Let's turn now to a third type of long-lived asset—intangible assets. As with other assets we have discussed, we allocate the cost of an intangible asset over its service or useful life. However, for the few intangible assets with indefinite useful lives, amortization is inappropriate.
Intangible Assets Subject to Amortization
Allocating the cost of intangible assets is called amortization cost allocation for intangibles.. For an intangible asset with a finite useful life, we allocate its capitalized cost less any estimated residual value to periods in which the asset is expected to contribute to the company's revenue-generating activities. This requires that we determine the asset's useful life, its amortization base (cost less estimated residual value), and the appropriate allocation method, similar to our depreciating tangible assets.
The cost of an intangible asset with a finite useful life is amortized.
USEFUL LIFE. Legal, regulatory, or contractual provisions often limit the useful life of an intangible asset. On the other hand, useful life might sometimes be less than the asset's legal or contractual life. For example, the useful life of a patent would be considerably less than its legal life of 20 years if obsolescence were expected to limit the longevity of a protected product.
RESIDUAL VALUE. We discussed the cost of intangible assets in Chapter 10. The expected residual value of an intangible asset usually is zero. This might not be the case, though, if at the end of its useful life to the reporting entity the asset will benefit another entity. For example, if Quadra Corp. has a commitment from another company to purchase one of Quadra's patents at the end of its useful life at a determinable price, we use that price as the patent's residual value.
ALLOCATION METHOD. The method of amortization should reflect the pattern of use of the asset in generating benefits. Most companies use the straight-line method. We discussed and illustrated a unique approach to determining the periodic amortization of software development costs in Chapter 10. Recall that the periodic amortization percentage for software development costs is the greater of (1) the ratio of current revenues to current and anticipated revenues (percentage of revenue method), or (2) the straight-line percentage over the useful life of the asset.
Intel Corporation reported several intangible assets in a recent balance sheet. A note, shown in Graphic 11-8, disclosed the range of estimated useful lives and the use of the straight-line method of amortization.
Intangible Asset Useful Life Disclosure—Intel Corporation
Real World Financials
Summary of Significant Accounting Policies (in part)
Identified Intangible Assets
Intellectual property assets primarily represent rights acquired under technology licenses and are generally amortized on a straight-line basis over periods of benefit, ranging from 3 to 17 years. We amortize acquisition-related developed technology on a straight-line basis over approximately 4 years. We amortize other intangible assets over 4 years. We classify all identified intangible assets within other long-term assets. In the quarter following the period in which identified intangible assets become fully amortized, the fully amortized balances are removed from the gross asset and accumulated amortization amounts.
Like depletion, amortization expense traditionally is credited to the asset account itself rather than to accumulated amortization. However, the use of a contra account is acceptable. Notice in Graphic 11-8 that Intel uses an accumulated amortization contra account. Let's look at an example in Illustration 11-4.
Amortization of Intangibles
Hollins Corporation began operations in 2011. Early in January, the company purchased a franchise from Ajax Industries for $200,000. The franchise agreement is for a period of 10 years. In addition, Hollins purchased a patent for $50,000. The remaining legal life of the patent is 13 years. However, due to expected technological obsolescence, the company estimates that the useful life of the patent is only 8 years. Hollins uses the straight-line amortization method for all intangible assets. The company's fiscal year-end is December 31.
The journal entries to record a full year of amortization for these intangibles are as follows:
Similar to depreciation, amortization is either a product cost or a period cost depending on the use of the asset. For intangibles used in the manufacture of a product, amortization is a product cost and is included in the cost of inventory (and doesn't become an expense until the inventory is sold). For intangible assets not used in production, such as the franchise cost in our illustration, periodic amortization is expensed in the period incurred.
Intangible Assets Not Subject to Amortization
An intangible asset that is determined to have an indefinite useful life is not subject to periodic amortization. Useful life is considered indefinite if there is no foreseeable limit on the period of time over which the asset is expected to contribute to the cash flows of the entity.9
Indefinite does not necessarily mean permanent. For example, suppose Collins Corporation acquired a trademark in conjunction with the acquisition of a tire company. Collins plans to continue to produce the line of tires marketed under the acquired company's trademark. Recall from our discussion in Chapter 10 that trademarks have a legal life of 10 years, but the registration can be renewed for an indefinite number of 10-year periods. The life of the purchased trademark is initially considered to be indefinite and the cost of the trademark is not amortized. However, if after several years management decides to phase out production of the tire line over the next three years, Collins would amortize the remaining book value over a three-year period.
