Intangible assets 1 Meaning of Intangible assets are

Intangible assets 1

Meaning of Intangible assets are assets which have no physical existence. n They are long-lived non-material rights which may generate future revenues n 2

Example of intangible assets Goodwill n Research and development expenditures n Patents n Copyrights n Franchises n Trademarks n 3

Problems in accounting for intangible assets n n n Some intangible assets are self-developed. Their costs cannot be measured objectively and easily Some intangible assets such as goodwill do not have definite lives and they are not capable of being amortized over their indefine lives It is difficult to identify specific revenues arising from the use of intangibles 4

Accounting for an intangible asset 5

To record the cost of an intangible asset Dr. Intangible assets Cr. Bank 6

n n n An intangible asset should be recognized if it is probable that the future economic benefits that are attributable to the asset will flow to the enterprise; the cost of the asset can be measured reliably An intangible asset should be measured its initially at cost The cost of an intangible asset comprises its purchase price including all other expenditures on preparing the asset for its intended use such as import duties and professional fees for legal services. Any trade discount and rebates are deducted in arriving at the cost 7

To write off the expenditure incurred from which no intangible asset can be created Dr. Profit and loss Cr. Bank 8

n With creating intangible assets, the following expenditures should be recognized as expenses when it is incurred: Expenditure on start-up activities which comprises establishing cost, pre-opening cost for new facility, new operation or business n Expenditure on training activities, advertising and promotional activities and relocating or reorganizing part of all of an enterprises n 9

n Expenditure on an intangible item that was initially recognized as an expense in previous annual financial statement or interim financial reports should not be recognized as part of the cost of an intangible asset at a later date 10

To recognize the subsequent expenditure as an intangible asset Dr. Intangible assets Cr. Bank 11

n Subsequent expenditure can be capitalized if the expenditure will enable the asset to generate future economic benefits in excess of its original level; and the expenditure can be measured and attributed to the asset reliably 12

To record the provision for amortization Dr. Profit and loss Cr. Accumulated amortization 13

After initial recognition, an intangible asset should be carried at its cost less any accumulated amortization and any accumulated impairment losses n The intangible asset should be amortized on a systematic basis over its useful lives (not exceed 20 years or the period of legal right) n 14

To record the provision for impairment loss Dr. Profit and loss Dr. Accumulated amortization Cr. Intangible assets 15

n When the carrying amount (cost less accumulated amortization) exceeds the recoverable amount of an intangible asset, there is an impairment loss 16

After revaluation To record revaluation surplus Dr. Intangible asset Dr. Accumulated amortization Cr. Revaluation reserve To record the reversal of previous impairment loss that was recognized as an expenses Dr. Intangible asset Dr. Accumulated amortization Cr. Profit and loss 17

After initial recognition, an intangible asset should be carried at a revalued amount n After revaluation, the intangible asset should be stated at its fair value less any subsequent amortization and any subsequent accumulated impairment losses n 18

Accounting for Goodwill 19

Definition n Goodwill is the difference between the value of a business as a whole and the aggregate of the fair value of its separable net assets Goodwill = Selling price as a going concern – Fair value of separable net assets = Selling price – ( Assets – Liabilities) 20

Nature of Goodwill n n A business may be valued higher as a going concern, or a buyer may be willing to pay more for a business as a going concern than the total value of net assets because of the favourable attributes a firm owns. Some of advantages which may add to the value of a business as a going concern n n n Good location Good customer relations Good reputation Well-known products Experienced and efficient employees and management team Good relation with suppliers 21

Characteristics Is intrinsic to the business n Is self-developed n The value of goodwill may fluctuate widely according to internal and external circumstances n The value of goodwill is subjective according to different valuers. n 22

Why intrinsic? Its existence depends on the continuance of the business. It cannot be realized separately from the business as a whole. back 23

Calculation of goodwill Subjective Judgement n Average Sales/Fees/Profits Method n Super Profit Method n 24

