Intangible assets UCM UL fae 1IAS 38 Mntangible Assets 2 Research and development costs ‘3 Goodwill (FAS 3 Business Combinations) Si Introduction We begin our examination of intangible non-current assets witha discussion of TAS 38. Goodwill and its treatment is a controversial area, as isthe accounting for ters similar to goodwil, such as brands. Goodwill is very important in group accounts and we will look at it again in Part D. reStudy guide BS5 —_ Intangible assets and goodwill Discuss the nature and possible accounting treatments of both internally generated and Purchased goodwill Distinguish between goodwill and other intangible assets Define the criteria for the initial recognition and measurement of intangible assets Identity the circumstances in which a gain on a bargain purchase (negative goodwill arises, and its subsequent accounting treatment Describe and apply the requirements of IFRSs to internally generated assets other than goodwill (eg research and development) 1 IAS 38 Intangible Assets Intangible assets are defined by IAS 38 as non-monetary assets without physical substance, 1.1 The objectives of the standard (@) Te establish the criteria for when an intangible asset may or should be recognised (b) To specify how intangible assets should be measured (c) To specity the disclosure requirements for intangible assets 1.2 Definition of an intangible asset The definition of an intangible asset is @ key aspect of the standard, because the rules for deciding whether ‘or not an intangible asset may be recognised in the financial statements of an entity are based on the definition of what an intangible asset is. Key term {An intangible asset is an identifiable non-monetary asset without physical substance. The asset must (a) Controlled by the entity as a result of events in the past (b) Something from which the entity expects future economic benefits to flow (IAS 38: para. 8) Examples of items that might be considered as intangible assets include computer software, patents, ‘copyrights, motion picture flims, customer lists, tranchises ang fishing rignts. An item should not be recognised as an intangible asset, however, unless it fully meets the definition in the standard. The uidelines go into great detail on this matte. 1.3 Intangible asset: Must be identifiable {An intangible asset must be identifiable in order to distinguish it from goodwill. With non-physical items, ‘there may be @ problem with ‘identifiability’. (2) fan intangible asset is acquired separately through purchase, there may be a transfer of a legal Tight that would help to make an asset identifiable, (b) An intangible asset may be identifiable if itis separable, ie iit could be rented or sold separately However, ‘separability’ is not an essential feature of an intangible asset. BET 7 sri sets and godt | Par 8 mers fran stamens BPP1.4 Intangible asset: Control by the entity Another element of the definition of an intangible asset is that it must be under the control of the entity as a result of a past event. The entity must therefore be able to enjoy the future economic benefits from the asset, and prevent the access of others to those benefits. A legally enforceable right is evidence of such control, but is not always a necessary condition. (a) Control over technical knowle (IAS 38: para. 14). (b) The skill of employees, arising out of the benefits of training costs, are most unlikely to be recognisable as an intangible asset, because an entity does not control the future actions of its staff (IAS 38: para, 18). (c) Similarly, market share and customer loyalty cannot normally be intangible assets, since an entity cannot control the actions of its customers (IAS 98: para. 16). ige or know-how only exists itt is protected by a legal right 1.5 Intangible asset: Expected future economic benefits {An item can only be recognised as an intangible asset if economic benefits are expected to flow in the future from ownership of the asset. Economic benefits may come from the sale of products or services, or ‘rom a reduetion in expenditures (cost savings). An intangible asset, when recognised initially, must be measured at cost. It should be recognised if, and only if both the following occur. (@) ‘tis probable that the future economic benefits that are attributable to the asset will flow to the entity. (b) The cost of the asset can be measured reliably’. (IAS 38: para, 21) Management has to exercise its judgement in assessing the degree of certainty attached to the flow of economic benefits to the entity. External evidence is best. {a) If an intangible asset is acquired separately. its cost can usually be measured reliably as its purchase price (including incidental costs of purchase such as legal fees, and any costs incurred in ‘getting the asset ready for use). (b) When an intangible asset is acquired as part of a business combination (ie an acquisition or takeover), the cost of the intangible asset is its fair value at the date of the acquisition. IFRS 3 Business Combinations explains that the fair value of intangible assets acquired in business combinations can normally be measured with sufficient reliability to be recognised separately from goodwil In accordance with IAS 20 Accounting for Government Grants and Disclosure of Government Assistance, intangible assets acquired by way of government grant and the grant itself may be recorded intially either at cost (which may be zero) or fair value (IAS 38: para. 44) 1.6 Exchanges of assets It one intangible asset Is exchanged for another, the cost of the intangible asset is measured at fair value unless (IAS 38: para. 45): (a) "The exchange transaction lacks commercial substance, or (b) The fair value of neither the asset received nor the asset given up can be measured reliably’ Otherwist 1.7 Internally generated goodwill Internally generated goodwill may not be recognised as an asset its cost is measured at the carryina