Week 3 - Intangible assets

Question 1

Intangible assets + basic definition of goodwill

Answer 1

1. Present economic resource
2. Potential to produce ECONOMIC BENEFITS
3. No physical substance (eg. unlike a chair)

eg. goodwill (= difference between value of a biz & the FAIR VALUE of its IDENTIFIABLE NET ASSETS); represents the economic advantage of an existing business
- operating licenses and franchises
- brands
- patents
- R&D

Question 2

Why do intangible assets matter?

Are Earnings better in predicting future cash flows?

Answer 2

1. New economic paradigm; modern economy: intellectual knowledge, brands, patents, human capital etc. may be more significant sources of wealth than, eg. PPE, for some companies
2. Yes, because of INTANGIBLES (Ball & Nikolaev, JAE 2022)
   - b/c of the relationship that HIGHER EXPENSES now means higher FUTURE REVENUES -> HIGHER EARNINGS (=rev - exp) as have a strong relationship with revenue
   > current debate b/c there are arguments that there are too many acct. rules and regulations and DISCRETION that makes earnings worse at predicting CFs than CFs themselves

Question 3

Case study: WorldCom Intangibles fraud

Answer 3

1. Misled investors and overstated income by $9 billion
2. FEES (cable expenses) paid to 3rd parties for their services were treated as “customer relationship” intangibles and capitalised as assets…
3. …although these had to be incurred as EXPENSES instead
4. Capitalisation thus allowed smearing out of amortisation expense over many years, to inflate earnings & consistently outperform benchmarks and market expectations
5. Internal accountants spotted the fraud and went to the SEC
6. Arthur Andersen was the auditor; WorldCom was their most valuable client

Question 4

IAS 38 Intangible assets
1. Definition -> vague and thus companies can use LEEWAY to use intangibles OPPORTUNISTICALLY
2. Conditions for recognition

Answer 4

1. IDENTIFIABLE, NONMONETARY asset, without physical substance
   - Identifiable: SEPARABLE and/or LEGAL RIGHTS
   » separable = we can detach it from the entity and sell it to someone else, eg. patents but not brand value
   » legal rights like lawsuits, processes
2. Recognise ONLY IF:
   - probable future ECONOMIC BENEFITS & costs be measured RELIABLY
   - CONTROL of asset can be demonstrated

Question 5

IAS 38 Intangible assets
Measurement

Answer 5

1. Cost or fair value (similar to PPE)
2. Cost model, or revaluation model

However,
3. UNIQUE and INTERNALLY GENERATED intangibles cannot be capitalised
4. We can only recognise assets with an ACTIVE MARKET
5. but if acquired, capitalised and AMORTISED

Question 6

IAS 38 Intangible assets
Different treatment of Research and Development (R&D)

Answer 6

1. R is UNIQUE & INTERNALLY GENERATED (NO ACTIVE MARKET), not related to an economic benefit yet
   -> EXPENSED
   » not allowed to capitalise b/c if research fails and we have to remove it from BS, we’ll get a volatile balance sheet
2. D is associated with sth that can be SOLD & represents a clear(er) ECONOMIC BENEFIT
   -> CAPITALISED & AMORTISED
   - essential characteristics: technical feasibility, ability to use/sell the asset, generate future economic benefits, be measured reliably

Question 7

IAS 38 Intangible assets
1. Subsequent measurement - intangibles with finite vs infinite useful life
2. Similarity and difference from PP&E

Answer 7

1. Finite useful life - AMORTISED
2. Infinite useful life - do not amortise & need more IMPAIRMENT TESTS to compensate
   eg. brand value

Similarity
3. Amortisation expense is calculated similarly to depreciation expense for PP&E
Difference
4. Amortisation starts when ASSET IS AVAILABLE FOR USE, and CEASES when classified as held for sale or derecognised
» ie. If intangible is not yet ready for use (like for development), we don’t amortise yet.
» This means we can TEMPORARILY STORE EXPENSES that will only be depreciated later on.

Question 8

Goodwill
Microsoft-Nokia example

Answer 8

1. From 2014 to 2015, 33% drop in Microsoft’s operating income
2. Microsoft purchased Nokia’s mobile phone division in 2014 for about $10 billion…
3. …but had to WRITE OFF the recorded value of Goodwill and report it as a LOSS when Microsoft acknowledged that $10 billion in Nokia-related intangible assets was worth just $2.5 billion

Question 9

Is goodwill an asset?

Answer 9

• the IASB considers goodwill to be an asset
• represents economic reality, PROBABLE future economic benefits
• COST can be measured RELIABLY once a company has been acquired

Question 10

Concerns after recognition of goodwill

Answer 10

1. Goodwill cannot be reliably measured SEPARATELY from the business as a whole
2. Value of goodwill may FLUCTUATE widely and unsystematically (like for Microsoft-Nokia)
3. Acct. treatment of goodwill and other assets is inconsistent
   » cannot reliably estimate if internally generated but can reliably measure if someone buys your co.

Question 11

What if goodwill is not an asset?
ie. What do we do if we overpay for goodwill?

Answer 11

1. Do we ELIMINATE goodwill directly against RESERVES in the year of acquisition? - Which (profit) reserve should we write it off against?
2. Whichever reserve we use for the immediate write-off, SHAREHOLDERS’ EQUITY could go down to 0 or negative funds if a co. makes numerous acquisitions
   - does NOT necessarily represent economic reality!

