Session 22

Intangible Assets
• R&D
• Goodwill
– Impairment
• Other Intangibles
• Customer Satisfaction
 R&D
Asset or Expense?
• Expense it all
• Expense up to a certain point in the development
• Capitalize it all and write off the amounts
associated with projects deemed unsuccessful
• Capitalize it all
– Are the costs of “failed projects” part of the cost of
the identifying the “good projects”
– Oil and Gas – Full cost vs Successful Efforts
• Mark it to Market
 R&D – SFAS #2 - (1974)
Rationale for Expensing
• There is normally a high degree of uncertainty about the
future benefits of individual research and development
projects
– The element of uncertainty may diminish as a project progresses.

• Even after a project has passed beyond the research and

development stage, and a new or improved product or
process is being marketed or used, the failure rate is high.
• A direct relationship between research and development
costs and specific future revenue generally has not been
demonstrated, even with the benefit of hindsight.
– For example, three empirical research studies, which focus on companies in
industries intensively involved in research and development activities,
generally failed to find a significant correlation between research and
development expenditures and increased future benefits as measured by
subsequent sales, earnings, or share of industry sales.
 R&D – SFAS #2 - (1974)
• Equipment or facilities that are acquired or constructed for
research and development activities and that have
alternative future uses (in research and development projects
or otherwise) shall be capitalized as tangible assets when
acquired or constructed.
• The cost of such materials consumed in research and
development activities and the depreciation of such
equipment or facilities used in those activities are research
and development costs

• Disclosure shall be made in the financial statements of the

total research and development costs charged to expense in
each period for which an income statement is presented.
 Computer Software Development –
SFAS 86 – (1985)
• Costs incurred internally in creating a computer software
product shall be charged to expense when incurred as
research and development until technological feasibility
has been established for the product.
• Technological feasibility is established upon completion of
a detail program design or, in its absence, completion of a
working model.
• Thereafter, all software production costs shall be
capitalized and subsequently reported at the lower of
unamortized cost or net realizable value.
• Capitalized costs are amortized based on current and
future revenue for each product with an annual minimum
equal to the straight-line amortization over the remaining
estimated economic life of the product.
 Software to be used Internally

• Capitalize once the “application development”

stage has been reached
• This is much earlier than “technological
feasibility”
Do R&D Expenditures improve your ability to
predict future profits?
• Lagged regression of Operating Income on on Prior R&D
expenditures (all scaled by sales)

OpIncome t TotAssets t 1 R & D Invest t k

  0  1    2,k
Sales t Sales t 1 k Sales t k

– For virtually industries, the relationship is significant and the R 2 is high

(.60 to .89)
• We Can use this to construct an amortization schedule for R&D
– The lag structure varies significantly by industry (e.g. it’s much shorter in
computers and electronics than it is in Chemicals and Pharmaceuticals
 Is the “Constructed" R&D Asset Priced?
Price = a + b Reported + c Adjustment + d Adjustment
Earnings To Earnings to Balance Sheet
for R&D for R&D

Coeffient 6.3 8.8

T-statistic 16.2 8.3
Adjusted R2 = .46

Coefficient 4.7 2.4 2.1

T-statistic 16.9 2.5 11.7
Adjusted R2 = .55
 In Process R&D

• In many High Tech acquisitions that are accounted for as a

purchase, a substantial portion of the acquisition price
(relative to book value) is assigned to the value of R&D
projects that are “in process”
• Because it is R&D, it is expensed immediately.
– However, it is often highlighted as a “non-recurring
item.”
– Moreover, companies often emphasize in their MD&A
“pro-forma” results with this charge removed
 In Process R&D - continued

• With most of the acquisition premium off the books, the

purchase method is similar to the pooling of interests
numbers in the years subsequent to the acquisition
 In Process R&D Disclosures

• See Sun Microsystems

 In Process R&D
FASB Exposure Draft

• Acquired IPR&D shall be measured at their fair

value and recognized as an intangible asset
• The intangible asset should be considered
indefinite-lived until the completion or
abandonment of the associated research and
development efforts
• at which point the acquiring entity would
make a separate determination of the useful
life of that asset.
 Where Does Goodwill Come From?
Acquisitions and The Purchase Method

• Recognize individual assets and liabilities acquired at their

fair market value
• Intangible assets acquired shall be recognized as an asset
apart from goodwill if that asset arises from
– contractual or other legal rights
– or if it can be separated from the acquiring entity and
sold, transferred, licensed, rented, etc.

