EITF Issue No. 03-9 The views in this report are not Generally Accepted Accounting Principles until a consensus is reached and it is FASB Emerging Issues Task Force Issue No. 03-9 Title: Interaction of Paragraphs 11 and 12 of FASB Statement No. 142, Goodwill and Other Intangible Assets, Regarding Determination of the Useful Life and Amortization of an Intangible Asset Document: Working Group Report No. 1 * Date Prepared: February 27, 2004 FASB Staff: McBride (ext. 394) / Durbin (ext. 296) Date Previously Discussed: November 12-13, 2003 Previously Distributed EITF Materials: Issue Summary No. 1, dated July 18, 2003; Issue Summary No. 1, Supplement No. 1, dated October 23, 2003 References: FASB Statement No. 141, Business Combinations (FAS 141) FASB Statement No. 142, Goodwill and Other Intangible Assets (FAS 142) * The alternative views presented in this Working Group Report are for purposes of discussion by the EITF. No individual views are to be presumed to be acceptable or unacceptable applications of Generally Accepted Accounting Principles until the Task Force makes such a determination and it is EITF Issue No. 03-9 Working Group Report No. 1, p. 1
Background 1. The useful life of an intangible asset is defined in Appendix F of FAS 142 as The period over which an asset is expected to contribute directly or indirectly to future cash flows. 2. Paragraph 11 of FAS 142 provides the following guidance for estimating the useful life of an intangible asset: The accounting for a recognized intangible asset is based on its useful life to the reporting entity. An intangible asset with a finite useful life is amortized; an intangible asset with an indefinite useful life is not amortized. The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity. 9 The estimate of the useful life of an intangible asset to an entity shall be based on an analysis of all pertinent factors, in particular: a. The expected use of the asset by the entity b. The expected useful life of another asset or a group of assets to which the useful life of the intangible asset may relate (such as mineral rights to depleting assets) c. Any legal, regulatory, or contractual provisions that may limit the useful life d. Any legal, regulatory, or contractual provisions that enable renewal or extension of the asset's legal or contractual life without substantial cost (provided there is evidence to support renewal or extension and renewal or extension can be accomplished without material modifications of the existing terms and conditions) e. The effects of obsolescence, demand, competition, and other economic factors (such as the stability of the industry, known technological advances, legislative action that results in an uncertain or changing regulatory environment, and expected changes in distribution channels) f. The level of maintenance expenditures required to obtain the expected future cash flows from the asset (for example, a material level of required maintenance in relation to the carrying amount of the asset may suggest a very limited useful life). 10 EITF Issue No. 03-9 Working Group Report No. 1, p. 2
If no legal, regulatory, contractual, competitive, economic, or other factors limit the useful life of an intangible asset to the reporting entity, the useful life of the asset shall be considered to be indefinite. The term indefinite does not mean infinite. Appendix A includes illustrative examples of different intangible assets and how they should be accounted for in accordance with this Statement, including determining whether the useful life of an intangible asset is indefinite. 9 The useful life of an intangible asset shall reflect the period over which it will contribute to the cash flows of the reporting entity, not the period of time that it would take that entity to internally develop an intangible asset that would provide similar benefits. 10 As in determining the useful life of depreciable tangible assets, regular maintenance may be assumed but enhancements may not. 3. In applying the guidance in paragraph 11, questions have arisen in practice as to how the pertinent factors in sub-paragraph 11(d) should be interpreted and applied. In particular, those questions surround the evaluation of "substantial cost" and "material modifications" in determining whether or not an intangible asset has an indefinite useful life and, if not, the appropriate useful life for the intangible asset. FAS 142 provides only limited guidance on how to apply those concepts by way of illustrative examples and some discussion in the Basis for Conclusions. 4. The concepts of useful life and fair value of an intangible asset, from an economic standpoint, are inextricably linked. FAS 141 and FAS 142 both indicate that the useful life of an intangible asset is related to the period over which the asset is expected to generate cash flows. In some cases, however, the guidance in FAS 142 regarding useful life appears to be more restrictive than the guidance provided in FAS 141 with respect to considering the period over which an intangible asset is likely to contribute to an entity's cash flows for the purpose of determining the intangible asset's fair value. 5. On the one hand, paragraph B46 of FAS 142 indicates that the useful life of an intangible asset that is based on legal or contractual rights is constrained by the duration of those legal or contractual rights. Therefore, the useful life cannot extend beyond the expiration of the legal rights. However, the Board also acknowledged, in paragraph B47, that certain intangible assets may be routinely renewed at little or no cost (that is, without substantial cost) and that marketplace transactions often indicate that renewal is implied in the value of certain intangible assets. For those types of assets, the useful life is not necessarily limited to the legal or EITF Issue No. 03-9 Working Group Report No. 1, p. 3
