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Course: ACC/291 Principles of Accounting II

Textbook: Financial Accounting: Tools For Business Decision Making

Chapter 9 Reporting And Analyzing Long-Lived Assets

Reference:Kimmel, P.D., Weygandt, J.J., & Kieso, D.E. (2013). Financial accounting: Tools for business decision making (7th ed). Hoboken, NJ: John Wiley & Sons.

Week 1 Discussion Questions: Chapter 9Reporting And Analyzing Long-Lived Assets

Wk1 DQ #1: Assets

What are the main differences between accounting for plant assets and accounting for intangible assets? What are some of the issues / challenges related to accounting for intangible assets?

Wk1 DQ #2:Depreciation

Identify the main methods used to determine depreciation expense.Compare and contrast the methods and identify a situation / scenario where youthink each method would be most appropriate.

Course: ACC/291 Principles of Accounting II Textbook: Financial Accounting: Tools For Business Decision Making Chapter 9 Reporting And Analyzing Long-Lived Assets Reference: Kimmel, P.D., Weygandt, J.J., & Kieso, D.E. (2013). Financial accounting: Tools for business decision making (7th ed). Hoboken, NJ: John Wiley & Sons. ACCOUNTING 101 CHAPTER 8: LONG-TERM ASSETS Plant assets Plant assets, also known as fixed assets or property, plant and equipment, have three defining characteristics. They are 1. Tangible 2. Used in business operations, and 3. Have useful lives greater than one year. In Chapter 8, we will study the lifecycle of a plant asset. The lifecycle of a plant asset can be summarized as follows: 1. The purchase of a plant asset and determining its cost 2. The allocation of the plant asset's cost to the periods benefitted (depreciation) 3. Accounting for repairs and improvements to the plant asset 4. Accounting for the disposal of the plant asset. Determining the cost of a plant asset Plant assets are recorded at cost. This is consistent with the cost principle. Costs include not only the purchase price, but all costs necessary to get the plant asset ready for its intended use. The following summarizes many of the expenditures that are capitalized (added to the purchase price of the plant asset) to determine the cost of the plant asset. Plant asset Capitalized costs Land Purchase price; real estate commissions; title fees; legal fees; accrued property taxes paid by the buyer. Costs paid for surveying, grading, and removing existing structures are also capitalized. Costs for parking lot surfaces, driveways, fencing, plants and shrubs, and lighting systems. Purchase price; brokerage fees, taxes, title fees, attorney fees, and necessary renovations. Design or architectural fees are also capitalized. Purchase price, taxes, freight, and installation and testing the equipment. In a lump sum purchase, various assets are Land improvements Buildings Machinery and Equipment Lump-Sum Purchase 1 purchased for a single price. Costs are allocated to each asset based on relative market values. Any costs paid to repair assets damaged during installation are recorded as expense. Depreciation Methods The factors that determine depreciation are cost, salvage value and useful life. The three most widely used methods that are acceptable under generally accepted accounting principles are (1) the straight-line method, (2) the units- of- production method, and (3) the declining-balance method. They are described below. Straight-Line Method Units-of-Production Method The same amount of depreciation expense is charged each full year the asset is used. A different amount of depreciation is recorded depending on the plant asset's usage. This method is called an accelerated method as it results in more depreciation expense in the early years of a plant asset's life and less depreciation in the latter years of its life. The formula for straight-line depreciation is: A two-step process is needed to compute depreciation: A three-step process is needed to compute depreciation: (Cost-Savage Value) divided by useful life in periods. (1) Calculate depreciation per unit: (Cost-Salvage Value) divided by total units of production. (2) Multiply depreciation per unit by the number of units produced. Declining-Balance Method (1) Calculate the straightline rate (percentage) (2) Double the straightline rate (percentage) (3) Multiply the rate (percentage) determined in step 2 by the asset's book value. The book value is its cost less accumulated depreciation. Salvage value is not considered. However, depreciation stops once the book value equals the salvage value. 2 Example: On January 1, Horizon Corporation installs a machine costing $67,000. The machine has an estimated useful life of ten years, or 420,000 units of product, and a $4,000 salvage value. During the year, the machine produced 29,900 units of product. Depreciation for the year ended December 31using each of these methods would be calculated as follows. Straight-line: ($67,000 - $4,000) / 10 = $6,300 Units of Production: (1) Depreciation per unit = ($67,000 - $4,000)/420,000 units = $.15 (2) Depreciation expense = $.15 * 29,900 units produced = $4,485 Double-Declining Balance: (1) Straight-line rate = 1/10 years = 10% (2) Declining balance rate = 10% * 2 = 20% (3) Depreciation expense = 20% * Book Value = 20% * ($67,000 - $0 accumulated depreciation) = 20% * $67,000 = $13,400 Depreciation is recorded with a debit to Depreciation Expense and a credit to a contra-asset account called Accumulated Depreciation. If management changes its estimated useful life or estimated salvage value of a plant asset, the change is accounted for as a change in accounting estimate. Depreciation in the years following the change in estimate would be calculated as follows: Book value in year of change in estimate - revised salvage value / Revised remaining life Additional expenditures The accounting for costs to maintain, repair, or improve plant and equipment is summarized below. Ordinary repairs and maintenance, sometimes called revenue expenditures, are recorded as expense. Improvements (betterments) are expenditures to make a plant asset more efficient or productive. They are capitalized (added to the cost of the plant asset). Extraordinary repairs extend the asset's life beyond its original estimated useful life. Their costs are capitalized or charged to accumulated depreciation. 3 Disposals of plant assets A plant asset may be disposed of in three ways: 1. Discarded, with no cash received 2. Sold for cash 3. Traded in In ACCT 101 we will review the accounting for assets discarded or sold for cash. Accounting for assets traded in will not be covered. The accounting for plant asset disposals requires two journal entries: One to bring depreciation up to date and (2) a second journal entry to record the disposal. Upon disposal, the plant asset's cost and related accumulated depreciation should be removed from the books. Any cash received is recorded. If the cash received is greater than the book value of the asset disposed, the company will record a gain. If the cash received is less than the book value of the asset disposed, the company will record a loss. These gains or losses are reported as \"Other Income \"or \"Other Expense,\" respectively, in the income statement. Example: A company owns equipment that cost $8,000, and that had accumulated depreciation of $6,000 as of January 1. This equipment is depreciated at a rate of $1,000 annually. On July 1, it is sold for $3,500 cash. After depreciation is updated, the equipment has a book value of $1,500 (cost of $8,000 less accumulated depreciation of $6,500). The company would record a gain of $2,000 (cash received of $3,500 less book value of $1,500). The necessary journal entries to bring depreciation up to date and to record the sale would be: July 1 Depreciation Expense 500 Accumulated Depreciation 500 (1/2 year * $1,000 annual depreciation) July 1 Cash 3,500 Accumulated Depreciation ($6,000 + $500) 