Intangible Assets - Term Paper Example

INTANGIBLES: A DISCUSSION Introduction Intangibles have no physical reality but are an important consideration in the preparation of financial ments. When the purchase price of a business exceeds the its book value, the difference is accounted for by intangible assets, of which goodwill normally form a very significant part. Accounting treatment of intangibles have evolved through the years, whether under GAAP or IFRS. The treatment of intangibles have important implications for how revenues and expenses are presented and it also opens the issue of possible manipulation of income statements in attempts to manage earnings and thus deceive investors and other stakeholders. Concept and value of intangibles in financial statements Intangible assets is a term used to describe assets that are used in the operation of the business but have no physical substance and are non-current. (Meigs et al. 1999). It includes patents, copyrights, trademarks, franchises, and goodwill, among others, but it does not include such current assets as accounts receivable, investments, capitalised lease rights and prepaid rent although they are intangible from the legal viewpoint (Pahler and Tearney 2001). The basis of valuation of intangible assets is cost, and it does so appear in the Balance Sheet. These assets are listed if significant costs are incurred in their acquisition or development; if insignificant, they are treated as ordinary expenses. The problem with some intangibles is the uncertainty regarding their ability to yield benefits to the firm in subsequent years. Advertising expenditures to promote a new product or the cost of training new employees to use a new office equipment are examples. Because of the uncertain duration of the benefits of some of these costs, the usual practice is to charge them as expense for the current period. If an intangible asset such as goodwill is expected to yield future benefits, it is amortised, on a straight-line basis, for the number of years such benefits are expected to continue producing revenue. For some time, under the previous rules of the Financial Accounting Standards Board (FASB), such period of amortisation was not to exceed 40 years. This was going to change in 2001. Not being separable from the business, an intangible represents an existing and future capability to achieve future earnings.(Pahler and Mori 1994). A normal return on net identifiable assets, on the other hand, refers to the return that investors expect to receive in an industry to justify their buying a business at its fair market value. a. Goodwill A distinct intangible asset item that has been the subject of much controversy in the past is goodwill. The most common meaning of goodwill among accountants concerns the benefits derived from a favorable reputation among customers. Specifically, for accountants, it means the present value of future earnings in excess of the normal return of net identifiable assets. Net identifiable assets consist of total assets except goodwill, minus all liabilities. (See Meigs et al 1999). Such above-average earnings may be due to superior management, manufacturing efficiency, weak competition, as well as good customer relations. A business has goodwill when investors pay higher price on account of earnings in excess of the normal return. The above-normal earnings benefits derived from acquired goodwill are expected to go on for a number of years after acquisition. In most cases very few businesses or brands are able to maintain that performance beyond a few years. Thus the buyer of a business usually limit payment of goodwill to four or five times the amount by which annual earnings exceed normal earnings. If the business ceases to earn the excess returns, the goodwill has lost its economic value and must be written off immediately. The fair value of a goodwill is estimated by using either of two methods: a. By valuing the business as a whole, then subtracting the current market value of the net identifiable asset. The price-earnings ratio is used to derive the market value of the stock, then from it deduct the market value of the net identifiable asset to arrive at the goodwill figure. b. By capitalising the amount by which earnings exceed normal amounts. In this case divide the earnings excess by a target return on investment. Goodwill can also be generated internally – through superior management, good customer relations, and various factors that result in above-average earnings. But such internally created goodwill is not recorded in the books according to GAAP rules. It has no economic value and becomes real only when the business is sold and the buyer pays a higher price on that account. Research and development cost Research and development costs vary with the industry type and sise of the business. Computer software, pharmaceutical, computer hardware, and chemical industries lead in terms of the ratio of R&D costs to total outlays and expenses. The treatment of R&D costs has varied widely among different companies, from immediate expensing to amortising the intangible asset over a number of years. The Financial Accounting Standards Board has ruled that such cost be treated as expense in the year it is incurred. Other intangible assets Patents are granted for 17 years in the United States and the period of amortisation should not be beyond that length of time. If the patent is likely to lose its value before that limit is reached, it must be amortised based on a shorter estimated life. Payment for a franchise can be substantial and should be amortised over a longer period not exceeding 40 years. However, if the cost is small it can be expensed immediately or amortised over a short period such as 5 or 10 years. The purchase of a trademark, brand name or commercial symbol can also be substantial and should be treated in the same way as a franchise: Expense it or amortise it for a few years, or else longer provided it does not exceed 40 years. Copyright entitle the owner to such right during the creators life plus 50 years. The costs of obtaining a copyright is normally small and the benefits are generated for only a few years. If the purchase cost is high, it can be