FINANCIAL ACCOUNTING 1

INTANGIBLE ASSETS

PRESENTED BY:

Shakira Mansoor

Maryam Jameela

Bishara Abdullahi

Sana Zahra Zaidi

Types of Assets• There are two categories of assets in the

balance sheet of any company :i. Physical Assets: have physical

substance and can be measured and quantified.

ii. Non physical Assets: do not have any physical substance and they can not be measured or quantified.

• Intangible Assets are those assets which have no physical substance rather they give the enterprise the right of ownership or use, because of which they generate revenue.

• Examples: patents, copyrights, goodwill, franchises, brand names, good customer relations etc.

• Non current, Non monetary assets.• No physical substance.• They are beneficial to the firm for

many accounting periods.• In the Balance Sheet, classified as

subgroup of plant assets.• They are valued at cost• The cost of assets consumed is

systematically allocated to the periods in which revenues are earned by using those assets.

Non-Physical Assets Vs Intangible AssetsNon-Physical Assets Vs Intangible Assets

• Intangible assets have a long term nature Intangible assets have a long term nature as opposed to non-physical assets.as opposed to non-physical assets.

• They are assets that are used in the They are assets that are used in the operation of the business i.e. they contribute operation of the business i.e. they contribute to the production or operating cycle of a to the production or operating cycle of a business. While, non-physical assets are not business. While, non-physical assets are not used in the operation of the business. used in the operation of the business.

• For example, Accounts Receivable or For example, Accounts Receivable or Prepayments have no physical attributes but Prepayments have no physical attributes but they are current assets, not intangible ones.they are current assets, not intangible ones.

• It is the systematic write-off to expenses of the cost of an intangible asset over its useful life, since it is not indefinite.

• It is the parallel of depreciation. The straight line method is most commonly used.

• The accounting entry to record amortization is: Amortization Expense…………….X Intangible Asset Account………….X• It is difficult to estimate the useful life of some intangible

assets like that of a trademark. Amortization should be carried out over the shorter of the two: legal or economic life. So amortization is carried over the useful life only.

• They will not benefit the firm forever. • Intangible assets can be amortized for a maximum period

of 40 years.

GOODWILLIt is the present value of future earnings in excess of the normal return on net identifiable assets.

Generally, there are two types of goodwill• Purchased Goodwill: It arises on the acquisition of one business by

another. It is defined as the excess of the purchase price of the acquired business over the fair value of its net tangible and identifiable intangible assets.

• Internally generated Goodwill: it is developed by the firm itself. Examples: Managerial talent, labour force etc. such non purchased goodwill is not recognized in the Balance sheet. International Financial reporting Standards does not recognize internally developed goodwill as an asset but it recognizes purchased goodwill.

Estimating Internally Generated Goodwill

Two methods are used:• Value the business as a whole and then subtract

the current market value of the net identifiable assets. The current market value is determined from the p/e ratio.

Example: XYZ Company sells for 5 times annual earnings. The yearly income is $2 million. The value of the business is $10 million. Net identifiable assets are $8 million, so goodwill is $10-$8=$2million.

• Capitalize the amount by which earnings exceed normal amounts. Capitalizing an earnings stream is done by dividing those earnings by the investor’s rate of return.

Estimating Purchased Goodwill

• Goodwill in financial statements arises when a company is purchased for more than the book value of the company. It is the difference between the purchase price and the sum of the fair value of the net assets.

• The acquiring company must recognize • goodwill as an asset.• Negative goodwill refers to the • acquisition of a company for an • amount less than the fair value of its • net assets. It is recognized as a liability in• the financial statements.

Goodwill Impairment• Impairment involves a comparison

of the book value of the asset with its estimated recoverable amount.

• The recoverable amount is defined as the value of an asset, either the price it would fetch if sold, or its value to the company when used, whichever is the larger figure.

• If the recoverable amount is less than carrying value, the cash generating unit is said to be impaired. In this case the goodwill value needs to be reduced so that the recoverable amount of the cash generating unit is equal to its carrying value.

• The impairment loss is reported as a separate line item on the income statement, and new adjusted value of goodwill is reported in the balance sheet.

Most Goodwill never gets recorded:o Many businesses develop goodwill

internally. o There is no objective way of determining it.

o So, it is not included in the accounting records despite being an important asset.Goodwill or bad judgment?o Huge amounts paid for goodwill, only to

discover that the business does not continue to earn above average rates of return.

o If goodwill has no economic value, written off immediately.