6,500 Equipment (cost) 8,000 Gain on Disposal of Equipment 2,000 4 Natural Resources Assets that are physically consumed when used are called natural resources. They include timber, mineral deposits such as copper, and oil and gas. All costs necessary to acquire the natural resource asset, and prepare it for its intended use, are capitalized. Once activity begins, the natural resource asset is depleted on the books. Depletion is similar to depreciation for fixed assets. Natural resource assets are depleted using the units-of- production method discussed earlier. The journal entry to record depletion debits Depletion Expense and credits Accumulated Depletion. Intangible Assets Intangible assets are nonphysical assets, used in operations, which provide rights, privileges, or competitive advantage to their owners. For example, a patent issued by the federal government gives the patent holder an exclusive right to sell the product under patent. If the intangible asset has a limited life, it is amortized over that life. Amortization is similar to depreciation for fixed assets. Intangible assets are amortized using the straight-line method. The journal entry to record amortization debits Amortization Expense and credits Accumulated Amortization. The following intangible assets are amortized. Intangible asset Description Patent An exclusive right granted to the patent holder to sell a patented item. The maximum legal life of a patent is 20 years. Copyrights An exclusive right to publish and sell a musical, literary or artistic work. Franchises and Licenses Rights given by a company to deliver a product of service, under specified conditions. Examples include Pizza Hut and McDonald's. Most franchise agreements have limited lives. Leasehold improvements Improvements to leased property. 5 Some intangible assets do not have a limited life. For example, a trademark, such as the Nike \"swoosh,\" gives Nike the exclusive right to use the swoosh on its products and in its marketing. Although the trademark has a limited life, it is easily renewable and is not amortized. Another intangible that is not amortized is goodwill. Goodwill is recorded when one company purchases another company. Goodwill is calculated as the cost paid to purchase the company, less the acquired company's net asset values. For example, if Parent Company paid $1,000,000 to acquire Subsidiary Company's net assets of $900,000, the remaining $100,000 would be recorded as Goodwill on Parent Company's books. Goodwill is not amortized but is tested for impairment, a subject covered in Intermediate Accounting courses. 6 7126dc12_1-32 11/7/01 4:50 PM Page 1 RKAUL-1 RKAUL-1:Desktop Folder:PQ182-5986F_11-07: CHAPTER Intangible Assets T rying to Grasp the Intangible In 1494, a mathematically minded Venetian monk named Luca Pacioli published his Summa de Arithmetica, Geometrica, the first accounting textbook. It illustrated double-entry accounting, a system that makes the modern corporation manageable, even possible. Today, half a millennium later, Pacioli's process, still pretty much intact, is being challenged like never before. Pacioli's accounting system lets businesses keep track of changes in their assets. But this system deals primarily with tangible assets such as cash, inventory, investments, receivables, and property, plant, and equipment. What go unrecorded are intangible assets such as quality of management, customer loyalty, information infrastructure, trade secrets, patents, goodwill, research, and, considered by some the ultimate intangible, knowledgea company's intellectual capital. As present FASB chairman Edmund Jenkins attests, \"The components of cost in a product today are largely R & D, intellectual assets, and services. The old accounting system, which tells us the cost of material and labor, isn't applicable.\" Argues Professor James Quinn of Dartmouth College, \"Even in manufacturing, perhaps three-fourths of the value added derives from knowledge.''1 12 LEARNING OBJECTIVES After studying this chapter, you should be able to: Describe the characteristics of intangible assets. Identify the costs included in the initial valuation of intangible assets. Explain the procedure for amortizing intangible assets. Identify the types of intangible assets. Explain the conceptual issues related to goodwill. Describe the accounting procedures for recording goodwill. This refrain is echoed by the managing editor of Fortune magazine, Walter Kiechel, who says, \"To be sure, there are still industries in which the factory confers a competitive advantage. But this is changing fast, as more and more companies realize that their edge derives less from their machines, bricks, and mortar than from what we used to think of as the intangibles, like the brainpower resident in the corporation.\"2 Explain the accounting In this emerging economy of knowledge, even some banks have concluded that \"soft\" assets (like computer programming know-how and information infrastructure) can be a better credit risk than \"hard\" assets (like buildings). But how should the \"soft assets\" be valued? Accountants get little solace from former FASB chairman Donald Kirk, who acknowledges, \"There are arguments that balance sheets ignore certain intangibles, but the reporting issues of trying to recognize them are, in my mind, insurmountable.\"3 It appears that the assets that really count are the ones accountants can't countyet. Describe the accounting issues related to intangible asset impairments. Identify the conceptual issues related to research and development costs. procedures for research and development costs and for other similar costs. Indicate the presentation of intangible assets and related items. 1 Thomas Stewart, \"Your Company's Most Valuable Asset: Intellectual Capital,\" Fortune, October 3, 1994, p. 68. 2 \"Searching for Nonfiction in Financial Statements,\" Fortune, December 23, 1996, p. 38. 3 Ibid. 1 7126dc12_1-32 11/7/01 4:50 PM Page 2 RKAUL-1 RKAUL-1:Desktop Folder:PQ182-5986F_11-07: PREVIEW OF CHAPTER 12 As the opening story indicates, the accounting and reporting of intangibles is taking on increasing importance in this information age. The purpose of this chapter is to explain the basic conceptual and reporting issues related to intangible assets. The content and organization of the chapter are as follows: INTANGIBLE ASSETS Intangible Asset Issues Characteristics Valuation Amortization Types of Intangible Assets Marketing-related Customer-related Artistic-related Contract-related Technology-related Goodwill Impairment of Intangibles Limited life Indefinite life Goodwill Research and Development Costs Indentifying R&D Accounting for R&D Other costs Conceptual questions Presentation of Intangibles and Related Items Intangibles R & D costs INTANGIBLE ASSET ISSUES Characteristics OBJECTIVE Describe the characteristics of intangible assets. Gap Inc.'s most important asset is not store fixturesbrand image is. The major asset of Coca-Cola is not its plant facilitiesits secret formula for making Coke is. America Online's most important asset is not its Internet connection equipmentits subscriber base is. As these examples show, we have an economy dominated today by information and service providers, and their major assets are often intangible in nature. Accounting for these intangibles is difficult, and as a result many intangibles are presently not reported on a company's balance sheet. Intangible assets have two main characteristics.4 They lack physical existence. Unlike tangible assets such as property, plant, and equipment, intangible assets derive their value from the rights and privileges granted to the company using them. They are not financial instruments. Assets such as bank deposits, accounts receivable, and long-term investments in bonds and stocks lack physical substance, but are not classified as intangible assets. These assets are financial instruments and derive their value from the right (claim) to receive cash or cash equivalents in the future. 