The purpose of IAS 38, Intangible Asset is to prescribe the recognition and measurement criteria for intangible assets that are not covered by other Standards. This Standard will enable users of financial statements to understand the extent of an entity’s investment in such assets and the movements therein. The principal issues involved relate to the nature and recognition of intangible assets, determining their costs, and assessing the amortization and impairment losses that need to be recognized.
In some cases, an intangible asset may be contained on or in a tangible item. Obvious examples are computer software, films, and licensing agreements. In such situations, judgment is required to determine which is the more significant element. In the case of a machine incorporating software that cannot be operated without the software, the entire item would be treated as property, plant, and equipment under IAS 16. However, add-in software on a computer, such as some forms of report writing software or antivirus software, is not required for operating the tangible asset and therefore would be accounted under IAS 38.
This Standard DOES apply to expenditure such as: advertising, training, start-up costs, research and development, patents, licensing, motion picture film, software, technical knowledge, franchises, customer loyalty, market share, market knowledge, customer lists, and the like.
The Standard is to be applied in accounting for all intangible assets EXCEPT: Those that are within the scope of another Standard, Financial assets as defined in IAS 39, Mineral rights and expenditure on the exploration for, or development and extraction of, minerals, oil, natural gas, and similar non-regenerative resources.
The Standard DOES NOT apply to those intangible assets covered by other Standards, such as: Intangible assets held for sale in the ordinary course of business (IAS 2), Deferred tax assets (IAS 12), Leases within the scope of IAS 17, Assets arising from employee benefit plans (IAS 19), Financial assets covered by IAS 39, IAS 27, IAS 28, or IAS 31, Goodwill acquired in a business combination (IFRS 3), Deferred acquisition costs and intangible assets arising from insurance contracts (IFRS 4) (However, the disclosure requirements for such intangible assets are applicable), Noncurrent intangible assets classified as held for sale in accordance with IFRS 5.
Elaboration And Interpretation Of The Definitions
Identifiability – In order to meet the definition of an intangible asset, expenditure on an item must be separately identifiable in order to distinguish it from goodwill. An asset meets the identifiability criterion when it:
- Is capable of being separated from the entity and sold, transferred, licensed, or rented either individually or in combination with a related contract, asset, or liability; or
- Arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or other rights or obligations.
Control – An entity controls an asset if it has the power to obtain the future economic benefits flowing from the underlying resource and to restrict the access of others to those benefits. Usually this control would flow from legally enforceable rights. However, legal enforceability is not necessary if control can be enforced in some other way. For example, one method of control is keeping something secret through employee confidentiality. Control needs to be looked at carefully. An entity may be able to identify skills in its workforce and to measure the costs of providing those skills to its staff (via training). However, the entity usually does not have control over the expected economic benefits arising from the skilled staff, as they can leave their employment. Even if the skills are protected in some way such that departing staff are not permitted to use them elsewhere, the entity has lost the future benefit of the skills imbued in the departing staff member. Similarly, the purchase of customer lists or expenditure on advertising, while identifiable, does not provide control to an entity over the expected future benefits. Customers are not forced to buy from the entity and can go elsewhere.
Future Economic Benefit – Future economic benefit may include revenue from the sale of products, services, or processes, but also includes cost savings or other benefits from use of an asset. Use of intellectual property can reduce operating costs rather than produce revenue.
Recognition And Measurement Of Intangible Asset
An item may be recognized as an intangible asset when it meets the definition of an intangible asset [see above] and meets these recognition criteria:
- It is probable that the expected future economic benefits that are attributable to the asset will flow to the entity; and
- The cost of the asset can be measured reliably.
Initially, intangible assets shall be measured at cost. The cost of separately acquired intangible assets comprises:
- Purchase price, including any import duties and non-refundable purchase taxes, less discounts and rebates; and
- Directly attributable costs of preparing the asset for use.
Directly attributable costs can include employee benefits, professional fees, and costs of testing.
Costs that CANNOT be included are: Costs of introducing new products or services, such as advertising, Costs of conducting new business, Administration costs, Costs incurred while an asset that is ready for use is awaiting deployment, Costs of redeployment of an asset, Initial operating losses incurred from operation
Fact: In the corporate world, it is often noticed that entities spend huge sums of money on advertising campaigns to launch new products. Some multinational entities even hire famous performing artists or movie stars to act as brand ambassadors of the new products. Because the amounts spent on these advertising campaigns are so huge, these entities sincerely believe that the benefits from this promotion would last longer than a year and thus they are inclined to defer the costs of introducing new products over a period of two to three years. When the financial statements of these entities have to be audited, this is usually a contentious issue. Auditors generally find it very difficult to convince the entity’s management that the Standard categorically disallows deferring such costs.
Here are the rule of thumb to follow:
- If payment for an intangible asset is deferred beyond normal credit terms, then the cost is the cash price and the balance is treated as a finance charge over the period of the finance.