• Goodwill will be recognized as the excess of the cost of

the entity over the net of the amounts assigned to assets
acquired and liabilities assumed
 Effective Date
• No pooling for combinations initiated after June 30, 2001
• New goodwill amortization rules begin for fiscal years
beginning after December 15, 2001 (earlier adoption is
allowed)
• Retro-active application is not permitted
• Previously recognized goodwill should be accounted for in
accordance with the new rules
– stop future amortization (and conduct
impairment tests)
– But you can’t undo the previously recognized
amortization
 Impairment Test for Goodwill

• Goodwill should be tested for impairment annually at the

reporting unit level (at or one step below an operating
segment)
• Two step Process
– Compare the fair value of the reporting unit to its
carrying value (including its goodwill)
– If Fair Value < Carrying Value, then compare the
carrying amount of the goodwill to the implied fair
value of the goodwill
• Write off any excess of carrying value above implied fair value
of the goodwill
 Disclosure of Impairment of Goodwill

• A separate line in the operating section of the income

statement
• Once an impairment loss is recognized, it cannot be restored
in future years
• Conduct an impairment view more frequently than annually if
“significant adverse events” occur

• See Sun Microsystem’s Disclosures

 Disposals and Discontinuations

• If a reporting unit is disposed of, include its goodwill in

the cost of the disposal
• If a reporting unit is partially disposed of, write-down a
proportion of that reporting unit’s goodwill in proportion to
the fair value of the assets retained versus disposed of
 Amortization of Intangibles
Other Than Goodwill
• Intangible assets with Finite Lives
– amortized the asset over its life (use your best guess as to
what the life will be)
– also review it for impairment
• Intangible assets with Indefinite Lives (a trademark is
renewable every 10 years)
– do not amortize until its life is determined to be finite
– Review it (at least annually) for impairment
 INTANGIBLE ASSETS :
Brand Names
• How Big Are They?

• Do They Appear to Be Priced?

• How are they Estimated?

– Interbrand method
 Regression of Market Value of Equity
(MVE)
Variable Coefficient T-stat

Book Value (BVE) 0.64 8.84

Net Op Income 5.23 12.78
Brand Value* 0.29 5.57
R2 = 0.56
How do you interpret the lower coefficient on Brand
Value compared to “regular” Book Value?
* Brand Values from Interbrand survey reported in Financial World
 What variables determine Brand Value?

Regress Brand Value from Interbrand on more

fundamental factors
Variable CoefficientT-stat

Advertising Expense 1.70 6.40

Brand margin 3.58 17.34
Firm Sales Growth -2.03 -0.47
Brand Market Share 0.06 2.89
R2 = 0.58
Note: the negative coefficient on sales growth was unexpected
 Customer Satisfaction
• Is It Related to Customer Retention?

• Is It Related to Future Revenue?

• Does It Appear to Be Priced?

• What Could (Should) Companies Disclose

about Customer Satisfaction?
 Is Customer Satisfaction
Valued By the Market?
Market Book Book Customer
Value = a + b1 Value + b2 Value + b3 Satisfaction
Equity Assets Liabilities Index

Coefficient 2.19 -2.25 235.67

t-statistic 18.22 -17.13 2.39
Adjusted R2 = .77
 Pressure to Begin Putting Non-Financial
Measures into Financial Statements
• How will these be “standardized” so they are
comparable across firms, yet still meaningful?