As the word intangible suggests, assets in this classification have no physical substance. Leading examples are goodwill. patents, and trademarks. Intangible assets are classified in the balance sheet as a subgroup of plant assets. However, not all assets that lack physical substance are regarded as intangible assets. An account receivable, for example, has no physical attributes but is classified as a current asset and is not regarded as an Intangible. In brief, intangible assets are assets that are used ill the operation of the business but that have II() physical substance and are noncurrent.
Operating Expenses Versus ‘Intangible Assets
For an expenditure to qualify as an intangible asset, there must be reasonable evidence of future benefits. Many expenditures offer some prospects of yielding benefits in subsequent YCHrs, hut the existence and life span of these benefits are so uncertain that most
companies treat these expenditures as operating expenses: Examples arc the expcnditurcs for Intensive advertising campaigns to introduce new products and the expense of trainingemployees to work with new types of machinery or office equipment. There is lillie doubt that some benefits from these outlays continue beyond the current period, hut because of thc uncertain duration of the benetits, it is almost universal practice to treat expenditures of this nature as expense of the current period
The term amortization is used to describe the systematic write-off .to expense of the cost of an intangible asset over its useful life. The usual accounting entry for amortization consists of a debit to Amortization Expense and a credit to the intangible asset account. There is no theoretical objection to crediting an accumulated amortization account rather than the intangible asset account, but this method is seldom encountered in practice.
Business executives used the term goodwill in a variety of ways before ‘it became part of accounting terminology. One of the most common meanings of goodwill in a non accounting sense concerns the benefits derived from a favorable reputation among customers. To accountants, however, goodwill has a very specific meaning not necessarily limited to customer relations. It means the present value of future earnings in excess of the normal return on net identifiable assets. Above-average earnings may arise not only from favorable customer relations but also from such factors as superior management. manufacturing efficiency, and weak competition
An investor presumably would be willing to pay $ 1,000,000 to buy Mandarin Coast, because this restaurant earns the normal 15% return that justifies the fair market value of its net identifiable assets: Although Golden Dragon has the same amount of net identifiable assets, an investor probably would be willing to pay more for Golden Dragon than for Mandarin Coast, because Golden Dragon has a long record of superior earnings. The extra amount that a buyer would pay to purchase Golden Dragon represents the value of this business’s goodwill.
How much will an investor pay for goodwill? Above-average earnings in past years are of significance to prospective purchasers only if they believe that these earnings will continue after they acquire the business. Investors’ appraisals of goodwill; therefore, will vary with their estimates of the future earning power of the business.
Very few businesses, however, are able to maintain above-average earnings for more than a few years. Consequenlly, the purchaser of a business will usually limit any amount paid for goodwill to not more than four or five times the amount by which annual earnings exceed normal earnings
Arriving at a fair value for the goodwill of an ongoing business is a difficult and subjective process. Any estimate of goodwill is in large part a matter of personal opinion. The following are two methods that a prospective purchaser might use in estimating a value for goodwill
Notice that our two approaches resulted in.very different estimates of Golden Dragon’s goodwill-$300,000 and ‘$200,000. ‘Such differences occur often in practice. The value of goodwill depends on future performance. Therefore, there is’no “surefire way” of determining its real value. At best, the value of a company’s goodwill is only an educated guess.
Recording Goodwill In the Accounts
Because of the difficulties in objectively estimating the value of goodwill, this asset is recorded only when it is purchased. Goodwill is purchased when one company buys another. The purchaser records the identifiable assets it has purchased at their fair market values and then debits any additional amount paid to an asset account entitled Goodwill.
Generally accepted accounting principles require that recorded goodwill be amortized to expense over a period that does not exceed 40 years. However, the accounting concept of conservatism suggests that goodwill usually should be amortized over a much shorter period. For this reason. many companies amortize purchased goodwill over periods of 10 or 20 years
But Most Goodwill Never Gets Recorded!
Many businesses never purchase goodwill but generate it internally by developing good customer relations, superior management, or other factors that result in above-average earnings. Because there is no objective way of determining the value of goodwill unless the business is sold, internally generated goodwill is not recorded in the accounting records. Thus goodwill may be an important asset of a successful business but may not even appear in ‘the .company’s balance sheet. The absence of internally generated goodwill is, perhaps, the principal reason why a balance sheet does not indicate a company’s current market value
Goodwill or Bad Judgment?
Some companies have paid huge amounts for “goodwill,” only to discover that the businesses they have purchased do not continue to earn above- ‘normal rates of return. In these cases, the goodwill is not an asset with future economic value. Rather, it indicates that the company paid too high a price to acquire the other business. If it becomes apparent that purchased goodwill does not have real economic value, it should be written off immediately.
Trademarks and Trade Names
Coca-Cola’s famous name, usually written in “adistinctive typeface, is a classic example of a trademark known around the world. A trademark is a name, symbol, or design that identifies a product or group of products. A permanent exclusive right to the use of a trademark, brand name, or commercial symbol may be obtained by registering it with the federal government.
A franchise is a right granted by a company or a governmental unit to conduct a certain type of business in a specific geographical area. An example of a franchise is the right to operate a McDonald’s restaurant in a specific neighborhood, The cost of franchises varies greatly and often is quite substantial. When the cost of a franchise is small, it may be charged immediately to expense or amortized over a short period such as 5 years.
When the cost is material, amortization should be based 011 the life of the franchise (if limited); the amortization period, however, may not exceed 40 years
Other Intangibles and Deferred Charges
Among the other intangibles found in the published balance sheets of large corporations are moving costs, plant rearrangement costs, formulas, processes, name lists, and film rights. Some companies group items of this type under the title of Deferred Charges, , meaning expenditures that will provide benefits beyond the current year and that will be written off to expense over their useful economic lives. It is also common practice to . combine these items under the heading of Other Assets, which is listed at the bottom of the balance sheet