Business Combinations,
Goodwill and Intangibles
FASB 141 and 142
Intangible assets generally
result from legal or
contractual rights which do not
have a physical substance.
U.S. Patent
Copyright
Holder: P. Bye
Process: no-fade,
brake fluid
Artist: B. Joel
Song: Uptown
Girl
Intangibles may be purchased
from others or developed
internally.
The costs of internally
developed unidentifiable
intangible assets, such as
employee training, are
expensed as incurred.
When a company internally
develops an intangible asset,
only certain costs can be
capitalized such as legal and
related costs.
U.S. Patent
Holder: P. Bye
Process: no-fade,
brake fluid
Tangible and intangible assets
have the following common
characteristics:
• Held for use and not for investment
• Expected life greater than one year
• Derive their value from their ability to
generate revenue (future cash inflows)
• Can have an indefinite life (not
depreciated or amortized)
• Can have a limited life (depreciated or
amortized)
Intangible assets have four
unique characteristics that
distinguish them from tangible
assets:
• More uncertainty about future benefits
• Value subject to wider fluctuations
• Value may be applicable to only one
particular company.
• Indeterminate lives.
For financial reporting purposes,
identifiable and unidentifiable
intangible assets are treated the
same - they are both capitalized.
XYZ Co.
Balance She
12/31/9
Cash
Equipment 54
Goodwill 32,010
Patents
1,430
But . . .
Only if
purchased!
Identifiable vs. Unidentifiable
• Identifiable:
– Patents
– Copyrights
– Trade names, trade
marks
– Secret formulas
– Franchise
– License
• Unidentifiable:
– Goodwill
Many new types of intangible assets are
discussed in FASB 141
Acquisition of an Entire Company
--Business Combination
There is one way to account
for a business combination-pooling of interest and
purchase.
The purchase method raises
a problem in how to allocate
the purchase price to the
various assets acquired.
Page 149
Acquisition of an Entire Company
--Business Combination
Compared to pooling of interest, the
purchase method records assets at their
fair market value, which results in lower
earnings in subsequent years due to higher
amortization and depreciation charges.
Page 149
Despite opposition from the
business community, the FASB
has eliminated the pooling of
interest method in FASB 141.
Acquiring an entire company
• When we acquire an entire company,
the specific assets may be worth LESS
than we paid
• This difference is called GOODWILL -an intangible asset
Goodwill
• Defined: “The excess amount paid for
a company in a business combination
over the fair market value of the
O
company’s
identifiable
assets.”
K
• Recording Goodwill
1. Write identifiable assets up to FMV.
2. Record excess purchase price over net
assets at FMV as goodwill.
Purchased goodwill arises when
a company is acquired and is
the difference between the
purchase price of a company and
the fair market value of its
identifiable net assets.
Purchase
Agreement
Page 149
Price $100,000
Appraisal
Land
$10,000
Bldg.
40,000
FMV $50,000
Sources of Goodwill
• Going concern goodwill
• Combination goodwill
FASB ended up not using this terminology
in the actual standards that they issued.
There is no requirement that we
distinguish between the different sources
of goodwill.
Goodwill
• Defined in FASB 142:
– The excess of the cost of an acquired
entity over the net of the amounts assigned
to assets acquired and liabilities assumed.
• The amounts assigned are fair values
• Goodwill includes all intangible assets that do
not meet the criteria for recognition as an asset
apart from goodwill.
– You only have goodwill if you've purchased
another entire company.
The “Plug” Figure
• Goodwill is what it takes to balance the
journal entry when you record the purchase
of another company.
• Procedures
 Value all identifiable assets and liabilities.
 Difference between cost and fair value of net
assets = Goodwill.
 Usually positive but occasionally the fair value is
GREATER than purchase price. This is
sometimes called "Negative Goodwill."
Value all identifiable assets
and liabilities
• Fixed assets--may be undervalued
• Patent--might not be on books if internally
developed.
• Trade names will probably not be recorded
• Estimate for doubtful accounts could be off.
