Solution manual intermediate accounting 9e by nicolai ch11

Q11-14 From an asset valuation standpoint, goodwill is the difference between the purchase price market value of the company as a whole and the fair value of the net identifiable assets.

CHAPTER 11

INTANGIBLES

CONTENT ANALYSIS OF EXERCISES AND PROBLEMS

E11-1 Patent Amount to be capitalized Determination of

E11-2 Patent Journal entries to record all transactions 5-10 E11-3 Tradename Computation of ending carrying value 5-10 E11-4 Start-up Costs Determination of amount to be expensed 5-10 E11-5 Research and Development Costs Preparation of journal entry

E11-6 (AICPA adapted) Research and Development Costs

Determination of amount charged to income 5-10 E11-7 Research and Development Determination and justification of

E11-8 Research and Development Determination and justification of

E11-9 Intangibles Computation of amortization expense 10-15 E11-10 Tradename Preparation of journal entry to record impairment 10-15 E11-11 Goodwill Preparation of journal entry to record impairment 15-20 E11-12 Goodwill Computation with fair values of assets given 10-15 E11-13 (Appendix) Normal Earnings and Goodwill Computation

from numerous items Extraordinary gain, liquidation of LIFO layer, amortization, depreciation, profit sharing payments

10-15

E11-14 (Appendix) Goodwill Computation of implied goodwill using

five-year averages Changes in capitalization rates 10-15 E11-15 (Appendix) Goodwill Computation under two different

proposals and determination of most reasonable approach 10-15

Number Content Time Range (minutes) E11-16 (Appendix) (AICPA adapted) Goodwill Computation of

implied goodwill, given the past five years' cumulative earnings and the annual earnings based on an average rate of return

5-15

E11-17 (Appendix) Goodwill Computation under various

assumptions Different capitalization rates and annual earnings life spans

10-15

E11-18 (Appendix) Estimated Future Annual Earnings Computation

from various items Purchase price, goodwill, capitalization and normal rate of return percentages

10-15

P11-1 Intangibles Patent, franchise, rights to a novel Journal entries

P11-2 Intangibles Franchise, tradename, copyright Journal entries

to record transactions and any amortization 20-30 P11-3 Classification of Intangibles Adjusting journal entries to

P11-4 Patents Adjusting journal entries to correct the patent

P11-5 Patents Journal entries to record various transactions

Purchase, costs of improving, legal fees, licensing, royalty receipt

20-30

P11-6 (AICPA adapted) Research and Development

Determination of amount charged to income Materials used, equipment acquired, personnel, consulting fees, indirect costs

10-15

P11-7 Intangibles Straight-line (to nearest month) amortization

method Patent, franchise, R&D costs, tradename, goodwill

Journal entries

20-30

P11-8 Copyright Journal entries to record various events

P11-9 Research and Development Preparation of the financial

statements according to GAAP Return on assets 20-30 P11-10 Intangibles Preparation of journal entries to record correct

P11-11 Impairment Preparation of journal entries to record impairment

P11-12 Goodwill Computation of implied goodwill if differing amounts

are paid Journal entries to record acquisition and amortization

30-40

Number Content Time Range (minutes) P11-13 (AICPA adapted) Intangibles: Expense and Disclosure

Prepare schedules to determine intangible assets and related expenses

20-30

P11-14 (AICPA adapted) Intangibles: Assets and Expenses Prepare

schedules to determine intangible assets and income statement effects of several transactions and events

20-30

P11-15 (AICPA adapted) Comprehensive: Intangibles Numerous

intangible asset transactions Worksheet to adjust accounts

Preparation of financial statements

45-60

P11-16 (AICPA adapted) Comprehensive: Intangibles Prepare

schedules to determine intangible assets and related expenses 35-45 P11-17 (AICPA adapted) Comprehensive Adjustments Prepare

correcting entries for software, bad debts, inventories, prepaid insurance, depreciation, research and development, and other items Prepare corrected financial statements

45-80

P11-18 (Appendix) Goodwill Computation using five-year averages

P11-19 (Appendix) Goodwill Determination of implied goodwill if

cash is paid, if earnings are based on a five-year average, if earnings are based on apparent trend

40-60

ANSWERS TO QUESTIONS

Q11-1 Intangible assets are distinguished from tangible assets by the fact that intangibles do

not have a physical substance In addition, intangible assets generally have a higher degree of uncertainty regarding the future benefits to be derived, their value is subject to wider fluctuations, they may have value only to a particular company, and they may have indeterminate lives Intangible and tangible assets do have characteristics in common since both are held for use in the course of business, have useful lives of more than one year, and contribute to the generation of revenues Tangible assets are depreciated Intangible assets are separated into three

categories to determine whether or not they are amortized, and how they are

reviewed for impairment An intangible asset with a finite (limited) life is amortized over its useful life; an intangible asset with an indefinite life and goodwill are not amortized but are reviewed for impairment at least annually