4 \"Goodwill and Other Intangible Assets,\" Statement of Financial Accounting Standards No. 142 (Norwalk, Conn.: FASB, 2001). 2 7126dc12_1-32 11/7/01 4:55 PM Page 3 RKAUL-1 RKAUL-1:Desktop Folder:PQ182-5986F_11-07: Intangible Asset Issues 3 In most cases, intangible assets provide services over a period of years. As a result, they are normally classified as long-term assets. The most common types of intangibles are patents, copyrights, franchises or licenses, trademarks or trade names, and goodwill. Valuation Purchased Intangibles Intangibles purchased from another party are recorded at cost. Cost includes all costs of acquisition and expenditures necessary to make the intangible asset ready for its intended usefor example, purchase price, legal fees, and other incidental expenses. If intangibles are acquired for stock or in exchange for other assets, the cost of the intangible is the fair value of the consideration given or the fair value of the intangible received, whichever is more clearly evident. When several intangibles, or a combination of intangibles and tangibles, are bought in a \"basket purchase,\" the cost should be allocated on the basis of fair values. Essentially the accounting treatment for purchased intangibles closely parallels that followed for purchased tangible assets. Internally-Created Intangibles Costs incurred internally to create intangibles are generally expensed as incurred. Thus, even though a company may incur substantial research and development costs to create an intangible, these costs are expensed. Various reasons are given for this approach. Some argue that the costs incurred internally to create intangibles bear no relationship to their real value; therefore, expensing these costs is appropriate. Others note that with a purchased intangible, a reliable number for the cost of the intangible can be determined; with internally developed intangibles, it is difficult to associate costs with specific intangible assets. And others argue that due to the underlying subjectivity related to intangibles, a conservative approach should be followedthat is, expense as incurred. As a result, the only internal costs capitalized are direct costs incurred in obtaining the intangible, such as legal costs. OBJECTIVE Identify the costs included in the initial valuation of intangible assets. U N D E R LY I N G CONCEPTS The basic attributes of intangibles, their uncertainty as to future benefits, and their uniqueness, have discouraged valuation in excess of cost. I N T E R N AT I O N A L INSIGHT In Japan the cost of intangibles can be capitalized whether they are externally purchased or internally developed. Amortization of Intangibles Intangibles have either a limited (finite) useful life or an indefinite useful life. An intangible asset with a limited life is amortized; an intangible asset with an indefinite life is not amortized. Limited-Life Intangibles As you learned in Chapter 11, the expiration of intangible assets is called amortization. Limited-life intangibles should be amortized by systematic charges to expense over their useful life. The useful life should reflect the periods over which these assets will contribute to cash flows. Factors considered in determining useful life are: The expected use of the asset by the entity. The expected useful life of another asset or a group of assets to which the useful life of the intangible asset may relate (such as mineral rights to depleting assets). Any legal, regulatory, or contractual provisions that may limit the useful life. Any legal, regulatory, or contractual provisions that enable renewal or extension of the asset's legal or contractual life without substantial cost. (This factor assumes that there is evidence to support renewal or extension and that renewal or extension can be accomplished without material modifications of the existing terms and conditions.) OBJECTIVE Explain the procedure for amortizing intangible assets. 7126dc12_1-32 11/7/01 4:50 PM Page 4 RKAUL-1 RKAUL-1:Desktop Folder:PQ182-5986F_11-07: 4 Chapter 12 Intangible Assets The effects of obsolescence, demand, competition, and other economic factors. (Examples include the stability of the industry, known technological advances, legislative action that results in an uncertain or changing regulatory environment, and expected changes in distribution channels.) The level of maintenance expenditure required to obtain the expected future cash flows from the asset. (For example, a material level of required maintenance in relation to the carrying amount of the asset may suggest a very limited useful life.)5 The amount of amortization expense for a limited-life intangible asset should reflect the pattern in which the asset is consumed or used up, if that pattern can be reliably determined. For example, assume that Second Wave, Inc. has purchased a license to provide a limited quantity of a gene product, called Mega. The cost of the license should be amortized following the pattern of use of Mega. If the pattern of production or consumption cannot be determined, the straight-line method of amortization should be used. For homework problems, assume the use of the straight-line method unless stated otherwise. When intangible assets are amortized the charges should be shown as expenses, and the credits should be made either to the appropriate asset accounts or to separate accumulated amortization accounts. The amount of an intangible asset to be amortized should be its cost less residual value. The residual value is assumed to be zero unless at the end of its useful life the intangible asset has value to another entity. For example, if U2D Co. has a commitment from Hardy Co. to purchase its intangible asset at the end of its useful life, U2D Co. should reduce the cost of its intangible asset by the residual value. Similarly, if market values for residual values can be reliably determined, market values should be considered. What happens if a limited-life intangible asset's useful life is changed? In that case the remaining carrying amount should be amortized over the revised remaining useful life. Limited-life intangibles should be continually evaluated for impairment. Similar to property, plant, and equipment, an impairment loss should be recognized if the carrying amount of the intangible is not recoverable and its carrying amount exceeds its fair value. The accounting for impairments is discussed below. Indefinite-Life Intangibles If no legal, regulatory, contractual, competitive, or other factors limit the useful life of an intangible asset, the useful life is considered indefinite. Indefinite means that there is no foreseeable limit on the period of time over which the intangible asset is expected to provide cash flows. An intangible asset with an indefinite life is not amortized. To illustrate, assume that Double Clik, Inc. acquired a trademark that is used to distinguish a leading consumer product. The trademark is renewable every 10 years at minimal cost. All evidence indicates that this trademark product will generate cash flows for an indefinite period of time. In this case, the trademark has an indefinite life because it is expected to contribute to cash flows indefinitely. Indefinite-life intangibles should be tested for impairment at least annually. The impairment test compares the fair value of an intangible asset with its carrying amount. This impairment test is different from the one used for a limited-life intangible. That is, there is no recoverability test related to indefinite-life intangibles, only the fair value test. The reason: Indefinite-life intangible assets might never fail the undiscounted cash flows recoverability test because cash flows could extend indefinitely into the future. In summary, the accounting treatment for intangible assets is shown in Illustration 12-1. 5 Ibid, par. 11. 