Studying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.

This article was first published in the January 2019 international edition of Accounting and Business magazine.

Let’s go back to 1998. In many ways, the world wasn’t so very different from now. Many of the famous bands and celebrities 20 years ago are still in the public eye, and nostalgia has played its part in keeping many of these things front and centre. Yet in some ways, the world has changed enormously.

In September 1998 the Diamond Rio PMP300 was launched. It may not be a product that immediately rings any bells for many people, but it was the first commercially successful portable MP3 player. It cost US$200 and could hold up to an hour of music. It’s fair to say the technology has moved on since then.

In the very same month, a far more exciting breakthrough was made, which I’m sure all readers are aware of. That’s right: IAS 38, Intangible Assets, was published. Doubtless, many readers will have celebrated the 20-year anniversary in style, so let’s take a time machine to back then. Imagine that we’re standing, in our shell suits, at the launch of the standard, with Britney Spears playing in the background. The surrounding computer screens run Windows 98 and we dream of a brave new world, knowing that as technology develops, so will the accounting for it.

Only that hasn’t quite happened with the accounting for technological items. Most of the accounting for tech-based items falls under IAS 38, or IAS 16, Property, Plant and Equipment, which was first issued in 1982. IAS 38 has been subject to tweaks ever since, particularly with the introduction of new standards for consolidated financial statements such as IFRS 3, Business Combinations, in 2004. While there have been minor adaptations, the core principles of IAS 38 remain the same, in particular its definition and recognition criteria.

The rules

According to IAS 38, an intangible asset is ‘an identifiable, non-monetary asset without physical substance’. Or, U Can’t Touch This, as the era’s great rapper, MC Hammer, put it in another context. Some of the items covered by IAS 38 may have some physical substance, such as patents and trademarks with their physical legal document, but the words of the man who gave us ‘Hammer time!’ remain largely true.

A key part of the definition is the word ‘identifiable’. The standard goes on to state that an asset is identifiable if it is separable (ie it can be sold separately from the underlying business itself) or arises from legal or contractual rights. If the item meets either of these conditions, then it is capitalised as a non-current asset.

From there we get into the measurement criteria. The asset is recognised initially at cost, and most intangible assets remain held under this model, as we will see. In one sense this helps preparers, as the use of the cost model is simple and straightforward, just amortising the cost over the asset’s expected useful life.

Safety first

While the cost model may be easy to apply, it is not necessarily a reflection of the true value of the item, particularly in the modern business world. A company may capitalise costs in the development of a new technology, but the true value of the technology is likely to far outweigh the cost of the inputs in developing it to completion. There is a remedy to this in that IAS 38 states that entities can choose to hold intangible assets under the revaluation model.

At this point, everything sounds reasonable, and the framework seems perfectly adequate. The issue arises in that the application of the revaluation model is unlikely in practice, as IAS 38 states that this can be done only with reference to an active market.

The standard itself recognises that an active market for intangible assets is rare, and even the examples it gives (fishing licences, taxi licences, production quotas) do not get to the heart of the modern world of intangible items. As there is no market for unique items, this essentially prevents most technology businesses from recognising their assets at market value.

In practice

The reality is that some of the largest entities in the world have a market capitalisation that far outweighs their balance sheet value. In itself, that is nothing new, but it does highlight the problem of how to recognise the assets of these entities.

For example, at the time of writing, Alphabet, the parent company of Google, has a market capitalisation of US$714bn compared with total assets of just US$197bn on its statement of financial position; recognised intangible assets make up less than US$3bn of that total. This is Google, a famous hub of innovation and development, at the very forefront of technology. Instinctively we know that the true value of the technology, the algorithms and the customer data is huge, which is what makes Google so valuable. Yet the accounting world struggles to find an accurate way to capture that value.

Similarly, Airbnb has a vast network of home owners and contacts it has utilised to create its brand, but none of this will be recognised in the financial statements. The hardware and servers will be recorded there, but there will be nothing on the intangible network itself, where the real value is generated.

This value often arises in consolidated financial statements when a company is acquired. In these cases, it is recognised at fair value, as it then becomes part of the acquired assets of the subsidiary entity. The accepted wisdom is that its intangibles form part of the acquisition price, so a value is allocated to them at acquisition. This provides better information than simply subsuming everything into goodwill, which is already the subject of scrutiny and concern over whether excessive amounts are being recognised, and more work is needed on impairment.

The argument is that if a fair value can be assigned in the acquisition case, why can it not be assigned in an individual set of financial statements? This loops back to the revaluation question, and currently is where the discussion ends, as revaluation is not permitted.

Internally generated assets

A long held principle of IAS 38 is that the majority of internally generated intangible assets cannot be capitalised. Internally generated brands are often cited as the big example here, prohibiting entities from recognising items, due to their subjective and fluctuating nature. The fear that companies can manipulate their financial statements by recognising an inflated brand strength has brought us to a situation where almost no internally generated intangibles can be recognised. The big question is how long this can continue.

We live in an information age, where innovation and ideas are rightly seen as the heart of many of the global businesses but cannot actually be recognised in the financial statements.

At this point, some readers may be screaming ‘research and development!’. And, of course, they would be right. Development costs for new projects can indeed be capitalised, but only when the capitalisation criteria are met.

Some R&D criteria are easy to demonstrate – for example, identifying the expenditure on the project and demonstrating an intention and resources to complete the project. Other R&D criteria, though, are more difficult to capitalise, such as the project being technically feasible and having a probable economic benefit.

This realistically results in costs only being eligible for capitalisation towards the end of the project. As a consequence, the value of the asset in the statement of financial position is not a reflection of either the costs incurred on the project nor the expected value to be derived from it. In short, it feels like the worst of both worlds.

The road ahead

In a recent conference, Hans Hoogervorst, chairman of the International Accounting Standards Board (IASB), acknowledged that the standard-setter should consider looking at the accounting for intangible assets. We have a situation where it is widely acknowledged that a large amount of value in certain entities is not captured in statements of financial position. This state of affairs surely cannot continue.

The accounting rules for intangible assets have been stable for a long time, and they lead to sensible recording of items at cost. They are good at lowering the risk of vastly inflated asset values. These are very good reasons for keeping the status quo. However, in an age of innovation, where ideas and development underpin many of the largest elements of the global economy, it can all feel a bit safe and a bit dated.

The IASB may not want to embark on another process of redrafting a major accounting standard, but if financial statements are going to continue to be the mainstay of financial reporting, it’s time for a rethink of this area. Otherwise we could be left with a set of analogue standards in a digital age.

Adam Deller is a financial reporting specialist and lecturer.