•A patent is an intangible asset, issued by the federal government, giving its A patent is an intangible asset, issued by the federal government, giving its owner the exclusive legal right to the commercial benefit of a specified owner the exclusive legal right to the commercial benefit of a specified product or process.product or process.•They are generated internally or can be purchasedThey are generated internally or can be purchased•A patent does not have inherent protection from infringementA patent does not have inherent protection from infringement•In the U.S, the U.S Patents Office issues patents In the U.S, the U.S Patents Office issues patents for 17 years. However, the economically useful for 17 years. However, the economically useful life maybe much shorter if technological life maybe much shorter if technological developments render the product or process obsolete.developments render the product or process obsolete.

For example, purchase price:$25000, For example, purchase price:$25000, economic life: 5 years and legal life: 8 years.economic life: 5 years and legal life: 8 years.

Amortization expense……………$5000Amortization expense……………$5000 Patent………………………………$5000Patent………………………………$5000

COPYRIGHTSCOPYRIGHTS• A copyright is an intangible asset that gives its owner an exclusive legal right to the reproduction and sale of a literary or artistic work. It is granted by the federal government and lasts for the life of the creator plus 50 years. •Their legal life is very small but the economic life is limited to the period for which a commercial market exists for the publication. Copyrights are amortized over a short period of time.•If the fee to establish a copyright is minimal, it is treated off as expense.•When the company purchases a copyright from the original owner, the expenditure is often substantial. The company must capitalize this cost as an intangible asset.

•A franchise is a right granted by a company or governmental unit to conduct a certain type of business in a specific geographical area.•When the cost of the franchise is small, it maybe charged immediately to expense or amortized over a short period such as 10 years.• When the cost is material, amortization should be based on the life of the asset.

Trademarks,TradenaTrademarks,Tradenamesmes and Secret and Secret FormulasFormulas•Trademarks, Trade Names and Secret Formulas are means used by companies to build and ensure consumer acceptance for new products.•A trademark is any word, name or symbol that is used by a manufacturer or merchant to identify their goods as distinguished from those made or sold by the others.•A trade name is a registered business name used by a company to identify itself when providing products or services.•If a trademark or brand name is purchased, the cost maybe substantial. Such cost should be capitalized and amortized.

Organization Costs

• Organizing a corporation demands a considerable amount of time, effort and cost

• Those involved, need to be compensated• All these expenditures are expected to benefit

future revenue. Logically, therefore, these costs should be treated as an asset.

• Theoretically, the economic life of these costs extends as the corporation remains a going concern.

• Despite that, companies amortize these costs over 5 years.

Research and Development Costs

•According to International Financial Reporting

Standards “research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding”.

• Development is the application of

research findings or other knowledge

to a plan or design for the production

of new or substantially improved

materials, devices, products,

processes, systems or services

before the start of commercial production or use

•Research and development Costs are expenditures incurred in discovering, planning, designing and implementing a new product or process.

Examples

• Research:Expenses to find a cure / medicine for different diseaseExpenses incurred on activities aimed at obtaining a new

knowledge• Development:Construction of pilot plant and

projectsExpenses on the development of

new drugs

Research and Development Costs

• Billions of dollars spent yearly on it• Accounting for this is a controversial issue because: Generally, they provide the firm with benefits but not always. It

is not clear whether research would be successful or not so all these expenses are not capitalized and expensed out.

The costs may be incurred in 2008, for a product that will be nonexistent till 2010.

In today’s highly competitive economy, where all firms strive to secure their position through innovation, the period for which the benefits will last is virtually impossible to measure. E.g. the failure of IBM’s PC Junior in the mid-1980s.

Continued….• In case of development, since it is

probable that future benefits will flow to the company, all expenses are capitalized and amortized.

• Financial Accounting Standards Board has decreed that these expenditures should be charged to expense when they are incurred

Deferred charges

• Intangible assets such as moving costs, plant rearrangement costs, name lists and film rights, are grouped under deferred Charges.

• Deferred charges are expenditures that will provide benefits beyond the current year and will be written off to expense over their useful economic lives.

• For example, the costs incurred in issuing bonds for funds and those incurred for machinery rearrangement, both generate revenue, so the costs should be allocated to revenue over a reasonable number of years.

Conclusion

• Intangible assets are non physical, non monetary assets. E.g. Goodwill, Patents etc.

• Costs are capitalized and amortized over the shorter of their economic or legal life.

• Amortization is the parallel of depreciation for intangible assets.

• Best value found when purchased from • another firm.• Internally generated intangible assets are not considered, which causes financial statements to depict a false picture.