7126dc12_1-32 11/7/01 4:50 PM Page 5 RKAUL-1 RKAUL-1:Desktop Folder:PQ182-5986F_11-07: Types of Intangible Assets Manner Acquired Type of Intangible Purchased Internally Created Amortization Impairment Test Limited-life intangibles Capitalize Expense* Over useful life Capitalize Expense* Do not amortize Fair value test *Except for direct costs, such as legal costs. TYPES OF INTANGIBLE ASSETS As indicated, the accounting for intangible assets depends on whether the intangible has a limited or an indefinite life. There are many different types of intangibles, and they are often classified into the following six major categories.6 Marketing-related intangible assets. Customer-related intangible assets. Artistic-related intangible assets. Contract-related intangible assets. Technology-related intangible assets. Goodwill. Marketing-Related Intangible Assets Marketing-related intangible assets are those assets primarily used in the marketing or promotion of products or services. Examples are trademarks or trade names, newspaper mastheads, Internet domain names, and noncompetition agreements. A very common form of a marketing-related intangible asset is a trademark or trade name. A trademark or trade name is a word, phrase, or symbol that distinguishes or identifies a particular enterprise or product. The right to use a trademark or trade name under common law, whether it is registered or not, rests exclusively with the original user as long as the original user continues to use it. Registration with the U.S. Patent and Trademark Office provides legal protection for an indefinite number of renewals for periods of 10 years each, so a business that uses an established trademark or trade name may properly consider it to have an indefinite life. Trade names like Kleenex, Pepsi-Cola, Oldsmobile, Excedrin, Wheaties, and Sunkist create immediate product identification in our minds, thereby enhancing marketability. If a trademark or trade name is acquired, its capitalizable cost is the purchase price. If a trademark or trade name is developed by the enterprise itself, the capitalizable cost includes attorney fees, registration fees, design costs, consulting fees, successful legal defense costs, and other expenditures directly related to securing it (excluding research and development costs). When the total cost of a trademark or trade name is insignificant, it can be expensed rather than capitalized. In most cases, the life of a trademark or trade name is indefinite and therefore its cost is not amortized. The value of a marketing-related intangible can be substantial. Consider Internet domain names as an example. The name Drugs.com recently sold for $800,000, and the bidding for the name Loans.com approached $500,000. 6 This classification framework has been adopted from \"Business Combinations,\" Statement of Financial Accounting Standards No. 141 (Norwalk, Conn.: FASB, 2001). 5 ILLUSTRATION 12-1 Accounting Treatment for Intangibles Recoverability test and then fair value test Indefinite-life intangibles OBJECTIVE Identify the types of intangible assets. 7126dc12_1-32 11/7/01 4:50 PM Page 6 RKAUL-1 RKAUL-1:Desktop Folder:PQ182-5986F_11-07: 6 Chapter 12 Intangible Assets Company names themselves identify qualities and characteristics that the companies have worked hard and spent much to develop. In a recent year an estimated 1,230 companies took on new names in an attempt to forge new identities and paid over $250 million to corporate-identity consultants. Among these were Primerica (formerly American Can), Navistar (formerly International Harvester), Nissan (formerly Datsun), and USX (U.S. Steel).7 Customer-Related Intangible Assets Customer-related intangible assets occur as a result of interactions with outside parties. Examples are customer lists, order or production backlogs, and both contractual and noncontractual customer relationships. To illustrate, assume that We-Market Inc. acquired the customer list of a large newspaper for $6,000,000 on January 1, 2003. The customer list is a database that includes name, contact information, order history, and demographic information for a list of customers. We-Market expects to benefit from the information on the acquired list for 3 years, and it believes that these benefits will be spread evenly over the 3 years. In this case, the customer list is a limited-life intangible that should be amortized on a straight-line basis over the 3-year period. The entry to record the purchase of the customer list and the amortization of the customer list at the end of each year is as follows: January 1, 2003 Customer List Cash (To record purchase of customer list) 6,000,000 December 31, 2003, 2004, 2005 Customer List Amortization Expense 2,000,000 Customer List (or Accumulated Customer List Amortization) (To record amortization expense) 6,000,000 2,000,000 In the preceding example it was assumed that the customer list had no residual value. If We-Market determined that it could sell the list for $60,000 to another company at the end of 3 years, this residual value should be subtracted from the cost in order to determine the proper amortization expense for each year. Amortization expense would therefore be $1,980,000 as shown below: ILLUSTRATION 12-2 Calculation of Amortization Expense with Residual Value Cost Residual value $6,000,000 60,000 Amortization base $5,940,000 Amortization expense per period: $1,980,000 ($5,940,000 3) The residual value should be assumed to be zero unless the asset's useful life is less than the economic life and reliable evidence is available concerning the residual value.8 7 To illustrate how various intangibles might arise from a given product, consider what the creators of the highly successful game, Trivial Pursuit, did to protect their creation. First, they copyrighted the 6,000 questions that are at the heart of the game. Then they shielded the Trivial Pursuit name by applying for a registered trademark. As a third mode of protection, the creators obtained a design patent on the playing board's design because it represents a unique graphic creation. 8 \"Goodwill and Other Intangible Assets,\" Statement of Financial Accounting Standards No. 142 (Norwalk, Conn.: FASB, 2001), par. B55. 7126dc12_1-32 11/7/01 4:50 PM Page 7 RKAUL-1 RKAUL-1:Desktop Folder:PQ182-5986F_11-07: Types of Intangible Assets Artistic-Related Intangible Assets Artistic-related intangible assets involve ownership rights to plays, literary works, musical works, pictures, photographs, and video and audiovisual material. These ownership rights are protected by copyrights. A copyright is a federally granted right that all authors, painters, musicians, sculptors, and other artists have in their creations and expressions. A copyright is granted for the life of the creator plus 50 years. It gives the owner, or heirs, the exclusive right to reproduce and sell an artistic or published work. Copyrights are not renewable. The costs of acquiring and defending a copyright may be capitalized, but the research and development costs involved must be expensed as incurred. Generally, the useful life of the copyright is less than its legal life (life in being plus 50 years). The costs of the copyright should be allocated to the years in which the benefits are expected to be received. The difficulty of determining the number of years over which benefits will be received normally encourages the company to write these costs off over a fairly short period of time. Copyrights can be valuable. Really Useful Group is a company that consists of copyrights on the musicals of Andrew Lloyd WebberCats, Phantom of the Opera, Jesus Christ-Superstar, and others. It has little in the way of hard assets, yet it has been valued at $300 million. Contract-Related Intangible Assets Contract-related intangible assets represent the value of rights that arise from contractual arrangements. Examples are franchise and licensing agreements, construction