amount of the asset aiven up. weet ot EE BPP @ Part 8 Elements of tnancal statements | 7:IAS 38 deliberately precludes recognition of internally generated goodwill because it requires that, for initial recognition, the cost of the asset rather than its fair value should be capable of being measured reliably and that it should be identifiable and controlled. Thus you do not recognise an asset which is. subjective and cannot be measured reliably 2 Research and development costs TESTED. poveiopment costs ats rcognised as an asst thay meet certain entra. «An intangible asset is initially recognised at cost and subsequently carried either at cost or revalued amount. ‘* Costs that do not meet the recognition criteria should be expensed as incurred. ‘+ An intangible asset with a finite useful life should be amortised over its useful life. An intangible asset with an indefinite useful life should not be amortised. 2.1 Research Research activities by definition do not meet the criteria for recognition under IAS 38. This is because, at ‘the research stage of a project, it cannot be certain that future economic benefits will probably flow to the entity from the project. There is too much uncertainty about the likely success or otherwise of the prolect. Research costs should therefore be written off as an expense as they are incurred. IAS 38 (para. 56) gives the following examples of research costs: (a) ‘Activities aimed at obtaining new knowledge (b) The search for, evaluation and final selection of, applications of research findings or other knowledge (c) The search for alternatives for materials, devices, products, processes, systems or services (4) The formulation, design evaluation and final selection of possible alternatives for new or improved materials, devices, products, systems or services’ 2.2 Development Development costs may qualify for recognition as intangible assets provided that the following strict criteria can be demonstrated (IAS 38: para, 57): (2) The technical feasibility of completing the intangible asset so that it will be available for us@ or sale (b) The entity's intention to complete the intangible asset and use or sell it (©) Theentity's abilty to use or sell the intangible asset (d) How the intangible asset will generate probable future economic benefits. Among other things, the entity should demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or if t isto be used internally, the usefulness of the intangible asset. (e) The availablity of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset. (1) The entity's ability to measure the expenditure attributable to the intangible asset during its development reliably Once these criteria are met, IAS 38 requires development expenditure to be capitalised (ie there is no option of not capitalising it). In contrast with research costs development costs are Incurred at a later stage in a project, and the probability of success should be more apparent. IAS 38 (para. 59) gives the following examples of development costs: (@) ‘The design, construction and testing of pre-production or pre-use prototypes and models (b) The design of tools, jigs, moulds and dies involving new technology BET sisi pore scaces ~@(©) The design, construction and operation of a pilot plant that is not of @ scale economically feasible for commercial production (d) The design, construction and testing ofa chosen alternative for new or improved materials, ‘devices, products, processes, systems or services 2.3 Other internally generated intangible assets The standard prohibits the recognition of internally generated brands, mastheads, publishing titles and customer lists and similar items as intangible assets. These al fil to meet one or more (in some cases all) ‘he definition and recognition criteria and in some cases are probably indistinguishable from internally generated goodwill. 2.4 Cost of an internally generated intangible asset The costs allocated to an internally generated intangible asset should be only costs that can be directly attributed or allocated on a reasonable and consistent basis to creating, producing or preparing the asset {or its intended use, The principles underlying the costs which may or may not be included are similar to those for other non-current assets and inventory. The cost of an internally generated intangible asset is the sum of the expenditure incurred from the date when the intangible asset frst meets the recognition criteria. If, as often happens, considerable costs have alroady boon recognised as expenses before management could demonetrato thatthe oritoria have boon met, this earlier expenditure should not be retrospectively recognised at a later date as part ofthe cost of an intangible asset. Exam focus point The treatment of development costs is examined frequently. The December 2013 exam, for instance, ‘ested it as part of the consolidation question in the form of an internally generated asset. The December 2018 exam asked students to explain the differance in treatment between internally generated and purchased brands, including demonstrating knowledge of the recognition criteria in each case. Treatment £ Doug Co is developing a new production process. During 20X3, expenditure incurred was $100,000, of which $90,000 was incurred before 1 December 20X3 and $10,000 between 1 December 20X3 and 34 December 20X3. Doug Co can demonstrate that, at 1 December 20X3, the production process met the criteria for recognition as an intangible asset. The recoverable amount ofthe know-how embodied in the process is estimated to be $50,000 Required How should the expenditure be treated? At the end of 20X3, the production process Is recognised as an intangible asset at a cost of $10,000. This is the expenditure incurred since the date whan the recognition criteria were met, that is 1 December 20X3. The $90,000 expenditure incurred before 1 December 20X3 is expensed, because the recognition criteria were not met. It will never form part of the cost of the production process recognised in the statement of financial position. 