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11.1 Identifying and Accounting for Intangible Assets

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. List the characteristics of intangible assets and provide several common examples.
  2. Understand that intangible assets are becoming more important to businesses and, hence, are gaining increased attention in financial accounting.
  3. Record the acquisition of an intangible asset.
  4. Describe the amortization process for intangible assets.
  5. Explain the accounting used to report an intangible asset that has increased in value since acquisition.

The Rise in the Importance of Intangible Assets

Question: Not so many years ago, the balance sheets of most large companies disclosed significant amounts of property and equipment but considerably smaller figures for intangible assetsAn asset lacking physical substance that is expected to help generate revenues for more than one year; common examples are patents, copyrights, and trademarks.. Businesses were often referred to as “bricks and mortar” operations because much of their money was invested in buildings and the long-lived tangible assets that were housed in those buildings.

Today, the basic nature of many corporate operations has changed dramatically. As of June 30, 2011, Microsoft Corporation reported a total of $13.3 billion for its “goodwill” and “intangible assets, net” versus only $8.2 billion in “property and equipment, net of accumulated depreciation.” For Yahoo! Inc., the difference is similarly striking. On December 31, 2010, Yahoo! disclosed $3.9 billion of “goodwill” and “intangible assets, net” but a mere $1.7 billion in “property and equipment, net.”

The rise in the number, value, and importance of intangible assets might well be the biggest change experienced in the reporting of businesses over the last ten to twenty years. The sudden growth of Internet and technology companies like Microsoft and Yahoo! has focused attention on the significance of ideas and innovation (rather than bricks and mortar) for achieving profits.

Financial accounting rules must evolve as the nature of business moves forward over time. Not surprisingly, considerable debate has taken place recently concerning the methods by which intangible assets are reported in a set of financial statements. A relatively minor topic in the past has gained a genuine level of importance in today’s accounting conversations. Should an idea or an invention be reported in the same manner as a building or a machine? For financial accounting, that is a very important question. As a starting point for this discussion, the basic nature of an intangible asset needs to be understood. What is an intangible asset and what are common examples?

 

Answer: As the title implies, an intangible asset is one that lacks physical substance. It cannot be touched but is expected to provide future benefits for longer than one year. More specifically, it will assist the reporting company in generating revenues in the future. Except for a few slight variations, intangible assets are reported in the same manner as a building or equipment. For example, historical cost serves as the basis for reporting. If the intangible has a finite life, the depreciation process (although the term amortizationA mechanically derived pattern allocating the cost of an intangible asset to expense over the shorter of the legal life or estimated useful life; it is the equivalent of depreciation but relates to intangible assets. is normally applied in reporting intangibles) reclassifies this cost from asset to expense over that estimated period.

U.S GAAP provides structure for the reporting process by placing all intangibles into six major categories:

  1. Artistic-related (such as copyrightsAn intangible asset that provides the owner with the right to use literary, dramatic, musical, artistic, and certain other intellectual works.)
  2. Technology-related (patents)
  3. Marketing-related (trademarks)
  4. Customer-related (a database of customer information)
  5. Contract-related (franchises)
  6. Goodwill

In all of these categories (except for goodwill, which will be explained later in this chapter), the intangible asset is actually an established right of usage. As an example, according to the Web site for the United States Copyright Office, a copyright provides its owner with the right to use “literary, dramatic, musical, artistic, and certain other intellectual works.” Similarly, the United States Patent and Trademark Office Web site explains that “a patent for an invention is the grant of a property right to the inventor.” Thus, most intangible assets represent a legal right that helps the owner to generate revenues.

Test Yourself

Question:

The Weddington Company reports a number of assets on its balance sheet. Which of the following should not be included as an intangible asset?

  1. Copyright
  2. Account receivable
  3. Patent
  4. Franchise

Answer:

The correct answer is choice b: Account receivable.

Explanation:

An intangible asset is one with no physical substance that provides a company with future benefit, usually a legal or contractual right, that helps to generate revenues for a period of over one year. Accounts receivable are not usually outstanding for that length of time and do not assist in the generation of future revenues. They help bring in cash that was earned in the past. Copyrights, patents, and franchises are rights that can be owned or controlled and are used to produce revenues.

The Acquisition of an Intangible

Question: Intangible assets are accounted for in a manner that is similar to property and equipment. To illustrate, assume that an automobile company is creating a series of television commercials for one of its new models. On January 1, Year One, the company pays $1 million cash to a famous musical group for the right to use a well-known song. The band holds the legal copyright on this piece of music and agrees to share that right with the automobile company so that the song can be played in one or more commercials. What accounting is made by a company that acquires an intangible asset such as a copyright?

 

Answer: The buyer of an intangible asset prepares a journal entry that is basically identical to the acquisition of inventory, land, or a machine. As with all those other assets, the intangible is recorded initially at historical cost.

Figure 11.1 January 1, Year One—Acquisition of Right to Use Copyrighted Song

Many intangible assets have defined legal lives. For example, copyrights last for seventy years beyond the creator’s life. Acquired intangibles (such as the copyright for this song) often have lives legally limited by contractual agreement. However, the true useful life of most intangibles is generally only a small number of years. Few intangibles manage to help a company generate revenues for decades. Amortization of the cost to expense should extend over the shorter of the asset’s useful life or its legal life.

