place a value on their
own goodwill and record this amount on the balance sheet would introduce a significant amount of added
subjectivity to the financial statements.
The differences in accounting for intangible assets acquired in a basket purchase and intangible assets
acquired as part of a business acquisition are summarize in Exhibit 12-11.
Exhibit 12-11
Intangibles Acquired in a Basket Purchase and in a Business Acquisition
Basket Purchase
(not an entire business)
Business Acquisition
Intangible
Assets*
Recognized
Contract based

or
 Separately tradable
or
 Probable future
economic benefit that is
reliably measurable
 Contract based
or
 Separately tradable
All other intangible assets
are included in the reported
amount of goodwill.
Purchase
Price
Allocation
Allocate the total purchase
price according to the
relative fair values of the
acquired assets.
Record all assets, including
intangibles, at their full
estimated fair value. Any
excess purchase price is
recorded as goodwill.
See the text discussion on negative
goodwill for the appropriate
procedure when there is no excess.
*In this table, the term “intangible assets” also includes acquired in-process research and development, which is not an
asset but instead is recognized as an expense in the period of acquisition.
NEGATIVE GOODWILL Occasionally, the amount paid for another company is less than the fair value
of the net identifiable items of the acquired company. This condition can arise when the existing
management of a company is using the assets in a suboptimal fashion. When this “negative goodwill”
exists, the acquiring company should first review all of the fair value estimates to make sure that they are
reliable. If after doing this there is still an excess of identifiable net fair value over the purchase price, it is
necessary to systematically reduce the recorded amount of the identified items by a pro-rata, or
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SFAS Nos. 141 and 142
proportional, amount. This reduction is NOT applied to the current assets but is applied to almost all of the
noncurrent assets (and any acquired in-process R&D); the exception is that the recorded amount of
noncurrent investment securities is not reduced below the fair value of the investments on the date of the
business acquisition. If this allocation reduces the noncurrent assets (and in-process R&D) to a zero
balance, any remaining excess is recognized as an extraordinary gain.
To illustrate, assume that the Speedy Freight acquisition described earlier was for $400,000 instead of
for $1,500,000. The fair value of net identifiable items for Speedy Freight is $1,280,500 ($37,500 cash +
$246,000 receivables + $427,000 inventory + $389,500 land, buildings, and equipment + $50,000 patent +
$400,000 acquired R&D – $269,500 liabilities). [Footnote: The $100,000 fair value of the existing work
force is excluded because it is not a separately-recognizable item in a business acquisition.] If the purchase
price is $400,000, the indicated negative goodwill is $880,500 ($1,280,500 – $400,000). The fair value of
noncurrent assets (and acquired R&D) totals $839,500 ($389,500 land, buildings, and equipment + $50,000
patent + $400,000 acquired R&D). Assignment of the negative goodwill reduces each of these items to
zero, and the acquisition is recorded as follows:
Cash ...................................................................................................................................................
Receivables ........................................................................................................................................
Inventory .............................................................................................................................................
Land, Buildings, and Equipment .........................................................................................................
Patents ................................................................................................................................................
R&D Expense .....................................................................................................................................
Extraordinary Gain ($880,500 - $839,500)...................................................................................
Current Liabilities .........................................................................................................................
Long-Term Debt ...........................................................................................................................
Cash ............................................................................................................................................
37,500
246,000
427,000
0
0
0
41,000
86,000
183,500
400,000
If the negative goodwill were less than the total fair value of the noncurrent assets (and acquired
R&D), no extraordinary gain would be recognized. Instead, the negative goodwill would be allocated to
reduce the recorded amounts of the noncurrent assets (and acquired R&D) based on their relative fair
values.
5. Discuss the issues impacting proper recognition of amortization or impairment for intangible
assets.
For accounting purposes, recorded intangible assets come in three varieties:
 Intangible assets that are amortized. The impairment test for these intangibles is the same as the
two-step test described earlier in the chapter for tangible long-term operating assets.
 Intangible assets that are not amortized. The impairment test for these intangibles involves a
simple one-step comparison of the book value to the fair value.