The cost of an intangible asset with an indefinite useful life is not amortized
Indefinite-Life Intangibles Disclosure—Eddie Bauer Holdings, Inc.
Real World Financials
Summary of Significant Accounting Policies (in part) Intangible Assets
Goodwill and trademarks were determined to have indefinite useful lives and are not amortized into results of operations, but instead are reviewed for impairment annually, or more often if impairment indicators arise.
Goodwill is the most common intangible asset with an indefinite useful life. Recall that goodwill is measured as the difference between the purchase price of a company and the fair value of all of the identifiable net assets (tangible and intangible assets minus the fair value of liabilities assumed). Does this mean that goodwill and other intangible assets with indefinite useful lives will remain in a company's balance sheet at their original capitalized values indefinitely? Not necessarily. Like other assets, intangibles are subject to the impairment of value rules we discuss in a subsequent section of this chapter. In fact, indefinite-life intangible assets must be tested for impairment annually, or more frequently if events or circumstances indicate that the asset might be impaired.
Goodwill is an intangible asset whose cost is not expensed through periodic amortization.
INTERNATIONAL FINANCIAL REPORTING STANDARDS
Valuation of Intangible Assets. IAS No. 3810 allows a company to value an intangible asset subsequent to initial valuation at (1) cost less accumulated amortization or (2) fair value, if fair value can be determined by reference to an active market. If revaluation is chosen, all assets within that class of intangibles must be revalued on a regular basis. Goodwill, however, cannot be revalued. U.S. GAAP prohibits revaluation of any intangible asset.
Notice that the revaluation option is possible only if fair value can be determined by reference to an active market, making the option relatively uncommon. However, the option possibly could be used for intangibles such as franchises and certain license agreements.
If the revaluation option is chosen, the accounting treatment is similar to the way we applied the revaluation option for property, plant, and equipment earlier in this chapter. Recall that the way the company reports the difference between fair value and book value depends on which amount is higher. If fair value is higher than book value, the difference is reported as other comprehensive income (OCI) and then accumulates in a revaluation surplus account in equity. On the other hand, if book value is higher than fair value, the difference is expensed.
Consider the following illustration:
Amershan LTD. prepares its financial statements according to IFRS. At the beginning of its 2011 fiscal year, the company purchased a franchise for $500,000. The franchise has a 10-year contractual life and no residual value, so amortization in 2011 is $50,000. The company does not use an accumulated amortization account and credits the franchise account directly when amortization is recorded. At the end of the year, Amershan chooses to revalue the franchise as permitted by IAS No. 38. Assuming that the fair value of the franchise, determined by reference to an active market, at year-end is $600,000, Amershan records amortization and the revaluation using the following journal entries:
With the second entry Amershan increases the book value of the franchise from $450,000 ($500,000 −50,000) to its fair value of $600,000 and records a revaluation surplus for the difference. The new basis for the franchise is its fair value of $600,000, and the following years' amortization is based on that amount. Thus, 2012 amortization would be $600,000 divided by the nine remaining years, or $66,667.
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To record the revaluation of franchise to its fair value.
DEPLETION AND AMORTIZATION
On March 29, 2011, the Horizon Energy Corporation purchased the mineral rights to a coal deposit in New Mexico for $2 million. Development costs and the present value of estimated land restoration costs totaled an additional $3.4 million. The company removed 200,000 tons of coal during 2011 and estimated that an additional 1,600,000 tons would be removed over the next 15 months.
Compute depletion on the mine for 2011.
On October 1, 2011, Advanced Micro Circuits, Inc., completed the purchase of Zotec Corporation for $200 million. Included in the allocation of the purchase price were the following identifiable intangible assets ($ in millions), along with the fair values and estimated useful lives:
In addition, the fair value of acquired tangible assets was $100 million. Goodwill was valued at $30 million. Straight-line amortization is used for all purchased intangibles.
During 2011, Advanced finished work on a software development project. Development costs incurred after technological feasibility was achieved and before the product release date totaled $2 million. The software was available for release to the general public on September 29, 2011. During the last three months of the year, revenue from the sale of the software was $4 million. The company estimates that the software will generate an additional $36 million in revenue over the next 45 months.
Compute amortization for purchased intangibles and software development costs for 2011.
Advanced will use the percentage-of-revenue method since it produces the greater amortization, $200,000.