Volume 8, No. 1, Spring 2003

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Impairment of Intangible Assets and Goodwill

A Valuation Overview

By G. Dennis Bingham, Appraiserl; & Scot A. Torkelson, Vice PResident

In June of 2001, the Financial Standards Accounting Board (FASB) issued two standards that significantly affected the accounting for intangible assets and goodwill: SFAS 141, Business Combination and SFAS 142, Goodwill and Other Intangible Assets.

This article provides an overview of the valuation requirements of SFAS 141 and 142 and presents a simplified illustration of the goodwill impairment test.

SFAS 141 and SFAS 142
SFAS 141 requires the use of the purchase accounting method and prohibits the use of the pooling-of-interest method of accounting for business combinations. SFAS 141 also requires that companies recognize and value acquired intangible assets separately from goodwill, if certain criteria are met.

When using the purchase accounting method for business combinations, the total fair market value of the consideration given up to acquire the target company is included in the investment account. The investor may pay more or less than the book value of the target company's assets when acquiring the target. This difference between cost and book value is composed of two elements: the first is the excess of fair market value over book value of the identifiable assets of the target company. The second element is goodwill.

SFAS 142 requires that companies no longer amortize goodwill, but must perform impairment tests annually, or earlier if indicators of potential impairment are identified. In addition, SFAS 142 requires that the amortization of intangible assets with indefinite lives must be discontinued, and the existing recognized intangible assets should have their remaining useful lives (RUL) reassessed.

For the purpose of this discussion, impairment is the difference between an intangible asset's current carrying cost and its current fair value. Goodwill impairment is the end result when the earnings of a company are compared to the value of the assets booked; if the earnings cannot "carry" the assets, then the goodwill is impaired and it is written down.

Intangible Assets and Intellectual Property Identification
Congress enacted IRS Revenue Code Section 197 as part of the Revenue Reconciliation Act of 1993. Section 197 was written for the capitalization and amortization of purchased intangible assets for tax purposes, though the definitions and guidelines are commonly applied to intangible asset valuation for other purposes as well.

According to the guidelines in Section 197, intangible assets are assets that lack physical substance, are created in the normal course of business and have certain attributes such as: a specific identification, legal existence, legal transferability, tangible evidence of existence, created at a specific, identifiable point in time or as a result of identifiable events, are subject to termination and destruction, and have the capacity to earn income. Appraisers frequently group intangible assets into categories that utilize the same or similar valuation methods. Shown below is one way of categorizing intangible assets:

• Artistic-related: musical composition copyrights, literary composition copyrights, and film copyrights
• Data processing-related: computer software copyrights, automated databases, and chip masks and masters
• Engineering-related: patents and trade secrets
• Marketing-related: trademarks, trade names, and service marks
• Technology-related: engineering drawings, technical documentation, and patent applications
• Goodwill-related: going-concern value

Intellectual property is a special class of intangible assets. Intellectual property is "created by human intellectual and/or inspirational activity"¹. Common categories of intellectual property include creative/artistic and innovative/engineering.

A brief description of some of the major intangible assets and intellectual properties is presented below².

• Copyright: According to Black's Law Directory a copyright is "An intangible, incorporeal right granted by statute to the author or originator of certain literary or artistic productions, whereby he is invested, for a specified period of time, with the sole, exclusive privilege of multiplying copies of the same and publishing and selling them." The copyright arises from the creation of the work-neither registration nor publication is a condition to obtaining a copyright. Works included as copyright include: literary works; musical works; dramatic works; pantomimes and choreographic works; pictorial, graphic, and sculptural works; motion pictures and other audio visual works; and sound recordings.
• Patent: There are three types of U.S. patents: design patents covering the ornamental appearance of articles of manufacture or machines; utility patents covering machines, articles of manufacture, compositions of matter, and process; and plant patents covering asexually reproduced plants. U.S. design patents have a term of 14 years from the date of issuance. Plant patents have a term of 17 years, while utility patents vary from 17 to 20 years.
• Trademark/Service Mark: A trademark may take many forms including a word, name, symbol or device, which indicates the source of origin of goods and is capable of distinguishing those goods from the goods of others. A service mark applies to services rather than goods.
• Trade Secrets: Proprietary information that may be protected is virtually limitless. Examples include such types of information as: architectural plans; blue prints; business plans; customer lists; computer software; designs; formulas; information on manufacturing techniques; marketing analysis and plans; and methods of doing business.