 Goodwill, which according to FASB Statement No. 142 is not amortized. The goodwill
impairment test is a process that first involves estimating the fair value of the entire reporting unit
to which the goodwill is allocated.
In accounting for an intangible asset after its acquisition, a determination first must be made as to whether
the intangible asset has a finite life. If no economic, legal, or contractual factors cause the intangible to
have a finite life, then its life is said to be indefinite, and the asset is not to be amortized until its life is
determined to be finite. An indefinite life is one that extends beyond the foreseeable horizon. [Footnote:
Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” Norwalk,
CT: Financial Accounting Standards Board, June 2001, par. B45.] An example of an intangible asset that
has an indefinite life is a broadcast license which includes an extension option that can be renewed
indefinitely. If an intangible asset is determined to have a finite life, then the asset is to be amortized over
its estimated life; the useful life estimate should be reviewed periodically. [Footnote: Before SFAS No.
142, intangible assets were amortizable over a maximum period of 40 years. The FASB considered
imposing a maximum amortization period of 20 years on intangibles. However, the final standard does not
include any arbitrary cap on the useful life of amortizable intangible assets.]
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SFAS Nos. 141 and 142
AMORTIZATION AND IMPAIRMENT OF INTANGIBLE ASSETS SUBJECT TO
AMORTIZATION
The very nature of intangible assets makes estimating their useful lives a difficult problem. The useful life
of an intangible asset may be affected by a variety of economic, legal, regulatory, and contractual factors.
These factors, including options for renewal or extension, should be evaluated in determining the
appropriate period over which the cost of the intangible asset should be allocated. A patent, for example,
has a legal life of 17 years in the United States; but if the competitive advantages afforded by the patent are
expected to terminate after 5 years, then the patent cost should be amortized over the shorter period.
Intangible assets are to be amortized by the straight-line method unless there is strong justification for
using another method. Amortization, like depreciation, may be charged as an operating expense of the
period or allocated to production overhead if the asset is related directly to the manufacture of goods.
Because companies must disclose both the original cost and the accumulated amortization for amortizable
intangibles, the credit entry should be made to a separate accumulated amortization account.
To illustrate the accounting for amortizable intangibles, consider the following example. Ethereal
Company markets products to real-estate agents and to new homeowners. Ethereal purchased a customer
list for $30,000 on January 1, 2005. Because of turnover among real-estate agents and because new
homeowners gradually become established homeowners, the list is expected to have economic value for
only four years. As with all amortizable intangibles, the presumption is that the residual value of the
customer list is zero; in this case there is no evidence to rebut this presumption. Similarly, there is no
evidence to justify the use of any amortization method other than straight line. On December 31, 2005, the
following journal entry is made to recognize amortization expense:
Amortization Expense ($30,000 / 4 years)
Accumulated Amortization – Customer List
7,500
7,500
On December 31, 2006, before amortization expense for the year is recognized, the customer list intangible
asset is tested for impairment. The impairment test is the same as that explained previously for tangible
long-term operating assets. The impairment test for the real-estate customer list was prompted by a
substantial downturn in the real-estate market in the area. At the time of the impairment test, the book value
of the intangible asset is $22,500 ($30,000 - $7,500). It is estimated that the customer list will generate
future cash flows of $5,000 per year for the next three years and that the fair value of the customer list on
December 31, 2006 is $12,000. The customer list intangible asset is impaired because the $15,000 ($5,000
× 3 years) sum of the future undiscounted cash flows is less than the book value of $22,500. The amount of
the impairment loss is the $10,500 ($22,500 - $12,000) difference between the book value and the fair
value and is recorded as follows:
Impairment Loss ($22,500 - $12,000)
Accumulated Amortization – Customer List
Customer List ($30,000 - $12,000)
10,500
7,500
18,000
The $12,000 fair value is the new basis for the intangible asset; no entry is made to recognize any
subsequent recovery in the value of the intangible. Amortization in subsequent years will be based on the
new book value of $12,000 and the estimated remaining useful life of three years. In the notes to the
financial statements for 2006, Ethereal Company would be required to disclose the amount of amortization
expense it expected to recognize in each year for the next five years.