Subject Judgement n Estimate the value of goodwill with reference to some intangible factors and according to their professional judgement 25

Average Sales/Fees/Profit Method n It can be calculated on gross average or weight average Goodwill = Average annual sales/fees/profits over a stated number of years * a factor The factor is usually stated as a certain number of years’ purchase of the average sales/fees/profits 26

Example 1 27

Year Annual Sales $ 1995 1996 1997 100000 200000 300000 (a) Goodwill is valued at 3 years’ purchase of the average annual sales of the past (b) 3 years: (c) (d) Average annual sales = ($100000+200000+300000 ) /3 = $200000 (e) (f) Goodwill = $200000 X 3 = $600000 28

(b) Goodwill is valued at the 3 years’ purchase of the weighted average of the annual sales of the past 3 years Weighted average annual sales = (100000 x 1 + 200000 x 2 + 300000 x 3) 1+2+3 = 1400000 6 = 233333 (Calculation to the nearest dollar) 29

Super Profit Method A business with goodwill is expected to be able to earn more profit than a business without goodwill n The extra profit earned is called the super profit n Statement Calculating Super Profit Average annual net profit Less: Reasonable remuneration to the owner X X Reasonable return on the capital employed in the tangible assets Super profit X X 30 X

Example 2 31

n n n Chan is leaving the partnership, and goodwill is to be revalued at 3 years’ purchase of the super profit. The expected rate of return on net tangible assets is 10 %, after paying a management fee of $500. The calculation of the super profit is to be based on the average profits of the last four years. Net profit from 1994 -1997 is $5000, $6500, $7000 Expected return on net tangible assets = Net tangible assets * 10%. Expected return is $5000. 32

Answer Statement Calculating Super Profit $ Average net profit (5000+6500+7000)/4 Less: Management fee 500 Expected rate of return on net tangible assets 5000 Super profit $ 6250 5500 750 Goodwill= $750 X 3 = $2250 33

Different types of goodwill Inherent goodwill n Purchased goodwill n Negative goodwill n 34

Inherent goodwill 35

Definition It is the goodwill developed by the business internally. n Over a long period in a certain trade, the business has developed many good relations n Therefore, the public estimates that the value of the business as a going concern is higher than the value of its net assets n 36

Accounting treatment n Non-purchased goodwill should not be recognized in the financial statements 37

Reasons supporting this argument n n It is an internally generated goodwill which cannot be attributed to separately intangible expenditures It is intrinsic to the business. It cannot be sold as a separate asset The value of non-purchased goodwill may fluctuate widely according to internal and external circumstances The valuation and verifiability of the existence of non-purchased goodwill are subjective 38

Purchased goodwill 39

Definition It arises when a business acquires another as a going concern n It is the difference between the purchase consideration of the company acquired as a going concern and the fair value of its net assets n 40

Accounting treatments n Purchased goodwill is recorded at cost less any accumulated amortization and any accumulated impairment losses 41

To record the cost of goodwill Dr. Goodwill Cr. Business purchase 42

Purchased goodwill should be measured initially at cost n Reasons n n Money has been spent to acquire the goodwill, so it is difficult to argue that purchased goodwill is not an asset 43

To record the provision for amortization Dr. Profit and loss Cr. Accumulated amortization 44

After initial recognition, purchased goodwill should be carried at its cost less any accumulated amortization n Purchased goodwill should be amortized on a systematic basis over its useful life (not exceed 20 years) n 45

To record the impairment loss Dr. Other assets Dr. Goodwill Cr. Profit and loss 46

When the carrying amount (cost less accumulated amortization) exceeds the recoverable amount of an intangible asset, there is an impairment loss n The impairment loss should be allocated firstly to the goodwill, and then the other assets proportional to the carrying amount of each asset n 47

Revaluation No entry 48

n There is no active market, hence goodwill should not be revaluated 49

Negative goodwill arises in a business acquisition when the fair market value of the net assets of the acquired company exceeds the purchase price paid n It is an unrealized capital profit which should be credited to the reserves n 50