contractual life. On the other hand, the guidance in paragraph B174 of FAS 141 (in the context of initial recognition of intangible assets) appears to permit, or perhaps even require, a more expansive view of useful life of an intangible asset by indicating that judgment is required in determining the period over which cash flows should be expected for purposes of determining the fair value of an intangible asset. Estimates should incorporate assumptions that marketplace participants would use in making estimates of fair value, such as assumptions about future contract renewals. In cases in which contractual or legal rights are routinely renewed, estimates of future cash flows should extend beyond the remaining contractual or legal term. FAS 141 does not limit the consideration of renewal to only those cases in which renewal can be effected with little or no cost. 6. The relevant examples in Appendix A of FAS 142 (Examples 4 6) provide only limited insight on this question because the examples assume that minimal costs are involved in renewal and that there will be no change to the terms of the arrangements. Furthermore, those examples generally illustrate the distinction between assets with a finite life limited to the contractual period and those with an indefinite life. There is no illustration of how to evaluate situations in which the life may be greater than the contractual life but not indefinite. Because many contractual arrangements or legal rights may be renewed, the issue of determining when such renewal is deemed to occur "without substantial cost" or "without material modification to the terms and conditions" is particularly relevant in assessing the useful life and, in turn, the fair value of intangible assets. 7. The issues for discussion at the July 31, 2003 EITF meeting were: Issue 1 When considering whether renewal of a contractual or legal right giving rise to an intangible asset requires "substantial cost" pursuant to sub-paragraph 11(d) of FAS 142, the expenditures that should be considered to be a "cost" of the renewal or extension. Issue 2 When analyzing the pertinent factors contained in sub-paragraph 11(d) of FAS 142, the "existing terms and conditions" that may be subject to change upon renewal or extension that are subject to the "material modifications" consideration. EITF Issue No. 03-9 Working Group Report No. 1, p. 4
Prior Task Force Discussion 8. At the July 31, 2003 EITF meeting, the Task Force discussed Issue 1 and generally agreed that the analysis of whether the useful life of an intangible asset should extend beyond its contractual term should be based on assumptions of renewal that are consistent with assumptions of marketplace participants. Given this view, the Task Force did not discuss Issue 2. The Task Force noted that the useful life the period over which an intangible asset is expected to contribute to an entity's cash flows for amortization purposes should be consistent with the estimated useful life considerations used in the determination of the fair value of that asset. 9. Task Force members noted that, in many cases, the fair value of the intangible asset is determined using probability-weighted expected future cash flows and, therefore, it may be difficult to discern a single point estimate for the useful life for amortization purposes. Some Task Force members also observed that it also may be difficult to differentiate an intangible asset with a relatively long, but finite, life from an intangible asset with an indefinite life. In the course of that discussion, some Task Force members also noted that linking the amortization period to the estimated useful life considerations used in the valuation model may indicate that straight-line amortization often may not best reflect the pattern in which the economic benefits of the intangible asset are consumed. The Task Force directed the FASB staff to further explore these issues for discussion at a future meeting. 10. At the November 12 13, 2003 EITF meeting, the Task Force considered an example fact pattern along with various valuation scenarios that illustrate the application of a "pattern-ofeconomic-benefit" amortization approach for renewable intangible assets. That approach assumes that the economic benefit is the cash flows derived from the intangible asset. To determine the pattern in which an intangible asset s economic benefits are consumed, the intangible asset s undiscounted cash flows 1 for a given period are compared to the sum of the intangible asset s undiscounted cash flows over its useful life; the resulting ratio represents the amount of the intangible asset to be amortized during the given period. 1 If the pattern of economic benefit was based on discounted cash flows, the time value of money would impact the amortization pattern resulting in a downward-sloping amortization curve even when the pattern of benefit is uniform. EITF Issue No. 03-9 Working Group Report No. 1, p. 5