• Unrecorded liabilities, particularly
contingencies. See new FASB 141 guidance on
valuing assets and liabilities on
page 156
Impairment Losses - Goodwill
At same time each year, the goodwill
of a reporting unit is subjected to a two
step impairment test
New GAAP - FASB 141 & 142
Page 186
2-step impairment test
• 1. Determine fair values of all
identifiable tangible and intangible
assets (other than goodwill) and the fair
values of all liabilities
– If fair value is greater than carrying value,
no impairment loss is recorded
– If fair value is LESS than carrying value,
perform step two
New GAAP - FASB 141 & 142
2-step impairment test
• Implied goodwill is the difference
between the fair values as determined
in step 1 and the carrying value without
goodwill
• 2. If implied goodwill is less than the
carrying value of goodwill, recognize an
impairment loss for the difference
New GAAP - FASB 141 & 142
Page 187
2-step impairment test
• Detailed evaluation can be carried forward to
the next year without change if
– No significant changes in assets and liabilities in
the reporting unit
– Most recent evaluation indicated substantial
margin of implied goodwill over the carrying value
of goodwill
– The likelihood that a current fair value
determination would be less than the current
carrying value is considered remote
New GAAP - FASB 141 & 142
Interim impairment tests
• If events and circumstances indicate
that impairment is more likely than not,
an interim impairment test must be
conducted:
– Adverse change in business climate
– Unanticipated competition
– Loss of key personnel
– Adverse action or assessment by a
regulator
New GAAP - FASB 141 & 142
Income Statement
Presentation
• Impairment losses on goodwill
– Presented in aggregate on income
statement as separate line item
– Presented before income from continuing
operations
New GAAP - FASB 141 & 142
Goodwill Example
“Target Company”
Net Accounts Receivable
$ 60,000
Inventory
90,000
Plant & Equipment (net)
190,000
Marketable Securities
30,000
Patent
10,000
Current liabilities
$20,000
LT debt
80,000 - 100,000
Owners’ equity
$280,000
Page 151
On Jan. 1, 1998, Diversified Inc.
purchased all the assets and
assumed all the liabilities of Target
Company for $290,000
•
•
•
•
•
•
A/R were estimated to be worth $50,000
Inventories were worth $95,000
PP&E were worth $200,000
Marketable securities were worth $30,000
The patent is worth $50,000
The liabilities were correctly stated
At what amount, if any, should
goodwill be recorded?
• Steps to work the problem:
Estimate fair value of the identifiable
assets
Compare fair value of identifiable
assets to purchase price
Goodwill is the difference
Fair values of identifiable assets
• A/R (overvalued by $10,000)
• Inventory (under by $5,000)
• PP&E (under by $10,000)
• Intangible assets (under by 40,000)
• Marketable securities (ok)
• Less liabilities (ok)
= Fair value of net assets
$ 50,000
95,000
200,000
50,000
30,000
-100,000
$325,000
Difference between purchase
price and fair value
• Fair value of net assets
• Purchase price
• Goodwill
$325,000
400,000
$ 75,000
Journal entry to record purchase
• A/R
Inventory
PP&E
Patent
Investments
Goodwill
Liabilities
Cash
• Total
$50,000
95,000
200,000
50,000
30,000
75,000
$500,000
Page 152
$100,000
400,000
$500,000
Compute amortization of
goodwill expense for 1998:
• $75,000 / 40 years =
• $1,875 per year
Dr
Cr
Amortization Expense $1,875
Goodwill
$1,875
New Rules
Under FASB 142:
• Goodwill is not amortized because
it has an indefinite life.
– Instead, a two-stage impairment test is performed
at least annually
– If goodwill appears to have declined in value, an
impairment loss is recognized in net income.
– We’ll talk more about this in conjunction with rules
on other impairment tests in Chapter 13
What if purchase price is
LESS than fair value of net
assets?