- If intangible assets are acquired as part of a business combination, as defined in IFRS 3, their cost is their fair value at the acquisition date.
- The probability of future economic benefit is reflected in the fair value, and, therefore, the probability of future economic benefit required for recognition is presumed.
- In a business combination, such intangible assets are to be recognized separately from goodwill.
Assessing the fair value of an intangible asset in a business combination can be difficult; obvious techniques are the use of comparable market transactions or quoted prices. Sometimes there may be a range of values to which probabilities can be assigned. Such uncertainty enters into the measurement of the asset rather than demonstrating an inability to measure the value. If an intangible asset has a finite life, then it is presumed to have a reliably measurable fair value.
In some circumstances, it may not be possible to reliably measure the fair value of an intangible asset in a business combination because it is inseparable or there is no history or evidence of exchange transactions for the asset, and any fair value estimates would be based on immeasurable variables.
If an intangible asset is acquired in exchange for another asset, then the acquired asset is measured at its fair value unless the exchange lacks commercial substance or the fair value cannot be reliably measured, in which case the acquired asset should be measured at the carrying amount of the asset given up, where carrying amount is equal to cost less accumulated depreciation and impairment losses. For impairment losses, reference should be made to IAS 36. In this context, any compensation received for impairment or loss of an asset shall be included in the income statement.
Case Example: Lie Dharma Record Inc. acquires copyrights to the original recordings of a famous singer. The agreement with the singer allows the company to record and rerecord the singer for a period of five years. During the initial six-month period of the agreement, the singer is very sick and consequently cannot record. The studio time that was blocked by the company had to be paid even during the period the singer could not sing.
These costs were incurred by the company:
(a) Legal cost of acquiring the copyrights $10 million
(b) Operational loss (studio time lost, etc.) during start-up period $ 2 million
(c) Massive advertising campaign to launch the artist $ 1 million
The question is: Which of the above items is a cost that can be capitalized as an intangible asset?
(a) The legal cost of acquiring the copyright can be capitalized.
(b) “Operational costs” during the start-up period are not allowed to be capitalized.
(c) Massive advertising campaign to launch the artist is not allowed to be capitalized.
Internally Generated Intangible Assets
With internally generated intangible assets, problems arise in identifying whether there is an identifiable asset that will generate future economic benefit and in reliably determining its cost.
Goodwill – The Standard proscribes the recognition of internally generated goodwill as an asset. The rationale behind this is that any expenditure incurred does not result in an asset that is an identifiable resource—it is not separable, nor does it arise from a contractual or other legal rights—or that is controlled by the entity. In addition, any costs incurred are unlikely to be specifically identifiable as generating the goodwill. The position that the difference between a valuation of a business and the carrying amount of its individual assets and liabilities may be capitalized as goodwill falls down insofar as that difference cannot be categorized as the cost and therefore cannot be recognized as an asset.
Other Internally Generated Intangible Assets – The Standard sets out rules for the recognition of other internally generated intangible assets and broadly defines such expenditures as research and development. It proscribes the recognition of internally generated brands, mastheads, publishing titles, customer lists, and similar items, because expenditure thereon, like expenditure on internally generated goodwill, cannot be distinguished from the cost of developing the business as a whole and is therefore not separately identifiable.
In order to determine whether an internally generated intangible asset qualifies for recognition, its generation is divided into a research phase and a development phase. If the two phases cannot be distinguished, then the entire expenditure is classified as research.
Expenditure on research (or the research phase of an internal project) is to be written off as an expense as and when incurred, as it is not possible to demonstrate that an asset exists that will generate future economic benefit. Examples include:
- Activities aimed at obtaining new knowledge
- The search for, evaluation, and selection of applications of research findings or knowledge
- The search for alternatives for materials, devices, products, systems, or processes
- The formulation, design, evaluation, and selection of possible alternatives for new or improved materials, devices, products, systems, or processes
Development expenditure may be recognized as an intangible asset when, and only when, all of the following can be demonstrated:
- The technical feasibility of completing the asset so that it will be available for use or sale
- The intention to complete the asset and use or sell it
- The ability to use or sell the asset
- How the asset will generate probable future economic benefit, including demonstrating a market for the asset’s output, or for the asset itself, or the asset’s usefulness
- The availability of sufficient technical, financial, and other resources to complete the development and to use or sell the asset
- The ability to reliably measure the expenditure attributable to the asset during its development
Examples of activities that may fail to be recognized as intangible assets include:
- The design, construction, and testing of pre-use prototypes or models
- The design of tools and jigs involving new technology
- The design, construction, and operation of a pilot plant that is not capable of commercial production
- The design, construction, and testing of a chosen alternative for new or improved materials, devices, products, systems, or processes
In order to implement the foregoing in practice, generally some form of business plan will be required to demonstrate the feasibility of a project, the availability of resources, and the future cash flows that can reasonably be expected to be derived there from.