11. The Task Force was not asked to reach a consensus on the pattern-of-economic-benefit amortization approach, noting that the proposed approach would result in most amortizable intangible assets being subject to that approach rather than the straight-line method. The Task Force also noted that the implication of that approach is that the guidance in paragraph 11 of FAS 142 is, in many cases, obviated by the decisions that are required in determining the fair value of intangible assets pursuant to FAS 141. 12. As a result of those concerns, the Task Force requested the FASB staff to form a Working Group to explore further those issues that have arisen in practice involving: a. The determination of the useful life of an intangible asset that is subject to legal, regulatory, or contractual limits b. The determination of when an intangible asset may be determined to have an indefinite life c. How to interpret the provisions of paragraph 12 of FAS 142 regarding the determination of the pattern in which the economic benefits are consumed and whether that pattern can be reliably determined. Working Group Discussion and Recommendations 13. The Working Group met on February 5, 2004, and discussed the determination of the useful life of an intangible asset that is subject to legal, regulatory, or contractual limits (Item (a) in paragraph 12) and the determination of when an intangible asset may be determined to have an indefinite life (Item (b) in paragraph 12). The Working Group observed that intangible assets span a continuum. At one end of that continuum are intangible assets that arise from renewable legal rights. For those assets, such as FCC licenses and trademarks, renewal is generally within the control of the entity, provided that the entity has complied with any legal requirements related to that license. At the other end of the continuum are intangible assets that are subject to legal, regulatory or contractual limits where control over renewal rests with both parties. Along that continuum are intangible assets that have contractual provisions that enable renewal or extension of the asset s legal or contractual life. The difficulty that arises in practice is determining the useful life of contract-based intangible assets that have contractual provisions EITF Issue No. 03-9 Working Group Report No. 1, p. 6
that enable renewal or extension. This Working Group Report addresses whether additional guidance is necessary to address that practice issue. 14. Some Working Group members indicated that the valuation of an intangible asset may include assumptions that the entity will take the economic actions necessary (from incurring renewal or extension costs to negotiating contract modifications) to obtain a contract extension or renewal. As a result, certain contract based intangible assets may appear to have rather long or in some cases indefinite lives. 15. The Task Force previously discussed this issue, and concluded that the analysis of whether the useful life of a contract based intangible asset should extend beyond its contractual term should be based on the factors used to value the intangible asset. Paragraph 11 of FAS 142 includes pertinent factors that should be considered in a reasonable valuation. Therefore, the Task Force could reach a consensus that the useful life of a contract based intangible asset should be based on the factors used to value the intangible asset, without conflicting with the pertinent factors included in paragraph 11. A majority of the Working Group supported the Task Force s conclusion. 16. Most Working Group members believe that, based on the Task Force s previous conclusion, there should be a common understanding in the application of the pertinent factors listed in paragraph 11. However, some Working Group members question whether the paragraph 11(d) terms substantial cost and material modification or perhaps other factors not considered in paragraph 11 could result in a useful life for amortization purposes that is shorter than the useful life for asset valuation purposes. 17. The issue, then, is whether there are limiting factors that could result in a useful life for amortization purposes that is shorter than the useful life for asset valuation purposes. If the Task Force believes that there are limiting factors that could result in a shorter useful life for amortization purposes, the next question is how those limiting factors should be taken into consideration in the determination of the intangible asset s useful life for amortization purposes. EITF Issue No. 03-9 Working Group Report No. 1, p. 7
Issue 1: Whether there are limiting factors that could result in a useful life for amortization purposes that is shorter than the useful life for asset valuation purposes. View A: There are no limiting factors that could result in a useful life for amortization that is shorter than the useful life for asset valuation purposes. 18. View A advocates believe that the intangible asset s useful life should, in all cases, be equal to the period in which the intangible asset is projected to contribute to an entity s cash flows. View A proponents cite the Task Force s tentative conclusion at the July 31, 2003 EITF meeting, that the useful life the period over which an intangible asset is expected to contribute to an entity's cash flows for amortization purposes should be consistent with the estimated useful life considerations used in the determination of the fair value of that asset. 19. Proponents of View A acknowledge that there is some dispute on the meaning of substantial costs and material modifications in paragraph 11(d) of FAS 142. View A proponents believe that the Task Force addressed this issue when it concluded that the analysis of whether the useful life of a contract based intangible asset should extend beyond its contractual term should be based on the factors used to value the intangible asset. As a result, View A advocates believe that substantial renewal costs and material modifications are defined in the context of whether the cost or the material modification results in an uneconomical change to an entity s future cash inflows and/or outflows. That is, a renewal cost that exceeds the present value of the cash flows subsequent to the renewal would be a significant cost; similarly, a material modification is a change in the contractual terms conveyed to the acquirer at acquisition date that results in a negative net present value over the renewal period. 20. View A proponents believe that a consensus on this view addresses the practice issue of determining the useful life of contractual based intangible asset that have contractual provisions that enable renewal or extension because a marketplace participant would not project cash flows beyond an uneconomical event. EITF Issue No. 03-9 Working Group Report No. 1, p. 8
