IAS® 38 Intangible Assets is one of the key standards in the Financial Reporting (FR) exam, covering how companies should account for intangible assets. This standard can be examined in all sections of the exam. A well-prepared candidate needs to be able to understand and explain the key principles of the standard, in addition to preparing calculations. These calculations mainly relate to the initial recognition or subsequent measurement of the asset.
An intangible asset is defined under International Financial Reporting Standards (IFRS®) as ‘an identifiable, non-monetary asset without physical substance’. This definition is already a little unhelpful for students, and this article will break it down more.
For an intangible asset to be identifiable, this means that it must be separable or arise from legal/contractual rights.
Separable intangible assets will be items that can be separated from the entity as a whole, meaning that they could be acquired from the entity without having to acquire the entire company. Items which may be categorised as separable intangible assets are commonly items such as licences or patents, where one entity can acquire the rights from another.
In addition to this, brand names are also likely to be separable. A company may operate many different product lines and may be willing to sell one of those brands, which could be done without selling the entire company. It is important to note that internally generated brands cannot be capitalised (ie recognised on the statement of financial position), which will be covered later in the article.
Legal/contractual rights often arise in consolidated accounts. For example, if an entity wanted to buy a controlling share in a company with many long-term contracts with major customers, these contracts would be recognised at fair value in the consolidated financial statements as key assets acquired with the subsidiary. In an entity’s individual accounts, legal/contractual rights might relate to something like a franchise agreement which the entity is not permitted to sell on to a third party. A franchise agreement such as this would still be identifiable for the purposes of the entity’s individual financial statements because it arose from legal/contractual rights, even though it cannot be sold separately.
(b) Non-monetary asset
Bank accounts or long-term investments where a fixed amount will be received will not qualify as intangible assets because these are monetary assets. This means that items such as trade receivables or loan receivables are not accounted for under IAS 38, even though they do not have physical substance. Another major asset you cannot physically touch could be an investment in shares in a company. All of these are examples of assets but would be accounted for in accordance with IFRS 9 Financial Instruments as financial assets and not intangible assets under IAS 38.
(c) Without physical substance
To keep it simple, the items covered under IAS 38 are items you cannot touch and are often technology-based. Therefore, this can include brand names, development costs related to research and development, patents, goodwill and similar items where all the company may physically hold is a legal document rather than a physical item.
In 20X3, Entertain Co entered into negotiations to acquire the Gadgetworks brand from Gadget Co for $1.2 million. This would give Entertain Co the ability to sell products under the Gadgetworks brand and give access to the Gadgetworks web domain name. Entertain Co did not wish to acquire any other assets of the Gadget Co business, such as the other brands or properties so therefore had no interest in acquiring the Gadget Co business as a whole.
In this example, the Gadgetworks brand is clearly separable as negotiations are underway to acquire it separately from the rest of the Gadget Co business. It is a non-monetary asset and it has no physical substance. Therefore, assuming the recognition criteria discussed later in this article are met, it would be recognised as an intangible asset in the individual statement of financial position of Entertain Co at the cost of $1.2m (Dr Intangible Asset, Cr Cash).
Financial Reporting exam focus:
These definitions are important in the FR exam. They could be examined within sections A or B where you might need to identify correct statements, but could also be examined in section C where you apply the key principles to a scenario and explain the correct treatment of an item.
Once it has been determined that an item meets the definition of an intangible asset, the entity must determine whether it meets the recognition criteria. An intangible asset can only be recognised if it is probable that the expected future economic benefits (eg revenue from the sale of products or services) that are attributable to the asset will flow to the entity and the cost of the asset can be measured reliably.
(a) Purchased intangible assets
The initial recognition rules of intangible assets under IAS 38 are relatively simple. If an asset has been purchased, it will be recognised initially at cost, as demonstrated in the above example of Entertain Co.
(b) Internally generated intangible assets
This is where the standard starts to get a little controversial. Generally, internally generated intangible assets cannot be capitalised. The reason that internally generated intangible assets often cannot be capitalised is that it is difficult to establish the true benefit from the asset or even to establish specific costs that can be attributable to items such as brand names.
Common misconceptions include the belief that training costs can be capitalised. Even though these may bring future benefit to the business, these costs cannot be separated from the entity and the company retains no legal or contractual right to these. This is because staff have a right to leave the company at any point, subject to their notice period, so the company cannot restrict the access of this economic benefit to others.
In addition to this, internally generated brands are specifically prohibited from being recognised. This has created a problem where some of the major assets in modern businesses can go unrecognised.
(c) Research and development costs
There is realistically one internally generated intangible asset that can be capitalised. These are development costs, where entities incur costs in order to develop new product lines or production methods. These can be capitalised from the point where six development criteria are met. The six criteria can be more easily memorised using the PIRATE mnemonic.
Probable economic benefits
Intention to complete the project
Resources available to complete the project
Ability to use or sell the item
Expenses on the project can be identified
In practice, an auditor will look at these criteria and determine if these have been met on the project. The principle of the six criteria is that an asset can only be recognised when a project has cleared hurdles such as regulatory testing, and the entity can demonstrate a willingness and ability to complete the project.