IMPAIRMENT OF INTANGIBLE ASSETS NOT SUBJECT TO AMORTIZATION
A major change in accounting for intangibles introduced by SFAS No. 142 in 2001 is that some
intangibles can now be identified as having indefinite lives and are not amortized. The FASB described the
following examples of intangibles with indefinite lives: [Footnote: Statement of Financial Accounting
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SFAS Nos. 141 and 142
Standards No. 142, “Goodwill and Other Intangible Assets,” Norwalk, CT: Financial Accounting Standards
Board, June 2001, Appendix A.]


Broadcast license. Broadcast licenses often have a renewal period of 10 years. Renewal is virtually
automatic if the license holder maintains an acceptable level of service to the public. Accordingly,
there is no foreseeable end to the useful life of the broadcast license; it has an indefinite life.
Trademark. A trademark right is granted for a limited time, but trademarks can be renewed almost
routinely. If economic factors suggest that the trademark will continue to have value in the
foreseeable future, then its useful life is indefinite.
Intangibles with indefinite lives are not amortized. However, an intangible with an indefinite life is
evaluated at least annually to determine (1) whether the end of the useful life is now foreseeable and
amortization should began and/or (2) whether the intangible is impaired. The impairment test is a very
simple one: the fair value of the intangible is compared to its book value, and if the fair value is less than
the book value an impairment loss is recognized for the difference.
To illustrate, assume that Impalpable Company has a broadcast license that has no foreseeable end
to its useful life. The broadcast license is recorded at its original acquisition cost of $60,000. In the past, it
was estimated that the broadcast license would generate cash flows of $7,000 per year. Recent changes in
the broadcast environment have reduced the cash flows expected to be generated by the license. The data
gathered by Impalpable Company suggest that, although the useful life of the license is still indefinite, the
possible future cash flows will be reduced to either $2,000 per year (with 70 percent probability) or to
$4,000 per year (with 30 percent probability). The risk-free interest rate to be used in the probabilityweighted present value calculation is five percent. The estimate of the fair value of the intangible is
computed as follows:
Present Value*
Probabilityof Indefinite
Weighted
Future Cash Inflows Annual Cash Flows
Probability
Present Value
Scenario 1
$2,000 per year
$40,000
70%
$28,000
Scenario 2
$4,000 per year
80,000
30%
24,000
Total estimated fair value
$52,000
*The present value of a stream of indefinite, or infinite, annual cash flows is simply (Annual Cash Flow / Discount Rate).
Because the estimated fair value of the broadcast license is less than its book value ($52,000 < $60,000),
the intangible asset is impaired. The impairment loss is recognized with the following journal entry:
Impairment Loss ($60,000 - $52,000)
Broadcast License
8,000
8,000
As with the recognition of other impairment losses, the $52,000 fair value is the new basis for the
intangible asset; no entry is made to recognize any subsequent recovery in the value of the intangible.
IMPAIRMENT OF GOODWILL
In spite of its cheerful name, goodwill has been the source of much accounting controversy over the past 40
years. As mentioned in Chapter 12, until 2001 many companies in the United States were careful to structure
their business acquisitions as “pooling of interests” to avoid being required to recognize goodwill. The
recognition of goodwill was viewed as something to avoid because the goodwill had to be amortized over a life
not to exceed 40 years. Transactions resulting in billions of dollars of recorded goodwill could saddle a
company with hundreds of millions of dollars in goodwill amortization expense each subsequent year. When
the FASB proposed the elimination of the pooling of interests method of accounting for business acquisitions,
the howl from the U.S. business community, fearful of the earnings impact of large amounts of goodwill
amortization, was instant and deafening. Many compromises were considered, including the reporting of
goodwill amortization expense as essentially a below-the-line item. In the end, the adopted solution was quite
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SFAS Nos. 141 and 142
an elegant one – goodwill would not be amortized at all but would instead be annually tested for impairment. In
addition to being acceptable to a business community concerned about the impact of goodwill amortization on
earnings, this approach is also sound from a conceptual standpoint. Goodwill is an economic asset and should
be reported in the financial statements, but it is an asset that does not necessarily decline in value systematically
over a set period of time.