permits, broadcast rights, and service or supply contracts. A very common form of contract-based intangible asset is a franchise. A franchise is a contractual arrangement under which the franchisor grants the franchisee the right to sell certain products or services, to use certain trademarks or trade names, or to perform certain functions, usually within a designated geographical area. For example, when you drive down the street in an automobile purchased from a Toyota dealer, fill your tank at the corner Texaco station, eat lunch at McDonald's, cool off with one of Baskin-Robbins' 31 flavors, work at a Coca-Cola bottling plant, live in a home purchased through a Century 21 real estate broker, or vacation at a Holiday Inn resort, you are dealing with franchises. The franchisor, having developed a unique concept or product, protects its concept or product through a patent, copyright, or trademark or trade name. The franchisee acquires the right to exploit the franchisor's idea or product by signing a franchise agreement. Another type of franchise is the arrangement commonly entered into by a municipality (or other governmental body) and a business enterprise that uses public property. In such cases, a privately owned enterprise is permitted to use public property in performing its services. Examples are the use of public waterways for a ferry service, the use of public land for telephone or electric lines, the use of phone lines for cable TV, the use of city streets for a bus line, or the use of the airwaves for radio or TV broadcasting. Such operating rights, obtained through agreements with governmental units or agencies, are frequently referred to as licenses or permits. Franchises and licenses may be for a definite period of time, for an indefinite period of time, or perpetual. The enterprise securing the franchise or license carries an intangible asset account entitled Franchise or License on its books only when there are costs (such as a lump sum payment in advance or legal fees and other expenditures) that are identified with the acquisition of the operating right. The cost of a franchise (or license) with a limited life should be amortized as operating expense over the life of the franchise. A franchise with an indefinite life, or a perpetual franchise, should be carried at cost and not be amortized. Annual payments made under a franchise agreement should be entered as operating expenses in the period in which they are incurred. They do not represent an asset to the concern since they do not relate to future rights to use public property. 7 7126dc12_1-32 11/7/01 4:50 PM Page 8 RKAUL-1 RKAUL-1:Desktop Folder:PQ182-5986F_11-07: 8 Chapter 12 Intangible Assets Technology-Related Intangible Assets Technology-related intangible assets relate to innovations or technological advances. Examples are patented technology and trade secrets. To illustrate, patents are granted by the U.S. Patent and Trademark Office. The two principal kinds of patents are product patents, which cover actual physical products, and process patents, which govern the process by which products are made. A patent gives the holder exclusive right to use, manufacture, and sell a product or process for a period of 20 years without interference or infringement by others. With this exclusive right, fortunes can be made. For example, companies such as Merck, Polaroid, and Xerox were founded on patents.9 If a patent is purchased from an inventor (or other owner), the purchase price represents its cost. Other costs incurred in connection with securing a patent, as well as attorneys' fees and other unrecovered costs of a successful legal suit to protect the patent, can be capitalized as part of the patent cost. Research and development costs related to the development of the product, process, or idea that is subsequently patented must be expensed as incurred, however. See pages 15-19 for a more complete presentation of accounting for research and development costs. The cost of a patent should be amortized over its legal life or its useful life (the period benefits are received), whichever is shorter. If a patent is owned from the date it is granted, and it is expected to be useful during its entire legal life, it should be amortized over 20 years. If it appears that the patent will be useful for a shorter period of time, say, for 5 years, its cost should be amortized to expense over 5 years. Changing demand, new inventions superseding old ones, inadequacy, and other factors often limit the useful life of a patent to less than the legal life. For example, the useful life of patents in the pharmaceutical and drug industry is frequently less than the legal life because of the testing and approval period that follows their issuance. A typical drug patent has 5 to 11 years knocked off its 20-year legal life because 1 to 4 years must be spent on tests on animals, 4 to 6 years on human tests, and 2 to 3 years for the Food and Drug Administration to review the testsall after the patent is issued but before the product goes on a pharmacist's shelves. From bioengineering to software design to the Internet,10 battles over patents are heating up as global competition intensifies. For example, Priceline.com filed suit against Microsoft for launching Hotel Price Matcher, a service that operates pretty much like the name-your-own-price-system pioneered by Priceline. And Amazon.com filed a complaint against Barnesandnoble.com, its bitter rival in the Web-retailing wars. The suit alleges that Barnesandnoble.com is infringing on Amazon.com's patent for oneclick shopping and asks the court to stop Barnesandnoble.com from using its own quickcheckout system, called ExpressLane. Legal fees and other costs incurred in successfully defending a patent suit are debited to Patents, an asset account, because such a suit establishes the legal rights of the holder of the patent. Such costs should be amortized along with acquisition cost over the remaining useful life of the patent. Amortization expense should reflect the pattern in which the patent is used up, if that pattern can be reliably determined. Amortization of patents may be credited directly to the Patent account, or it may be credited to an Accumulated Patent Amortization account. To illustrate, assume that Harcott Co. incurs $180,000 in legal costs on January 1, 2003, to successfully defend a patent. The patent has a useful life of 20 years, and is amortized on a straight-line basis. The entries to record the legal fees and the amortization at the end of each year are as follows: 9 Consider the opposite result: Sir Alexander Fleming, who discovered penicillin, decided not to use a patent to protect his discovery. He hoped that companies would produce it more quickly to help save sufferers. Companies, however, refused to develop it because they did not have the patent shield and, therefore, were afraid to make the investment. 10 \"Battle over Patents Threatens to Damp Web's Innovative Spirit,\" The Wall Street Journal, November 8, 1999. 