If the six criteria are met, then the entity can recognise an asset at cost. A key principle here is that costs can only be recognised as an asset from the point all six are met, up to the date that the project is complete. Any costs incurred before the criteria are met are expensed to the statement of profit or loss as they are incurred. Similarly, any costs associated with research into a new product will be incurred much earlier than the six criteria being met, so these would also be expensed.
Even though assets can be recognised for development costs, this is another area of criticism from the financial reporting community. These assets can only be recognised towards the end of the process, when the six criteria are met. This means that any asset recognised is still likely to be at a significantly lower value than the actual expected economic benefit to be realised from the asset itself.
(d) Consolidated financial statements
The recognition of intangible assets within consolidated financial statements raises something that appears to be an inconsistency. According to the principles of IFRS 3 Business Combinations, an intangible asset acquired as part of a business combination must be recognised at fair value. This means that some internally generated assets (such as brands or research costs) which cannot be recognised in the subsidiary’s own individual financial statements are now recognised in the consolidated financial statements. This is because for the group they are not internally generated but have actually been purchased as part of the subsidiary. Therefore, they are recognised at fair value in the consolidated financial statements, despite being unrecognised in the individual financial statements.
Res Co are developing a new line of pharmaceuticals and have spent $2m up to 1 January 20X5. On 1 January 20X5 the board gave approval to fully fund the rest of the project following promising results and spent a further $1m to 1 April 20X5. On 1 April 20X5 problems were discovered in the trials and approval was not given from the medical regulator for use of the pharmaceuticals. Res Co spent a further $1m to 1 July 20X5, at which point approval was given. From 1 July 20X5 to 1 October 20X5 Res Co spent $1.5m putting the product into the final finished stage of development. The new pharmaceuticals are expected to generate revenues in excess of $20m and have a useful life of five years.
In the financial statements of Res Co, only $1.5m of expenditure could be capitalised, as it is only from 1 July 20X5 that all of the development criteria are met. Even though the asset is likely to generate significant benefit and a total of $5.5m of costs have been incurred as part of research and development, the previously expensed costs cannot be recognised as assets.
Financial Reporting exam focus:
In the FR exam, you may be required to identify and explain the correct initial treatment of an item as to whether or not it can be capitalised. In terms of research and development, you may have to apply the six criteria to determine the date that costs can be capitalised from. This would then involve the calculation of any development cost asset and any amounts which must be expensed to the statement of profit or loss.
The recognition of internally generated intangible assets within the consolidated financial statements is regularly examined within section C of the exam. Candidates may be asked to produce calculations based on this fair value but may also be asked to explain why they are recognised in the group but not in individual company financial statements.
Similar to the principles of IAS 16 Property, Plant and Equipment there are two major models for accounting for intangible assets. These are the cost model and the revaluation model, and the methods used in the application are very much in line with the IAS 16 methodology.
(a) Cost model
Under the cost model, the intangible asset must be amortised over its useful life. Amortisation is the same as depreciation, but is simply the term used for intangible assets. The major difference between accounting for intangible assets under the cost model compared to tangible assets relate to intangible assets with an indefinite life. For intangibles with an indefinite life (such as goodwill or possibly brand names), there is no amortisation but the company is required to perform an annual impairment review to assess whether the asset is impaired or not.
(b) Revaluation model
In theory, IAS 38 allows for the revaluation of intangible assets and this would be accounted for in the same way as accounting for a revaluation of property, plant or equipment. Any increase in fair value would be added to the asset and recorded within other comprehensive income.
The main problem with revaluations under IAS 38 is that an item can only be revalued if there is an active market in place. This means that transactions would be taking place with sufficient regularity and volume to provide pricing information on an ongoing basis. This is unrealistic in practice as intangibles tend to be unique by their very nature. The examples quoted by the standard involve items such as fishing quotas and taxi licences, which goes some way to show that the standard itself is a little dated.
Financial Reporting exam focus:
In terms of calculations, the most commonly examined items are likely to be around the areas of amortisation or impairment. These could be in any area of the exam, but are unlikely to be particularly complex. In addition to this, candidates are expected to know the specific accounting rules for an intangible asset with an indefinite life and when intangibles can or cannot be revalued.
From the earlier examples of Entertain Co and Res Co, both of these would be held under the cost model. The useful life of the Gadgetworks brand would need to be established. If there is a finite life, it would be amortised over this. If not, it would have to have an annual impairment review. The development costs of the pharmaceuticals would be amortised over the useful life of five years.
Neither asset would qualify for being held under the revaluation model. Both are specific to the companies so would not have identical items regularly traded in order to assess a true market price.
The principles of intangible assets are key to both the FR and Strategic Business Reporting (SBR) exams. You should be aware of the general principles of how to account for them in addition to the necessary calculations. While IAS 38 is a key standard, there is an argument to be made that IAS 38 was not written with modern technological companies in mind. The standard was written in 1998, the same year as the first MP3 player which cost $200 and could hold a total of 1 hour’s music.
It is fair to say that the rules of the standard may fail to capture some of the key value in modern entities. This means that many modern technology firms have brands that are unrecognised on the statement of financial position, causing large discrepancies between a company’s market value and the value of the assets recorded in its financial statements. The International Accounting Standards Board (IASB) have acknowledged this problem, and it may well be that it is added to its standard-setting agenda in future periods.
Written by a member of the FR examining team