Chapter 13: Accounting for Intangible Assets
- 1 Learning Objectives
- 2 Characteristics of Intangible Assets
- 3 Common Intangible Assets
- 4 Fundamental Theory of Intangible Assets
- 5 Valuation and Recognition of Intangible Assets
- 6 Amortization of Intangible Assets
- 7 Impairment Testing of Intangible Assets
- 8 Research and Development
- 9 Financial Statement Presentation
- 10 Chapter Summary
- Characteristics of Intangible Assets
- Most Common Intangible Assets
- Fundamental Theory of Intangibles
- Valuation and Recognition of Intangibles
- Amortization of Intangibles
- Impairment Testing of Intangibles
- Research and Development
- Financial Statement Presentation
Characteristics of Intangible Assets
Intangible assets have the following characteristics:
- Non-Physical Form: An intangible asset does not have a physical form. This is in contrast to traditional assets like property, plant and equipment that manifest a physical form.
- Monetary Assets are Excluded: All monetary assets are not considered intangible assets. For example, an account receivable or cash in a bank account is not classified as an intangible asset.
- Future Economic Benefit: An intangible asset is an asset and therefore must meet the definition of being an asset. An asset is only an asset if it will bring in future economic benefit to the owner.
Intangible assets are generally long-term assets that provide value to the company over time. Valuing an intangible asset is difficult to do because the amount of value it provides is often indirectly provided to the business. For example, just think about a patent. How are we supposed to determine how much income that asset will be able to provide for the company? Such a determination is very difficult to make because the value of the patent is uncertain. Further difficulties are found in determining how to value the intangible asset over time. Similar to a physical long-term asset if the intangible asset will lose its value over time the asset will be subject to amortization. Amortization is the systematic recognition of a decrease in value of a balance sheet account and the recognition of an expense. Amortization is similar to depreciation.
Common Intangible Assets
Now that we know what an intangible asset is from a characteristics point of view, we can review typical intangible assets found in modern businesses:
Patents: Patents are exclusive protections granted by governments for the creation of new inventions. The patents are granted to the original inventor or business that has developed the technology. Within the United States, a patent will be granted for 20 years. Patents can be bought or sold. If other businesses are found to be infringing on a patent the owner of the patent can file a lawsuit against the business who has infringed on the patent. Patents can also be obtained by inventing a unique invention and applying for the patent directly. Patents are often obtained after research and development has been conducted. Within the United States, patents are granted through the United States Patent and Trademark Office (USPTO).
Copyrights: A copyright is an exclusive right of protection for works that are created by an original creator of the work. Copyrights are often associated with artistic creations, books, movies and music. Copyrights are only extended to the original expression. For example, an accounting method is not protected by copyright. Similar to a patent, a copyright is issued for a limited time. The legal life of a copyright is generally the life of the author plus a specific amount of years, often 50 to 100 years after the death of the author. The United States grants copyrights for the life of the author plus 70 years after death of the author. When a copyrighted work has fallen out of copyright protection it will enter the public domain.
Computer Software: Computer software is the data in a computer that allows the computer to perform specific actions. Computer software is often licensed for short periods of time. Licensed computer software is a limited-life intangible.
Goodwill: The determination of goodwill is generally taught in advanced financial accounting classes. In a nutshell, goodwill is created when a business buys another business for an amount that is in excess of the fair market value of the net assets. The excess amount is classified as goodwill. The excess value paid for a business is generally attributed to brand name, customer loyalty, company reputation and similar characteristics which the business has built up over time. Goodwill is an unlimited life intangible and is subject to impairment testing. Goodwill impairment losses are recorded directly to the income statement in the period when the impairment has occurred.
Franchises: A franchise is a license to use another company's brand name, logos, products or similar assets. The company purchases the rights to use the franchise assets for either a fixed fee or a similar agreement. Franchises generally have a fixed life and the agreement can be renewed as necessary if the franchisor (owner of the franchise brand) agrees to renew the contract.
Trademarks or Trade names: A trademark or trade name is a recognizable sign, design or expression which is associated with a business, product or service. Similar to a patent, a trademark can be registered with a government and granted exclusive protections. A trademark that has been registered is identified by a ® symbol next to the trademark. Within the United States, a registered trademark is protected for 10 years which can be renewed every 10 years (unlimited amount of times). An unregistered trademark is identified by the ™ symbol. Since a trademark can be registered for an unlimited amount of years, trademarks are considered unlimited life intangibles.
Customer Lists and Related Data: Customer lists and data have value to the business because it will allow the business to generate future revenue. For example, a company that has data about customers can use that data for marketing, research or selling it to other businesses.
Research and Development: Research and development is used to discover unknown facts about phenomena. Research and development is often pursued to end up commercializing a new product or technology.