7126dc12_1-32 11/7/01 4:50 PM Page 9 RKAUL-1 RKAUL-1:Desktop Folder:PQ182-5986F_11-07: Types of Intangible Assets January 1, 2003 Patents Cash (To record legal fees related to patent) December 31, 2003 Patent Amortization Expense Patents (or Accumulated Patent Amortization) (To record amortization of patent) 180,000 180,000 9,000 9,000 Amortization on a units-of-production basis would be computed in a manner similar to that described for depreciation on property, plant, and equipment in Chapter 11, page 553. Although a patent's useful life should not extend beyond its legal life of 20 years, small modifications or additions may lead to a new patent. The effect may be to extend the life of the old patent. In that case it is permissible to apply the unamortized costs of the old patent to the new patent if the new patent provides essentially the same benefits.11 Alternatively, if a patent becomes worthless (impaired) because demand drops for the product produced, the asset should be written down or written off immediately to expense. Goodwill Although companies are permitted to capitalize certain costs to develop specifically identifiable assets such as patents and copyrights, the amounts capitalized are generally not significant. Material amounts of intangible assets are recorded when companies purchase intangible assets, particularly in situations involving the purchase of another business (often referred to as a business combination). In a business combination, the cost (purchase price) is assigned where possible to the identifiable tangible and intangible net assets, and the remainder is recorded in an intangible asset account called Goodwill. Goodwill is often referred to as the most intangible of the intangibles because it can only be identified with the business as a whole. The only way it can be sold is to sell the business. The problem of determining the proper cost to allocate to intangible assets in a business combination is complex because of the many different types of intangibles that might be considered. Many of these types of intangibles have been discussed earlier. It is extremely difficult not only to identify certain types of intangibles but also to assign a value to them in a business combination. As a result, the approach followed is to record identifiable intangible assets that can be reliably measured. Other intangible assets that are difficult to identify or measure are recorded as goodwill.12 Recording Goodwill Internally Created Goodwill. Goodwill generated internally should not be capitalized in the accounts, because measuring the components of goodwill is simply too complex and associating any costs with future benefits too difficult. The future benefits of goodwill may have no relationship to the costs incurred in the development of that goodwill. To add to the mystery, goodwill may even exist in the absence of specific costs to develop it. In addition, because no objective transaction with outside parties has taken place, a great deal of subjectivityeven misrepresentationmight be involved. 11 A good example is Eli Lilly's drug Prozac (used to treat depression) which in 1998 accounted for 43% of its U.S. sales. The patent on Prozac is due to expire in 2001, but the company expects to get an additional 2 years of protection, to 2003, because the company has a seconduse patent covering appetite disorders. 12 The new business combination standard provides detailed guidance regarding the recognition of identifiable intangible assets in a business combination. Using this guidance, the expectation is that more identifiable intangible assets will be recognized in the financial statements as a result of business combinations. If this situation occurs, less goodwill will be recognized. OBJECTIVE Explain the conceptual issues related to goodwill. OBJECTIVE Describe the accounting procedures for recording goodwill. 9 7126dc12_1-32 11/7/01 4:50 PM Page 10 RKAUL-1 RKAUL-1:Desktop Folder:PQ182-5986F_11-07: 10 Chapter 12 Intangible Assets U N D E R LY I N G CONCEPTS Capitalizing goodwill only when it is purchased in an arm's-length transaction and not capitalizing any goodwill generated internally is another example of reliability winning out over relevance. Purchased Goodwill. Goodwill is recorded only when an entire business is purchased, because goodwill is a \"going concern\" valuation and cannot be separated from the business as a whole. To record goodwill, the fair market value of the net tangible and identifiable intangible assets are compared with the purchase price of the acquired business. The difference is considered goodwill, which is why goodwill is sometimes referred to as a \"plug,\" or \"gap filler,\" or \"master valuation\" account. Goodwill is the residual: the excess of cost over fair value of the identifiable net assets acquired. To illustrate, Multi-Diversified, Inc. decides that it needs a parts division to supplement its existing tractor distributorship. The president of Multi-Diversified is interested in buying a small concern in Chicago (Tractorling Company) that has an established reputation and is seeking a merger candidate. The balance sheet of Tractorling Company is presented in Illustration 12-3. ILLUSTRATION 12-3 Tractorling Balance Sheet TRACTORLING CO. Balance Sheet as of December 31, 2002 Assets Cash Receivables Inventories Property, plant, and equipment, net $ 25,000 35,000 42,000 153,000 Total assets $255,000 Equities Current liabilities Capital stock Retained earnings Total equities $ 55,000 100,000 100,000 $255,000 After considerable negotiation, Tractorling Company decides to accept MultiDiversified's offer of $400,000. What then is the value of the goodwill, if any? The answer is not obvious. The fair market values of Tractorling's identifiable assets are not disclosed in its historical cost-based balance sheet. Suppose, though, that as the negotiations progressed, Multi-Diversified conducted an investigation of the underlying assets of Tractorling to determine the fair market value of the assets. Such an investigation may be accomplished either through a purchase audit undertaken by Multi-Diversified's auditors in order to estimate the values of the seller's assets, or by an independent appraisal from some other source. The following valuations are determined. ILLUSTRATION 12-4 Fair Market Value of Tractorling's Net Assets Fair Market Values Cash Receivables Inventories Property, plant, and equipment, net Patents Liabilities Fair market value of net assets $ 25,000 35,000 122,000 205,000 18,000 (55,000) $350,000 Normally, differences between current fair market value and book value are more common among long-term assets, although significant differences can also develop in the current asset category. Cash obviously poses no problems, and receivables normally are fairly close to current valuation, although at times certain adjustments need to be made because of inadequate bad debt provisions. Liabilities usually are stated at book value, although if interest rates have changed since the liabilities were incurred, a different valuation (such as present value) might be appropriate. Careful analysis must be made to determine that no unrecorded liabilities are present. 7126dc12_1-32 11/7/01 4:50 PM Page 11 RKAUL-1 RKAUL-1:Desktop Folder:PQ182-5986F_11-07: Types of Intangible Assets The $80,000 difference in inventories ($122,000 $42,000) could result from a number of factors, the most likely being that Tractorling Company uses LIFO. Recall that during periods of inflation, LIFO better matches expenses against revenues, but in doing so creates a balance sheet distortion. Ending inventory is comprised of older layers costed at lower valuations. In many cases, the values of long-term assets such as property, plant, and equipment, and intangibles may have increased substantially over the years. This difference could be due to inaccurate estimates of useful lives, continual expensing of small expenditures (say, less than $300), inaccurate estimates of salvage values, and the discovery of some unrecorded assets (as in Tractorling's case where Patents are discovered to have a fair value of $18,000). Or, replacement costs may have substantially increased. Since the fair market value of net assets is now determined to be $350,000, why did Multi-Diversified pay $400,000? Undoubtedly, the seller pointed to an established reputation, good credit rating, top management team, well-trained employees, and so on, as factors that make the value of the business greater than $350,000. At the same time, Multi-Diversified placed a premium on the future earning power of these attributes as well as the basic asset structure of the enterprise today. At this point in the negotiations, price can be a function of many factors; the most important is probably sheer skill at the bargaining table. The difference between the purchase price of $400,000 and the fair market value of $350,000 is labeled goodwill. Goodwill is viewed as one or a group of unidentifiable values (intangible assets) the cost of which \"is measured by the difference between the cost of the group of assets or enterprise acquired and the sum of the assigned costs of individual tangible and identifiable intangible assets acquired less liabilities assumed.