The Accounting Process, Part Three - Module 4 of 6

The Accounting Process, Part Three

Intangible Assets

Intangible assets include patents, copyrights, trademarks, service marks, trade names, franchising rights and trade secrets.[1]  Some intangible assets are recorded as deferred charges, such as costs of incorporation or software development.  Acquisition of intangible assets can, as with other assets, be recorded as expenses as they are accrued or alternatively, included as part of the cost of development or acquisition and spread out over the life of the asset. Recall that an expense is deducted from revenue on the income statement while acquisition and capitalization of an asset affects the assets and liabilities on the balance sheet.   

The practice of spreading an intangible asset’s cost over the lifetime of the asset is called “amortization.”  If it is not possible to discern the value of an asset or its ultimate value when developed, such as with intellectual property, it’s impossible to amortize its cost and its costs must be periodically expensed.

For example, Acme Corporation spends $100,000 on advertising and promotion for a new wearable technology product.  Acme cannot immediately determine whether this innovative product will succeed so it records the $100,000 expenditure as an immediate expense, not an amortized cost.[2]  Acme also acquires a patent for $300,000 from Labtech Corporation with a life of 15 years.   Here, Acme amortizes the asset at a cost $20,000 a year for fifteen years.[3]

Research and development and computer software development costs are specifically cited by the rules of accounting as expenses rather than asset acquisitions that can be amortized.[4] 

Following the acquisition of an intangible asset, a firm can amortize its cost only if its useful life can be determined. Otherwise, it can only be treated as an expense.  However, businesses must periodically determine if any intangible asset has acquired a useful life due to change in circumstances, in which case the asset must be amortized over its remaining life.[5]

Goodwill, a business’s reputation,[6] is an intangible asset that is typically relevant when another business is acquired. Goodwill is part of the acquired company’s value, not a separately identifiable asset.[7]  Goodwill is typically computed as the market value of the business- as evidenced by its acquisition value- over its intrinsic value.[8]  If, after a periodic assessment, a company appears to have lost value, its goodwill amount is similarly reduced.[9]  Rather than performing periodic assessments, private companies may simply amortize goodwill over a period not to exceed 10 years when purchasing a company.[10] 

For example, Acme Corporation is valued at $10,000,0000 and its non-goodwill assets are valued at $9,000,000. The difference of $1,000,000 is Acme’s intangible goodwill.[11] If Beta Company purchases Acme for $10,000,000, it can amortize the $1,000,000 it paid for Acme’s goodwill over 10 years.

Securities and Debt Instruments

A business might purchase corporate or government bonds to earn interest payments.[12]  A bond is simply a loan. The issuer is the borrower, and it repays the bond's principal amount at its maturity date. Interest may be periodically recorded as income or, if a payment is pending, interest may be recorded as accrued.  Historically, investors clipped physical coupons from a bond and mailed them in to get their periodic payments.  Thus, bonds that gave out periodic payments acquired the name “coupon bonds,” though today they are normally handled electronically.  The rate of interest is called the coupon rate.  Dividing the annual amount of the coupon payment by the bond's face value gives the coupon rate.[13]   

For example, Acme Corporation buys a ten-year bond for $1,000,000 and periodic semi-annual interest payments at 7%, which pays $35,000 twice a year.  Acme records the payments as an increase to its interest revenue and an increase to its cash account.  

The amount that a bond pays is called its "yield."  The yield can be simply the coupon rate. However, when interest rates change, the value of the bond can increase or decrease (when rates rise, the value of current bonds locked in at the previous interest rates fall, and vice-versa).[14]

For example, Acme Corporation buys a $1,000,000 bond at a 10% annual rate of interest. Assume interest rates rise to 12.5% and consequently, the bond's price falls to $927,900 to simulate a competitive over-all 12.5% rate of return, commensurate with other investments in the market.  If prevailing rates fall to 7.5%, the bond's price would rise to $1,101,150.    

Bonds that sell at a price under their face value are called “discount bonds” and bonds that sell over their face value are called “premium bonds.”  Dividing the annual coupon payments by the bond price determines the bond's yield.  If the bond is selling at face value, then its yield is the same as its coupon rate. Otherwise, the difference between the face value and price must also be considered.[15]      

A company can also acquire stock in another company. There are three ways to record acquisitions of another company's stock.[16]  If a company owns less than 20% of another company's stock, it simply records the stock acquisition at cost and this is called, appropriately enough, "the cost method."[17]  The investing company records any dividends it received as income.  The investing company may adjust the value of the stock account to reflect the market value of the shares.