2.5 Recognition of an expense All expenditure related to an intangible which does not meet the criteria for recognition either as'an identifiable intangible aeeat or ae goodwill aricing on an acquicition chould be ox Incurred, IAS 36 (para. 69) gives examples of such expenditure: + Start up costs * Advertising costs + Training costs * Business relocation costs wot eceat ot EE #2@ Part 8 Elements of financial statements. | 7:Prepaid costs for services, for example advertising or marketing costs for campaigns that have been prepared but not launched, can stil be recognised as a prepayment. 2.6 Measurement of intangible assets subsequent to initial recognition The standard allows two methods of valuation for intangible assets after they have been first recognised. Applying the cost model, an intangible asset should be carried at its cost, less any accumulated ‘amortisation and less any accumulated impairment losses. The revaluation model allows an intangible asset to be carried at a revalued amount, which is its fair value at the date of revaluation, less any subsequent accumulated amortisation and any subsequent accumulated impairment losses. (a) The fair value must be able to be measured reliably with reference to an active market in that type of asset. (b) The entire class of intangible assets of that type must be revalued at the same time (to prevent selective revaluation). (©) Mfanintangible asset ina class of revalued intangible assets cannot be revalued because there is no active market for this asset, the asset should be carried at is cost less any accumulated amortisation and impairment losses. (¢) — Revaluations should be made with such regularity that the carrying amount does not differ from that which would be determined using fair value at the end of the reporting period. Point to note This treatment isnot available for the i asset must be reliably measured ial recognition of intangible assets. This is because the cost of the The guidelines state that there will not usually be an active market in an intangible asset; therefore the revaluation model will usually not be available, For example, although copyrights, publishing rights and film rights can be sold, each has a unique sale value. In such cases, revaluation to fair value would be Inappropriate. A fair value might be obtainable however for assets such as fishing rights or quotas or taxi cab licences. Where an intangible asset is revalued upwards to a falr value, the amaunt of the revaluation gain should be credited directly o equity under the heading of a revaluation surplus. However, ia revaluation gain is reversal of a revaluation decrease that was previously charged to profit or oss, the gain can be recognised in profit or loss. Where the carrying amount of an intangible asset is revelued downwards, the amount of the downward revaluation should be charged to profit or loss, unless the asset has previously been revalued upwards. A revaluation decrease should be first charged against any previous revaluation surplus in respect of that asset. Downward revaluation {An intangible asset is measured by a company at fair value. The asset was revalued by $400 in 20X3, and ‘there isa revaluation surplus of $400 in the statement of financial position. At the end of 20X4, the asset Is valued again, and a downward valuation of $500 is required Required State the accounting treatment for the downward revaluation. In this example, the downward valuation of $500 can first be set against the revaluation surplus of $400. The revaluation surplus will be reduced to $nil and a charge of $100 made as an expense in 20X4. BEE varie sets and gods | Par 8 ners fran stamens BPP @When the revaluation model is used, and an intangible asset is revalued upwards, the cumulative revaluation surplus may be transferred to relained earnings when the surplus is eventually realised. The surplus would be realised when the asset is disposed of. However, the surplus may also be realised over ‘time as the asset is used by the entity, The amount of the surplus realised each year is the difference between the amortisation charge for the asset based on the revalued amount of the asset, and the ‘amortisation that would be charged on the basis of the asset's historical cost. The realised surplus in such ‘cases should be transferred from revaluation surplus directly to retained earnings, and should not be ‘taken through profit or loss, 2.7 Useful life An entity should assess the useful life of an intangible asset, which may be finite or indefinite, An intangible asset has an indefinite useful life when there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows for the entity, Many factors are considered in determining the useful life of an Intangible asset, including (IAS 88: para. 90): Expected usage Typical product life cycles Technical, technological, commercial or other types of obsolescence ‘The stabiliy of the industry; expected actions by competitors The level of maintenance expenditure required Legal or similar mits on the use of the asset, such as the expiry dates of related leases Computer software and many other intangible assets normally have short lives because they are susceptible to technological obsolescence. However, uncertainty does not justify choosing a life that is unrealistically short. = The useful life of an intangible asset that arises from contractual or other legal rights should not exceed ‘the period of the rights, but may be shorter depending on the period over which the entity expects to use the asset. 