EXECUTIVE
SUMMARY |
EVEN WITH THE GUIDANCE IN
FASB STATEMENT NO. 142, th e
useful life of certain intangible assets
is difficult to judge, particularly assets
that involve contracted or other legally
set terms. Companies use the useful life
of assets to guide their decisions on
whether or not to amortize them on their
financial statements.
FOR INTANGIBLE ASSETS
THAT ARE THE RESULT of
contractual or legal rights, including
patents, licenses, trademarks, franchise
and servicing rights, CPAs should ask
whether the company intends and is able
to renew or extend the contract; whether
there are substantial costs associated
with renewal; and whether there will be
any material modifications to existing
contract terms. This will help determine
whether the benefits of the asset for
amortization purposes will continue
beyond the contract period.
IF A CONTRACT IS SILENT
ON RENEWAL POSSIBILITIES,
CPAs should consider the
company’s history on this or similar
contracts. If this type of contract is
new to the company, information from
other companies in the same industry
that have successfully renewed similar
agreements may be a useful benchmark.
ONCE IT APPEARS A
CONTRACT IS RENEWABLE OR
extendable without substantial
cost or modification, CPAs can defend
assigning it a useful life that is
longer than the contract term. If the
benefits of the asset will continue
indefinitely, it has an indefinite
useful life and the company should not
amortize it. If the useful life
stretches beyond the contract term but
is not indefinite, CPAs must make their
best estimate of the asset’s useful
life.
COMPANIES SHOULD ALWAYS
CONSIDER HOW A CHANGE in an
asset’s useful life relates to its value
and vice versa. The value of the asset
on the balance sheet may be higher or
lower than its fair value based on
information about the contract. If a
company determines that a previously
unamortized asset has a finite useful
life, the company should begin to
amortize it from that point on.
| JENNIFER
M. MUELLER, PhD, is a KPMG Faculty Fellow
at Auburn University in Auburn, Alabama.
Her e-mail address is
jmueller@auburn.edu .
|
ince FASB issued Statement no. 142,
Goodwill and Other Intangible Assets,
in 2001, CPAs and their companies have paid
considerable attention to its guidance on
goodwill. Far less thought, however, has been
given to other intangible assets that also may
escape amortization under the criteria in
Statement no. 142. (See the box
for key provisions.) Amortizing an asset
gradually reduces its value through periodic
write-downs and requires companies to recognize an
expense. Thus the decision whether to amortize an
asset in the current period has a direct effect on
the company’s bottom line. Any corporation
that purchases or otherwise acquires intangible
assets must answer the question of whether to
amortize them. The company’s independent auditors
then must evaluate those decisions. Interpreting
Statement no. 142, however, may be difficult for
intangibles with contractual or legal lives. This
article describes situations in which it is
appropriate to avoid amortization on these
intangible assets and offers an approach based on
Statement no. 142 and related interpretations CPAs
can use to answer the amortization question much
more efficiently.
PARTICULAR INTANGIBLE ASSETS
The key factor in
determining whether to amortize an “other”
intangible asset is its useful life. If it is
indefinite, the asset is not amortized. Although
the question of whether an asset’s useful life is
definite or indefinite may seem straightforward,
certain intangibles—particularly those that are a
result of contracted or other legally set
terms—are difficult to judge. For example, would a
contract that provides a buyer rights for five
years have an indefinite life? Perhaps, depending
on how the contract stacks up against the criteria
in Statement no. 142. The useful lives of
certain intangible assets will surprise some CPAs
given the way Statement no. 142 addresses legal or
contractual provisions. Consider examples of
intangible assets that are the result of
contractual or legal rights—patents, licenses,
trademarks and franchise and servicing rights. The
contract benefits typically are for a legally set
period of time and may or may not be explicitly
renewable. Statement no. 142 specifies that
companies should evaluate the provisions of the
legal arrangement to determine whether they limit
or extend an asset’s useful life. If the contract
includes renewal provisions, the useful life may
very well be indefinite.
Amortizing the Asset Before
FASB 142 P rior to the
issuance of FASB Statement no. 142, the
maximum useful life of an intangible asset
was 40 years. Could an asset a company was
amortizing over a useful life of less than
40 years now have an indefinite life under
Statement no. 142? The answer is “maybe.”
Prior to its implementation companies may
not have taken all of the three criteria
in Statement no. 142—renewability, costs
and modifications—into account in making
amortization decisions. Further, it was
not an option for an asset to have an
indefinite useful life, regardless of how
a company evaluated the criteria before
Statement no. 142. The limit was 40 years.
The bottom line? Even those intangibles
that weren’t assigned the full 40-year
useful life prior to Statement no. 142
should be evaluated against the
statement’s criteria. They may have
indefinite useful lives as well.
| A notable
finding from deep within an appendix to Statement
no. 142 is that even if the contract terms do not
provide for renewal, the asset’s useful life may
still be indefinite if certain conditions are met.
In other words, consistently basing the useful
life on the specified term of the contract is too
simplistic an approach, particularly when it is
reasonable to believe the benefits the asset
provides will continue beyond the contract period.
Based on the guidance in Statement no. 142, there
are three questions CPAs should ask to determine
the appropriate useful life: (1) Does the company
intend and have the ability to renew or extend the
contract? (2) Are there substantial costs
associated with the renewal/extension? (3) Will
there be material modifications to the existing
contract terms and conditions? Note: There
is one circumstance CPAs should consider before
exploring the three questions. If the benefits the
contract provides are not expected to continue to
the expiration date, there is no reason for the
CPA to explore these questions. The useful life
for amortization would be the best estimate of the
period over which the benefits will continue. (As
this circumstance is atypical, most should read on
to determine whether to amortize the asset.)