For example, Acme buys 150,000 shares of LabCo for $10 per share.  Acme records a reduction of $1,500,000 in its cash account and an increase by the same amount of its investments account. LabCo issues a quarterly dividend payment of $0.10, which entitles Acme to a $15,000 dividend payment.  Acme increases its cash and dividend income accounts accordingly.     

If a company acquires 20% or more of the voting stock of another company, but less than a majority, the acquiring company records the acquisition under "the equity method."[18] The investing company is presumed to have some significant influence over the second company, but not full control. It records its share of the second company's income or loss on its financial records, in proportion to its ownership.

For example, Acme Corporation purchases 25% of LabCo. Labco reports $100,000 in income in its financial statements for a given year.  Acme would consequently record a $25,000 gain in its investment and income accounts because that gain reflects its proportional ownership of LabCo’s stock.   

If a company forms a new company or acquires a majority of another company's voting stock, that is a takeover that results in the first company, called the “parent company,” controlling the second company, called the “subsidiary company.”  The financial statement columns of the acquiring parent company and the acquired subsidiary company are combined and the amounts are netted together.[19]  While the process is straightforward, a business will need to eliminate duplicate reporting.

For example, Acme Corporation acquires 70% of LabCo’s stock.  Acme is called the “parent” and LabCo is called the “subsidiary.”  Acme’s financial statements show $120,000 in revenue and LabCo’s financial statements show $90,000 in revenue. Acme would combine its financial statements with LabCo’s financial statements into one statement that shows $210,000 in revenue.  

A business might also issue its own debt instruments to raise capital. These are usually long-term obligations, meaning that their term for repayment extends more than a year.  Bonds are types of debt instruments. Bonds may be “unsecured” which means the bondholder has no recourse to make claims against the assets of the company if the company becomes insolvent.  An unsecured bond is called a “debenture bond.”  Bonds may alternatively be secured by assets the company owns, such as property, plant or equipment.

Accounting for bond issues involves a bond payable account for the amount the company must repay at maturity and an interest expense account for the company's periodic interest payments.[20]

A business may issue debt that an investor may, at the investor's option, convert to another form of ownership.  This is known as “convertible debt.”[21]  The investor could, for example, purchase a bond convertible at the investor’s option to common stock.  If the stock price is increasing it might be a profitable transaction for the investor, a perk that can entice investors.

Capital Accounts

Capital accounts indicate the values in the company held by the owners of a business.[22]  As we have observed, the owners of a corporation are called “shareholders” and they have fractional ownership of a business denominated in units of ownership called "shares."  Share ownership entitles a person to participate in the management of a business by voting on important matters, such as major financial changes and for the board of directors.  Share ownership additionally entitles shareholders to a percentage of the company's profits, typically in proportion to the shareholder's interest and payable in periodic installments called "dividends." 

Stock may come in different forms. “Common stock” is ordinarily voting stock which gives the owners of the shares the power to vote for directors, who, in turn, appoint officers to run the company. “Preferred stock” shareholders ordinarily do not have voting rights, but they receive their dividends ahead of common stock shareholders.    

In accounting, the value of stock is bifurcated into the par value and additional paid-in capital. Stock is typically issued at a nominal value called "par value," which often bears little relation to the actual value of the stock. Any excess value is recorded in a separate account called "contributed capital in excess of par value" or more simply, "additional paid-in capital."

For example, Acme Corporation issues 1,000 shares of common stock, par value of $1 and selling for $40 per share.  It records common stock at $1,000 and additional paid-in capital of $39,000.       

Aside from receiving cash from the sale of stock, businesses may also receive noncash property in exchange for company stock, in which case the transaction is recorded at the fair market value of the property received.

For example, Acme Corporation buys a manufacturing plant worth $1,000,000 by transferring to the seller 10,000 shares of its common stock at $10 per share, for a total of $100,000 in common stock, and excess paid-in capital of $900,000.   