Q11-2 Identifiable intangibles are assets, such as patents and franchises, that are clearly

identifiable and separate Unidentifiable intangibles are assets that cannot be acquired by themselves and cannot be separated from the other assets acquired

Q11-3 When accounting for the cost of identifiable or unidentifiable intangibles, a company

distinguishes between those that are purchased and those that are internally

developed It capitalizes all intangibles that are purchased, whereas it separates internally developed intangibles into identifiable or unidentifiable It then capitalizes the identifiable asset (except research and development) and expenses the

unidentifiable intangible

Q11-4 In accordance with FASB Statement No 142, intangible assets are separated into

three categories to determine whether or not they are amortized and how they are reviewed for impairment The three categories are: intangible assets with a finite (limited) life are amortized over their useful lives; intangible assets with an indefinite life and goodwill are reviewed for impairment at least annually (Some intangibles acquired prior to November 1, 1970 were considered not to have a decline in value

or a limited economic life and, therefore, are not amortized.)

Q11-5 A company selects the amortization method based on the expected pattern of

benefits the intangible asset will produce, except that if the company cannot reliably determine the pattern, it must use the straight-line method

Q11-6 In estimating the economic life of an intangible, a company should consider the

following factors:

1 The expected use of the asset

2 The expected useful life of another asset that is related to the life of the intangible asset, such as the mineral rights that relate to a depleting asset

3 Any legal, regulatory, or contractual provisions that enable renewal or extension

of the asset’s legal or contractual life without substantial cost

4 The effects of obsolescence, demand, competition, and other economic factors

5 The level of maintenance costs required to obtain the expected future cash flows from the asset

Q11-7 Research is the planned search or critical investigation aimed at discovery of new

knowledge with the hope that such knowledge will be useful in developing a new product or service or a new process or technique or in bringing about a significant improvement to an existing product or process Development is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use

Q11-8 Activities that are included in research and development (R&D) are as follows:

1 Laboratory research for new knowledge

2 Searching for application of new research and knowledge

3 Conceptual formulation and design of possible product/process alternatives

4 Testing of product/process alternatives

5 Modification of design of a product or process

6 Design, construction, testing of preproduction prototypes

7 Design of tools, etc., involving new technology

8 Design, construction, operation of pilot plant that is not economically feasible for commercial production

9 Engineering activity to advance the design of a product to meet requirements and get it ready for manufacture

Q11-8 (continued)

Among activities excluded from research and development are the following:

1 Engineering in early phase of commercial production

2 Quality control, testing, etc., during commercial production

3 Trouble-shooting in connection with breakdowns during production

4 Routine efforts to refine and enrich the qualities of existing products

5 Adaptation to a particular requirement or customer need

6 Seasonal and periodic design changes to existing products

7 Routine design of tools, jigs, molds, dies

8 Activities in construction, relocation, rearrangement, or start-up of facilities other than pilot plant or those used solely for research and development projects

9 Legal work in connection with patent applications, litigation, sale, or licensing Q11-9 A company includes expenditures for the following elements of R&D in R&D costs:

1 Materials, equipment, and facilities

2 Personnel

3 Intangibles purchased from others

4 Contract services

5 Reasonably allocated indirect costs

However, if any of the costs have alternative future uses, they are capitalized and then depreciated or amortized over their useful lives This depreciation or

amortization is included in R&D expense

Q11-10 One alternative considered by FASB Statement No 2 was to expense all R&D costs

when incurred The main argument in favor of this was the high degree of

uncertainty regarding the future benefits of R&D projects; opponents, on the other hand, argued that a policy of expensing all costs would result in a significant

understatement of assets if there were identifiable future benefits

A second alternative was to capitalize all costs as incurred Supporters felt that companies only undertook R&D projects to develop future benefits and thus an asset should be recorded Against this was the argument that this policy would be

inconsistent with the principle of recording the asset at cost and expensing this cost over the life of the asset, especially when such uncertainty existed about any future benefits

A third alternative, to capitalize those costs that meet specific conditions and

expense all others, was favored because it evaluated each project individually as to any future benefits However, opponents argued that the criteria for capitalization of costs would be difficult to establish and implement, thus reducing comparability between companies