Assume that this piece of music is expected to be included by the automobile company in its television commercials for the next four years. After that, a different advertising campaign will likely be started. If the straight-line method is applied (which is normal for intangible assets), annual amortization of this copyright is $250,000 ($1 million cost/4 year life).

Figure 11.2 December 31, Year One—First Year Amortization of Copyright Cost

At the end of the first year, the copyright appears on the automobile company’s balance sheet as $750,000, the remainder of its historical cost. As can be seen in Figure 11.2 "December 31, Year One—First Year Amortization of Copyright Cost", the credit in this adjusting entry is a direct decrease in the asset account. Although establishing a separate contra account (such as accumulated amortization) is permitted, most companies simply reduce the intangible asset balance because the utility is literally shrinking. Depreciation of a building or equipment does not mean that the asset is getting smaller. A four-story building remains a four-story building throughout its life. Reducing the building account directly is not a reflection of reality. In contrast, the right to use this song does get smaller over time. The automobile company went from holding a copyright to play this music in its commercials for an expected four years to a copyright that will likely only be used for three more years. A direct reduction of the cost is more appropriate.

Intangible Assets and Fair Value

Question: In this example, the automobile company acquired the right to use this music for $1 million. That was historical cost, the figure to be reported for intangible assets on the company’s balance sheet. The number was objectively determined and the accounting straightforward. However, the artist who originally created the music (or his or her recording company) still holds the original copyright. As indicated by the sale, the rights to this music are extremely valuable. How does the creator report an intangible asset such as a copyright? Should the copyright to this piece of music now be reported by the artist at its proven value of $1 million?

 

Answer: Depending on the specific terms of the contract, the creator often continues to possess the copyright and maintains that asset on its own balance sheet. In many cases, the original artist only conveys permission to a buyer to use this music (or other intellectual work) for specific purposes or a set period of time. However, the copyright is not adjusted on the creator’s books to this $1 million value; rather, it remains at historical cost less any amortization to date. That is the reporting basis for intangible assets according to U.S. GAAP in the same way as for land, buildings, and equipment. The figure shown on the balance sheet is not increased to reflect a rise in fair value.

The reported amount shown for copyrights and other similar intangibles contains all normal and necessary costs such as attorney fees and money spent for legal filings made with appropriate authorities. Subsequently, such intangible assets sometimes become the subject of lawsuits if other parties assert claims to the same ideas and creations. The cost of a successful defense is also capitalized and then amortized over the shorter of the remaining legal life or estimated useful life of the asset. If the defense proves unsuccessful, the remaining asset balance is written off as a loss.

Test Yourself

Question:

John Doe successfully creates an invention and, on January 1, Year One, receives a patent that gives him the exclusive rights to that invention for twenty years. One year later, John Doe sells all of his rights to the patent to Nahquan Corporation for $3 million. Nahquan pays another $400,000 to a legal firm to help ensure that the right is properly transferred. Nahquan hopes to use the patent for five years and then sell it for $200,000. On December 31, Year Two, another company offers to pay Nahquan $4 million for this intangible asset but that amount is rejected as being too low. On its balance sheet at that time, what balance is reported by Nahquan for the patent?

  1. $2,560,000
  2. $2,760,000
  3. $3,040,000
  4. $3,221,053

Answer:

The correct answer is choice b: $2,760,000.

Explanation:

The capitalized cost of this asset is $3.4 million—the normal and necessary amount to acquire the patent so that it can be used to generate revenues. Annual amortization is $640,000 ([$3.4 million less $200,000 residual value] divided by five-year life). After one year, reported value is $2,760,000 ($3.4 million less $640,000). The $4 million offer does not affect the balance since it was not accepted. Amortized historical cost is the basis for financial reporting unless the value is impaired.

Talking With an Independent Auditor about International Financial Reporting Standards

Following is a continuation of our interview with Robert A. Vallejo, partner with the accounting firm PricewaterhouseCoopers.

 

Question: Under U.S. GAAP, intangible assets with a finite life are reported at historical cost less any accumulated amortization recognized to date. Except in impairment cases, fair value is ignored completely. How are intangible assets reported when IFRS standards are applied?

Robert Vallejo: Unless a company chooses to revalue its intangible assets regularly (an option that is available under IFRS but that is rarely chosen because the process must then be done every reporting period), the accounting under U.S. GAAP and IFRS is basically the same. After initial recognition under IFRS, intangible assets are carried at cost less accumulated amortization (as well as any impairment losses). If an active market is available, similar intangible assets can then be adjusted to fair value but, again, that value must be updated each reporting period. Per IAS 38, Intangible Assets, the method of amortization that is used should reflect the pattern in which the asset’s future economic benefits are expected to be realized by the entity. If that pattern cannot be determined reliably, the straight-line method of amortization must be used.

Key Takeaway

The financial reporting of intangible assets has grown in significance in recent years because of the prevalence and success of businesses in industries such as technology and electronics. For the most part, intangible assets provide the owner with a legal right to use an idea, invention, artistic creation, or the like. Copyrights, patents, and trademarks are common examples. An intangible is recorded initially at historical cost. Most of these assets have a finite life, so the cost is then amortized to expense over the shorter of the legal life or estimated useful life. Consequently, intangible assets appear on the owner’s balance sheet at net book value. Amortization is usually reflected as a direct reduction in the asset balance rather than indirectly through a separate contra account. Other than this difference, accounting for intangibles resembles that used with property and equipment so that, for example, increases in value are not reported.