BUS103: Introduction to Financial Accounting

Although they have no physical characteristics, intangible assets have value because of the advantages or exclusive privileges and rights they provide to a business. Intangible assets generally arise from two sources: (1) exclusive privileges granted by governmental authority or by legal contract, such as patents, copyrights, franchises, trademarks and trade names, and leases; and (2) superior entrepreneurial capacity or management know-how and customer loyalty, which is called goodwill.

All intangible assets are nonphysical, but not all nonphysical assets are intangibles. For example, accounts receivable and prepaid expenses are nonphysical, yet classified as current assets rather than intangible assets. Intangible assets are generally both nonphysical and noncurrent; they appear in a separate long-term section of the balance sheet entitled "Intangible assets".

Initially, firms record intangible assets at cost like most other assets. However, computing an intangible asset's acquisition cost differs from computing a plant asset's acquisition cost. Firms may include only outright purchase costs in the acquisition cost of an intangible asset; the acquisition cost does not include cost of internal development or self-creation of the asset. If an intangible asset is internally generated in its entirety, none of its costs are capitalized. Therefore, some companies have extremely valuable assets that may not even be recorded in their asset accounts. To explain the reasons for this practice, we discuss the history of accounting for research and development costs next.

Research and development (R&D) costs are costs incurred in a planned search for new knowledge and in translating such knowledge into new products or processes. Prior to 1975, businesses often capitalized research and development costs as intangible assets when future benefits were expected from their incurrence. Due to the difficulty of determining the costs applicable to future benefits, many companies expensed all such costs as incurred. Other companies capitalized those costs that related to proven products and expensed the rest as incurred.

As a result of these varied accounting practices, in 1974 the Financial Accounting Standards Board in Statement No. 2 ruled that firms must expense all research and development costs when incurred, unless they were directly reimbursable by government agencies and others. Immediate expensing is justified on the grounds that (1) the amount of costs applicable to the future cannot be measured with any high degree of precision; (2) doubt exists as to whether any future benefits will be received; and (3) even if benefits are expected, they cannot be measured. Thus, research and development costs no longer appear as intangible assets on the balance sheet. The Board applies the same line of reasoning to other costs associated with internally generated intangible assets, such as the internal costs of developing a patent.

Amortization is the systematic write-off of the cost of an intangible asset to expense. A portion of an intangible asset's cost is allocated to each accounting period in the economic (useful) life of the asset. All intangible assets are not subject to amortization. Only recognized intangible assets with finite useful lives are amortized. The finite useful life of such an asset is considered to be the length of time it is expected to contribute to the cash flows of the reporting entity. (Pertinent factors that should be considered in estimating useful life include legal, regulatory, or contractual provisions that may limit the useful life). The method of amortization should be based upon the pattern in which the economic benefits are used up or consumed. If no pattern is apparent, the straight-line method of amortization should be used by the reporting entity.

Recognized intangible assets deemed to have indefinite useful lives are not to be amortized. Amortization will however begin when it is determined that the useful life is no longer indefinite. The method of amortization would follow the same rules as intangible assets with finite useful lives.

Straight-line amortization is calculated the same was as straight-line depreciation for plant assets. Generally, we record amortization by debiting Amortization Expense and crediting the intangible asset account. An accumulated amortization account could be used to record amortization. However, the information gained from such accounting would not be significant because normally intangibles do not account for as many total asset dollars as do plant assets.

A patent is a right granted by the federal government. This exclusive right enables the owner to manufacture, sell, lease, or otherwise benefit from an invention for a limited period. The value of a patent lies in its ability to produce revenue. Patents have a legal life of 17 years. Protection for the patent owner begins at the time of patent application and lasts for 17 years from the date the patent is granted.

When purchasing a patent, a company records it in the Patents account at cost. The firm also debits the Patents account for the cost of the first successful defense of the patent in lawsuits (assuming an outside law firm was hired rather than using internal legal staff). Such a lawsuit establishes the validity of the patent and thereby increases its service potential. In addition, the firm debits the cost of any competing patents purchased to ensure the revenue-generating capability of its own patent to the Patents account.

The firm would amortize the cost of a purchased patent over its finite life which reasonably would not exceed its legal life. If a patent cost USD 40,000 and has a useful life of 10 years, the journal entries to record the patent and periodic amortization are:

For a patent that becomes worthless before it is fully amortized, the company expenses the unamortized balance in the Patents account.