A fourth alternative was to establish a special classification on the balance sheet for the research and development costs An argument in favor of this alternative was that research and development costs could be specially classified in this account until sufficient information was available to make an objective decision about future benefits, if any Opponents argued that this procedure violated the fundamentals of accounting in that the research and development costs would be considered

neither an asset nor an expense

Q11-11 Patents have a legal life of 20 years, but may not be useful for that full amount of

time due to technological changes, competition, or a change in demand Thus, a patent is amortized over its expected useful life or 20 years, whichever is shorter Copyrights have a legal life of 70 years, but the expected useful life is generally indefinite Therefore, a copyright is not amortized unless there is evidence of a limited life

Goodwill is not amortized

Q11-12 A company records a patent acquired by purchase at cost Thus, in (a) it capitalizes

the asset at $90,000 It also capitalizes (b) internally developed identifiable

intangibles, but only those costs directly associated with the obtaining of the legal rights Only if the $100,000 is the total of such direct costs, would the company

capitalize this full amount

Q11-13 Four possible components of goodwill are an advantageous location, superior

employees or managers, a good reputation, or a group of reliable customers

Q11-14 From an asset valuation standpoint, goodwill is the difference between the purchase

price (market value) of the company as a whole and the fair value of the net

identifiable assets From an income perspective, goodwill can be defined as a company's ability to earn a rate of return on the fair value of its identifiable net assets that is higher than the normal rate of return

Q11-15 Factors that may account for the difference between the value of a company as a

whole and the book value of the net assets include:

1 Although assets are generally carried on the books at historical cost, the fair value

of these assets may be different

2 There may be identifiable intangible assets that have been expensed, such as research and development costs, or are undervalued

3 Unidentifiable assets may exist that have been expensed

Q11-16 Goodwill is capitalized at acquisition only when it results from the purchase of a

company or of a significant portion of a company (at a price greater than the fair value of the net identifiable assets acquired), the value can be established with reasonable reliability and by capitalizing this amount the buyer is recording the asset (goodwill) purchased at cost

Internally developed goodwill is expensed as the costs are incurred This procedure is favored because a company, by recognizing internal goodwill, is valuing assets based upon future expected earnings, not on the cost of those assets Also, a

reliable valuation of internally developed goodwill would be very difficult

Q11-17 Internal goodwill is the ability to earn excess profits, or the difference between the fair

value of the net assets and the value of the company as a whole, that the company itself has developed over the years External goodwill is that same ability or

difference but one that was purchased when another company or significant portion

of a company was acquired The cost of internal goodwill is expensed as incurred and external goodwill is capitalized when it is purchased, and is reviewed for

impairment at least annually

Q11-18 Goodwill is never amortized A company must review its goodwill for impairment at

least annually at the reporting unit level It must also review its goodwill for ment whenever events or changes in circumstances occur that would more-likely-than-not reduce the fair value of the goodwill below its carrying value Examples of events or changes in circumstances that indicate that goodwill may be impaired include a significant adverse change in the business climate or market, a legal issue,

impair-an action by regulators, unimpair-anticipated competition, a loss of key personnel, impair-and a more-likely-than-not expectation arises that a reporting unit will be sold

A company reviews its purchased goodwill for impairment using a two-step

approach First, the company compares the fair value of the reporting unit with its book value (including goodwill) The fair value of a reporting unit is the amount at which the unit as a whole could be bought or sold in a current transaction between willing parties If the fair value of the reporting unit is greater than the book value, goodwill is not considered to be impaired and the second step is not necessary If the fair value of the reporting unit is less than its book value, the second step of the impairment test must be performed to measure the amount of the impairment loss, if any The second step is the recognition of an impairment loss for the amount by which the implied fair value of the goodwill is less than its carrying value To

determine the implied fair value of the goodwill, the company first allocates the fair value of the reporting unit to all the identifiable assets and liabilities of the unit as if the unit had been acquired and the fair value was the purchase price Then the implied fair value of the goodwill is the excess “purchase price” over the amounts assigned to the identifiable assets and liabilities The impairment loss is the difference between the carrying value of the goodwill and the lower implied fair value of the goodwill When the company records the impairment loss, it reduces the carrying value of the goodwill to the lower fair value

Q11-19 It is true that goodwill is different from other assets in its nature However, writing off

goodwill directly to stockholders' equity recognizes goodwill neither as an asset nor as

an expense Also, although there is some inconsistency between expensing internal and capitalizing external goodwill, the purchase of goodwill in an arm's-length

transaction does establish a valuation for this asset And if this valuation is known, it should be capitalized as is done with other assets