2.8 Amortisation period and amortisation method An intangible asset with a finite useful life should be amortised over its expected useful life. (a) Amortisation should start when the asset is available for use. (b) _Amortisation should cease at the earlier of the date that the asset is classified as held for sale in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations and the dete that the asset is derecognised. (c) The amortisation method used should reflect the pattern in which the asset's future economic benefits are consumed. If such a pattern cannot be predicted reliably, the straight-line method should be used. (@) The amortisation charge for each period should normally be recognised in profit or loss, (IAS 38: para. 97) The residual value of an intangible asset with a finite useful fe is assumed to be zero unless third party {is committed to buying the intangible asset at the end of its useful ite or unless there is an active market for that type of asset (so that its expected residual value can be measured) and itis probable that there will be a market forthe asset at the end of its useful fe, The amortisation period and the amortisation method used for an intangible asset with a finite useful lite should be reviewed at each financial year end. wots ont EE “@ Part 8 Elements of tnancal statements | 7:2.9 Intangible assets with indefinite useful lives {An intangible asset with an indefinite useful life should not be amorlised. 1AS 36 requires that such an asset is tested for impairment at least annually. The useful life of an intangible asset that isnot being amortised should be reviewed each year to determine whether itis still appropriate to assess its useful life as indefinite. Reassessing the useful life of an intangible asset as finite rather than indefinite is an indicator thatthe asset may be impaired and therefore it should be tested for impairment. if OMS oll Intangible asset It may be difficult to establish the useful life of an intangible asset, and judgement will be needed. Required Consider how to determine the useful life of a purchased brand name, Factors to consider would include the following, (@) Legal protection ofthe brand name and the control ofthe entity over the (illegal) use by others of the brand name (ie control over pirating) (b) Age of the brand name (©) Status or position of the brand in its particular market (a) Ability of the management of the entity to manage the brand name and to measure activities that support the brand name (eg advertising and PR activities) (e) Stability and geographical spread ofthe market in which the branded products are sold (Pattern oF benefits thatthe rand name fs expected (o yenerate over line (Q) Intention of the entity to use and promote the brand name over time (as evidenced perhaps by a business plan in which there willbe substantial expenditure to promote the brand name) 2.10 Disposals/retirements of intangible assets {An intangible asset should be eliminated from the statement of financial position when it is disposed of or when there is no further expected economic benefit from its future use. On disposal the gain or loss arising from the difference between the net disposal proceeds and the carrying amount of the asset should be taken to profit or loss as @ gain or loss on disposal (le treated as income or expense). R&D ‘As an aid to your revision, list the examples given in IAS 38 of activities that might be included in either research or development. IAG 90 gives these examples. EE wari sets and gout | Par 8 ners fran stamens BPP @Research «Activities aimed at obtaining new knowledge ‘+ The search for, evaluation and final selection of, applications of research findings or other knowledge ‘+ The search for alternatives for materials, devices, products, processes, systems or services + The formulation, design, evaluation and final selection of possible alternatives for new or improved materials, devices, products, processes, systems or services (IAS 38: para. 56) Development + The design, construction and testing of pre-production prototypes and models ‘+ The design of tools, jigs, moulds and dies involving new technology ‘+ The design, construction and operation of a pilot plant that is not of a scale economically feasible for commercial production +The design, construction and testing of a chosen alternative for new or improved materials, devices, products, processes, systems or services (IAS 38: para. 59) 3 Goodwill (IFRS 3 Business Combinations) Purchased goodwill arising on consolidation is retained in the statement of financial position as an intangible asset under IFRS 3. It must then be reviewed annually for impairment, 3.1 What is goodwill? Goodwill is ereated by good relationships between a business and its customers. (2) By building up a reputation (by word of mouth perhaps) for high quality products or high standards of service (b) By responding promptly and helpfully to queries and complaints from customers (c) Through the personality of the staff and their atitudes to customers The value of goodwill toa business might be considerable, However, goodwill is not usually valued in the financial statements of a business at all, and we should not normally expect to find an amount for goodwill ints statement of financial position. For example, the friendly welcome given by a café’s staff may contribute more to the café’s profits than the fact that a new electronic cash register has recently been acquired. Even so, whareas the cash register will be recorded in the financial statements as a non-current asset, the value of staff would be ignored for accounting purposes. On reflection, we might agree with this omission of goodwill from the financial statements of a business. (a) The goodwill is inherent in the business but it has not been paid for, and it does not have an ‘objective’ value. We can guess at what such goodwill is worth, but such guesswork would be a matter of individual opinion, and not based on hard facts. (b) Goodwill changes from day to day. One act of bad customer relations might damage goodwill and one act of good relations might improve it, Statf with a favourable personality