Standard of Value
The standard of value to be used is fair value. Fair value is defined as the amount at which an asset could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidation sale³. Fair value is to be determined by quoted market prices in active markets. If quoted market prices are not available, then the best information available should be utilized.

With regard to the FASB rules, fair value and fair market value are equivalent.

Valuation Approaches and Methods
The valuation of intangible assets tends to follow the "Best Method Rule." This means that an appraiser would not typically use all three approaches (income, market, asset)-but would utilize the best method.

IRS Section 482 provides a comprehensive discussion of the various methods that can be used for the valuation of intangible assets specifically related to intercompany transfers. These techniques can also be applied to more general intangible asset valuation matters. FASB's use of the best method rule is a good example. In cases of intangible asset valuations the appraiser frequently finds that while all three approaches to value can theoretically be used, there is insufficient data to perform all three. The best method rule allows the appraiser to select and use the best method available, and, for intangible asset valuations, this analysis is deemed sufficient to support the concluded value.

For intangible assets, other than goodwill, valuation methods may include replacement cost, reproduction cost, income allocation, direct capitalization, yield capitalization, sales comparisons, license comparison, and royalty rates. For goodwill, the most frequently used method to demonstrate value is the excess earnings method, which is best at allocating earnings to the tangible assets and showing the excess earnings which are then allocated to the goodwill category. This gives the appraiser the total goodwill value and, in essence, the write-down target if there is impairment.

Impairment Testing
For intangible assets with a finite life, impairment testing is required only if an indication of impairment is identified. If an event has occurred, an appraiser must determine if the asset's useful life needs to be revised or if impairment should be determined using the undiscounted cash flow test.

For intangible assets with an indefinite life, an impairment test must be performed annually. If the asset's fair value is less than the carrying value, the carrying value should be adjusted for the impairment.

Goodwill is to be tested for impairment at the reporting unit level at least annually. A reporting unit is an operating segment or one level below an operating segment. An operating segment is a component of the enterprise that is characterized by the following: engages in business activities from which it may earn revenues and incur expenses; whose results are regularly reviewed; and for which discrete financial information is available.

The goodwill test is a two-part test. Step 1 is a test of the carrying value of the reporting unit to its fair value. If the fair value of the reporting unit is less than its carrying value, then step 2 must be completed. Step 2 compares the "implied fair value of goodwill" to the carrying value of goodwill. If the implied fair value is less than the carrying value, then the carrying value should be adjusted for the impairment. The best method of valuation for the test of impairment is the excess earnings method. Many valuation practitioners criticize the excess earnings method of valuation, but no other method can as effectively delineate between the tangible assets and the goodwill being valued: which is necessary for the test of impairment. It is therefore incumbent upon valuation experts to learn the appropriate application of this important and useful method in the area of intangible asset valuation.

It should be noted that if goodwill and another intangible asset of a reporting unit are tested at the same time, the other intangible asset must be tested for impairment before goodwill.

Example: Goodwill and Impairment Calculation

The following is a simplified example of the application of the accounting process used to determine goodwill and the impairment of intangible assets.