Q11-20 Negative goodwill is the excess of the book value of a company as a whole over the

fair value of its identifiable net assets The acquiring company allocates the negative amount proportionately to reduce the amounts assigned to the noncurrent assets acquired, except financial assets other than those accounted for by the equity method, assets to be sold, deferred tax assets, prepaid assets relating to pension and other postretirement benefits, and any other current assets Any excess that remains after reducing those assets to zero is reported as an extraordinary gain

Q11-21 The eight steps involved in estimating the value of goodwill are as follows:

1 Estimate average future annual earnings from identifiable net assets

2 Estimate the rate of return that should be earned on identifiable net assets

3 Estimate current fair value of identifiable net assets

4 Compute estimated excess annual earnings

5 Estimate expected life of excess annual earnings

6 Compute present value of excess annual earnings

7 Compute total value of acquired company

8 Apply sensitivity analysis

Q11-22 Average future expected annual earnings are estimates of the annual earnings

projected for a company averaged over a number of future years

Normal rate of return is the rate of return that should be earned by the company taking into account the riskiness of the investment and other alternatives

Excess annual earnings are the difference between the estimated average future annual earnings and the normal rate of return on the fair value of the identifiable net assets

The expected life of excess annual earnings is the period of time that the higher than normal rate of return can be expected to continue due to the goodwill existing at the time of purchase

The current fair value of identifiable net assets is the book value of identifiable net assets increased or decreased by any differences between book value and fair value of each asset or liability

ANSWERS TO CASES

C11-1 (AICPA adapted solution)

The legal costs in defending the validity of the patent and those costs incurred in the successful outcome of the infringement suit are properly capitalized according to sound accounting logic, as indicated in the detailed Patent account in the case However, the cost of litigation in successfully defending a patent case is required, in conforming to the income tax regulations, to be charged to expense in the tax year in which it is incurred As

an auditor, you should inform your client as to the income tax requirements, which also provide that damages received from such litigation are included in gross income

Correspondingly, costs of litigation are deductible as expenses

The cost of improvements, unpatented, have not extended the legal life of the patent, and are in the form of "repairs" to reduce the possibility of supersession by a better device There is no certainty that the improvement will affect the productive life of the patent, and

if so, the improvements should be patented Only expenditures necessary to protect the patent rights are elements of cost, which would include experimental, research and development, labor, materials, and overhead; government and attorney fees; models; etc The company has failed to amortize any portion of the patent The shorter useful life period should be the period of amortization Factors such as obsolescence, supersession, change in demand, and inadequacy should all be considered in determining the amount

of amortization to be taken The auditor should confer with the corporation officers

concerning this matter The amortization may be divided into charges to retained

earnings for the portion applicable to prior years, and to current income for the current portion

C11-2 (AICPA adapted solution)

1 The costs of research equipment used exclusively for Trouver would be reported as

research and development expenses in the period incurred

The costs of research equipment used on both Trouver and future research projects would be capitalized and shown as equipment (less accumulated depreciation) on the balance sheet An appropriate method of depreciation should be used

Depreciation on capitalized research equipment should be reported as a research and development expense

2 a Matching refers to the process of expense recognition by associating costs with

revenues on a cause and effect basis

b Research and development costs are expensed in the period incurred and may not

be matched with revenues This accounting treatment is justified by the high degree

of uncertainty regarding the amount and timing of future benefits A direct

relationship between research and development costs and future revenues generally cannot be demonstrated

3 Corporate headquarters' costs allocated to research and development would be

classified as general and administrative expenses in the period incurred, because they are not clearly related to research and development activities

4 On Clonal's statement of cash flows, the legal expenses incurred in defending the

patent should be reported under investing activities in the period paid

C11-3 (AICPA adapted solution)

1 Research, as defined in FASB Statement No 2, is "planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service or a new process or technique or in bringing about a significant improvement to an existing product or process."

Development, as defined in FASB Statement No 2 is "the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use."

2 The current accounting and reporting practices for R&D costs were promulgated by the FASB in order to reduce the number of alternatives that previously existed and to provide useful financial information about R&D costs The FASB considered four alternative

methods of accounting: (a) charge all costs to expense when incurred; (b) capitalize all costs when incurred; (c) selective capitalization; and (d) accumulate all costs in a special category until the existence of future benefits can be determined The FASB concluded that all R&D costs should be expensed as incurred (FASB Statement No 2 does not apply

to activities that are unique to enterprises in the extractive industries, and accounting for the costs of R&D activities conducted for others under a contractual arrangement is a part

of accounting for contracts in general and is beyond the scope of that statement.)

