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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, 10 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. 11 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: 12 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. 13