In addition, businesses must record net income, after deducting distributions and dividends to shareholders, in an account called "retained earnings."  Negative retained earnings are recorded as "accumulated deficit."[23] 

A business declares dividends by having the board of directors announce the dividends as of the "declaration date." Particulars of the payment are made on the "date of record." The "ex dividend date" occurs just before the date of record and only those who have stock as of that date are entitled to dividends. Historically, dividend payments were mailed, but many firms pay dividends electronically today.[24] 

A business also may distribute property or stock as a dividend payment instead of cash. It may also distribute the right to purchase additional shares at a price less than the current market price of the stock. A business may "split” its stock by doubling the number of outstanding shares, which will accordingly reduce its par value[25] or it may enact a "reverse stock split" which will reduce its outstanding shares and consequently increase its par value.

For example, Acme Corporation has 10,000 shares of authorized outstanding common stock valued at $30 per share. It splits its stock by giving its shareholders numbers of shares equivalent to double the amounts they currently possess and halving its stock value to $15 per share.  Alan holds 500 shares worth $1,500 and valued at $30 per share.  After the stock split Alan owns 1,000 shares, still worth $1,500, now valued at $15 per share. Twice the shares, half the price, same value.        

A business can also repurchase its outstanding shares, which reduces the number of shares available on the market. This repurchased stock is called "treasury stock."[26]  Employees may share in the stock ownership of the company by exercising "stock options," which can be classified as equity or liabilities depending upon how they are structured.[27]   

Similar to a corporation, partners in a partnership each have capital accounts in the partnership.[28]  The partnership agreement provides for the profit and loss allocations of the partners. Some partners may contribute more than others in terms of work or capital and share differently in the profits and losses.[29] Capital accounts may also be used to indicate that a partner is owed money for any capital contributions she has made to the partnership.

Some Other Types of Assets

A business's treatment of leases is another accounting consideration. A lease may be classified as an “operating lease” or a “capital lease.”[30]  An operating lease is recorded as an expense, which reflects periodic rental payments. A capital lease is recorded as a cost that is amortized for the term of the lease. 

In a capital lease, the business acquires title and ownership of the asset at the conclusion of the lease term or has the option to purchase the asset for a reduced price as a "bargain purchase option." How rental payments are structured or how the term of the lease is set up can also enable a business to classify a lease as a capital lease under the rules of accounting.   

The difference between the two is in the balance statement and the calculations of a business's financial health.  An operating lease is merely the periodic payment of rental expenses but does not affect the underlying assets of the business. A capital lease changes the assets and liabilities of a business because it involves the acquisition of an asset financed by a creditor.     

For example, Acme Corporation considers acquiring a machine under a lease agreement for $1,000 per month on a three-year lease.  The lease payments do not affect Acme’s balance sheet and are expenses reported only on income statements.  But say Acme’s management decides it will acquire the machine under a capital lease that will enable it to own the machine after five years.  This acquisition now increases Acme’s assets, because it is acquiring the machine. It also increases its liabilities, because it is financing the machine with lease payments.[31] 

Tax accounting is very complex as tax accountants’ key job is typically to minimize taxes. There is tension between maximizing the value of the shareholders’ investments and minimizing revenue and its associated tax liability. The tax code allows businesses to deduct losses. The Code even allows businesses to project losses against past years’ financial statement amounts to produce a refund. This aspect of the tax code is called "carryback" and a company may reach back up to two years to project its current losses to past years to reduce its tax liability, and up to three years in some cases.

A company may also use present losses as “carryforward” to reduce tax liability in future years. This option is available for up to twenty years.  Businesses may elect to combine carrybacks and carryforwards as would work best in the circumstances.

Assets held by the company in employees’ retirement or pension accounts must also be considered in a company’s accounting. There are two essential types of retirement plans.[32]  In a “defined benefit plan,” the beneficiary receives a fixed amount upon retirement according to the employee's salary, years of service and age.[33]  An employer must set aside the amount its retirees will expect to collect and, depending on retirements and fund performance, the company may need to make periodic adjustments, which may involve contributions to shore up the funds or address excess contributions.

In a “defined contribution plan,” the employer makes contributions to the employees’ retirement funds.[34]  The employees can typically choose the composition of their investment portfolios. The employer guarantees no particular level of income upon retirement. The assets of the retirement plan are held in a trust and not reflected on the balance sheet of the employer.   

            In our next module, we’ll turn to preparation of financial statements and documents.