might retire or leave to find another job, to be replaced by staff who need time to find their feet in the job, ete. Since ‘goodwill is continually changing in valua, it cannot realistically be recorded in the financial statements of the business. wot eeat ot EE BPP 9 Part 8 Elements of tnancal statements | 7:3.2 Purchased goodwill There is one exception to the general rule that goodwill has no objective valuation. This is when a business is sold. People wishing to set up in business have a choice of how to do it they can either buy ‘their own long-term assets and inventory and set up their business from scratch, or they can buy up an existing business from 2 proprietor wiling to sell it. When a buyer purchases an existing business, he will have to purchase not only its long-term assets and inventory (and perhaps take over its accounts payable and receivable too) but also the goodwill of the business. Purchased goodwill is shown in the statement of financial position because it has been paid for. It has no tangible substance, and so it is an intangible non-current asset. 3.3 How is the value of purchased goodwill decided? When a business is sold, there is likely to be some purchased goodwill in the selling price. But how is the amount of this purchased goodwill decided? This is not really a problem for accountants, who must simply record the goodwill in the financial statements of the new business. The value of the goodwill is @ matter for the purchaser and seller to agree upon in fixing the purchase/sale price. However, two methods of valuation are worth mentioning here (a) The seller and buyer agree on a price for the business without specifically quantifying the ‘goodwill. The purchased goodwill will then be the difference between the price agreed and the value of the identifiable net assets in the books of the new business, (b) However, the calculation of goodwill often precedes the fixing of the purchase price and becomes a central element of negotiation. There are many ways of ariving at a value for goodwill and most of them are related to the profit record of the businass in question. No matter how goodwill is calculated within the total agreed purchase price, the goodwill shown by the purchaser in his accounts will be the difference between the purchase consideration and his own valuation of the net assets acquired. It A values his net assets at $40,000, goodwill is agreed at $21,000 and B agrees to pay $61,000 for the business but values the net assets at only $38,000, then the goodwill in B's books will be $61,000 - $38,000 = $23,000. 3.4 IFRS 3 Business Combinations IFRS 3 covers the accounting treatment of goodwill acquired in a business combination. Key term Goodwill. An asset representing the future economic benefits arising from other assets acquired ina business combination that are not capable of being individually identiied and separately recognised. (IFRS 3: Appendix A) Goodwill acquired in a business combination is recognised as an asset and Is initially measured at cost. Cost is the excess of the cost of the combination over the acquirer's interest in the net fair value of the acquiree's identifiable assets, liabilities and contingent liabilities, Aiter initial recognition goodwill acquired in a business combination is measured at cost less any accumulated impairment losses. |t is not amortised. Instead itis tested for impairment at least annually, in accordance with IAS 36, Again on a bargain purchase (also known as ‘negative goodwill’) arises when the acquirer's interest in the net fair value of the acquiree’s identiiable assets, liabilities and contingent liabilities exceeds the cost of the business combination, A gain on a bargain purchase can arise because the entity has genuinely obtained a bargain, perhaps for example because the seller has been forced to sell ata low price. However, it can also arise as the result of errors in measuring the fair value of either the cost of the combination or the acquiree's identifiable net assets, BATE isan perescaes "@Before recognising a gain on a bargain purchase, an entity should frst reassess the amounts at which it has measured both the cost of the combination and the acquiree's identifiable net assets (IFRS 3: para. 36). This exercise should identity any errors, Any gain on the bargain purchase remaining should be recognised immediately in profit or loss. f Characteristics of goodwill What are the main characteristics of goodwill which distinguish it from other intangible non-current assets? To what extent do you consider that these characteristics should affect the accounting treatment ‘of goodwill? State your reasons. ESM Goodwill may be distinguished from other intangible non-current assets by reference tothe following characteristics. (a) tis incapable of realisation separately from the business as a whole. (b) Its value has no reliable or predictable relationship to any costs which may have been incurred. (c)__ Its value arises from various intangible factors such as skilled employees, effective advertising or a strategic location, These indirect factors cannot be valued. (a) The value of goodwill may fluctuate widely according to internal and external circumstances over relatively short periods of time, (€) The assessment of the value of goodwill is highly subjective It could be arqued thet, because goodwill is so different from other intangible non-current assets it does ‘not make sense to account for it in the same way. Thus the capitalisation and amortisation treatment would not be acceptable. Furthermore, because goodwil isso difficult to value, any valuation may be ‘misleading, and itis best eliminated from the staternent of financial position altogether. However, there are strong arguments for treating it ike any other intangible non-current asset. Ths issue remains controversial Part 8 Elements of trance statements | 7: Intangible assets and goodwill (EZ)