The following summary chart will help you to understand the accounting attributes of each intangible asset:
|Intangible Asset||Asset Life||Subject to Amortization?||Subject to Impairment Test?|
|Trade Mark/Trade Name||Unlimited||No||Yes|
|Research and Development||N/A||N/A - expense||N/A - expense|
Fundamental Theory of Intangible Assets
The difficult aspects of accounting for intangible assets are being able to value intangible assets over time. Just imagine an intangible asset like a brand name. The brand name is highly recognizable by consumers and people associate that brand with quality and similar attributes. Thus, the brand name has a value but how do we determine what value to place on the brand name? Such a task is quite difficult but we can use a set of fundamental guidelines to help us. The first guideline is to identify if the intangible asset will exist for a limited time. There are two types of intangible assets: limited-life and unlimited life. The following are limited-life intangible assets:
1) Patents (generally 20 years)
2) Copyrights (generally life of the author plus 70 years)
For these types of assets, we will use the time period to set up our amortization expense. As a reminder, amortization is a systematic transfer of an asset to an expense. It signifies a loss of value due to time progression.
For unlimited life intangibles, we will test the intangible for impairment instead of using amortization. Impairment is when the carrying value (book value) of the intangible exceeds the expected future value that the intangible will provide. We will test for impairment annually. Limited-life intangibles will also be tested annually for impairment. In other words, all intangible assets will be subject to an annual impairment test. The purpose of the impairment test is to prevent assets from being overstated on the balance sheet.
To assign a value to the intangible assets we will use the following criteria:
1) Purchased intangible assets are assigned their cost price and this is recorded as an asset. We use the cost due to the historical cost principle. If the asset was purchased with stock, we will use the fair market value of the stock to assign a value to purchased intangibles.
2) Internally created intangible assets will have their indirect costs expensed when incurred. We will only use direct costs to obtain the intangible asset.
In summary, we create an intangible asset by recording it to our books using either the purchase price or direct costs to obtain the intangible. When the intangible is on our books, we will test it annually for impairment and the intangible will be subject to amortization if it has a limited-life.
Valuation and Recognition of Intangible Assets
The valuation of intangible assets is a tricky subject in accounting due to assets needing to be able to provide future economic benefit to be classified as an asset. There are a few general guidelines we use to value intangible assets that generally provide a high-level of certainty.
1. Purchased intangible assets: If an intangible asset is purchased then the cost to purchase the intangible will be debited to an asset account. This initial cost includes all reasonable and necessary expenses to obtain the intangible assets and convert it to its intended use. For example, legal fees, registration fees or renewal fees are included in the total cost and are added to the intangible asset purchase price. The historical cost principle is the basis for using this accounting method.
Example: A corporation purchases a customer list for $5,000 cash from a company that specializes in customer data. The corporation hired a consultant to convert the data into a data format that would be acceptable for their computer system. The cost for the consultant was $500. The following journal entry would be used to record this transaction:
2. Internally Created Intangibles: Internally created intangible assets will have their indirect costs expensed when incurred. We will only use direct costs to obtain the intangible asset. For example, if a firm spent $500 million on research and development to obtain a patent then these expenses would NOT be assigned to the intangible asset. Let's assume that the company was able to obtain a patent as a result of the research expenses. If the company spent $5,000 on legal fees directly related to the patent and $500 for a patent application then the intangible asset would be recorded at $5,500 even though the company spent $500 million to discover the underlying knowledge. The reason we expense the research expense is because the company does not realistically know if the research will result in a future value to the business (through the creation of an asset that can provide future value to the firm). It is only after the research has occurred that the company knows if the research will produce a viable intangible asset.
Example: A corporation spent $100 million on project A and $200 million for project B. The projects were focused on trying to discover new scientific methods for electrical devices. Project A did not result in the discovery of anything significant. Project B resulted in the discovery of significant discoveries. The discoveries in project B were ultimately patented. The patent related to project B cost $10,000 in legal fees and a $500 application fee. The patent was approved 6 months later. Based on the above information, the following journal entry would be recorded related to these activities:
The $300 million in research and development expenses would be expensed in the period incurred.
The intangible assets that we have recorded will be reported on the balance sheet in the asset section.
Amortization of Intangible Assets
Intangible assets may be subject to obsolescence or lose their value over time due to a variety of factors. For example, the development of new technology by competitors could result in the value of your patent declining. We also have time factors that play a role. A patent has a legal life of only 20 years (in the United States). After 20 years the patent will no longer provide any legal protections and will essentially be worthless. To compensate for this decay of value we will use amortization. Amortization is simply the process of converting an asset into an expense based on a systematic set of guidelines. An intangible which eventually loses all of its value over a period of time is called a limited-life intangible.
Using our patent example, if we were to purchase a patent for $100,000 we could amortize this patent over 20 years. We will use the straight-line method to determine our rate of amortization on a monthly or annual rate. If we were to use an annual rate then we will record $5,000 of amortization expense per year. After 20 years, we will have amortized the entire cost of the patent to an expense account. Our books will record a patent asset of $0 after 20 years. We will debit our expense account (patent amortization expense) and credit our asset account (patent). Contra-asset accounts are not used for intangible assets. The amortization method used should reflect the loss of value of the intangible if it is evidently available. Otherwise, the straight-line method will be sufficient. If the remaining useful life of the intangible changes then the remaining value of the intangible should be amortized over the remaining useful life.
