Question & Answer

Merck & Co., Inc. and Johnson & Johnson are two leading producers of health-care products. Each has considerable assets, and each expends considerable funds each year toward the development of new products. The development of a new health-care product is often very expensive, and risky. New products frequently must undergo considerable testing before approval for distribution to the public. For example, it took Johnson & Johnson 4 years and $200 million to develop its 1-DAY ACUVUE contact lenses. Below are some basic data compiled from the financial statements of these two companies.

Instructions

(a) What kinds of intangible assets might a health-care products company have? Does the composition of these intangibles matter to investors—that is, would it be perceived differently if all of Merck’s intangibles were goodwill than if all of its intangibles were patents?

(b) Suppose the president of Merck has come to you for advice. He has noted that by eliminating research and development expenditures the company could have reported $4 billion more in net income. He is frustrated because much of the research never results in a product, or the products take years to develop. He says shareholders are eager for higher returns, so he is considering eliminating research and development expenditures for at least a couple of years. What would you advise?

(c) The notes to Merck’s financial statements note that Merck has goodwill of $1.1 billion. Where does recorded goodwill come from? Is it necessarily a good thing to have a lot of goodwill on a company’s books?

The financial statements of Marks and Spencer plc (M&S) are available at the book’s companion website or can be accessed at http://corporate.marksandspencer.com/documents/publications/2012/

Annual_Report_2012.

Instructions

Refer to M&S’s financial statements and the accompanying notes to answer the following questions.

(a) Does M&S report any intangible assets and goodwill in its financial statements and accompanying notes? Briefly explain.

(b) How much selling and marketing expenses does M&S report in 2011 and 2012? Briefly discuss the significance of these expenses to M&S’s operating results.

King Company is contemplating the purchase of a smaller company, which is a distributor of King’s products. Top management of King is convinced that the acquisition will result in significant synergies in its selling and distribution functions. The financial management group (of which you are a part) has been asked to analyze the effects of the acquisition on the combined company’s financial statements. This is the first acquisition for King, and some of the senior staff insist that based on their recollection of goodwill accounting, any goodwill recorded on the acquisition will result in a “drag” on future earnings for goodwill amortization. Other younger members on the staff argue that goodwill accounting has changed. Your supervisor asks you to research this issue.

Instructions

Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.)

(a) Identify the accounting literature that addresses goodwill and other intangible assets.

(b) Define goodwill.

(c) Is goodwill subject to amortization? Explain.

(d) When goodwill is recognized by a subsidiary, should it be tested for impairment at the consolidated level or the subsidiary level? Discuss.

Margaret Avery Company from time to time embarks on a research program when a special project seems to offer possibilities. In 2012, the company expends $325,000 on a research project, but by the end of 2012, it is impossible to determine whether any benefit will be derived from it.

(a) What account should be charged for the $325,000, and how should it be shown in the financial statements?

(b) The project is completed in 2013, and a successful patent is obtained. The R&D costs to complete the project are $130,000 ($36,000 of these costs were incurred after achieving economic viability). The administrative and legal expenses incurred in obtaining patent number 472-1001-84 in 2013 total $24,000. The patent has an expected useful life of 5 years. Record these costs in journal entry form. Also,record patent amortization (full year) in 2013.

(c) In 2014, the company successfully defends the patent in extended litigation at a cost of $47,200, thereby extending the patent life to December 31, 2021. What is the proper way to account for thiscost?Also, record patent amortization (full year) in 2014.

(d) Additional engineering and consulting costs incurred in 2014 required to advance the design of a new version of the product to the manufacturing stage total $60,000. These costs enhance the design of the product considerably, but it is highly uncertain if there will be a market for the new version of the product. Discuss the proper accounting treatment for this cost.

Use the information provided in IFRS12-8. Assume that the recoverable amount of the division is estimated to be $750,000. Prepare Waters’ journal entry, if necessary, to record impairment of the goodwill.

Waters Corporation purchased Johnson Company 3 years ago and at that time recorded goodwill of $400,000. The Johnson Division’s net assets, including the goodwill, have a carrying amount of $800,000. The recoverable amount of the division is estimated to be $1,000,000. Prepare Waters’ journal entry, if necessary, to record impairment of the goodwill.

