Identifiable long-term assets of a company having no physical existence are called intangible assets. They include goodwill, patents, copyrights, etc.
Intangible assets are either acquired in a business combination or developed internally. In case of acquisition in a business combination such assets are recorded at their fair value, while in case of internally generated intangible assets the assets are recognized at the cost incurred in development phase. In relation to the development of internally generated intangible assets there are two phases: research phase and development phase. Research phase includes all activities and costs incurred before the intangible asset is commercially feasible, while the development phase includes all activities and costs incurred after the asset is established to be commercially feasible. All costs in research phase are expensed in the period incurred while costs incurred in development phase are capitalized.
Following are the common intengible assets:
Goodwill is an intangible which is recognized when a business acquires another business. It represents the excess of cost paid by the purchasing business to the purchased business over the fair value of purchased business identifiable assets.
Tennis Ltd. acquired Racket Ltd. for $10 million. The fair value of Racket's net assets (assets minus liabilities) equaled $8 million at the time of purchase. The difference between the cost of $10 million paid by Tennis and $8 million fair value of the assets of Racket is goodwill which amounts to $2 million. Goodwill is an intangible asset and represents Racket's business reputation, etc.
Copyrights grant a business sole authority to reproduce and sale a software, book, magazine, journal, etc.
Patents grant a manufacturing and research company control over the use and sale of a specific design in manufacturing process, etc.
Amortization of Intangible Assets
Amortization is the process of expensing out intangible assets over their useful life. It is in effect the depreciation of intangible assets.
Some intangible assets have indefinite or unlimited useful life, such as goodwill. Such assets are not amortized. Others have a definite useful life and are amortized over their useful life. Most of intangible assets are amortized using straight line method. Useful life is the shorter of legal life and economic life.
Innovative Gadgets Ltd. patented one of their products at a cost of $100,000. The patent is enforceable for 10 years, so the legal life is 10 years. However, the company expects to produce the patented product for only 5 years and expects to replace it with an advanced version at the end of 5 years. The company uses straight line method of amortization. The company is required to amortize the patent over 5 years which is the shorter of legal life and economic life and hence per year amortization would be $20,000 ($100,000/5).
Although intangible assets with unlimited useful life are not amortized, they are periodically tested for impairment.