C11-3 (continued)

2 (continued)

In reaching this decision, the FASB considered the three pervasive principles of expense recognition: (a) associating cause and effect; (b) systematic and rational allocation; and (c) immediate recognition The FASB found little or no evidence of a direct causal

relationship between current R&D expenditures and subsequent future benefits The high degree of uncertainty surrounding future benefits, if any, of individual R&D projects makes

it doubtful that there is any useful purpose to be served by capitalizing the costs and allocating them over future periods In view of the above, the FASB concluded that the first two principles of expense recognition do not apply, but rather that the "immediate recognition" principle of expense recognition should apply

The high degree of uncertainty about whether R&D expenditures will provide any future benefits, the lack of objectivity in setting criteria, and the lack of usefulness of the resulting information led the FASB to reject the alternatives of capitalization, selective capitalization, and accumulation of costs in a special category

3 In accordance with FASB Statement No 2, the following costs attributable only to research and development are expensed as incurred:

Design and engineering studies

Prototype manufacturing costs

Administrative costs related solely to research and development

The cost of equipment produced solely for development of the

product ($200,000)

The remaining $300,000 of equipment is capitalized and shown on the statement of

financial position at cost The depreciation expense resulting from the current year is a part of research and development expense for the year The market research direct costs and related administrative expenses are not R&D costs These costs are treated as period costs and are shown as expense items in the current earnings statement

C11-4 (AICPA adapted solution)

1 In a purchase transaction, assets are recorded at their acquisition price, which becomes the cost basis to the acquiring corporation The book values of the assets for Felzar

Company are irrelevant

2 When a price is paid for a group of assets, the total price must be allocated to the

individual assets Because we know neither the total fair value of the tangible and other intangible assets acquired from Felzar Company nor the price to be paid by the Rothman Corporation, we cannot determine whether Rothman Corporation has any goodwill to record The total price to be paid by the Rothman Corporation is indefinite but it may be estimated by discounting the expected receipts (1% of net sales) at the end of each of the next 5 years and adding the initial $450,000 cash payment If the estimated purchase price exceeds the sum of the estimated fair values of the tangible and other assets

purchased, then the excess may be recorded as goodwill

C11-5 (AICPA adapted solution)

1 Goodwill represents the expectation of extraordinary financial performance in the future Justification for expecting superior future performance depends on the degree of certainty that the causes (for example, customers' preferences or established business locations) of superior performance in the past will operate in the future If there is justification for

expecting superior future performance, goodwill may be expressed as the present value of the future earnings in excess of that amount which is considered normal; or the excess of the current value of an entire business over the sum of the current fair values of the

individual assets; or the excess of the valuation of a group of assets working together over the sum of the valuations of the assets if acquired separately

2 The value of goodwill, after prior-year profits are adjusted for this purpose, may be

be used in the future operations

3 The book and fair values of the goodwill of Elson Corporation differ because of changes in conditions since the date of acquisition (2000) Because one cannot be certain that the conditions out of which goodwill arises will continue to exist in the future, goodwill normally

is recognized in the accounts only when it is "purchased" by an independent party Since the date of acquisition, conditions have improved and along with them, the fair value (but not the book value) of goodwill For example, sales volume has increased, and the market demand is generally more favorable The interest of investors also may have increased with the growth rate in sales by Elson Corporation Inflation, too, may have had some effect on the fair value of goodwill, but its effects should be eliminated since general changes in the price level represent only a change in the value of the monetary unit

4 (a) Increasing the stated value of goodwill on the balance sheet prior to negotiations

would represent a departure from accepted practice, an unjustified departure in this situation since the value of goodwill cannot be measured reliably until after an

agreement is reached on the selling price The evidence to support such a

departure would not be conclusive enough to prevent a subjective measurement The lack of conclusive evidence is the result of uncertainty about (risk in) the future, particularly with reference to the amount of potential earnings and their worth at the present time Disclosing an estimate of the fair value of goodwill in a note to the financial statements would not circumvent this objection since the auditor's report applies to the notes as an integral part of management's financial statements Of course, management could and should present its estimate of the fair value of

goodwill separate from the financial statements on which it desires an unqualified opinion

C11-5 (continued)

4 (continued)

(b) Goodwill is purchased in recognition of an advantage created by the prior owner of the business Whether a new owner can maintain that advantage is problematical The advantage created by the prior owner may last for only a few years after the purchase After the purchase, therefore, goodwill may become impaired