Use the information in IFRS12-6. Assume that at the end of the year following the impairment (after recording amortization expense), the estimated recoverable amount for the patent is $130,000. Prepare Kenoly’s journal entry, if needed.

Kenoly Corporation owns a patent that has a carrying amount of $300,000. Kenoly expects future net cash flows from this patent to total $210,000 over its remaining life of 10 years. The recoverable amount of the patent is $110,000. Prepare Kenoly’s journal entry, if necessary, to record the loss on impairment.

Indicate whether the following items are capitalized or expensed in the current year.

(a) Purchase cost of a patent from a competitor.

(b) Research costs.

(c) Development costs (after achieving economic viability).

(d) Organizational costs.

(e) Costs incurred internally to create goodwill.

Treasure Land Corporation incurred the following costs in 2014.

Cost of laboratory research aimed at discovery of new knowledge $120,000

Cost of testing in search for product alternatives 100,000

Cost of engineering activity required to advance the design of a product to the manufacturing stage 210,000

Prototype testing subsequent to meeting economic viability 75,000

$505,000

Prepare the necessary 2014 journal entry(ies) for Treasure Land.

Briefly discuss the convergence efforts that are underway in the area of intangible assets.

Briefly describe some of the similarities and differences between GAAP and IFRS with respect to the accounting for intangible assets.

Where can authoritative IFRS guidance related to intangible assets be found?

King Company is contemplating the purchase of a smaller company, which is a distributor of King’s products.

Top management of King is convinced that the acquisition will result in significant synergies in its selling and distribution functions. The financial management group (of which you are a part) has been asked to prepare some analysis of the effects of the acquisition on the combined company’s financial statements.

This is the first acquisition for King, and some of the senior staff insist that based on their recollection of goodwill accounting, any goodwill recorded on the acquisition will result in a “drag” on future earnings for goodwill amortization. Other younger members on the staff argue that goodwill accounting has changed. Your supervisor asks you to research this issue.

Instructions

If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.

(a) Identify the accounting literature that addresses goodwill and other intangible assets.

(b) Define goodwill.

(c) Is goodwill subject to amortization? Explain.

(d) When goodwill is recognized by a subsidiary, should it be tested for impairment at the consolidated level or the subsidiary level? Discuss.

The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report, including the notes to the financial statements, can be accessed at the book’s companion website,

www.wiley.com/college/kieso.

Instructions

Refer to P&G’s financial statements and the accompanying notes to answer the following questions.

(a) Does P&G report any intangible assets, especially goodwill, in its 2011 financial statements and accompanying notes?

(b) How much research and development (R&D) cost was expensed by P&G in 2010 and 2011? What percentage of sales revenue and net income did P&G spend on R&D in 2010 and 2011?

Czeslaw Corporation’s research and development department has an idea for a project it believes will culminate in a new product that would be very profitable for the company. Because the project will be very expensive, the department requests approval from the company’s controller, Jeff Reid.

Reid recognizes that corporate profits have been down lately and is hesitant to approve a project that will incur significant expenses that cannot be capitalized due to the requirements of the authoritative literature.

He knows that if they hire an outside firm that does the work and obtains a patent for the process, Czeslaw Corporation can purchase the patent from the outside firm and record the expenditure as an asset. Reid knows that the company’s own R&D department is first-rate, and he is confident they can do the work well.

Instructions

Answer the following questions.

(a) Who are the stakeholders in this situation?

(b) What are the ethical issues involved?

(c) What should Reid do?

Cuevas Co. is in the process of developing a revolutionary new product. A new division of the company was formed to develop, manufacture, and market this new product. As of year-end (December 31, 2014), the new product has not been manufactured for resale. However, a prototype unit was built and is in operation.

Throughout 2014, the new division incurred certain costs. These costs include design and engineering studies, prototype manufacturing costs, administrative expenses (including salaries of administrative personnel), and market research costs. In addition, approximately $900,000 in equipment (with an estimated useful life of 10 years) was purchased for use in developing and manufacturing the new product. Approximately

$315,000 of this equipment was built specifically for the design development of the new product.