Goodwill at Acquisition
Assume that P Company acquires 100% of S Company for $5,000,000. At the time of the acquisition, S had recorded assets of $10,500,000 and liabilities of $7,300,000. The assets had a fair market value (FMV) of $11,800,000.
FMV of assets $ 11,800,000
Less: liabilities 7,300,000
Net assets 4, 500,000
Less: purchase price -5,000,000
Differential $ (500,000)
Further, P determines that S has recognizable intangible assets apart from goodwill. S has definite life intangible assets of $100,000 and indefinite life intangible assets of $150,000. The remaining unidentified intangible asset ($250,000) is goodwill.
Definite life of intangible assets $ 100,000
Indefinite life of intangible assets 150,000
Goodwill 250,000

Test of impairment
Assume that two years later, P is preparing the year-end financial statements. The company's appraiser is asked to perform an impairment test of P's intangible assets. The following financial information pertains to P's latest 12-months operations.

Balance Sheet As of December 31, 2003
ASSETS
Current assets $ 7,500,000
(cash, receivables & inventory)
Fixed assets-net 9,000,000
Intangible assets 1,500,000
Total assets $ 18,000,000
LIABILITIES & EQUITY
Current liabilities $ 6,000,000
(payables and accruals)
Long-term debt 6,000,000
Equity 6,000,000
Total Liabilities & Equity $ 18,000,000
Net Cash Flow As of December 31, 2003
Net cash flow (invested capital basis) $ 2,250,000

• Definite life intangible assets: The appraiser first determines if there is any indication of impairment of the intangible assets that are subject to amortization. A few of the impairment indicators an appraiser may consider include the following: a significant decrease in the market value of the asset(s); any significant change in the useful life of the asset(s); significant changes in the business climate that could adversely impact the value of the asset(s); and a current period cash flow loss coupled with a history of cash flow losses.
  Assume, in this example, that there are no indications of impairment and net cash flow is positive. Accordingly, there is no indication of impairment and no adjustment is required.
• Indefinite life intangible assets: As noted above, the appraiser first attempts to determine if there is any indication of impairment. A few of the impairment indicators an appraiser may consider include the following: a significant change in the business climate; a change in the regulatory environment; and the loss of key personnel.
  Assume that there was a recent major breakthrough in technology and that the value of the indefinite intangible asset has fallen by $100,000. After determining the amount of impairment the appraiser should also consider whether the asset now has a definite life.
• Goodwill: Using the excess earnings method, the appraiser must determine two rates of return: a reasonable rate of return on the subject's net tangible assets and an excess earnings capitalization rate. In this example, 12% and 25%, respectively. Using this analysis, the estimated intangible asset value of P is $1,080,000. From this amount the appraiser must subtract the estimated fair value of the definite life and indefinite life intangible assets. This results in an estimated fair value of goodwill of $180,000. The $180,000 fair value is less than the subject's carrying value. Accordingly, there is an impairment of goodwill in the amount of $320,000.

Excess Earnings Calculation of Impaired Goodwill
Net cash flow (after-tax) $ 2,250,000
Fair market value
tangible assets 16,500,000
Required return on
tangible assets 12%
Required level of economic income 1,980,000
Excess economic income 270,000
Direct capitalization rate 25%
Estimated intangible asset value $ 1,080,000
Estimated intangible asset value $ 1,080,000
Less: fair value
definite life intangible assets -500,000
indefinite life intangible assets -400,000
Estimated fair value of goodwill 180,000
Carrying value of goodwill 500,000
Impaired Goodwill $ (320,000)

Conclusion
Each valuation of intangible assets, including intellectual property and goodwill, is unique and requires the close cooperation of the company, its public accountants, and the appraiser. Accordingly, by following a well-planned, step-by-step appraisal process, each team member can complete his/her work assignment in a timely and cost efficient manner. The end result is a reasonable, defensible indication of value.

¹ Schweihs, Robert S., Valuing Intellectual Property. Washington D.C.: The Institute of Business Appraisers' 2002 Conference. ² Overview of Intellectual Property for Business Lawyers, 8th Edition. (Minneapolis: Kinney & Lange, P.A., 1995) ³ SFAS 141