Negative goodwill arises when There is a bargain purchase due to a quick sale n The purchase price has been reduced for the expected future cost or losses n 51

3 steps for accounting negative goodwill n n n Ascertain the amount of the negative goodwill Identify future losses and expenses Remaining negative goodwill n n The amount of negative goodwill not exceeding the fair value of acquired identifiable non-monetary assets should be recognized as income on a systematic basis over the remaining weighted average useful life of the identifiable acquired depreciable/amortizable asset The amount of negative goodwill in excess of the fair value of acquired identifiable non-monetary assets should be recognized as income immediately 52

Example 53

On 1 January 2001, Big Ltd. acquired Small Ltd. for a purchase consideration of $200000. The fair value of the net assets of Small Ltd. at the date of acquisition was $440000 including: Tangible assets $100000 Intangible assets $20000 Cash $320000 $440000 The negative goodwill = $440000 -$200000 = $240000 It is expected that Small Ltd. will incur a loss of $30000 Over the next two years 54

3 steps for accounting negative goodwill are shown as follows: (a) Ascertain the amount of the negative goodwill 1 Jan 2001 Dr. Business purchase $240000 Cr. Negative goodwill $240000 (b) Identify the negative goodwill of $30000 relating to future losses and expenses over the next two years 31 Dec 2001 Dr. Negative goodwill $15000 Cr. Profit and loss $15000 31 Dec 2002 Dr. Negative goodwill $15000 Cr. Profit and loss $15000 ( c) Remaining negative goodwill 1. the first of $120000 will be released over the weighted average useful lives of tangible and intangible asset 55 1. $90000 will be credited to P/L immediately

Accounting for Goodwill in Partnership 56

Accounting for goodwill in partnership n n Only purchased goodwill is to be brought into the accounts. In sole trader’s accounts, goodwill is to be recognized and recorded in the books only if the business is acquired as a going concern In partnerships, however, goodwill is brought into the books whenever there is a change in the partnership such as: n n n Admission of a new partner Retirement of an old partner Change of the profit-sharing ratio 57

n Each partner has a share of the profitsharing ratio. At a change in the partnership, goodwill must be taken into account and shared among the existing partners, according to the existing profit-sharing ratio 58

Goodwill on the admission of a new partner 59

Goodwill on the admission of a new partner n n n The new partner is required to pay for his share of the tangible assets as well as the goodwill, according to the profit-sharing ratio On the admission of a new partner, goodwill must be revalued However, not all business keep a goodwill account in their books. Goodwill adjustments can be done: n n Goodwill account opened Goodwill account not opened 60

Goodwill account opened n The value of the goodwill be credited to the old partners’ capital accounts, which represents an increase in the resources they own, while the new partner will not have a share of the goodwill Dr Goodwill account Cr Capital account ( old partners only With the value of goodwill With their share of goodwill in old ratio Dr Goodwill account Cr Capital account ( old partner With the increase in the value of goodwill, share in the old ratio Dr Capital account (old partner) Cr Goodwill account With the decrease in the value of goodwill, share in the old artio 61

Goodwill account not opened Goodwill is intangible in nature. It cannot be disposed of separately. Therefore, some businesses prefer not to maintain a goodwill account n The new partner may be required to pay extra cash, or have his capital balance reduced, for his share of goodwill Dr Goodwill account Share goodwill among old partners in old Cr Capital account (old profit-sharing ratio partners only) n Dr Capital account ( all Written off goodwill among all partners) in the new profit-sharing ratio Cr Goodwill account 62

Example 3 63

n n n Chan and Wong were partners sharing profits and losses equally. On 1 January 1998, they admitted Lee as a new partner who was required to introduce $600 as capital. The profits are now to be shared among Chan, Wong and Lee equally. Goodwill is valued at $300. The balance sheet before the admission of the new partner is shown as follows: Chan and Wong Balance Sheet as at 31 December 1997 Assets 1, 200 Capital Chan Wong 600 1, 200 64