\"13 This procedure for valuation is referred to as a master valuation approach because goodwill is assumed to cover all the values that cannot be specifically identified with any identifiable tangible or intangible asset; this approach is shown in Illustration 12-5. Cash Receivables Inventories Property, plant, and equipment, net Assigned to Patents purchase price Liabilities of $400,000 Fair market value of net identifiable assets Purchase price Value assigned to goodwill $ 25,000 35,000 122,000 205,000 18,000 (55,000) $350,000 400,000 $ 50,000 The entry to record this transaction would be as follows: Cash Receivables Inventories Property, Plant, and Equipment Patents Goodwill Liabilities Cash 25,000 35,000 122,000 205,000 18,000 50,000 55,000 400,000 Goodwill is often identified on the balance sheet as the excess of cost over the fair value of the net assets acquired. 13 The Board expressed concern about measuring goodwill as a residual but noted that there is no real measurement alternative, since goodwill is not separable from the enterprise as a whole. \"Business Combinations,\" Statement of Financial Accounting Standards No. 141 (Norwalk, Conn.: FASB, 2001), par. B145. ILLUSTRATION 12-5 Determination of GoodwillMaster Valuation Approach 11 7126dc12_1-32 11/7/01 4:50 PM Page 12 RKAUL-1 RKAUL-1:Desktop Folder:PQ182-5986F_11-07: 12 Chapter 12 Intangible Assets Goodwill Write-off Goodwill acquired in a business combination is considered to have an indefinite life and therefore should not be amortized. The Board's position is that investors find the amortization charge of little use in evaluating financial performance. In addition, although goodwill may decrease over time, predicting the actual life of goodwill and an appropriate pattern of amortization is extremely difficult. On the other hand, knowing the amount invested in goodwill is important to the investment community. Therefore, income statements are not charged unless goodwill has been impaired. This approach will have a significant impact on the income statements of some companies because goodwill often is the largest intangible asset on a company's balance sheet. Prior to the new FASB standard, companies were required to amortize this intangible. For example, it is estimated that as a result of the new rules, earnings per share in 2001 will increase 21 percent for International Paper, 16 percent for Johnson Controls, and 30 percent for Pepsi Bottling Group. Some believe that goodwill's value eventually disappears and therefore that goodwill should be charged to expense over the periods affected. Amortizing goodwill, they argue, provides a better matching of expense with revenues. Others note that the accounting treatment for purchased goodwill and goodwill created internally should be consistent. Goodwill created internally is immediately expensed and does not appear as an asset; the same treatment, they argue, should be accorded purchased goodwill. Even though these arguments may have some merit, the FASB decided that nonamortization of goodwill combined with an adequate impairment test provides the most useful financial information to the investment community. Negative GoodwillBadwill Negative goodwill arises when the fair value of the assets acquired is higher than the purchase price of the assets. This situation is a result of market imperfection, because the seller would be better off to sell the assets individually than in total. However, situations do occur in which the purchase price is less than the value of the net identifiable assets and therefore a credit develops. This credit is referred to as negative goodwill or, alternatively, as excess of fair value over the cost acquired, badwill, or bargain purchase. The FASB requires that this remaining excess be recognized as an extraordinary gain. The Board noted that extraordinary gain treatment is appropriate in order to highlight the fact that an excess exists and to reflect the unusual nature and infrequent occurrence of the item. Some disagree with the approach, as it results in a gain at the time of the purchase. However, it appears that the Board took a practical approach, given that this transaction rarely occurs. IMPAIRMENT OF INTANGIBLE ASSETS Limited-Life Intangibles OBJECTIVE Explain the accounting issues related to intangible asset impairments. The rules that apply to impairments of long-lived assets also apply to limited-life intangibles. As indicated in Chapter 11, long-lived assets to be held and used by a company are to be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable (recoverability test). In performing the review for recoverability, the company would estimate the future cash flows expected to result from the use of the asset and its eventual disposition. If the sum of the expected future net cash flows (undiscounted) is less than the carrying amount of the asset, an impairment loss would be measured and recognized. Otherwise, an impairment loss would not be recognized.14 The impairment loss is the 14 \"Accounting for the Impairment of Long-Lived Assets,\" Statement of Financial Accounting Standards No. 121 (Norwalk, Conn.: FASB, 1994). 7126dc12_1-32 11/7/01 4:50 PM Page 13 RKAUL-1 RKAUL-1:Desktop Folder:PQ182-5986F_11-07: Impairment of Intangible Assets 13 amount by which the carrying amount of the asset exceeds the fair value of the impaired asset (fair value test). To illustrate, assume that Lerch, Inc. has a patent on how to extract oil from shale rock. Unfortunately, reduced oil prices have made the shale oil technology somewhat unprofitable, and the patent has provided little income to date. As a result, a recoverability test is performed, and it is found that the expected net future cash flows from this patent are $35 million. Lerch's patent has a carrying amount of $60 million. Because the expected future net cash flows of $35 million are less than the carrying amount of $60 million, an impairment loss must be measured. Discounting the expected net future cash flows at its market rate of interest, Lerch determines the fair value of its patent to be $20 million. The impairment loss computation (fair value test) is shown in Illustration 12-6. Carrying amount of patent Fair value (based on present value computation) $60,000,000 20,000,000 Loss on impairment $40,000,000 ILLUSTRATION 12-6 Computation of Loss on Impairment of Patent The journal entry to record this loss is: Loss on Impairment Patents 40,000,000 40,000,000 After the impairment is recognized, the reduced carrying amount of the patents is its new cost basis. The patent's new cost should be amortized over its useful life or legal life, whichever is shorter. Even if oil prices increase in subsequent periods, and the value of the patent increases, restoration of the previously recognized impairment loss is not permitted. Indefinite-Life Intangibles Other Than Goodwill Indefinite-life intangibles other than goodwill should be tested for impairment at least annually. The impairment test for an indefinite-life asset other than goodwill is a fair value test. This test compares the fair value of the intangible asset with the asset's carrying amount. If the fair value of the intangible asset is less than the carrying amount, impairment is recognized. This one-step test is used because it would be relatively easy for many indefinite-life assets to meet the recoverability test because cash flows may extend many years into the future. As a result, the recoverability test is not used. To illustrate, assume that