According to Anthony and Breitner, “Intangible assets are assets that have no physical substance (other than pieces of paper) but give the entity valuable rights. Some intangible assets are prepaid expenses, notes payable, and goodwill” (2010, p. 89). Several years ago, I sat down with a V.P. of a regional bank to negotiate a commercial line of credit. After examining the pro forma (projected) financial statements that I had put together, the officer said, “Ok, so you are paying this much for ‘xyz’ and this much for ‘etc.’ and the rest…you are paying for ‘blue sky’.” Now I had been booking literally millions in intangible assets as part of my job for years, but somehow, seeing the connection to my back pocket made me re-think the whole concept of goodwill, customer lists and non-compete contracts. Were they really worth between one to three times annual revenues?
This is the issue at hand when you are dealing with an acquisition. For example, in my hometown of Fairfield, California, there is this hamburger stand <pseudonymed> Homer’s Giant Hamburgers. You know the kind of place; it’s a local establishment that is pretty much legendary. I used to take my wife there when we were in our 20s and still ate red meat. Anyway, let’s say you were going to purchase this establishment. You could add up the property, plant and equipment and come up with a figure, but what is the name “Homer’s” worth? Well, let’s just say the name is worth $100k, fair enough. So above everything else tangible, you pay Homer $100k for his name and that goodwill goes on your balance sheet as an intangible asset. But, as noted by Anthony and Breitner, you do not depreciate an intangible asset; you amortize it over its useful life (p. 100). Usually such contracts contain some sort of non-compete where old man Homer cannot open up shop three doors down and put you out of business.
Now here is the conundrum. When dealing with service contracts (such as a contract with a municipality), what is the reasonable amortization of that goodwill? Or for that matter, the amortization of the name Homer’s Enormous Hamburgers? GAAP allows for up to 40 years (Anthony & Breitner, p. 100). Do you bank on winning that contact in the future? If not, what happens? A huge write down to both your balance sheet and income statement.
Reference:
Anthony, R. & Breitner, L. (2010). Core Concepts of Accounting (10th Edition). Upper Saddle River, NJ: Pearson Prentice Hall Publisher.
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