Goodwill account opened Goodwill 150 Balance c/f 150 Capital: Chan (1/2) Wong (1/2) 300 300 Capital Balance c/f Chan Wong Lee 750 750 600 Chan Wong Balance b/f 600 Goodwill Cash 150 Lee 600 750 600 65

Goodwill account opened Balance Sheet as at 31 December 1998 Assets Goodwill Other Assets (1, 200 + 600) 300 1, 800 2, 100 Capital Chan Wong Lee New capital balance 750 600 2, 100 66

Goodwill account. Capital not opened Chan Goodwill : new ratio Balance c/f Wong Lee Balance b/f 100 650 100 500 750 600 Before admission Chan Wong 600 Goodwill: old ratio 150 Cash 750 150 750 Lee 600 After admission Partner Old ratio Share of goodwill New ratio Share of goodwill Gain/loss Chan 1/2 $150 1/3 $100 $50 loss Wong 1/2 $150 1/3 $100 $50 loss 1/3 $100 gain Lee $300 67

Goodwill account not opened Balance Sheet as at 31 December 1998 Assets (1, 200 + 600) 1, 800 Capital Chan Wong Lee 650 500 1, 800 68

Accounting for Research and Development Expenditures 69

Definition n Pure research n n Applied research n n An investigation undertaken in order to gain new scientific knowledge but not directed towards any specific aim or application An investigation undertaken in order to gain new scientific knowledge but directed towards any specific aim or application Development research n The use of existing scientific or technical knowledge in order to produce new or improved products for the sake of commercial production or application 70

Accounting treatment – research cost n Pure and applied research Research costs should be written off as incurred n The prudence concept requires the costs to be written off unless it is reasonably certain that sales will be made in the future which will fully cover those costs n 71

Accounting treatment – development cost n Development expenditures should be written off as incurred OR n Development expenditures can be deferred to future periods and recorded as an asset 72

n Development expenditures can be deferred to future periods and recorded as an asset, when the following conditions are satisfied: n n n The project is clearly defined The expenditures are identified separately There is reasonable certainty about the outcome of the project The deferred development expenditures are expected to be recover from related future sales or other revenues The business has adequate resources to complete the project 73

n n n Deferred development expenditures should be amortized on a systematic basis over the period in which the product is sold. The amortization starts in the year that commercial production starts When there is any doubt about the certainty of the future revenue, the unamortized amount of deferred expenditures must be written off immediately Reinstatement of previously written-down deferred expenditure should be credited to P/L 74

Reversal of impairment loss is rstricted to the amount that would restore the carrying amount as if no impairment loss has been recognized n Any fixed assets acquired for development activities should be capitalized and depreciated over their useful lives n 75

Accounting for Trademark 76

Definition n A trademark is the legal protection afforded the names, symbols, and other specific identities assigned to a product 77

Valuation of trademark n The costs capitalized include design, registration and the legal cost of successfully defending the trademark in court 78

Accounting for trademark A trademark is deferred and amortized as an expense over the shorter if the legal life or economic life n It is generally considered to have no limited term of existence or natural limited life. However, the legal protection of a trademark is subject to renewal after a number of years n 79

Accounting for Patent 80

Definition n A patent is an exclusive right to use, manufacture, process, or sell a product granted by the government 81

The valuation of patent n n n Patent can be purchased from the inventor or holder, or they can be generated internally When a patent is purchased from the inventor, the cost capitalized include the acquisition cost, legal cost and the legal costs of successfully defending a patent in court It a patent results from successful research and development efforts, the costs capitalized include only the legal costs such as registration fees and attorney fees, incurred in obtaining the patent 82

Accounting treatment The research and development costs spent to develop the patent must be written off to expenses as they are incurred n A patent should be amortized over its remaining legal life or economic life, whichever is shorter n It the patent is lost in court, it should be written off and shown as an exceptional loss n 83