The remaining $585,000 of equipment was used to manufacture the pre-production prototype and will be used to manufacture the new product once it is in commercial production.

Instructions

(a) How are “research” and “development” defined in the authoritative literature (GAAP)?

(b) Briefly indicate the practical and conceptual reasons for the conclusion reached by the FinancialAccounting Standards Board on accounting and reporting practices for research and development costs.

(c) In accordance with GAAP, how should the various costs of Cuevas described above be recorded on the financial statements for the year ended December 31, 2014?

On June 30, 2014, your client, Ferry Company, was granted two patents covering plastic cartons that it had been producing and marketing profitably for the past 3 years. One patent covers the manufacturing process, and the other covers the related products.

Ferry executives tell you that these patents represent the most significant breakthrough in the industry in the past 30 years. The products have been marketed under the registered trademarks Evertight, Duratainer, and Sealrite. Licenses under the patents have already been granted by your client to other manufacturers in the United States and abroad, and are producing substantial royalties.

On July 1, Ferry commenced patent infringement actions against several companies whose names you recognize as those of substantial and prominent competitors. Ferry’s management is optimistic that these suits will result in a permanent injunction against the manufacture and sale of the infringing products as well as collection of damages for loss of profits caused by the alleged infringement.

The financial vice president has suggested that the patents be recorded at the discounted value of expected net royalty receipts.

Instructions

(a) What is the meaning of “discounted value of expected net receipts”? Explain.

(b) How would such a value be calculated for net royalty receipts?

(c) What basis of valuation for Ferry’s patents would be generally accepted in accounting? Give supporting reasons for this basis.

(d) Assuming no practical problems of implementation, and ignoring generally accepted accounting principles, what is the preferable basis of valuation for patents? Explain.

(e) What would be the preferable theoretical basis of amortization? Explain.

(f) What recognition, if any, should be made of the infringement litigation in the financial statements for the year ending September 30, 2014? Discuss.

After securing lease commitments from several major stores, Auer Shopping Center, Inc. was organized and built a shopping center in a growing suburb.

The shopping center would have opened on schedule on January 1, 2014, if it had not been struck by a severe tornado in December. Instead, it opened for business on October 1, 2014. All of the additional construction costs that were incurred as a result of the tornado were covered by insurance.

In July 2013, in anticipation of the scheduled January opening, a permanent staff had been hired to promote the shopping center, obtain tenants for the uncommitted space, and manage the property.

A summary of some of the costs incurred in 2013 and the first nine months of 2014 follows.

January 1, 2014 through

2013 September 30, 2014

Interest on mortgage bonds $720,000 $540,000

Cost of obtaining tenants 300,000 360,000

Promotional advertising 540,000 557,000

The promotional advertising campaign was designed to familiarize shoppers with the center. Had it been known in time that the center would not open until October 2014, the 2013 expenditure for promotional advertising would not have been made. The advertising had to be repeated in 2014.

All of the tenants who had leased space in the shopping center at the time of the tornado accepted the

October occupancy date on condition that the monthly rental charges for the first 9 months of 2014 be canceled.

Instructions

Explain how each of the costs for 2013 and the first 9 months of 2014 should be treated in the accounts of the shopping center corporation. Give the reasons for each treatment.

Montana Matt’s Golf Inc. was formed on July 1, 2013, when Matt Magilke purchased the Old Master Golf Company. Old Master provides video golf instruction at kiosks in shopping malls. Magilke plans to integrate the instructional business into his golf equipment and accessory stores. Magilke paid $770,000 cash for Old Master. At the time, Old Master’s balance sheet reported assets of $650,000 and liabilities of $200,000 (thus owners’ equity was $450,000). The fair value of Old Master’s assets is estimated to be $800,000. Included in the assets is the Old Master trade name with a fair value of $10,000 and a copyright on some instructional books with a fair value of $24,000. The trade name has a remaining life of 5 years and can be renewed at nominal cost indefinitely. The copyright has a remaining life of 40 years.

Instructions

(a) Prepare the intangible assets section of Montana Matt’s Golf Inc. at December 31, 2013. How much amortization expense is included in Montana Matt’s income for the year ended December 31, 2013?