In the case of the Elson Corporation the facts indicate that the goodwill not only has been maintained but also has been increased To write off goodwill altogether when there is no indication of loss in its value would be illogical and contrary to the basic nature of the intangible (an indefinite life) Although the book value of goodwill on the balance sheet is smaller than the current fair value of goodwill, the negotiators should be aware that the book value of goodwill represents goodwill purchased in a previous transaction and not goodwill subsequent to that date

C11-6

1 Patents and computer software would typically be amortized They would be amortized based on the expected pattern of benefits the intangible asset will produce, except that if the pattern cannot be reliably determined, the straight-line method is used Copyrights and tradenames would typically not be amortized They are not amortized because they are considered to have indefinite lives Goodwill is never amortized

2 Any intangible that is not amortized must be reviewed for impairment annually Therefore, copyrights and tradenames (if they are not amortized), and goodwill must be reviewed for impairment at least annually

C11-7 (AICPA adapted solution)

1 Accounting for the penalty as a charge to the current period is justified if the penalty is considered the result of an unusual event (the assessment) occurring within the period The penalty is an extraordinary item rather than a part of income before extraordinary items; it is unusual and of a nonrecurring nature Installation of the air pollution control equipment should prevent the assessment of further penalties This is probably the most preferable treatment of the three under consideration

2 Accounting for the penalty as a correction of prior periods is justified if the penalty is

considered a result of the business activities of prior periods, rather than a result of an event

of the current period The penalty is assessed to correct damage that occurred as a result

of production of prior periods and thus represents a cost of production that was omitted from the reported results of those prior periods Further justification is provided by the fact that determination of the amount of the penalty was presumably made by someone other than management (the Pollution Control Agency) and could not be reasonably estimated before determination

A prior period adjustment should be reported as an adjustment of the current year's

beginning balance of retained earnings, as previously reported If statements of prior periods are presented, they should be restated to include in income before extraordinary items the portion of the penalty allocable to each period, with appropriate adjustments to other items affected, such as retained earnings, liabilities, and earnings per share

expense will recur from period to period, it should be included in income before

extraordinary items Amortization should be computed in a rational and systematic

manner

C11-8 (AICPA adapted solution)

1 A dollar to be received in the future is worth less than a dollar received today because of

an interest or discount factor often referred to as the time value of money The

discounted value of the expected royalty receipts can be thought of either in terms of the present value of an annuity of 1 or in terms of the sum of several present values of 1

2 If the royalty receipts are expected to occur at regular intervals and the amounts are to be fairly constant, their discounted value can be calculated by multiplying the value of one such receipt by the present value of an annuity of 1 for the number of periods the receipts are expected On the other hand, if receipts are expected to be irregular in amount or if they are to occur at irregular intervals, each expected future receipt would have to be multiplied by the present value of 1 for the number of periods of delay expected In each case, some interest rate (discount factor) per period must be assumed and used As an example, if receipts of $10,000 are expected each 6 months over the next 10 years and an 8% annual interest rate is selected, the present value of the 20 $10,000 payments is equal to

$10,000 times the present value of an annuity of 1 for 20 periods at 4% Twice as many periods as years and half the annual interest rate of 8% are used because the payments are expected at semiannual intervals Thus, the discounted (present) value of these

receipts is $135,903 ($10,000 x 13.590326) Because of the interest rate, this discounted value is considerably less than the total expected collections of $200,000 Continuing the example, if instead it is expected that $10,000 will be received 6 months hence, $20,000 one year from now, and a terminal payment of $15,000 is expected 18 months hence, the calculation is as below:

$10,000 x present value of 1 at 4% for 1 period = $10,000 x 0.961538

$20,000 x present value of 1 at 4% for 2 periods = $20,000 x 0.924556

$15,000 x present value of 1 at 4% for 3 periods = $15,000 x 0.888996

Adding the results of these three calculations yields a total of $41,441 (rounded),

considerably less than the $45,000 total collections, again due to the discount factor

3 The basis of valuation for the patents that is generally accepted in accounting is cost Evidently the cartons were developed and the patents obtained directly by the client corporation Therefore, their cost would include applicable experimental and

developmental costs, government and legal fees, and the costs of any models and

drawings The proper initial valuation would be the sum of these costs plus any other costs incident to obtaining the two patents This is in accord with the accounting principle that the initial valuation of any asset generally includes virtually all costs necessary to acquire and make it ready for normal use Such values are reliably determined and rest upon actual completed transactions rather than upon estimates and future expectations

C11-8 (continued)