View B: The existence of a substantial cost or a material modification or any pertinent factor that creates a risk of nonrenewal is a limiting factor that results in a useful life for amortization purposes that is shorter than the useful life for asset valuation purposes. 21. View B supporters define substantial costs and material modifications more narrowly than View A proponents and, as a result, believe that a marketplace participant may project cash flows beyond the point of a substantial cost or a material modification. Proponents of View B define substantial costs and material modification as follows. a. Substantial costs. View B proponents look to paragraph B60 of FAS 142 to define substantial renewal costs; paragraph B60 states that whether the cost of renewal is substantial should be determined based on the relationship of the renewal cost to the fair value of the intangible asset at the time it is acquired. b. Material modifications. A modification to the contractual rights conveyed to the entity at the time the intangible asset is acquired that causes a diminution in the value of the intangible asset. 22. View B supporters observe that the existence of pertinent factors (such as a material modification, substantial renewal cost or the effects of obsolescence or demand) that cause a diminution in the value of the intangible asset is reflected in the intangible asset s valuation as the risk of nonrenewal. While the existence of these pertinent factors does not change the period in which the intangible asset is projected to contribute to an entity s future cash flows, their existence does reduce the period in which the intangible asset is expected to contribute to the entity s cash flows. That is, there is a direct correlation between the presence of factors that cause a diminution in the value of the intangible asset and the risk of nonrenewal. As the risk of nonrenewal increases, the period in which the intangible asset is expected to contribute to the entity s cash flows decreases. View B advocates believe that it is not representationally faithful to amortize an intangible asset beyond the period in which it is expected to contribute to the entity s cash flows. EITF Issue No. 03-9 Working Group Report No. 1, p. 9
23. View B supporters agree with the concept that useful life and fair value of an intangible asset, from an economic standpoint, are inextricably linked. Because of that linkage, View B advocates believe that an entity should rely on the information used to estimate fair value in the evaluation of significant costs and material modifications. Therefore, View B proponents believe that this view is consistent with the Task Force s prior conclusion that evaluation of useful life should be based on the factors used to value the intangible. Issue 1A: If the Task Force decides that there are limiting factors that could result in a shorter useful life for amortization purposes than used for asset valuation purposes, a follow-on issue is how those limiting factors should be taken into consideration in the determination of the intangible asset s useful life. View A: The useful life is equal to the probability-weighted expected life of the intangible asset. 24. Advocates of View A cite the useful life definition in Appendix F of FAS 142, which states that the useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity. Proponents of View B also cite paragraph 12 of FAS 142, which states, If an intangible asset has a finite useful life, but the precise length of that life is not known, that intangible asset shall be amortized over the best estimate of its useful life. View A proponents believe that Example 1 in Appendix A of FAS 142 illustrates the concept in paragraph 12, which supports the use of a probability weighted expected life. In that example, a direct-mail marketing company acquired the customer list and expects that it will be able to derive benefit from the information on the acquired customer list for at least one year but for no more than three years. Given that information, the example states that the customer list would be amortized over 18 months, management s best estimate of its useful life (emphasis added). View B: The useful life should be limited to the end of the contractual period prior to the renewal period with the risk of nonrenewal. EITF Issue No. 03-9 Working Group Report No. 1, p. 10
25. Advocates of View B believe that the useful life of an intangible asset should be limited to end of the contractual period prior to the renewal period with the risk of nonrenewal. View B proponents observe that the application of View A may results in amortization over a period that does not correlate to the contractual renewal period. That is, despite whether a contract has a 50 percent risk of nonrenewal, the entity has two options: renew or cancel. The probability weighted approach results in a contract period that does not reflect those two choices, and in fact may result in a period that extends beyond the life of the asset if the entity cancels. Opponents of View B observe that the entity may choose to renew, but opt to use the asset for a period less than the contractual period. Amortization of Finite Lived Intangibles 26. The Working Group also discussed practice issues that arise in the determination of the pattern in which the economic benefits are consumed and whether that pattern can be reliably determined. The Working Group did not identify any significant practice issues that arise in this area, but expressed concern about the pattern-of-economic-benefit approach (described below as Approach A). Therefore, the Working Group developed and recommended an alternative approach (Approach B). Approach A: The pattern in which the economic benefits are consumed should be based on the cash flows generated by the intangible asset. 