capitalised over a number of years and amortised accordingly. Other intangibles are moving costs, plant rearrangement costs, formulas, processes, name lists, and film rights. In the balance sheet these can be reflected as either deferred charges or other assets. The goodwill controversy Prior to 2001, goodwill had been a controversial issue for more than a century (Iqbal et al 1997). The controversy had been more pronounced during recent years when goodwill constituted a larger and larger percentage of business combination purchase prices, sometimes even exceeding the value of the equity. The controversy centered around whether goodwill - - be it purchased or internally generated -- should be reported as an asset. The alternatives were capitalising it, or charging it to equity either directly or through the income statement. The second issue was: If recorded as an asset, how should its valuation be determined? The alternatives were: a) treating it as a permanent asset, b) amortising it systematically, or c) write it down when its value has been impaired. The APB Opinion No. 17 requires a straight-line amortisation not exceeding 40 years. If the benefit from the intangible is shorter than this period it must be amortised for that shortened period, reflecting its true useful life. Despite the opposing argument that some intangibles such as trademarks and purchased goodwill should not be amortised because they have unlimited life, APB Opinion No. 17 rejected that notion in favor of compulsory amortisation. However, Statement No. 142 issued in June 2001by the FASB revised this requirement by stating that "goodwill and intangible assets that have indefinite useful lives will not be amortised but rather will be tested at least annually for impairment." Intangible assets that have finite useful lives will continue to be amortised over their useful lives, but without the constraint of an arbitrary ceiling. (Summary of Statement 142). The FASB had initially proposed to reduce the maximum goodwill amortisation period from 40 years to 20 years, which was to have the effect of reducing earnings, and earnings per share, though not the cash flows. However, during the discussions on the proposal, FASB made a radical departure from its original position by deciding that goodwill should not be amortised and adding the provision that goodwill be subject to annual impairment testing. Some quarters saw this turnaround as a concession to its critics.(Gowthorpe and Amat 2006). It was obvious that interest groups had lobbying efforts to prevent the FASB from converting acquisitions accounting from pooling of interest method to the purchase method which would paint an inferior picture in their financial statements. The removal of the amortisation requirement was evidently made as a concession to the lobbyists who opposed the planned change. (Gowthorpe and Amat 2006). The implication of this development is that the goodwill impairment provision can result in companies using the requirement to creatively "manage" their earnings. SFAS No. 2 on research and development costs rules that in view of the uncertainty of realising the benefits, R&D expenditures should be expensed when incurred, thus stressing the primacy of reliability over relevance. It emphasises verifiability of benefits over "representational faithfulness" or relevance (Wolk and Tearney 2001). A proposal was made to treat such costs in the same way as software development, per SFAS No. 86, which allows capitalisation based on technological feasibility. Lev and Zarowin (cited in Wolk and Tearney 2001) point out that the capitalisation of an intangible upon attaining technological feasibility would provide relevant information for aiding to predict future earnings. A project, according to them, should pass a technological feasibility test such as a working model for software or a clinical test for a drug, and then its cost be allowed to be capitalised. Further, they proposed a restatement of current and previous income statements for understatements of incomes in periods when the costs were written off and overstatement of income in subsequent periods (ibid.). It is believed that such a rectification would put the present into a more appropriate and useful perspective. Current regime relating to intangibles, in summary. Under SFAS No. 142, acquired intangible assets are recognised at their fair value. For intangible assets that are not specifically identifiable, internally developed intangible assets are treated in the same way as in APB Opinion No. 17. They are not recognised as an asset n the balance sheet. Thus cost of such assets are expensed when incurred. An intangible asset with a finite useful life must be amortised over its useful life. Amount to be amortised is the value (residual) that net of cost. The amortisation method should reflect the pattern of economic benefits if determinable. If the economic benefits cannot be determined, the straight line method of amortisation must be used. The original exposure draft proposal was to reduce the maximum period of amortisation from 40 years to 20 years. However, the SFAS No. 142 rejected this and instead ruled that goodwill should not be amortised, but should be subject to annual impairment tests.. Goodwill is impaired if the fair value thereof is less than the carrying amount. If certain events would reduce the fair value below the carrying amount, impairment tests should be conducted between the scheduled annual tests. Brief comparison between GAAP and IFRS on treatment of intangibles With regard to research and development costs, the US GAAP and the IFRS differ. The former rules that research and development expenditures should be expensed when incurred. On the other hand, the IFRS says that they are recognised provided certain criteria are met. There is no convergence yet between the two.