Show all supporting computations.

(b) Prepare the journal entry to record amortization expense for 2014. Prepare the intangible assets section of Montana Matt’s Golf Inc. at December 31, 2014. (No impairments are required to be recorded in 2014.)

(c) At the end of 2015, Magilke is evaluating the results of the instructional business. Due to fierce competition from online and television (e.g., the Golf Channel), the Old Master reporting unit has been losing money. Its book value is now $500,000. The fair value of the Old Master reporting unit is $420,000. The implied value of goodwill is $90,000. Magilke has collected the following information related to the company’s intangible assets.

On July 31, 2014, Mexico Company paid $3,000,000 to acquire all of the common stock of Conchita Incorporated, which became a division of Mexico. Conchita reported the following balance sheet at the time of the acquisition.

It was determined at the date of the purchase that the fair value of the identifiable net assets of Conchita was $2,750,000. Over the next 6 months of operations, the newly purchased division experienced operating losses. In addition, it now appears that it will generate substantial losses for the foreseeable future. At December 31, 2014, Conchita reports the following balance sheet information.

It is determined that the fair value of the Conchita Division is $1,850,000. The recorded amount for

Conchita’s net assets (excluding goodwill) is the same as fair value, except for property, plant, and equipment, which has a fair value $150,000 above the carrying value.

Instructions

(a) Compute the amount of goodwill recognized, if any, on July 31, 2014.

(b) Determine the impairment loss, if any, to be recorded on December 31, 2014.

(c) Assume that fair value of the Conchita Division is $1,600,000 instead of $1,850,000. Determine the impairment loss, if any, to be recorded on December 31, 2014.

(d) Prepare the journal entry to record the impairment loss, if any, and indicate where the loss would be reported in the income statement.

Salaries and Other Expenses

Number Employee (excluding Building of Projects Benefits Depreciation Charges)

Completed projects with long-term benefits 15 $ 90,000 $50,000

Abandoned projects or projects that benefit the current period 10 65,000 15,000

Projects in process—results indeterminate 5 40,000 12,000

Total 30 $195,000 $77,000

Current assets $ 800,000 Current liabilities $ 600,000

Noncurrent assets 2,700,000 Long-term liabilities 500,000

Total assets $3,500,000 Stockholders’ equity 2,400,000

Total liabilities and stockholders’ equity $3,500,000

Current assets $ 450,000

Noncurrent assets (including goodwill recognized in purchase) 2,400,000

Current liabilities (700,000)

Long-term liabilities (500,000)

Net assets $1,650,000

During 2012, Robin Wright Tool Company purchased a building site for its proposed research and development laboratory at a cost of $60,000. Construction of the building was started in 2012. The building was completed on December 31, 2013, at a cost of $320,000 and was placed in service on January 2, 2014. The estimated useful life of the building for depreciation purposes was 20 years. The straight-line method of depreciation was to be employed, and there was no estimated residual value.

Management estimates that about 50% of the projects of the research and development group will result in long-term benefits (i.e., at least 10 years) to the corporation. The remaining projects either benefit the current period or are abandoned before completion. A summary of the number of projects and the direct costs incurred in conjunction with the research and development activities for 2014 appears below.

Salaries and Other Expenses

Number Employee (excluding Building of Projects Benefits Depreciation Charges)

Completed projects with long-term benefits 15 $ 90,000 $50,000

Abandoned projects or projects that benefit the current period 10 65,000 15,000

Projects in process—results indeterminate 5 40,000 12,000

Total 30 $195,000 $77,000

Upon recommendation of the research and development group, Robin Wright Tool Company acquired a patent for manufacturing rights at a cost of $88,000. The patent was acquired on April 1, 2013, and has an economic life of 10 years.

Instructions

If generally accepted accounting principles were followed, how would the items above relating to research and development activities be reported on the following financial statements?

(a) The company’s income statement for 2014.

(b) The company’s balance sheet as of December 31, 2014.

Be sure to give account titles and amounts, and briefly justify your presentation.

Information concerning Sandro Corporation’s intangible assets is as follows.