“negative goodwill” situation
Page 153
Assume purchase price was $300,000
A/R
Inventory
PP&E
Intangible asset
Marketable securities
– Less liabilities
= Net fair value
$ 50,000
95,000
200,000
50,000
30,000
-100,000
$325,000
• Purchase price
• NEGATIVE Goodwill =
$300,000
($ 25,000)
“Negative Goodwill”
Page 152
• If the fair value of the acquired net assets
exceeds the purchase price, the excess is
allocated as a pro rata reduction of the
amounts that would otherwise have been
assigned to noncurrent assets
– EXCEPTIONS:
• Marketable securities carried at fair value
• See notes for other exceptions
• You can go all the way to ZERO if necessary
to eliminate the “negative goodwill”
“Negative Goodwill”
New Rules
• If the acquisition is a really, really great
bargain, it is possible to write down all
the noncurrent (non-financial) assets to
zero and still need a credit to balance
the journal entry.
• Under FASB 141, this amount would be
recognized immediately (at acquisition)
as an extraordinary gain.
Reduce noncurrent assets to
eliminate negative goodwill
Fair values - Noncurrent assets:
PP&E
Patent
Total
$200,000 80%
50,000 20%
$250,000 100%
Page 153
$20,000
$ 5,000
$25,000
Record
PP&E = $200,000 – 20,000 = $180,000
Patent = $50,000 – 5,000 = $ 45,000
Goodwill =
$
0
Journal entry to record purchase
• A/R
Inventory
PP&E
Patent
Investments
Liabilities
Cash
• Total
$50,000
95,000
180,000
45,000
30,000
$100,000
300,000
$400,000 $400,000
Tax Issues
• Amortization of Goodwill may or may
not be tax deductible
• Amortization of goodwill acquired
BEFORE 8-11-93 is NOT tax deductible
– It is a permanent difference between book
income and taxable income
Page 154
Tax Issues
• Amortization of goodwill acquired
AFTER 8-10-93 is tax deductible over a
15 year period
– It will be a temporary difference between
book income & taxable income
Research &
Development
Expense immediately
Expense
Amortize over useful life
Intangible Assets
with Finite Life
Cost of
Intangibles
Intangible Assets
with Indefinite Life
Tradename
Goodwill
Patent
License agreement
Annual impairment test
Impairment
Loss
What can be capitalized?
• The rules governing classification as an
(purchased) intangible asset are in the chart
on page 155:
– Arises from contractual or other legal rights
even if those rights are not transferable, or
– It is capable of being separated or divided
from the acquired entity and sold,
transferred, licensed, or exchanged even if
there is no intention to do so.
• Refer back to examples on page 130
Intangibles capitalized
• The rules governing classification as an
(purchased) intangible asset are in the
chart on page 155:
– Valued at acquisition cost if acquired
individually
– When acquired in a group of other
assets, acquisition cost is allocated to
each item based on relative fair value
Current accounting principles
require that an intangible
asset be amortized over its
economic life, but not to
exceed 40 years.
Page 183
Amortization Expense =
Cost
Economic life
Amortization of Intangibles
• Apparently "unlimited" life is really
just indefinite--use maximum period
40 years.
• Before APB Opinion #17, unlimited
life intangibles were not amortized.
– "Grandfather Clause" for intangible assets
acquired before 11/1/70 - they do not have
to be amortized.
Page 183 – NEW MATERIAL – FASB 142
Amortization of Intangibles
Finite Useful Life
Indefinite
Useful Life
Goodwill
N/A
Not amortized.
Subject to impairment
test annually. Any
goodwill impairment
is recognized as an
expense.
Other intangible
assets
Amortized over
expected useful life.
Not amortized.
Subject to impairment
test at least annually.
If useful life becomes
finite, the carrying
value is amortized
over useful life.
Determining useful life
Expected use by the organization
Expected useful life of similar or related
assets
Legal, regulatory or contract provisions
and provisions for renewal/extension.
– Patents max, 17 years
– Copyrights max 50 years after death of
author.
Page 183
Determining useful life
Renewal or extension provisions under
laws, regulations or contracts
Effects of obsolescence, demand,
competition, technological change.
Level of maintenance expenditures
necessary
– High future costs suggests short useful life
Determining useful life
• If the precise length of the useful life is
not known, use the best estimate of the
useful life
• If no known factors limit the useful life,
the useful life is considered to be
indefinite.
