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Financial Repor ting Intangible Assets
Intangible Assets
Robert Kirk examines IFRS3 and IAS38 and asks are intangible assets a
growth business in financial reporting?
Introduction
Intangible assets have suddenly become one of ‘big stars’
in financial reporting after the recent case publicised by the
Financial Reporting Review Panel in London in October of
Brewin Dolphin Holdings Plc concerning their financial
statements for the 52 weeks ended 30th September 2007.
The company was criticised for failing to recognise customer
related intangibles in their acquisition of investment
management businesses under IFRS 3 Business
Combinations. They have had to adjust goodwill downwards
by £2.2m and incorporate the intangible asset of customer
relationships on to their statement of financial position.
This article sets out to examine the main issues in both
IFRS 3 and IAS 38 Intangible assets and the linkages
between the two standards in accounting for intangible
assets.
IAS 38 was last revised in 2003. Its objective is to
prescribe the accounting treatment for intangible assets and
how to recognise an intangible asset if, and only if, certain
criteria are met. It also specifies how to measure the carrying
amount of intangible assets and requires certain disclosures.
Scope
The standard is applied to all intangible assets, except:
(a) intangible assets covered by another standard e.g.
those for sale in the ordinary course of business,
deferred tax assets, leases under IAS 17, employee
benefits under IAS 19 and goodwill;
(b) financial assets as defined per IAS 32 and IAS 39;
(c) mineral rights and exploration for oil and gas
expenditure (see IFRS 6);
(d) insurance contracts with policyholders (see IFRS 4).
Some intangibles may be contained in a physical asset
itself e.g. compact disc. Judgement is therefore required to
decide whether or not IAS 16 Property, plant and
equipment or IAS 38 should be applied in practical
situations. However, where software is not an integral part
of related hardware, it must be treated as an intangible
asset.
IAS 38 also applies to advertising, training, start-up, and
research and development costs. Licensing agreements,
patents, copyrights etc are excluded from IAS 17 and
therefore also fall within the scope of IAS 38.
Intangible Assets
Intangible assets are defined as identifiable non-monetary
assets without physical substance. Examples include
computer software, patents, copyrights, motion picture films,
customer lists, mortgage servicing rights, fishing licences,
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import quotas, franchises, customer or supplier
relationships, customer loyalty, market share and marketing
rights.
To be capitalised they must meet the definition of an
intangible asset i.e. they must be identifiable, control must
exist over a resource and there must be an existence of
future economic benefits. If it fails any of these criteria, then
expenditure on intangibles should be expensed. The three
criteria can be examined in more detail below:
Identifiability
An intangible asset meets the identifiability criterion in the
definition of an intangible asset when it:
(a) is separable i.e. capable of being separated or
divided from the entity and sold, transferred,
licensed, rented or exchanged, either individually or
together with a related contract, asset or liability; or
(b) arises from contractual or other legal rights,
regardless of whether those rights are transferable
or separable from the entity or from other rights and
obligations.
Control
An entity controls an intangible asset if it has the power
to obtain future economic benefits and/or it can restrict the
access of others to those benefits. Capacity to control is
usually achieved via legal rights but that is not a necessary
condition.
Future economic benefits
This can include revenue from the sale of products or
services, cost savings or other benefits resulting from the
use of the asset e.g. use of intellectual property may reduce
future production costs rather than increase future
revenues.
Recognition and Initial Measurement of an Intangible
Asset
Recognition of an intangible asset requires an entity to
demonstrate that the item meets the:
(a) definition of an intangible asset; and
(b) the recognition criteria set out above.
An intangible asset must only be recognised if, and only
if:
(a) it is probable that future economic benefits
attributable to the asset will flow to the entity; and
(b) the cost of the asset can be measured reliably.
In assessing the probability of future economic benefits
entities must use reasonable and supportable assumptions
that represent management’s best estimate of the set of
economic conditions that will exist over the useful life of the
asset. However, greater weight must be put on external
Financial Repor ting Intangible Assets
evidence when using judgement as to the degree of certainty
attached to future flows.
Initially an intangible asset must be measured at cost.
Separate Acquisition
The price an entity pays to acquire separately an intangible
asset normally reflects expectations about the probability that
the future economic benefits embodied in the asset will flow
to the entity. Probability is assumed to be already reflected in
the cost of the acquired asset.
In addition, the cost of a separately acquired intangible asset
can usually be measured reliably. That is especially the case if
it has been acquired for cash.
The cost of a separately acquired intangible asset comprises:
(a) its purchase price, including import duties but after
deducting trade discounts and rebates; and
(b) any directly attributable expenditure on preparing the
asset for its intended use e.g. any costs of employee
benefits as per IAS 19 Employee benefits, professional
fees etc.
However, any costs incurred in using or redeploying
intangible assets are excluded from the cost of those assets
e.g. costs incurred while the asset is capable of operating in the
manner intended by management and initial operating losses
as well as any incidental operations that are not necessary to
bringing an asset to its normal working condition.