1. On January 1, 2014, Sandro signed an agreement to operate as a franchisee of Hsian Copy Service, Inc. for an initial franchise fee of $75,000. Of this amount, $15,000 was paid when the agreement was signed, and the balance is payable in 4 annual payments of $15,000 each, beginning January 1, 2015. The agreement provides that the down payment is not refundable and no future services are required of the franchisor. The present value at January 1, 2014, of the 4 annual payments discounted at 14% (the implicit rate for a loan of this type) is $43,700. The agreement also provides that 5% of the revenue from the franchise must be paid to the franchisor annually. Sandro’s revenue from the franchise for 2014 was $900,000. Sandro estimates the useful life of the franchise to be 10 years. (Hint: You may want to refer to Chapter 18 to determine the proper accounting treatment for the franchise fee and payments.)

2. Sandro incurred $65,000 of experimental and development costs in its laboratory to develop a patent that was granted on January 2, 2014. Legal fees and other costs associated with registration of the patent totaled $17,600. Sandro estimates that the useful life of the patent will be 8 years.

3. A trademark was purchased from Shanghai Company for $36,000 on July 1, 2011. Expenditures for successful litigation in defense of the trademark totaling $10,200 were paid on July 1, 2014. Sandro estimates that the useful life of the trademark will be 20 years from the date of acquisition.

Instructions

(a) Prepare a schedule showing the intangible assets section of Sandro’s balance sheet at December 31,

2014. Show supporting computations in good form.

(b) Prepare a schedule showing all expenses resulting from the transactions that would appear on

Sandro’s income statement for the year ended December 31, 2014. Show supporting computations in good form.

Fields Laboratories holds a valuable patent (No. 758-6002-1A) on a precipitator that prevents certain types of air pollution. Fields does not manufacture or sell the products and processes it develops. Instead, it conducts research and develops products and processes which it patents, and then assigns the patents to manufacturers on a royalty basis. Occasionally it sells a patent. The history of Fields patent number 758-6002-1A is as follows.

Date Activity Cost

2005–2006 Research conducted to develop precipitator $384,000

Jan. 2007 Design and construction of a prototype 87,600 March 2007 Testing of models 42,000

Jan. 2008 Fees paid engineers and lawyers to prepare patent application; patent granted June 30, 2008 59,500 Nov. 2009 Engineering activity necessary to advance the design of the precipitator to the manufacturing stage 81,500

Dec. 2010 Legal fees paid to successfully defend precipitator patent 42,000

April 2011 Research aimed at modifying the design of the patented precipitator 43,000

July 2015 Legal fees paid in unsuccessful patent infringement suit against a competitor 34,000

Fields assumed a useful life of 17 years when it received the initial precipitator patent. On January 1, 2013, it revised its useful life estimate downward to 5 remaining years. Amortization is computed for a full year if the cost is incurred prior to July 1, and no amortization for the year if the cost is incurred after June 30. The company’s year ends December 31.

Instructions

Compute the carrying value of patent No. 758-6002-1A on each of the following dates:

(a) December 31, 2008.

(b) December 31, 2012.

(c) December 31, 2015.

Reichenbach Co., organized in 2013, has set up a single account for all intangible assets. The following summary discloses the debit entries that have been recorded during 2014 and 2015.

Intangible Assets

7/1/14 8-year franchise; expiration date 6/30/22 $ 48,000

10/1/14 Advance payment on laboratory space (2-year lease) 24,000

12/31/14 Net loss for 2013 including state incorporation fee, $1,000, and related legal fees of organizing, $5,000 (all fees incurred in 2013) 16,000

1/2/15 Patent purchased (10-year life) 84,000

3/1/15 Cost of developing a secret formula (indefinite life) 75,000

4/1/15 Goodwill purchased (indefinite life) 278,400

6/1/15 Legal fee for successful defense of patent purchased above 12,650

9/1/15 Research and development costs 160,000

Instructions

Prepare the necessary entries to clear the Intangible Assets account and to set up separate accounts for distinct types of intangibles. Make the entries as of December 31, 2015, recording any necessary amortization and reflecting all balances accurately as of that date. (Ignore income tax effects.)