As noted earlier, all R&D costs incurred in the internal development of a product, process, or idea that is later patented must be expensed, rather than capitalized. In the previous example, the company amortized the cost of the purchased patent over its useful life of 10 years. If the patent had been the result of an internally generated product or process, the firm would have expensed its cost of USD 40,000 as incurred, in accordance with Statement No. 2 of the Financial Accounting Standards Board.

A copyright is an exclusive right granted by the federal government giving protection against the illegal reproduction by others of the creator's written works, designs, and literary productions. The finite useful life for a copyright extends to the life of the creator plus 50 years. Most publications have a limited (finite) life; a creator may amortize the cost of the copyright to expense on a straight-line basis or based upon the pattern in which the economic benefits are used up or consumed.

A franchise is a contract between two parties granting the franchisee (the purchaser of the franchise) certain rights and privileges ranging from name identification to complete monopoly of service. In many instances, both parties are private businesses. For example, an individual who wishes to open a hamburger restaurant may purchase a McDonald's franchise; the two parties involved are the individual business owner and McDonald's Corporation. This franchise would allow the business owner to use the McDonald's name and golden arch, and would provide the owner with advertising and many other benefits. The legal life of a franchise may be limited by contract.

The parties involved in a franchise arrangement are not always private businesses. A government agency may grant a franchise to a private company. A city may give a franchise to a utility company, giving the utility company the exclusive right to provide service to a particular area.

In addition to providing benefits, a franchise usually places certain restrictions on the franchisee. These restrictions generally are related to rates or prices charged; also they may be in regard to product quality or to the particular supplier from whom supplies and inventory items must be purchased.

If periodic payments to the grantor of the franchise are required, the franchisee debits them to a Franchise Expense account. If a lump-sum payment is made to obtain the franchise, the franchisee records the cost in an asset account entitled Franchise and amortizes it over the finite useful life of the asset. The legal life (if limited by contract) and the economic life of the franchise may limit the finite useful life.

A trademark is a symbol, design, or logo used in conjunction with a particular product or company. A trade name is a brand name under which a product is sold or a company does business. Often trademarks and trade names are extremely valuable to a company, but if they have been internally developed, they have no recorded asset cost. However, when a business purchases such items from an external source, it records them at cost and amortizes them over their finite useful life.

A lease is a contract to rent property. The property owner is the grantor of the lease and is the lessor. The person or company obtaining rights to possess and use the property is the lessee. The rights granted under the lease are a leasehold. The accounting for a lease depends on whether it is a capital lease or an operating lease.

Capital leases A capital lease transfers to the lessee virtually all rewards and risks that accompany ownership of property. A lease is a capital lease if, among other provisions, it (1) transfers ownership of the leased property to the lessee at the end of the lease term or (2) contains a bargain purchase option that permits the lessee to buy the property at a price significantly below fair market value at the end of the lease term.

A capital lease is a means of financing property acquisitions; it has the same economic impact as a purchase made on an installment plan. Thus, the lessee in a capital lease must record the leased property as an asset and the lease obligation as a liability. Because a capital lease is an asset, the lessee depreciates the leased property over its useful life. The lessee records part of each lease payment as interest expense and the balance as a payment on the lease liability.

The proper accounting for capital leases for both lessees and lessors has been an extremely difficult problem. We leave further discussion of capital leases for an intermediate accounting text.

Operating leases A lease that does not qualify as a capital lease is an operating lease. A one-year lease on an apartment and a week's rental of an automobile are examples of operating leases. Such leases make no attempt to transfer any of the rewards and risks of ownership to the lessee. As a result, there may be no recordable transaction when a lease is signed.

In some situations, the lease may call for an immediate cash payment that must be recorded. Assume that a business signed a lease requiring the immediate payment of the annual rent of USD 15,000 for each of the first and fifth years of a five-year lease. The lessee would record the payment as follows:

Since the Leasehold account is actually a long-term prepaid rent account for the fifth year's annual rent, it is an intangible asset until the beginning of the fifth year. Then the Leasehold account becomes a current asset and may be transferred into a Prepaid Rent account. Accounting for the balance in the Leasehold account depends on the terms of the lease. In the previous example, the firm would charge the USD 15,000 in the Leasehold account to expense over the fifth year only. It would charge the balance in Prepaid Rent to expense in the first year. Thus, assuming the lease year and fiscal year coincide, the entry for the first year is:

The entry in the fifth year is:

The accounting for the second, third, and fourth years would be the same as for the first year. The lessee records the rent in Prepaid Rent when paid in advance for the year and then expenses it. As stated above, the lessee may transfer the amount in the Leasehold account to Prepaid Rent at the beginning of the fifth year by debiting Prepaid Rent and crediting Leasehold. If this entry was made, the previous entry would have credited Prepaid Rent.

