EXECUTIVE SUMMARY

EVEN WITH THE GUIDANCE IN FASB STATEMENT NO. 142, the 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.

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.

PRACTICAL TIPS TO REMEMBER

When determining the appropriate useful life of a contract-related intangible asset, ask these three questions: (1) Does the company intend and have the ability to renew or extend the contract? (2) Are there substantial costs associated with the renewal? (3) Will there be material modifications to the existing contract terms and conditions? After determining which contract renewal costs to include, evaluate them in relation to the value of the asset to determine whether they are “substantial.” This will help establish whether the contract is renewable or extendable without substantial cost. The best indicator of whether a company will renew a contract or do so without material modification is the company’s history of renewals/extensions of this or similar contracts. If this information is not available, the history of other companies in the same circumstances can be useful. Revisit an intangible asset with an indefinite life during each reporting period to determine whether the life is still indefinite. When acquiring an intangible asset, consider what circumstances would later limit or reduce its useful life; this will make them easier to spot in future years.

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.

A company should measure an intangible asset at its fair value at the time of acquisition.

The costs of internally developing, maintaining or restoring intangible assets generally should be expensed as incurred (with some exceptions).

Intangible assets other than goodwill may or may not be amortized depending on their useful lives to the entity: Assets with finite lives are amortized; assets with indefinite lives are not. Goodwill is not amortized.

There is no arbitrary ceiling on the useful life of an amortized asset. (Prior to Statement no. 142 the amortization period of an asset was limited to 40 years.)

The amortization method should reflect the pattern in which the company uses up the benefits the asset provides, with the straight-line method the default choice.

Intangible assets other than goodwill that a company is not amortizing should be reevaluated in each reporting period to determine whether amortization should begin (if the assets’ useful lives go from indefinite to definite).

Companies should test intangible assets, including goodwill, for impairment at least annually. It should recognize an impairment loss in any period where the asset’s recorded value is higher than its fair value.