Arcon Radio purchased a broadcast license for $2,000,000. The license is renewable every 10 years if the company provides appropriate service and does not violate Federal Communications Commission (FCC) rules and procedures. The license has been renewed with the FCC twice, at a minimal cost. Cash flows were expected to last indefinitely, and therefore Arcon reported the license as an indefinitelife intangible asset. Recently the FCC decided to no longer renew broadcast licenses, but to auction these licenses to the highest bidder. Arcon's existing license has 2 years remaining, and cash flows are expected for these 2 years. Arcon performs an impairment test and determines that the fair value of the intangible asset is $1,500,000. It therefore reports an impairment loss of $500,000 computed as follows. Carrying amount of broadcast license Fair value of broadcast license $2,000,000 1,500,000 Loss on impairment $ 500,000 The license would now be reported at $1,500,000, its fair value. Even if the value of the license increases in the remaining 2 years, restoration of the previously recognized impairment loss is not permitted. ILLUSTRATION 12-7 Computation of Loss on Impairment of Broadcast License 7126dc12_1-32 11/7/01 4:50 PM Page 14 RKAUL-1 RKAUL-1:Desktop Folder:PQ182-5986F_11-07: 14 Chapter 12 Intangible Assets Goodwill The impairment rule for goodwill is a two-step process. First, the fair value of the reporting unit should be compared to its carrying amount including goodwill. If the fair value of the reporting unit is greater than the carrying amount, goodwill is considered not to be impaired, and the company does not have to do anything else. To illustrate, assume that Kohlbuy Corporation has three divisions in its company. One division, Pritt Products, was purchased 4 years ago for $2 million. Unfortunately, it has experienced operating losses over the last 3 quarters, and management is reviewing the division for purposes of recognizing an impairment. The Pritt Division's net assets including the associated goodwill of $900,000 from purchase are listed in Illustration 12-8. ILLUSTRATION 12-8 Net Assets of Pritt Division, Including Goodwill Cash Receivables Inventory Property, plant, and equipment (net) Goodwill Less: Accounts and notes payable Net assets $ 200,000 300,000 700,000 800,000 900,000 (500,000) $2,400,000 It is determined that the fair value of Pritt Division is $2,800,000. As a result, no impairment is recognized because the fair value of the division is greater than the carrying amount of the net assets. However, if the fair value of Pritt Division is less than the carrying amount of the net assets, then a second step must be performed to determine whether impairment has occurred. In the second step, the fair value of the goodwill must be determined (implied value of goodwill) and compared to its carrying amount. To illustrate, assume that the fair value of Pritt's Division was $1,900,000 instead of $2,800,000. The implied value of the goodwill in this case is computed in Illustration 12-9. ILLUSTRATION 12-9 Determination of Implied Value of Goodwill Fair value of Pritt Division Net identifiable assets (excluding goodwill) ($2,400,000 $900,000) $1,900,000 1,500,000 Implied value of goodwill $ 400,000 The implied value of the goodwill is then compared to the recorded goodwill to determine whether an impairment has occurred, as shown in Illustration 12-10. ILLUSTRATION 12-10 Measurement of Goodwill Impairment Carrying amount of goodwill Implied value of goodwill $900,000 400,000 Loss on impairment $500,000 Illustration 12-11 summarizes the impairment tests for various intangible assets. ILLUSTRATION 12-11 Summary of Intangible Asset Impairment Tests Type of Intangible Asset Limited life Indefinite life Goodwill Impairment Test Recoverability test, then fair value test Fair value test Fair value test on reporting unit, then fair value test on implied goodwill 7126dc12_1-32 11/7/01 4:50 PM Page 15 RKAUL-1 RKAUL-1:Desktop Folder:PQ182-5986F_11-07: Research and Development Costs 15 RESEARCH AND DEVELOPMENT COSTS Research and development (R & D) costs are not in themselves intangible assets. The accounting for R & D costs is presented here, however, because research and development activities frequently result in the development of something that is patented or copyrighted (such as a new product, process, idea, formula, composition, or literary work). Many businesses spend considerable sums of money on research and development to create new products or processes, to improve present products, and to discover new knowledge that may be valuable at some future date. The following schedule shows the outlays for R & D made by selected U.S. companies: Company R & D Dollars % of Profits $ 444,400,000 272,000,000 70,000,000 2,269,000,000 121,900,000 1,821,100,000 Deere & Co. Dell Computer General Mills Johnson & Johnson Kellogg Merck % of Sales 3.73% 1.49% 1.12% 9.59% 1.80% 6.77% 43.51% 18.63% 13.10% 74.17% 24.25% 34.70% The difficulties in accounting for these research and development (R & D) expenditures are (1) identifying the costs associated with particular activities, projects, or achievements and (2) determining the magnitude of the future benefits and length of time over which such benefits may be realized. Because of these latter uncertainties, the accounting practice in this area has been simplified by requiring that all research and development costs be charged to expense when incurred.15 OBJECTIVE Identify the conceptual issues related to research and development costs. ILLUSTRATION 12-12 R & D Outlays, as a Percentage of Sales and Profits I N T E R N AT I O N A L INSIGHT Contrary to U.S. practice, in most other nations (the Netherlands, Canada, and Japan, for example) the capitalization of research and development costs is allowed under specified circumstances. Identifying R & D Activities To differentiate research and development costs from similar costs, the following definitions are used for research activities and development activities.16 Research Activities Development Activities Idea Planned search or critical investigation aimed at discovery of new knowledge. Prototy pe 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. Examples Examples Laboratory research aimed at discovery of new knowledge; searching for applications of new research findings. Conceptual formulation and design of possible product or process alternatives; construction of prototypes and operation of pilot plants. 15 \"Accounting for Research and Development Costs,\" Statement of Financial Accounting Standards No. 2 (Stamford, Conn.: FASB, 1974), par. 12. 16 Ibid., par. 8. ILLUSTRATION 12-13 R & D Activities 7126dc12_1-32 11/7/01 4:50 PM Page 16 RKAUL-1 RKAUL-1:Desktop Folder:PQ182-5986F_11-07: 16 Chapter 12 Intangible Assets It should be emphasized that R & D activities do not include routine or periodic alternatives to existing products, production lines, manufacturing processes, and other ongoing operations even though these alterations may represent improvements. For example, routine ongoing efforts to refine, enrich, or improve the qualities of an existing product are not considered R & D activities. Accounting for R & D Activities The costs associated with R & D activities and the accounting treatment accorded them are as follows: OBJECTIVE Describe the accounting procedures for research and development costs and for other similar costs. I N T E R N AT I O N A L INSIGHT International accounting standards require the capitalization of appropriate development expenditures. This conflicts with U.S. GAAP. Materials, Equipment, and Facilities. Expense the entire costs, unless the items have alternative future uses (in other R & D projects or otherwise), then carry as inventory and allocate as consumed; or capitalize and depreciate as used. Personnel. Salaries, wages, and other related costs of personnel engaged in R & D should be ex