Measuring the fair value of an intangible asset acquired in a
business combination
Quoted market prices are the most reliable estimates of fair
values of intangible assets. That is usually the current bid price
or, if not available, the price of the most recent similar
transaction provided no significant change in the economic
circumstances has occurred between the transaction date and
date of measuring the fair value. If there is no active market for
the asset, fair value should be measured at the amount that an
entity would have paid for the asset, at acquisition date, in an
arms length transaction.
However, certain entities that are regularly involved in the
purchase and sale of unique intangible assets have developed
techniques for estimating their fair values indirectly. These
techniques may be used to calculate the initial measurement
of an intangible asset if their objective is to estimate fair value
for that purpose.
An example of intangibles being created on a business
combination comes from Icon Plc’s acquisition of Healthcare
Discoveries Inc in February 2008:
Icon Plc Year ended 31st December 2008
Notes to the Financial Statements (Extract)
Acquisition as Part of a Business Combination
Under IFRS 3, the fair value of an intangible asset reflects
market expectations about the probability that future economic
benefits will flow to the entity. As for separately acquired
intangible assets probability is already reflected in the fair value
measurement and thus the probability criterion is always
satisfied for acquired intangible assets in a business
combination.
To be recorded separately there must be sufficient evidence
to reliably measure a fair value that is separable from the entity.
It is therefore unlikely that a workforce and its related
intellectual capital would be measured with sufficient reliability
to be separately recognised.
Under IFRS 3 most Irish groups now record a wide array of
intangibles separately from goodwill on acquisitions. A
selection of these is provided below:
•
•
•
•
•
•
•
•
CPL Resources Plc - Brands, customer databases
DCC Plc - Customer relationships
First Derivatives Plc - Brands, software, customer lists
Fyffes Plc - Customer relationships
Glanbia Plc - Brands/knowhow, customer relationships
Icon Plc - Customer relationships, volunteer list
IFG Group Plc - Computer software
Independent News & Media Plc - Mastheads, radio
licences, transit & electronic systems
• Origin Enterprises Plc - Customer relationships, brands,
supplier agreements
• Paddy Power Plc - Bookmakers licences, customer
relationships
• Veris Plc - Customer related
Internally Generated Goodwill
Internally generated goodwill must never be recognised as
an asset. It is not an identifiable resource (i.e. it is not separable
nor does it arise from contractual or other legal rights)
controlled by the entity that can be measured reliably at cost.
Internally Generated Intangible Assets
It is difficult to assess whether or not an identifiable internal
intangible asset exists or not. Thus, in addition to ensure that
there are probable economic benefits flowing to the entity and
measuring cost reliably an entity must classify the generation of
the asset into its research and development phases. If it
cannot separate between the two, it must be classified as
research.
Research
This is defined as original and planned investigation
undertaken with the prospect of gaining new scientific or
technical knowledge and understanding.
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Financial Repor ting Intangible Assets
No intangible asset can arise from the research phase and thus it
must be written off as an expense. There is no demonstration of the
existence of probable future economic benefits. Examples include:
Total Produce Plc
Year ended 31st December 2008
Accounting Policies (Extract)
(a) activities aimed at obtaining new knowledge;
(b) the search for, evaluation and final selection of, applications of
research findings.
(c) the search for alternatives for materials, devices, products,
processes, systems or services;
(d) the formulation, design, evaluation and final selection of
possible alternatives for new or improved materials, products,
devices, processes, systems or devices.
Development
This represents the application of research findings or other
knowledge to a plan or design for the production of new or
substantially improved materials, devices, products, processes,
systems or services prior to the commencement of commercial
production or use.
Development should only be recognised if, and only if, an entity can
demonstrate all of the following:
(a)
the technical feasibility of completing the intangible asset so that
it will be available for use or sale;
(b) its intention is to complete the intangible asset and use or sell it;
(c) it has the ability to use or sell the intangible asset;
(d) the intangible asset will generate probable future economic
benefits. It must demonstrate the existence of a market for the
output of the intangible asset or, if used internally, its usefulness;
(e) the availability of adequate technical, financial and other resources
to complete the development and to use or sell the intangible
asset; and
(f) its ability to measure the expenditure attributable to the intangible
asset during its development reliably.
Examples of development activities are:
(a) the design, construction and testing of pre-production or preuse prototypes and models;
(b) the design of tools, jigs, moulds and dies involving new
technology;
(c) the design, construction and operation of a pilot plant that is
not of a scale economically feasible for commercial
production; and
(d) the design, construction and testing of a chosen alternative for
new or improved materials, devices, products, processes,
systems or services.
Subsequent Expenditure
Subsequent expenditure must be expensed when incurred unless:
(a) it is probable that the expenditure will increase future
economic benefits beyond that originally assessed prior to
the expenditure taking place; and
(b) the expenditure can be attributed to the asset and be reliably
measured.
If both conditions are met the subsequent expenditure should be
added to the cost of the intangible asset. Normally the nature of such
assets is that it is not possible to determine whether or not the
subsequent expenditure is likely to enhance or maintain the future
economic benefits. Only rarely will they pass (a) and (b) above.