When goodwill is recognized in conjunction with the acquisition of a business, that goodwill is assigned to an
existing “reporting unit” of that business. For example, if Disney were to acquire another TV network in
addition to its existing ABC network, any goodwill associated with the acquisition would be assigned to
Disney’s Media Networks segment. If necessary, goodwill created in an acquisition can be split up and assigned
to several different existing operating segments.
As discussed in Chapter 12, for accounting purposes goodwill is computed as the residual amount left over after
the purchase price of a business has been allocated to all of the identifiable tangible and intangible assets. This
residual nature of goodwill is the key to the testing of whether goodwill is impaired after its acquisition.
Clearly, by definition goodwill cannot be valued by itself but is instead the remaining value not explained by
the fair values of all of the identifiable assets. The procedures in testing goodwill for impairment stem from this
idea and are outlined below.
Procedures in Testing Goodwill for Impairment:
1. Compute the fair value of each reporting unit to which goodwill has been assigned. This can be done using
present value of expected future cash flows or by using earnings or revenue multiples.
2. If the fair value of the reporting unit exceeds the net book value of the assets and liabilities of the reporting
unit, the goodwill is assumed to not be impaired and no impairment loss is recognized.
3. If the fair value of the reporting unit is less than the net book value of the assets and liabilities of the
reporting unit, then a new fair value of goodwill is computed. The value of goodwill cannot be measured
directly. Instead, goodwill value is always a residual amount; it is the amount of fair value of a reporting
unit that is left over after the values of all identifiable assets and liabilities of the reporting unit have been
considered. Accordingly, the fair values of all assets and liabilities of the reporting unit are estimated, these
amounts are compared to the overall fair value of the reporting unit, and the implied amount of goodwill is
computed.
4. If the implied amount of goodwill computed in (3) is less than the amount initially recorded, a goodwill
impairment loss is recognized for the difference.
To illustrate the goodwill impairment test, assume that Buyer Company acquired Target Company on January
1, 2005. As part of the acquisition, $1,000 in goodwill was recognized; this goodwill was assigned to Buyer’s
Manufacturing reporting unit. For 2005, earnings from the Manufacturing reporting unit were $350. Separatelytraded companies with operations similar to the Manufacturing reporting unit have market values approximately
equal to six times earnings (i.e., their price-earnings ratios are six). As of December 31, 2005, book and fair
values of assets and liabilities of the Manufacturing reporting unit are as follows:
Book
Fair
Values
Values
Identifiable Assets
3,500
4,000
Goodwill
1,000
???
Liabilities
2,000
2,000
Procedure 1
Using the earnings multiple, the fair value of the Manufacturing reporting unit is estimated to be $2,100 ($350
× 6). This fair value estimation could also be done using cash flow estimates and present value techniques.
Procedure 2
The net book value of the assets and liabilities of the Manufacturing reporting unit is computed as follows:
Assets ($3,500 + $1,000) – Liabilities ($2,000) = $2,500
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SFAS Nos. 141 and 142
Because the estimated fair value of the reporting unit ($2,100) is less than the net book value of the reporting
unit ($2,500), further computations are needed to determine the amount of a goodwill impairment loss, if any.
Procedure 3
Using the $2,100 estimated fair value of the Manufacturing reporting unit, along with the estimated fair values
of the identifiable assets and liabilities, the implied fair value of goodwill is computed as follows:
Estimated fair value of Manufacturing reporting unit
Fair value of identifiable assets – fair value of liabilities
($4,000 - $2,000)
Implied fair value of goodwill
$2,100
2,000
$100
Procedure 4
The implied fair value of goodwill is less than the recorded amount of goodwill ($100 < $1,000). Accordingly,
the goodwill is impaired. The journal entry necessary to recognize the goodwill impairment loss is as follows:
Goodwill Impairment Loss
Goodwill ($1,000 - $100)
900
900
The total amount of goodwill impairment losses should be reported as a separate line item in the income
statement.
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SFAS Nos. 141 and 142
17