4 Intangible assets represent rights to future benefits The ideal measure of the value of intangible assets is the discounted present value of their future benefits For the Sprauge Corporation, this would include the discounted value of expected net receipts from

royalties as suggested by the financial vice-president as well as the discounted value of the expected net receipts to be derived from the Sprauge Corporation's production Other valuation bases that have been suggested are current cash equivalent or fair market value

5 The amortization policy is implied in the definition of intangible assets as rights to future benefits As the benefits are received by the firm, the cost or other value should be

charged to expense or to inventory to provide a proper matching of revenues and

expenses Under the discounted-value approach, the periodic amortization would be the decline during the year in the present value of expected net receipts

6 The litigation can, and probably should, be mentioned in the notes to the financial

statements Some indication of the expectations of legal counsel in respect to the

outcome can properly accompany the statements It would be inappropriate to record a contingent asset reflecting the expected damages to be recovered Costs incurred by September 30, 2004 in connection with the litigation should be carried forward and

expensed (or to loss if the cases are lost) as royalties (or damages) are collected from the parties against whom the litigation has been instituted; however, the conventional

treatment would be to charge these costs as ordinary legal expenses If the final outcome

of the litigation is successful, the costs of prosecuting it should be capitalized Similarly, if the client were the successful defendant in an infringement suit on these patents, the generally accepted accounting practice would be to add the costs of the legal defense

to the Patents account

Developments to the time that the statements are prepared and released can be

reflected in the notes to the statements as a post-balance-sheet (or subsequent-event) disclosure

C11-9 (AICPA adapted solution)

Interest on mortgage bonds: An amount equal to the interest cost incurred in 2004

($60,000) is clearly a cost that can be associated with the normal construction period and can be regarded as a normal element of the capitalized cost of the physical assets of the shopping center because the construction period would have ended at the end of the year if the tornado had not occurred The decision to use debt capital to finance the shopping center was made with full knowledge that interest would accrue during the construction period and add to the total cost of building the center and bringing it to the point at which it would produce revenue The future income to be generated by the shopping center must have been estimated to be more than sufficient to recover all of the expected costs of building the center and preparing it for occupancy, including interest during the construction period

C11-9 (continued)

Instead of treating interest during construction as an element of the cost of the physical assets, it can be argued that it represents an element of the general cost of bringing the business to the point of revenue production and should therefore be treated as an

organization cost This view regards interest during construction as just another of the many expenditures that are necessary to acquire and organize the physical assets of a new business but do not attach to any specific assets Treated as an organization cost, interest during construction would be expensed as a start-up cost

Another alternative to capitalizing an amount equal to the 2004 interest cost is to treat it as interest expense This treatment is inappropriate because it assumes that the decision to use debt capital to finance construction is a decision deliberately to incur an expense for the interest that accrues during the expected construction period

The extension of the construction period to October 2005 because of the tornado was externally imposed and so the interest capitalization period continues until final

construction is complete That is, the additional interest cost is capitalized and not

expensed as a loss from the tornado

Cost of obtaining tenants: Both the 2004 and 2005 costs of obtaining tenants should be capitalized and amortized over the life of the leases The fact that all of the tenants who were signed when the tornado occurred accepted the October occupancy date

indicates that the total cost of obtaining tenants was not affected by the delay

The cost of obtaining tenants has a direct and easily identifiable relationship to the rental income to be earned over the terms of the leases Under these circumstances, the

problem of reliably measuring periodic net income is best solved by matching costs with the revenues to which they are directly related

Promotional advertising: The 2004 cost of promotional advertising should be written off as

a start-up cost The 2005 cost of promotional advertising should also be expensed

The initial expense treatment of the 2004 advertising cost is appropriate because it is a start-up cost and is expensed under AICPA SOP 98-5

The 2005 advertising cost may also be considered as a start-up cost or simply expensed as advertising cost incurred

measures of performance such as return on assets are overstated There is also a potential effect on income since such "assets" would have to be amortized However, amounts spent on enhancing the value of these "assets" in the current period are expensed under GAAP and so there might not be any material impact on income compared to

capitalization and amortization

C11-10 (continued)

Accumulated Amortization: Trademarks and

C11-11

Note to Instructor: This case does not have a definitive answer From a financial reporting perspective, GAAP is identified and summarized From an ethical perspective, various issues are raised for discussion purposes