27. Proponents of Approach A believe that, if the Task Force reaches a consensus on View A in Issue 1, Approach A is the only appropriate method to address the diminution in the value of an intangible asset caused by the risk of nonrenewal. Approach A proponents believe that the pattern in which the economic benefits are consumed further extends the concept that the useful life and fair value of an intangible asset, from an economic standpoint, are inextricably linked. Approach A (1) defines the economic benefits as the cash flows generated by the intangible asset, (2) uses an amortization method that links the intangible asset s amortization to its cash flows, and (3) uses the period over which an intangible asset is projected to contribute to an entity's cash flows as the useful life of the intangible asset. EITF Issue No. 03-9 Working Group Report No. 1, p. 11
28. Opponents of Approach A observe that if the expected cash flows are negative for a given period, the proposed approach would result in negative amortization. Opponents of Approach A also express concern about the susceptibility of the amortization to the timing of cash payments, such as in situations where the cash outflows are prepaid at the date the intangible asset is acquired. Approach B: The pattern in which the economic benefits are consumed should be based on the rights conveyed by the intangible asset. A method of amortization other than straight-line is appropriate only if those rights are constrained. 29. Proponents of Approach B cite paragraph B54 of FAS 142, which states: In considering the methods of amortization, the Board noted that Opinion 17 required that a straight-line method be used to amortize intangible assets unless another method was demonstrated to be more appropriate. However, the Board also noted that circumstances may exist in which another method may be more appropriate, such as in the case of a license that entitles the holder to produce a finite quantity of product. [Emphasis added.] 30. Therefore, View B proponents generally focus on the rights conveyed by the intangible asset as the economic benefit rather than its cash flows. In cases in which the intangible asset is available for unconstrained output over a finite life, the economic benefit unlimited availability over a fixed period of time is consumed equally over time. Under this view, straight-line amortization is appropriate in situations in which the intangible asset provides the right to unconstrained output. In cases in which the intangible asset conveys the acquirer the right to produce a finite quantity of product, the economic benefit limited availability over a fixed period of time is consumed as the product is produced. 31. Proponents of Approach B also believe that the amortization of an intangible asset is analogous to the depreciation of tangible assets, and cite paragraph 4, chapter 9C of ARB 43 which states: EITF Issue No. 03-9 Working Group Report No. 1, p. 12
The cost of a productive facility is one of the costs of the services it renders during its useful economic life. Generally accepted accounting principles require that this cost be spread over the expected useful life of the facility in such a way as to allocate it as equitably as possible to the periods during which services are obtained from the use of the facility. This procedure is known as depreciation accounting, a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. It is a process of allocation, not of valuation. [Emphasis added.] 32. Opponents of Approach B do not believe that straight-line amortization is generally appropriate, and cite paragraph 54 of FAS 142, which states that the amortization method adopted should reflect the pattern in which the asset is consumed if that pattern can be reliably determined, with the straight-line method being used as a default (emphasis added). 33. The following example illustrates the difference between Approach A and Approach B. Company A acquires Company B and obtains an intangible asset that is available for unconstrained output over a six year life. The intangible asset generates negative cash flows for the first three years and positive cash flows for the last three years. Approach A would result in the recognition of amortization during years four through six while Approach B would recognize amortization ratably over the six year period. 34. In other cases, the difference between Approach A and Approach B is less dramatic. Company A acquires Company B and obtains certain customer relationships. Company A s forecasts cash flows reflect a rapid dissipation of the relations in the earlier periods following the acquisition, with the rate declining over time until relatively few customers remain who persist for an extended period. Approach A would result in amortization according to the decline in cash flows that result from customer dissipation. Approach B would identify the rights conveyed by the customer relationship the economic benefit as (a) the information about the customer and regular contact with the customer and (b) the customer has the ability to make direct contact with the entity. This benefit is constrained since it provides the acquirer with limited availability over a finite period of time (due to customer attrition). In this case, Approach B would amortize the customer relationship using an accelerated method of amortization. EITF Issue No. 03-9 Working Group Report No. 1, p. 13