In some cases, when a lease is signed, the lump-sum payment does not cover a specific year's rent. The lessee debits this payment to the Leasehold account and amortizes it over the life of the lease. The straight-line method is required unless another method can be shown to be superior. Assume the USD 15,000 rent for the fifth year in the example was, instead, a lump-sum payment on the lease in addition to the annual rent payments. An annual adjusting entry to amortize the USD 15,000 over five years would read:

In this example, the annual rental expense is USD 18,000: USD 15,000 annual cash rent plus USD 3,000 amortization of leasehold (USD 15,000/5).

The lessee may base periodic rent on current-year sales or usage rather than being a constant amount. For example, if a lease called for rent equal to 5 percent of current-year sales and sales were USD 400,000 in 2010, the rent for 2010 would be USD 20,000. The rent would either be paid or an adjusting entry would be made at the end of the year.

A leasehold improvement is any physical alteration made by the lessee to the leased property in which benefits are expected beyond the current accounting period. Leasehold improvements made by a lessee usually become the property of the lessor after the lease has expired. However, since leasehold improvements are an asset of the lessee during the lease period, the lessee debits them to a Leasehold Improvements account. The lessee then amortizes the leasehold improvements to expense over the period benefited by the improvements. The amortization period for leasehold improvements should be the shorter of the life of the improvements or the life of the lease. If the lease can (and probably will) be renewed at the option of the lessee, the life of the lease should include the option period.

As an illustration, assume that on 2010 January 2, Wolf Company leases a building for 20 years under a nonrenewable lease at an annual rental of USD 20,000, payable on each December 31. Wolf immediately incurs a cost of USD 80,000 for improvements to the building, such as interior walls for office separation, ceiling fans, and recessed lighting. The improvements have an estimated life of 30 years. The company should amortize the USD 80,000 over the 20-year lease period, since that period is shorter than the life of the improvements, and Wolf cannot use the improvements beyond the life of the lease. If only annual financial statements are prepared, the following journal entry properly records the rental expense for the year ended 2010 December 31:

Thus, the total cost to rent the building each year equals the USD 20,000 cash rent plus the amortization of the leasehold improvements.

Although leaseholds are intangible assets, leaseholds and leasehold improvements sometimes appear in the property, plant, and equipment section of the balance sheet.

In accounting, goodwill is an intangible value attached to a company resulting mainly from the company's management skill or know-how and a favorable reputation with customers. A company's value may be greater than the total of the fair market value of its tangible and identifiable intangible assets. This greater value means that the company generates an above-average income on each dollar invested in the business. Thus, proof of a company's goodwill is its ability to generate superior earnings or income.

A goodwill account appears in the accounting records only if goodwill has been purchased. A company cannot purchase goodwill by itself; it must buy an entire business or a part of a business to obtain the accompanying intangible asset, goodwill.

To illustrate, assume that Lenox Company purchased all of Martin Company's assets for USD 700,000. Lenox also agreed to assume responsibility for a USD 350,000 mortgage note payable owed by Martin. Goodwill is the difference between the amount paid for the business including the debt assumed (USD 700,000 + USD 350,000 = USD 1,050,000) and the fair market value of the assets purchased. Notice that Lenox would use the fair market value of the assets rather than book value to determine the amount of goodwill. The following computation is for the goodwill purchased by Lenox:

The USD 75,000 is the goodwill Lenox records as an intangible asset; it records all of the other assets at their fair market values, and the liability at the amount due.

Exhibit 18: Partial balance sheet

Specific reasons for a company's goodwill include a good reputation, customer loyalty, superior product design, unrecorded intangible assets (because they were developed internally), and superior human resources. Since these positive factors are not individually quantifiable, when grouped together they constitute goodwill. The journal entry to record the purchase is:

The intangible asset goodwill is not amortized. Goodwill is to be tested periodically for impairment. The amount of any goodwill impairment loss is to be recognized in the income statement as a separate line before the subtotal income from continuing operations (or similar caption). The goodwill account would be reduced by the same amount.

Look at Exhibit 18, a partial balance sheet for ANY company. Unlike plant assets or natural resources, intangible assets usually are a net amount in the balance sheet.