From a financial reporting perspective, the company's policies are within the constraints imposed by GAAP which require amortization of intangible assets with a finite (limited) life, assuming that management has made a meaningful evaluation of the life of each

intangible Also, the company has not stated that any intangibles with an indefinite life, or goodwill, are impaired So, assuming the company has tested for impairment each year, it followed GAAP The company’s disclosures, though vague, satisfy some of the

requirements of GAAP, assuming the company has disclosed the appropriate “line-items”

in the balance sheet and income statement However, the company has not disclosed the weighted-average amortization period

From an ethical perspective, an issue is whether the company's disclosures are adequate The primary stakeholders are the company's current and potential stockholders and

creditors The purpose of financial reporting is to provide useful information to users Do the minimum disclosures required by GAAP necessarily satisfy that purpose? The

appropriateness of 9 years for patents is difficult to evaluate without more knowledge of the particular patents The disclosure is lacking because it does not identify what the other intangibles are, and the identification of them as “patents” would be helpful Also, when a range of lives is given, many users may tend to assume that the average life is the average

of the range of lives provided (i.e., 10 years) Accounting principles allow for judgment on the selection of useful lives and expect that professional judgment be exercised On the other hand, if the net income amount is not grounded in economic reality, current and potential shareholders may be misled about the value of an investment in the company

C11-11 (continued)

The non-amortization of goodwill in high-tech environments is particularly controversial because some users may believe that such goodwill has a limited life due to changes in technology, and therefore would prefer that the goodwill be systematically amortized However, the user has to trust that management, and the auditor, has made sure that the goodwill is not impaired

ANSWERS TO MULTIPLE CHOICE

SOLUTIONS TO EXERCISES

E11-1

1 The legal and patent application costs of $12,000 should be capitalized Also, the costs of a successful defense of patent infringement should be capitalized Research and development costs are expensed Total costs capitalized:

$32,000

2 The legal life of 20 years from the date of filing is the maximum useful life that could be used However, in order to estimate the economic life of the patents, such factors as competition, changes in technology, and changes in demand would have to be considered

E11-2

2004

Note: The patent is not amortized over 15 years because its remaining legal life is 12 (20-8) years

2005

11 years remaining

The company expenses start-up costs of $20,000 ($3,000 + $12,000 + $5,000) in

2004 The company expenses $600 ($6,000 10 years) of leasehold

E11-6 (AICPA adapted solution)

Each category of costs is included in research and development costs in FASB Statement No 2 Therefore, the total of $250,000 is expensed in the year in which the costs are incurred 2004

E11-8

1 Research and development indirect cost clearly related to R&D projects

2 Not research and development advertising cost

3 Research and development a direct R&D cost

4 Research and development administrative cost that can be clearly identified with R&D

5 Not research and development but part of the salary could be allocated to R&D if the _ estimate was considered reliable

6 Research and development (for those items in (4) and (5) classified as

R&D) related cost of personnel engaged in R&D activities

E11-9

Amortization expense: Patent = $20,000 10 years = $2,000

Amortization expense: Computer software = $10,000 x (60 120) = $5,000*

*The company uses the “units-of-production method” because it best

measures the pattern of benefits that will result as the software is phased out over 3 years

The copyright and tradename are not amortized because they have indefinite lives

Goodwill is never amortized

E11-11

indicating the goodwill is impaired

$720,000 fair value of subsidiary - $660,000 allocated to identifiable assets and liabilities = $60,000 implied fair value of goodwill

$60,000 implied fair value - $100,000 carrying value = $(40,000) impairment loss Note to Instructor: The book value of the subsidiary’s identifiable net assets is

$800,000 ($900,000 - $100,000 goodwill) Since the fair value of the identifiable net assets is $660,000 the company would recognize additional impairment losses on the relevant assets of $140,000 ($660,000 - $800,000)

Revaluation of property, plant,

Less profit sharing based on normal earnings

E11-14

1 Estimated average future annual earnings

Average earnings - $14,000 for 5 years

Add extraordinary loss 10,000

5

Normal annual earnings 12% x ($120,000 - $35,000) = $10,200

Excess annual earnings = ($13,000 - $10,200)

E11-15 (continued)

2 The Hayes Company would appear to have the more reasonable approach Using a 14% capitalization rate is more conservative, as is recognizing a limited life for the goodwill The Ryan Company applies the normal rate of return to the fair value of the net assets which is more reasonable if there is a significant difference between fair value and book value However, Ryan's contention that the excess earnings will last forever is not reasonable

E11-16 (AICPA adapted solution)

*Factor from Table 4 of Appendix D

E11-18

Goodwill valuation = Excess annual earnings capitalized at 20% in perpetuity

$25,000 = Excess annual earnings 0.20

Excess annual

earnings = $5,000

Estimated annual future earnings = Normal annual earnings