Fact: Very often a project will commence with a research phase and after a time will evolve into the development phase. It will be necessary to determine at what point in time the project has so evolved, as expenditure up to that date will have to be recognized as an expense in the income statement and expenditure incurred after that date can be capitalized as an intangible asset.
The use of hindsight and the resultant claim to capitalize the entire expenditure is not permissible, as research expenditure must be expensed when incurred and the Standard does allow the reinstatement of previously written-off costs. One is not permitted accumulate costs in an account and then consider the nature of the entire project only when preparing the year-end financial statements.
Case Example: Lie Dharma Inc. is a newly established enterprise. It was set up by an entrepreneur who is generally interested in the business of providing engineering and operational support services to aircraft manufacturers. Lie Dharma Inc., through the contacts of its owner, received a confirmed order from a well known aircraft manufacturer to develop new designs for ducting the air conditioning of their aircraft. For this project, Lie Dharma Inc. needed funds aggregating to $1 million. It was able to convince venture capitalists and was able to obtain funding of $1 million from two Silicon Valley venture capitalists.
The expenditures Lie Dharma Inc. incurred in pursuance of its research and development project follow, in chronological order:
- January 15, 20X8: Paid $175,000 toward salaries of the technicians (engineers and consultants)
- March 31, 20X8: Incurred $250,000 toward cost of developing the duct and producing the test model
- June 15, 20X8: Paid an additional $300,000 for revising the ducting process to ensure that product could be introduced in the market
- August 15, 20X8: Developed, at a cost of $80,000, the first model (prototype) and tested it with the air conditioners to ensure its compatibility
- October 30, 20X8: A focus group of other engineering providers was invited to a conference for the introduction of this new product. Cost of the conference aggregated to $50,000.
- December 15, 20X8: The development phase was completed and a cash flow budget was prepared.
- Net profit for the year 20X8 was estimated to equal $900,000.
The question is: What is the proper accounting treatment for the various costs incurred during 20X8?
Treatment of various costs incurred during 20X8 depends on whether these costs can be capitalized or expensed as per IAS 38. Although IAS 38 is clear that expenses incurred during the research phase should be expensed, it is important to note that not all development costs can be capitalized. In order to be able to capitalize costs, strict criteria established by IAS 38 should be met. Based on the criteria prescribed by IAS 38, these conclusions can be drawn:
- It could be argued that the technical feasibility criterion was established at the end of August 20X8, when the first prototype was produced.
- The intention to sell or use criterion was met at the end of August 20X8, when the sample was tested with the air-conditioning component to ensure it functions. But it was not until October 20X8 that the product’s marketability was established. The reason is attributable to the fact that the entity had doubts about the new models being compatible with the air conditioners and that the sample would need further testing, had it not functioned.
- In October 20X8, the existence of a market was clearly established.
- The financial feasibility and funding criterion was also clearly met because Lie Dharma Inc. has obtained a loan from venture capitalists and it had the necessary raw materials.
- Lie Dharma Inc. was able to measure its cost reliably, although this point was not addressed thoroughly in the question. Lie Dharma Inc. can easily allocate labor, material, and overhead costs reliably.
Therefore, the costs that were incurred before October 20X8 should be expensed. The total costs that should be expensed = $175,000 + $250,000 + $300,000 + $80,000 = $805,000.
The costs eligible for capitalization are those incurred after October 20X8. However, conference costs of $50,000 would need to be expensed because they are independent from the development process.
Thus there are no total costs to be capitalized in terms of IAS 38.
Recognition Of An Expense On An Intangible Asset
The Standard requires that all expenditure on an intangible item be written off as an expense unless it meets the recognition criteria or it is acquired as part of a business combination and cannot be separately identified, in which case it is subsumed as part of goodwill and treated in accordance with IFRS 3. Examples include:
- Expenditure on start-up activities (start-up costs) or on opening a new facility or business (pre-operative expenses)
- Expenditure on training
- Expenditure on advertising and promotional activities
- Expenditure on relocating or reorganizing part or all of an entity
Web Site Development Costs
The advent of the Internet has created new ways of performing tasks that were unknown in the past. Most entities have their own Web site that serves as an introduction of the entity and its products and services to the world at large. A Web site has many of the characteristics of both tangible and intangible assets. With virtually every entity incurring costs on setting up its own Web site, there was a real need to examine this issue from an accounting perspective. An interpretation was issued that addressed the Web site costs:
SIC 32, Intangible Assets—Web Site Costs
SIC 32 lays down guidance on the treatment of Web site costs consistent with the criteria for capitalization of costs established by IAS 38. According to SIC 32, a Web site that has been developed for the purposes of promoting and advertising an entity’s products and services does not meet the criteria for capitalization of costs under IAS 38. Thus costs incurred in setting up such a Web site should be expensed.
Measurement after recognition is the next topic that you should not miss. It is available on my next post. The following topics is covered on the post: valuation and revaluation of intangible asset, Useful Life Of Intangible Asset, Amortization, Impairment, Retirements And Disposals, and Disclosures. Read it [here]