Question One

External disclosure of information on intangibles is useful only insofar as it is understood and is

relevant to investors. It appears that investors are increasingly interested in and understand
disclosures relating to intangibles. A concern is that, due to the nature of IFRS disclosure
requirements, investors may feel that the information disclosed has limited usefulness, thereby
making comparisons between companies difficult. Many companies spend a huge amount of
capital on intangible investment, which is mainly developed within the company and thus may not
be reported. Often, it is not obvious that intangibles can be valued or even separately identified for
accounting purposes.

The Integrated Reporting Framework may be one way to solve this problem.

Required:

a) Discuss the potential issues which investors may have with:

- Accounting for the different types of intangible asset acquired in a business combination.

- The choice of accounting policy of cost or revaluation models, allowed under IAS 38 Intangible
Assets for intangible assets

- The capitalisation of development expenditure

b) Discuss whether integrated reporting can enhance the current reporting requirements for
intangible

assets

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ANSWER

The general meaning of intangible ‘is without physical substance‘. There are some assets that may
not have a physical substance, but are still a valuable resource for an entity. They enable the
business to run and earn profits in the same manner as tangible assets do.
An intangible asset is an identifiable non-monetary asset without physical substance.

Some intangible assets may be contained in or on a physical substance such as a compact disc (in
the case of computer software), legal documentation (in the case of a license or patent) or film. In
determining whether an asset that incorporates both intangible and tangible elements should be
treated under IAS 16 Property, Plant and Equipment or as an intangible asset under this Standard,
an entity uses judgment to assess which element is more significant. For example, computer
software for a computer-controlled machine tool that cannot operate without that specific software
is an integral part of the related hardware and it is treated as property, plant and equipment. The
same applies to the operating system of a computer. When the software is not an integral part of
the related hardware, computer software is treated as an intangible asset.

Accounting for the different types of intangible asset acquired in a business combination.

In accordance with IFRS 3 Business Combinations, if an intangible asset is acquired in a business

combination, the cost of that intangible asset is its fair value at the acquisition date. The fair value
of an intangible asset will reflect market participants’ expectations at the acquisition date about
the probability that the expected future economic benefits embodied in the asset will flow to the
entity. In other words, the entity expects there to be an inflow of economic benefits, even if there
is uncertainty about the timing or the amount of the inflow.

If an asset acquired in a business combination is separable or arises from contractual or other legal
rights, sufficient information exists to measure reliably the fair value of the asset. Thus, the reliable
measurement criterion is always considered to be satisfied for intangible assets acquired in
business combinations.

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An acquirer recognises at the acquisition date, separately from goodwill, an intangible asset of the
acquiree, irrespective of whether the asset had been recognised by the acquiree before the business
combination. This means that the acquirer recognises as an asset separately from goodwill an in-
process research and development project of the acquiree if the project meets the definition of an
intangible asset.

The choice of accounting policy of cost or revaluation models, allowed under IAS 38
Intangible Assets for intangible assets

An entity shall choose either the cost model or the revaluation model as its accounting policy. If
an intangible asset is accounted for using the revaluation model, all the other assets in its class
shall also be accounted for using the same model, unless there is no active market for those assets.

Cost model
After initial recognition, an intangible asset shall be carried at its cost less any accumulated
amortisation and any accumulated impairment losses.

Revaluation model
After initial recognition, an intangible asset shall be carried at a revalued amount, being its fair
value at the date of the revaluation less any subsequent accumulated amortisation and any
subsequent accumulated impairment losses. For the purpose of revaluations under this Standard,
fair value shall be measured by reference to an active market. Revaluations shall be made with
such regularity that at the end of the reporting period the carrying amount of the asset does not
differ materially from its fair value.

The capitalisation of development expenditure

Expenditure incurred for research and development can be treated as development cost only if it
satisfies the following conditions. Therefore, the expenses which do not meet the criteria of
development costs are treated as research.

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An intangible asset arising from development or from the development phase of an internal project
shall be recognised if, and only if, an entity can demonstrate all of the following:

 The technical feasibility of completing the intangible asset so that it will be available for use
or sale.
 Its intention to complete the intangible asset and use or sell it.
 Its ability to use or sell the intangible asset.
 How the intangible asset will generate probable future economic benefits. Among other things,
the entity can demonstrate the existence of a market for the output of the intangible asset or
the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset.
 The availability of adequate technical, financial and other resources to complete the
development and to use or sell the intangible asset.
 Its ability to measure reliably the expenditure attributable to the intangible asset during its
development.

Whether integrated reporting can enhance the current reporting requirements for intangible
assets

Integrated reporting as “a process founded on integrated thinking that results in a periodic

integrated report by an organization about value creation over time and related communications
regarding aspects of value creation.”1 An integrated report is “a concise communication about
how an organization’s strategy, governance, performance and prospects, in the context of its
external environment, lead to the creation of value in the short, medium and long term. Integrated
reporting is being adopted by companies around the world but is still considered to be a practice
in its early stages.