Question 12

Cryptocurrencies are a NEW type of digital asset.
In October 2022, FASB announced FAIR VALUE ACCOUNTING for crypto assets - for more transparency, fin stt. users can better understand what’s happening at the firm (same as market prices), more informative fin stt.s

How were cryptocurrencies treated before that?

Answer 12

ASC 350: indefinite-lived intangible assets
» acct. boards said that crypto is intangible although clearly MONETARY
1. recognition at acquisition costs
2. NOT AMORTISED (b/c we don’t depreciate currency)
3. at least annual IMPAIRMENT TEST
-> if FV < CV, impairment loss
-> if FV > CV, do nothing
4. when sold and CV differs from FV, recognise loss (if FV<CV) / gain (if FV > CV)

ie. using the COST MODEL, we can only IMPAIR DOWN and never recognise an increase in value even if it does go up
- but if we sell it, we can recognise GAIN ON SALES (or loss)

Question 13

Case: Crypto accounting at Tesla & MicroStrategy

Answer 13

• For both companies’ 4 quarters, there was a huge MISMATCH between the value of Bitcoin in the books and in the market
  eg. Bitcoin’s value was higher than the CARRYING VALUE recorded by Tesla & MS, but they COULD NOT REVALUE UPWARDS due to acct. rules
• thus, financial statement users were misled by the acct. rules that weren’t so applicable in this case

Question 14

Case: Crypto accounting at MicroStrategy (reporting incentives & Non-GAAP earnings)

Answer 14

1. Mgmt wanted non-GAAP reporting (=adjusted earnings) to help facilitate decision-making
2. as they argue that they have no control/influence over Bitcoin price, since can only report losses in Bitcoin price but not when they increase in value
3. MS’s CEO claims that Bitcoin is very important to their firm but reporting as though not part of their normal business -> doesn’t make sense, misleading

Question 15

US GAAP vs IFRS (vs Fair value accounting) - better representation of economic reality?

Answer 15

Under IFRS: CV can be adjusted upwards until the original acquisition cost
-> MATCHES PRICE closely, so IFRS does a better job at portraying economic reality

But, FASB wants Fair value acct. approach. Why?
Drawback: introduces a lot of VOLATILITY
Pro: but has more TRANSPARENCY, better matches ECONOMIC REALITY (since directly matches Bitcoin price), better understanding of what is happening to firms

Question 16

Facebook’s acquisition of WhatsApp case
3 key points + challenges that emerged from comparing the 2013 and 2014 fin stt.s

Answer 16

1. DATA is an extremely valuable resource & one of the strategic motives for the acquisition
   - access to phone numbers + users’ contact lists
2. Because WA has NET LOSS & NEGATIVE CASH FLOWS, cannot use traditional models like DCF or residual income model for valuation…
3. …instead a value PROXY used in the tech sector is the NO. OF USERS <- data & users possess are very valuable
4. Recognition of intangible assets (+ GOODWILL) upon acquisition -> SIGNIFICANT INCREASE in assets/balance sheet total
   - previously could not be recognised b/c internally generated
5. PROFITABILITY RATIOS and PERFORMANCE MEASUREMENT become DISTORTED because of the scaling effect of measuring intangibles, due to negative earnings divided by very high assets
   - affects the ratios many ppl would use for valuation
6. AMORTISATION on intangible assets annually…
7. …but IMPAIRMENT TEST on goodwill annually & NOT amortised, hence no IS effect

Question 17

Facebook’s acquisition of WhatsApp case
How will the intangible assets that Facebook acquired in the WhatsApp deal can be accounted for in the fin stt.s going forward (IFRS perspective)?

Answer 17

1. Finite-lived intangibles: amortized over their useful life using straight-line amortization
2. Infinite-lived intangibles: do not amortize
3. All are regularly tested for impairment, but infinite-lived more often (at least annually)
4. Goodwill is the largest recorded intangible from the acq ($15.34 billion), so most of the purchase price will be recognised w/o having an impact on the periodic IS

Question 18

Trueman et al., (JAR, 2000) & Facebook’s acquisition of WhatsApp case
Takeaways + 2 reasons why Internet stocks are (were) difficult to value

Answer 18

1. It is NOT EARNINGS that drive up the value of Internet firms
   » b/c often include large transitory items, eg. merger-related costs
   » & investors might consider some items as INVESTMENTS rather than expenses, eg. sales and marketing expenses, R&D costs
2. GROSS PROFIT rather than bottom-line profits matter
   » reflect a firm’s current operating performance and are likely to be more permanent
3. Other metrics that are far better: unique visitors, pageviews <- measures of usage
   » generate revenues by attracting visitors to their websites and selling products OR from advertising
4. But also depends on the type of firm

*unique visitors = estimated no. of different individuals who visit the firm’s website during a particular month
*pageviews = estimated no. of pages viewed by individuals visiting the firm’s website during the month

Why difficult to value Internet stocks
1. The industry and the firms are very young that there is very little historical financial info. available for forecasting future predictability
2. The industry is evolving at a rapid & unpredictable pace that any historical info. that exists is likely to be less useful for valuing these firms than for valuing firms in more established industries

Question 19

Impairment test for Intangible assets / Goodwill

Answer 19

IAS 38: Irrespective of any indication of impairment, an intangible asset with indefinite useful life should be tested for impairment annually
1. Intangible assets are allocated to CGUs (cash-generating units)
2. CGUs are tested for impairment
3. Impairment loss recognized if carrying amount > recoverable amount
- intangible impairment might trigger GOODWILL IMPAIRMENT, reducing the CGU carrying value
- then CGU carrying value reduces with OTHER INTANGIBLES (pro rata)