Can it be renewed or extended?
CPAs first should address whether
the company intends to renew or extend the
contract. For example, a broadcast company may be
abandoning its operations in an unprofitable
service area and will not need to renew a
broadcast license for the area. Once the company
has decided it will not renew the license, then
the next two questions need not be considered. The
useful life is limited to the term of the
contract. If the company intends to renew
the contract because it will continue to service
the area, the CPA should determine whether renewal
or extension is possible. In some cases, the
contract will stipulate that it is. If the
contract is silent on this issue, CPAs should look
to the company’s history. If it has successfully
extended this contract or similar ones in the
past, this is evidence of what it may do in the
future. If the type of contract is new for the
company, the CPA might obtain information from
other companies in the same industry. For example,
competing broadcasters may have renewed similar
contracts, providing a basis for believing this
company could do the same. Of course, if there are
stipulations in the contract that prohibit the
company from renewing or extending it, the useful
life likely is limited to the contract term.
Is there a substantial cost to renew or
extend? Once a case for renewal
or extension has been established, CPAs should
consider the associated costs. For instance, the
broadcast license may be renewable at a much
higher price than the company originally paid,
making the cost of renewal prohibitive. The
difficulty in evaluating the cost variable is what
to include. The FASB Emerging Issues Task Force
(EITF) has considered the issue of renewal costs.
Normal costs directly associated with the renewal
or extension process, such as legal and filing
fees, always should be taken into account. There
also may be costs that arise as a result of the
negotiations between the two contracting parties,
as when one party makes renewal or extension
conditional upon receiving some dollar amount. A
conservative view would be to include this as a
renewal cost. Next, CPAs should look at the costs
in relation to the value of the asset to determine
whether they are “substantial.” There is no
explicit benchmark for this; rather it is a matter
of judgment. It may help to ask whether the costs
are “minimal” compared to the value of the asset
or “inconsequential” to the renewal or extension.
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| |
Will material modifications be required?
The third element in whether an
intangible asset is limited to its
contractual/legal life is whether the asset or
associated rights will substantively change as a
result of contract renewal or extension. If the
renegotiation will yield a substantively different
asset, then the current asset’s life is limited to
the contract term. However, if renegotiation will
produce only technical changes in the contract
terms (such as improved protection for one party
or another) without affecting the actual asset, it
remains substantively the same. The EITF
considered the material modification variable and
generally concluded that what constitutes such a
variable is a matter of judgment. It said the
spirit of Statement no. 142 is to consider whether
the life of the asset being evaluated is
definite—not the life of some other asset that is
a variant of the original. Consider again the
broadcast license. Assume the license-granting
authority changed the nature of the broadcasts the
license allows. This contractual modification
would likely change the manner in which the
license provides a benefit to the company, as well
as the associated cash flows. Although the company
can renew the original contract, the result is a
new asset. Anticipating the material modification
of the new license agreement, the company would
limit the useful life of the original license to
its contract term. As with renewal and costs,
absent other information the best indicator of
likely modifications is the company’s history of
renewals and extensions of this or similar
contracts.
IS THE LIFE INDEFINITE?
Once it appears the
contract is renewable or extendable without
substantial cost or modification, a useful life
longer than the contract term is a defensible
option for the company. CPAs now must decide
whether the benefits the asset provides will
continue indefinitely. If they will, the asset has
an indefinite useful life and the company should
not amortize it. If for some reason the asset’s
life stretches beyond its legal term but is not
indefinite, calculate a best estimate of that
useful life. (Note that indeterminate life and
indefinite life are not synonymous—Statement no.
142 requires companies to make a best estimate for
the former.) The exhibit
provides a decision path CPAs can use to
determine the useful life of contractual/legal
intangible assets.
Critical
Decisions for
Determining the Useful Life of an
Intangible Asset |
|
REVISIT THE ASSET PERIODICALLY
Statement no. 142
requires that companies revisit intangible assets
with indefinite lives each reporting period to
determine whether the lives are still indefinite.
As a practical matter it may help to consider, at
the time of acquisition, what circumstances might
limit or reduce an asset’s useful life, making
them easier to spot in future years. If the
company determines a useful life is finite, it
should assign that life to the asset and begin
amortization over that period. It’s also necessary
to periodically consider whether the value of an
asset has been impaired; Statement no. 142
requires companies to test intangible assets,
including goodwill, for impairment at least
annually by comparing their carrying value to
their fair value. Any excess of carrying value
over fair value should be eliminated by reducing
the asset’s carrying value to fair value and
recognizing an impairment loss for that amount.
As a practical matter, CPAs should always
consider how a change in useful life is related to
an asset’s value and vice versa. For example, if
management decides it will not seek to renew a
contract, the related intangible asset that once
had an indefinite life now has a life equivalent
to the remaining contract term (or even shorter).
Because of the new perspective on the contract,
the value of the asset on the balance sheet may be
higher than its fair value, particularly since it
previously had not been amortized. Similarly, if
the same intangible asset (which has an indefinite
life and is not being amortized) is suddenly
impaired, the asset’s indefinite life should be
carefully reevaluated. Since the fair value has
declined, the foreseeable period of benefit from
the asset now is limited. In this case the company
would assign the asset a finite useful life and
amortize it henceforth. |