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Question Two

The directors of Aron have observed that IFRS 9 Financial Instruments relies very heavily on fair
value measurement. They are concerned that fair value measurement is both judgemental and
volatile. They believe that reliance on fair value measurement when accounting for financial
instruments makes the financial statements less useful to stakeholders.

Required:

Discuss the validity of the director’s observations

Answer

Fair value is the price for which a company could sell a liability or an asset. Many accountants use
fair value as a means of financial measurement and apply it to the price of hypothetical or real
transactions in the marketplace. In this context, accountants make various businesslike and
reasonable assumptions. A financial asset shall be measured at fair value through profit or loss
unless it is measured at amortized cost or at fair value through other comprehensive income.
However, an entity may make an irrevocable election at initial recognition for particular
investments in equity instruments that would otherwise be measured at fair value through profit or
loss to present subsequent changes in fair value in other comprehensive income. Director o Aron
believe that reliance on fair value measurement when accounting for financial instruments makes
the financial statements less useful to stakeholders due to the following reason.

Sometimes accountants may not be able to obtain fair values for all the liabilities and assets of a
company. Similarly, fair-value comparisons among companies could be hard to make if teams of
accountants use subjective assessment criteria for risks and expectations. Also fair value estimates
do not always allow for economic trends or anticipated cash flows. As a result, the estimates do
not reflect shareholder view.

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Also fair-value accounting evaluates liabilities and assets from one particular time to another and
therefore fails to account for liability or asset appreciation. Another disadvantage that director
highlight is the expense of making regular valuations of liabilities and assets.

Fair value accounting can also present challenges to companies and users of reported financial
information. Conditions of the markets in which certain assets and liabilities are traded may
fluctuate often and even become volatile at times. Applying fair value accounting, companies
reevaluate the current value of certain assets and liabilities even in volatile market conditions,
potentially creating large swings in the value of those assets and liabilities. However, as markets
stabilize, such value changes likely reverse back to previous normal levels, making any reported
losses or gains temporary, which means fair value accounting may have provided misleading
information at the time.

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Question Three

The difference between debt and equity in an entity’s statement of financial position is not easily
distinguishable for preparers of financial statements. The classification of a financial instrument
as debt or equity can have a large impact on the financial statements of an entity.

Required:

Explain the likely impact on the financial statements if a financial liability was misclassified as an
equity item

ANSWER

Liability is a present obligation of the entity to transfer an economic resource as a result of past
events. An obligation is a duty of responsibility that the entity has no practical ability to avoid.
Also debts are capital provided by external contributors other than the legal owners. Equity is the
residual interest in the assets of the entity after deducting all its liabilities. The difference between
debt and equity in an entity’s statement of financial position is not easily distinguishable for
preparers of financial statements. The classification of a financial instrument as debt or equity can
have a large impact on the financial statements of an entity.

The following are the impact on the financial statements if a financial liability was
misclassified as an equity item

Incorrect representation of the financial position

If liability was misclassified as equity in financial statement it leads to incorrect representation of

financial position due to incorrect classification which does not give a true picture of a financial
position of an entity.

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Difficulty in raising funds from the capital market because of inaccurate information

Also misclassification of financial liability into equity items inn financial statements which will
result in to incorrect representation of financial statements will result in to difficulty of raising
funds from the capital market due to incorrect classification.

Non-Compliance with GAAP and other accounting standards

Misclassification of financial liability as equity items will result into noncompliance of General
Accepted Accounting Principle (GAAP) and other standards which emphasize adhering of
accounting rules and principles in preparation of financial statement into reach true representation
of financial statements.

Difficulty in obtaining a good credit rating

Difficulty in obtaining a good credit rating because the debt and current liabilities would be mixed
up and it will not be certain whether timely payments are made to creditors or debt holders because
the financial liability were misclassified into equity items so it will be difficulty in obtaining a
good rating.

Equity shareholders will not be able to assess the capital structure.

If financial liability was classified as equity item, the equity shareholders will not be able to assess
the capital structure of the firm due to incorrect representation of financial information. This will
not give them a clear picture of the burden on earnings. They will face difficulties in planning their
investments.

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Difficulty in calculating and analyzing financial ratios

When financial liability was misclassified as equity items it will lead to difficulty in calculating
and analyzing financial ratio such as gearing ratio because it will be difficulty to obtain the long
term debt of a firm due to incorrect classification of financial liability as equity item.

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References
Association of Chartered Certified Accountants. (2000). Financial Reporting Environment, Foulks
Lynch Ltd.

Ballou, B., Heitiger, D.L. and Tabor, R. (2003). Financial performance measures. Financial
Reporting, 5(1): 11-16.

Committee on Terminology. (1955). Proceeds, Revenue, Income, profit, and earnings, Accounting
Terminology Bulletin No.2, AICPA.

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