– Indefinite  infinite
Page 184
New Materials - FASB 142
Amortization Methods:
• Method should reflect the pattern in
which the economic benefits are
consumed or used up
• If pattern is unknown - use straight-line
method:
Amortization Expense =
Page 185
Cost - Residual Value
Economic life
New GAAP - FASB 142
Amortization Methods
• Residual value is presumed to be zero
unless
– Another entity which has committed to
purchase it for a certain price at a future date
– A market for intangible exists and is expected
to exist at end of asset’s useful life to current
owner
Amortization Expense =
Cost - Residual Value
Economic life
Accounting for Amortization
• "Accumulated amortization" account not
generally used -- amortize by crediting
asset account directly.
– Note that under FASB 142, historical cost
and accumulated amortization WILL BE
DISCLOSED
• Write-off Intangibles when it becomes
evident that their value has been
impaired (FASB 121). FASB 144
Page 185
Annual evaluation
(other than goodwill)
• Evaluate estimated remaining useful life
and adjust current and future
amortization if needed
• Apply impairment test per FASB 144
and write-down if expected future cash
inflows are less than carrying value
New GAAP - FASB 142 & FASB 144
Impairment test for intangibles
not amortized
• At least annually:
– Compare fair value to carrying amount
– If carrying amount > fair value, recognize
impairment loss
– In other words, write intangible down to its fair
value
• If an impairment is recognized, the fair value
at that date becomes the new carrying value
– If fair value later increases, there is no restoration
-- no upward adjustments are permitted!
New GAAP - FASB 142 & FASB 144
Page 188
Example 1
• A company acquires a broadcast license that
expires in 5 years. The license is renewable
every 10 years if the license holder provides
at least an average level of service and
complies with Federal Communication
Commission (FCC) rules and policies. The
previous owner renewed the license twice.
The new owner intends to renew the license
in the foreseeable future.
– What is the useful life? Should the cost be
amortized or subject only to an annual impairment
test?
Example 2
• The company in example 1 operates the
television station for 10 years (easily
obtaining a renewal license as expected).
The FCC decides that it will no longer renew
licenses. Instead, broadcast rights will be put
up for bid. The current license has five years
before it expires.
– What is the useful life? Should the cost be
amortized or subject only to an annual impairment
test?
Example 3
• A direct mail marketing company acquires a
customer list and expects to be to derive benefit
from the information for at least one year but no
more than three years. The acquiring company
intends to add customer names and other
information to the list in the future. Management’s
best estimate of the useful life of the names on the
list at acquisition (given the pattern in which the
expected benefits will be consumed) is about 18
months.
– What is the useful life? Should the cost be amortized or
subject only to an annual impairment test?
Specific Types of Intangible
Assets
Page 188
Intangible assets acquired in a business
combination are recognized separately from
goodwill if they arise from contractual or legal
rights -- or because the asset is separable
Marketing-related intangibles
• Trademarks, tradenames
• Trade dress (unique color, shape,
package design)
• Newspaper mastheads
• Internet domain names
• Noncompetition agreements
New GAAP - FASB 141 & 142
Customer related
• Legal or contractual
rights
• Separable
– Order or production
backlog
– Customer contracts
and related customer
relationships
– Customer lists
– Noncontractual
customer
relationships such as
bank depositors
New GAAP - FASB 141 & 142
Technology-based
• Legal or contractual
rights
– Patented technology
– Computer software
and mask works
– Trade secrets such
as secret formulas,
processes, recipes
• Separable
– Unpatented
technology
– Databases, including
title plants
– Trade secrets not
protected by law
New GAAP - FASB 141 & 142
Artistic-related
• Plays, operas, ballets
• Books, magazines, newspapers and
other literary works
• Muscial works such as compositions,
song lyrics, advertising jingles
• Video and audiovisual material including
motion pictures, music videos, television
programs
New GAAP - FASB 141 & 142
Contract-based
• Licensing, royalty and standstill agreements
• Advertising, construction, management,
service or supply contracts
• Lease agreements
• Construction permits
• Operating and broadcast rights
• Use rights such as drilling, water, air, mineral,
timber cutting, and route authorities
New GAAP - FASB 141 & 142