(Accounting alert) IAS 38, adopted in 1998 and re-issued in 2004 divides intangibles into two: identifiable intangibles such as trademarks, patents, copy rights, customer lists, etc., which are identifiable and transferable without conveying physical assets; and goodwill, which assets are not identifiable. IRS allows internally generated goodwill to be recorded in the companys balance sheet. Goodwill is only recognisable in the context of a business acquisition or assets part of whose value is goodwill. Certain criteria apply. The US GAAP draws a distinction between identifiable intangible assets and goodwill. With few exceptions, the cost of internally generated goodwill should be expensed when incurred. Only intangible assets acquired from third parties or through mergers/combination are recognised; but internally generated goodwill is not. In terms of valuation, intangible assets are based on their stand-alone market value; under IFRS companies are allowed to put a valuation corresponding to the useful value to the current owner. Goodwill is still amortised under IFRS rules for a maximum of 20 years coupled with impairment testing but this is done only when an event necessitates it, not annually. Under GAAP rules R&D cost must be immediately expensed, whereas under IFRS acquired "in-process" R&D is capitalised. The Cadbury case: Treatment of intangibles Brands and other acquisition intangibles are capitalised and valued using the discounted cash flow method for the probable useful economic life of the brand. Assumptions are made regarding growth of revenue ascribable to the brand and the projections reflect the managements best estimates, although there are some inherent uncontrollable uncertainties. Since the company asserts that “we are in the brands business” management expects to acquire, hold, and support brands for an indefinite period of time. Support takes the form of significant investments in promotions. Brands are also safeguarded through zeal in protecting legal rights on the brands reinforced by the absence of “regulatory, economic, and competitive factors that could truncate the life of the brand name.” A brand that the company carries is presumed to have an indefinite useful life, a practice that dates back to 1989. Only one brand out of many has had its indefinite useful life changed to definite life. In such event, the remaining carrying value of the brand is revised over the remaining useful life. Each year the company re-evaluates it brands and other intangibles to determine if a change in the assumption is necessary. The balance of an intangible is assessed for recoverability every year, and in instances where events may provide indications of impairment, the carrying value is compared with the recoverable amount based on the higher of vair value, less costs, and the value in use. An impairment is charged if it is determined that the recoverable value is less than the carrying value of the intangible asset (Cadbury China in 2007 has been used as an example.). This practice is consistent with GAAP rules. The acquisition intangibles consist of brand intangibles and franchise intangibles cum customer relationships. Software intangibles are considered separately. Franchise rights to brands not owned by the Group are amortised consistent with the life of the contract. Customer relationships are amortised over their expected useful life which is between 5 to 10 years. The amortisation period for software intangibles is no greater than 8 years. The 2008 demerger of Cadburys subsidiary Americas Brewery caused a negative offset on goodwill amount of $871 million. In 2007 the company recognised goodwill that accompanied the acquisition of subsidiaries in Turkey, Japan, Romania, and the United States, plus an adjustment in the opening balance following 2008 acquisitions. The impairment charge related to its business in China had to be done because of a “change in focus to concentrate on key brands and streamline the distribution network.” The test of impairment is done annually or oftener, and uses the following methodology. Indicators that guide the group in the discount rates, long-term growth rates, and the expected cash flows generated from each cash generating unit (CGU). If the recoverable value based on a post-tax country risk-adjusted discount rate based on the WACC of 8 percent is below the carrying value, an impairment test using pre-tax discount rate and cash flow is performed too establish its existence and magnitude. Conclusion The treatment of intangibles is important for businesses as well as for stakeholders and lenders as it affects the evaluation of the firm in the equity market as well as debt market. Where intangibles are a big proportion of equity, the analysis of financial statements can become quite tricky. The users of financial statements should, in addition to understanding the income statement, read the balance sheet using net tangible assets (or net identifiable assets) - i.e., total assets less intangibles -- in performing their analysis. Another matter to look into is whether a company is not using creative accounting using the impairment principle under the new accounting rules in order to make the financial statements, especially the income statement, look better than they actually are. Where the external auditors are in complicity with management, the difficulty in interpreting financial statements can become compounded. BIBLIOGRAPHY Accounting alert 2009/02 - March AASB meeting highlights. Viewed December 17, 2009 at http://www.deloitte.com/view/en_AU/au/services/assurance/accountingalerts/article/d45e63ec49101210VgnVCM100000ba42f00aRCRD.ht Cadbury website. Viewed December 17, 2009 www.cadbury.com/media/press/Pages/nigeriafinancialposition.aspx Gowthorpe, C & Amat Oriol, 2006 March, Creative Accounting: Some Ethical Issues of Macro- and Micro-Manipulation Journal of Business Ethics, Springer, Netherlands. Iqbal, MZ, Melcher, TU & Elmallah, AA 1997, International accounting: A global perspective, South-Western College Publishing, Cincinnati, OH Meigs, RF, Williams, JR, Haka, SF & Bettner, MS 1999, Accounting: The basis for business decisions, 11th edn., Irwin-McGraw Hill, Boston, MA Pahler, AJ & Mori, JE 1994, Advanced Accounting: Concepts and practice, 5th edn., The Dryden Press, Orlando, FL Wolk, HI & Tearney, MG 2001, Accounting theory: A conceptual and institutional approach, 5th edn., South-Western College Publishing, Cincinnati, OH. Summary of Statement No. 142, FASB. Viewed December 17, 2009 at http://www.fasb.org/summary/stsum142.shtml Read More