Reading 29

Intangible assets are nonmonetary assets that lack physical substance. They are either:

• Identifiable — acquired separately or result of rights/privileges (e.g., patents, trademarks, copyrights)
• Unidentifiable — cannot be acquired separately, may have unlimited life (e.g., goodwill)

Measurement of purchased intangibles:

• IFRS: cost model or revaluation model (revaluation only if an active market exists)
• U.S. GAAP: cost model only

Internally created intangibles:

• U.S. GAAP: expensed as incurred (with limited exceptions)
• IFRS:
  • Research stage → expensed
  • Development stage → capitalized if: technically feasible, resources exist, market exists, intention and resources to complete and sell

Amortization:

• Finite-lived intangibles → amortized over useful life, tested for impairment (same as PP&E)
• Indefinite-lived intangibles → not amortized, tested for impairment at least annually

Under both IFRS and U.S. GAAP, the following are always expensed as incurred: start-up and training costs, administrative overhead, advertising and promotion costs, relocation and reorganization costs, termination costs.

Goodwill = purchase price − fair value of acquired company's identifiable net assets. Only created in a purchase acquisition; internally generated goodwill is expensed.

Why acquirers pay more than fair value: the target may have off-balance-sheet assets (reputation, customer loyalty, unrecorded R&D), or the price reflects perceived synergies.

Goodwill treatment:

• Not amortized (indefinite life)
• Tested for impairment at least annually
• If impaired: carrying value decreases, loss recognized in income statement — no cash flow impact

Analyst adjustments: To improve comparability, eliminate goodwill from balance sheets and goodwill impairment charges from income statements. Evaluate future acquisitions relative to the earning power of acquired assets.

Accounting goodwill (from past acquisitions) ≠ economic goodwill (expected future excess returns). Acquiring firms may inflate goodwill to reduce depreciable asset values and boost net income.

Financial instruments include investment securities, derivatives, loans, and receivables on the asset side. Measurement bases depend on classification:

Key U.S. GAAP definitions:

• Held-to-maturity securities: debt securities acquired with intent to hold until maturity → amortized cost. Subsequent market value changes ignored.
• Trading securities (held-for-trading): acquired with intent to sell in near term → fair value; unrealized G/L in income statement. All equity securities with quoted prices treated this way.
• Available-for-sale (AFS) securities: debt securities not HTM or trading → fair value; unrealized G/L in OCI (equity), not income statement.
• All categories: dividend/interest income and realized G/L → income statement.

Key IFRS vs. U.S. GAAP differences:

• Under IFRS, firms may make an irrevocable choice at purchase to classify equity securities as FV through OCI (not available under U.S. GAAP — equity securities cannot be AFS under U.S. GAAP).
• Under IFRS, any security can be irrevocably designated as FV through profit and loss at purchase (not available under U.S. GAAP).

Long-term financial liabilities (bank loans, notes payable, bonds payable) are generally reported at amortized cost if not issued at face value. Premiums/discounts are amortized through interest expense over the liability's life, causing the balance sheet liability to move toward face value at maturity.

Some financial liabilities are reported at fair value: held-for-trading liabilities (e.g., short position in a stock), derivative liabilities, and nonderivative liabilities with exposures hedged by derivatives.

Deferred tax liabilities (DTL) arise when income tax expense in the income statement exceeds taxes payable using tax accounting — i.e., when expenses are tax-deductible before they are recognized in the income statement. Common example: accelerated depreciation for tax vs. straight-line for financial reporting. DTLs reverse when taxes are eventually paid.

A vertical common-size balance sheet expresses each line item as a percentage of total assets. This standardizes the balance sheet by eliminating size effects, allowing:

• Time-series analysis — trends over time within a firm
• Cross-sectional analysis — comparisons across firms

Liquidity ratios measure the firm's ability to satisfy its short-term obligations:

The quick ratio (acid-test ratio) excludes inventory. The cash ratio also excludes receivables. Higher ratios indicate greater liquidity.

Solvency ratios measure the firm's ability to satisfy its long-term obligations:

Note: Debt typically refers to interest-bearing obligations. The financial leverage ratio captures the impact of all liabilities (interest-bearing and non-interest-bearing).

Limitations of balance sheet ratio analysis:

• Comparisons are limited by differences in accounting standards and estimates
• Ratios may not be comparable for firms in different industries
• Interpretation requires significant judgment
• Balance sheet data are measured at a single point in time