However, subsequent expenditure on brands, mastheads, customer
lists, publishing titles should always be expensed to avoid the
recognition of internally generated goodwill.
Total Produce Plc provide detailed accounting policies for both
development expenditure which has been capitalised and other
intangible assets:
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Notes to the financial statements (Extract)
Financial Repor ting Intangible Assets
Measurement Subsequent to Initial Recognition
Benchmark Treatment
Intangible assets must be carried at cost less accumulated
amortisation and impairment losses.
Allowed Alternative Treatment
Review of Amortisation Period and Amortisation Method
The amortisation period and method adopted must be reviewed at
the end of each annual reporting period. If the expected useful life is
different from previous estimates, the amortisation period must be
adjusted and the book value amortised over the remaining life as a
change in accounting estimates per IAS 8 Accounting policies,
changes in accounting estimates and errors e.g. it may become
apparent that the diminishing balance method is more appropriate
than straight line in some circumstances.
Intangibles must be carried at a revalued amount, being its fair
value at the date of the revaluation less any subsequent accumulated
amortisation and impairment losses. Fair value should refer to an
active market. Revaluations should be carried out with sufficient
regularity so that the carrying values are not materially different from
the fair value at the balance sheet date.
Intangible Assets with Indefinite Useful Lives
It is uncommon to find an active market in intangible assets but
they can occur e.g. taxi licences, fishing licences, production quotas
etc. However, it cannot exist for brands, newspaper mastheads, music
and film publishing rights, patents or trademarks because each asset
is unique and transactions are infrequent.
Review of Useful Life Assessment
The frequency of revaluations depends on the volatility of the fair
values and, if they are significant, an annual valuation may be
necessary. It has to be said that the allowed alternative method is
rarely used and there are no examples in Irish financial statements.
Amortisation
Amortisation is the systematic allocation of the depreciable amount
of an intangible asset over its useful life. An entity must assess
whether the useful life of an intangible asset is infinite or finite. An
indefinite life is one where there is no foreseeable limit to the period
over which the asset is expected to generate net cash inflows for the
entity.
An intangible asset with a finite life should be amortised but not an
intangible asset having an indefinite life.
Many factors must be considered in determining the useful life
including:
(a) the expected usage of the asset and whether it can be
managed efficiently;
(b) typical product life cycles;
(c) technical, technological, commercial or other types of
obsolescence;
(d) the stability of the industry in which the asset operates and
changes in market demand;
(e) expected actions by competitors;
(f) the level of maintenance expenditure required to obtain
future benefits;
(g) the period of control over the asset;
(h) whether the useful life is dependent on the useful life of other
assets in the entity.
The term indefinite does not mean infinite. A conclusion that the
useful life is indefinite should not depend on planned future
expenditure in excess of that required to maintain the asset at that
standard of performance.
Computer software is susceptible to changes in technology and
should therefore be written off over a short useful life.
Residual Value
It should be assumed to be zero unless:
(a) there is a commitment by a third party to purchase the asset
at the end of its useful life; or
(b) there is an active market for the asset and:
(i) residual value can be determined by reference to the
market; and
(ii) it is probable that such a market will exist at the end of
the asset’s useful life.
An intangible asset with an indefinite useful life must not be
amortised. However it is required to be tested annually for
impairment and also whenever there is an indication of an
impairment.
Similarly the useful life of an intangible asset should be reviewed
each period to determine whether events and circumstances support
an indefinite useful life. If not, the change should be treated as a
change in accounting estimate by amortising the asset over its
remaining useful life.
A reassessment of useful life is also a sign that the asset should be
tested for impairment. Any excess of the carrying amount over the
recoverable amount should be treated as an impairment loss.
Disclosure
General
There is considerable disclosure required under IAS 38 including:
(a) whether the useful lives are indefinite or finite and, if the latter,
their useful lives or amortisation rates used;
(b) the amortisation methods adopted;
(c) the gross carrying amount and accumulated amortisation at
the start and end of the period;
(d) the line item of the income statement in which the
amortisation charge is included;
(e) a reconciliation of the carrying amount at the start and end of
the period showing all the movements during the accounting
period for each class of intangible assets
There is considerable additional disclosure under the allowed
alternative treatment including details of fair value methodology.
Research and Development Expenditure
The aggregate amount of research and development expenditure
expensed during the period must also be disclosed.
Summary
Intangible assets are covered in two major international financial
reporting standards and are playing an increasingly important role in
business combinations. They are obviously very difficult in practice to
distinguish from goodwill but the IASB are convinced that by
separating them from goodwill it helps to better explain what assets
the acquirer has actually bought and why the price for some
acquisitions is far in excess of the fair value of tangible assets
acquired. It is clear that home-grown or internally generated
intangibles do not pass the tests for capitalisation except for
development expenditure, but only under fairly strict criteria. There
are, however, differences in the accounting treatment between IAS 38
and the new IFRS for SMEs published in July in that in the latter
document development may not be capitalised in that standard – it
must be expensed immediately. However, the introduction of the
wide range of intangibles that listed companies disclose will be
available to the SME sector.
Robert Kirk is Professor of Financial Reporting at the University of Ulster.
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