ILLUSTRATION 12-1 TYPES OF INTANGIBLE ASSETS INTANGIBLE ASSETS Identifiable Intangible Assets (Rights Type) Externally Acquired Internally Developed Financial Statement Treatment Unidentifiable Intangible Assets (Goodwill Type) Externally Internally Acquired Developed Patent Rights Legal Costs Copyrights Legal Costs Trademarks & Trade Names Legal Costs Amortize over 17 years or less Amortize over 40 years or less Expense Goodwill Franchises & Licenses (Usually much less, except for Goodwill) Organization Costs Legal Costs Research & Development Expense as Incurred 90
ILLUSTRATION 12-1 (continued) NON-"OWNED" ASSETS Identifiable Non-"Owned" Assets (Property-Rights Type) Financial Statement Treatment Internally Developed Externally Acquired Lease Prepayments Classify as a Prepaid Expense Recognize as Rent Expense over Time Capital Leases (Installment Purchases) Classify as Property, Plant, and Equipment Depreciate over the Useful Life of the Leased Asset Lease-hold Improvements Classify as Property, Plant, and Equipment Depreciate over the Useful Life of the Improvement or of the Underlying Asset, if Less Note: "Internally Developed" and "Externally Acquired" columns are reversed from Illustration 12-1. 91
ILLUSTRATION 12-2 RECORDING GOODWILL: THE MASTER VALUATION APPROACH EXAMPLE Global Corporation purchased the net assets of Local Company for $300,000 on December 31, 1997. The balance sheet of Local Company just prior to acquisition is listed below along with an appraisal of the fair values of its identifiable net assets. FINANCIAL POSITION AND FAIR VALUES ASSETS Local Company BALANCE SHEET December 31, 1997 Fair Values Increase (Decrease) Cash $15,000 $15,000 0 Receivables 10,000 10,000 0 Inventories (LIFO) 50,000 70,000 $20,000 Prop., plant & equip. 80,000 130,000 50,000 Total assets $155,000 $225,000 EQUITIES $130,000 $200,000 Net Assets Current liabilities $25,000 $25,000 0 Capital stock 100,000 Retained earnings 30,000 Total equities $155,000 92
ILLUSTRATION 12-2 (continued) ANALYSIS PURCHASE PRICE (COST) $300,000 FAIR VALUE OF IDENTIFIABLE NET ASSETS $200,000 BOOK VALUE OF IDENTIFIABLE NET ASSETS $130,000 $100,000 Goodwill $70,000 Revaluations ACQUISITION JOURNAL ENTRY Cash. 15,000 Receivables. 10,000 Inventories 70,000 Property, Plant, & Equipment 130,000 Goodwill. 100,000 Current Liabilities. 25,000 Cash 300,000 93
ILLUSTRATION 12-3 DETERMINATION OF GOODWILL AND PURCHASE PRICE Step 1: Step 2: Determine adjusted average net earnings of the firm. Adjust for accounting changes, extraordinary items, and other such special items. Determine normal earnings. Multiply the industry average rate of return times the fair value of the identifiable net assets of the firm. Step 3: Determine excess earnings. This is the average earnings from Step 1 less the normal earnings from Step 2. Step 4: Step 5: Value goodwill. This can be done by using an appropriate discount rate and choosing the number of periods for which the excess earnings will be maintained. It could be treated as a perpetuity. Alternatively, the number of years method could be used. Determine purchase price. This will be the sum of the value of goodwill and the fair value of identifiable net assets of the firm. Apply the 5 steps above to numerical example given in Illustration 12-2. Emphasize to the students that the Global Corporation would employ an analysis similar to the 5 steps below in order to arrive at an approximate purchase price to be used in the negotiations for the acquisition of Local Company. Step 1: Determine average net earnings of Local Company. Historical earnings: 1993 $21,000 1994 30,000 1995 19,000 1996 55,000 1997 50,000 Total earnings (5 years) $175,000 $175,000 5 years = $35,000 Average Net Earnings Step 2: Determine normal earnings. Normal average earnings rate for industry = 10% (Obtained from industry sources) Industry Average Rate of Return Fair Value of identifiable Net Assets 10% $200,000 = $20,000 Normal Earnings 94
ILLUSTRATION 12-3 (continued) Step 3: Determine excess earnings. Average net earnings from Step 1 less normal earnings from Step 2. $35,000 $20,000 = $15,000 Excess Earnings Step 4: Value goodwill. Appropriate discount rate in perpetuity for global Corporation = 15% Divide excess earnings by discount rate. $15,000.15 = $100,000 Value for Goodwill Step 5: Determine purchase price. The sum of value for goodwill plus the fair value of identifiable net assets. $100,000 + $200,000 = $300,000 Purchase Price 95