Example: Hope Corporation purchased a patent for $100,000 with a 20 year useful life. After 3 years, the company evaluated the patent and determined it only had 5 years of useful life left. What is the annual amortization expense for year 4?
In this example we need to first determine how much amortization has already been recorded at the time the evaluation occurred. When the company first purchased the patent, their annual amortization expense was calculated as follows:
$100,000 / 20 = $5,000 per year.
After 3 years has passed, the company has recorded a total of $15,000 of amortization expense related to the patent. In year 3, the patent would have a net book value of $85,000 ($100,000 – $15,000 amortization). Using our net book value for the patent, we now calculate the annual amortization amount based on the remaining useful life of the patent which in this case is 5 years.
$85,000 / 5 = $17,000 per year
Therefore, for year 4 we would record annual amortization of $17,000. The following chart illustrates the net book value and annual amortization expense for the patent:
|Year||Net Book Value||Amortization Expense|
If an intangible asset will have a residual value the residual value should not be amortized. Instead, the residual value should be subtracted from the amortization base amount. If an intangible asset has an indefinite life (i.e. a trade mark) then it should not be subject to amortization. Instead the indefinite life intangible should be tested at least annually for impairment. Limited-life intangibles are also subject to an annual impairment test to determine if the intangible has lost more value than our rate of amortization.
Example: A corporation has purchased a patent for $50,000. The company plans to hold this asset for 10 years and then sell it for $10,000. Our amortization expense would be calculated as: ($50,000 - $10,000) = $40,000/10 = $4,000 per year. The following journal entry would be used to record our annual amortization expense:
Impairment Testing of Intangible Assets
Impairment is when an asset is reported at a higher value than the expected value it will bring to the business over the course of its lifetime. When an asset is impaired it must be written down to its correct valuation using fair value methods.
The first step with impairment testing is to determine which assets are overstated on the books. This is done by performing a recoverability test which should be done annually or when conditions indicate that the asset could be impaired. When performing the recoverability test we will use the undiscounted future cash flows over the life of the asset and compare that amount to what we are currently reporting the asset at. If the reporting amount is higher than the undiscounted future cash flows then the asset is impaired and must be written down. The recoverability test is only performed for limited-life assets because unlimited life assets can theoretically generate cash flows forever and always be able to pass the recoverability test.
The second step is to determine at what valuation the asset should be reported. For this step we will use the fair value of the asset. The difference between the book value of the asset and the fair value is the impairment loss. The impairment loss is reported on the income statement.
Example: A company has a patent for an electronic device. Competitors in the market have developed a similar technology that reduces the need for the company's patent. The future income from the patent has been greatly reduced as a result. The accounting department has prepared an assessment that indicated the patent will produce $10,000,000 in undiscounted cash flows for the remaining years of the patent. The patent is currently being reported at $14,000,000 on the books. Based on the recoverability test, this asset is impaired because the undiscounted cash flows of $10,000,000 are less than the $14,000,000 book value.
As a result of this test, you have told your accounting department to determine the fair value of the asset using present value computations based on future cash flows from the patent. The accounting department performed the calculations and gave you a report showing the fair value of the asset to be $9,500,000. Using this number, you have calculated the impairment loss to be $4,500,000 ($14,000,000 book value - $9,500,000 fair value). You will record this event using the following journal entry:
The remaining book value of the intangible will be amortized over the remaining legal or useful life of the patent, whichever is shorter. Unlimited life intangibles are not subject to amortization, even if they have been written down to fair value.
Research and Development
Intangible assets are often created through a company spending money on research or development.
Research: Conducting experiments or other investigations to discover new knowledge.
Development: Converting knowledge obtained from research into a viable product or improving an existing product.
Within accounting, research and development is considered highly uncertain and there is no guarantee of future benefit from the expenses. Due to the rule of conservatism, all research and development expenses are expensed when incurred as a current expense. An exception to this rule is when assets have future use (e.g. fixed assets or machines). In that case, the machine is capitalized and depreciated over the life of the asset.
Once a viable product has been developed any additional development expenses to improve the product should be capitalized to an asset account.
Financial Statement Presentation
Intangible assets have an impact on the income statement and the balance sheet. First, intangibles impact the income statement because intangible assets are amortized to expense. This amortization expense will impact the income statement. Second, intangible assets have value as assets which are to be reported on the balance sheet.
The income statement below shows intangible asset amortization being reported:
The balance sheet below shows intangible assets reported on the balance sheet:
Any aspect of an intangible asset valuation or amortization that cannot be recorded quantitatively (by numbers) should be disclosed in the notes of the financial statements. The method used for amortization should be disclosed. Take note that on the balance sheet presented above we can see long-term assets being reported with their related accumulated depreciation account. Intangible assets are not reported with a contra-asset account such as accumulated amortization.
The chart below will help guide you in valuation, amortization and impairment of intangible assets:
|Intangible Asset||If Purchased||If Internally Created||Subject to Amortization?||Subject to Impairment Test?|
|Limited-Life||Capitalized||All R&D Expensed||Yes - Over useful life||Yes - Recoverability + Fair Value Test|
|Unlimited Life||Capitalized||All R&D Expensed||No||Yes - Fair Value Test|