Concepts, Rules, and Examples | WILEY IAS 2003: Interpretation and Application of International Accounting Standards

Background

Over the years, the role of intangible assets has grown more important for the operations and prosperity of many types of businesses, as the "knowledge-based" economy becomes more dominant. However, until recently, accounting standards have tended to give scant attention to, or ignore entirely, the appropriate means of reporting upon such assets. As a consequence, practice has been exceptionally diverse, with enterprises in nations whose standards had not addressed accounting for intangibles typically being much more aggressive in capitalizing a range of intangibles, including internally generated goodwill, vis-a-vis those entities operating under more strictly defined rules limiting cost deferral and requiring rapid amortization of those costs which could be deferred.

Thus, in many countries it has been common practice to defer recognition of certain types of expenditures, including advertising costs and setup costs, the future benefits of which are very difficult to demonstrate. In addition, when intangibles such as "brand names" and "internally generated goodwill" have been capitalized, there has often been a great reluctance to amortize the costs against earnings over a reasonable time horizon, on the basis that these have either indefinite or infinite lives.

While advocates for such practices have made the claim that future benefits will flow from such expenditures (else, why incur those costs?), experience has shown that these deferrals often result in a subsequent year in large "big bath" write-offs. This pattern of foregone periodic expense and sporadic charge-offs clearly impedes the utility of financial statements for one of their primary purposes, namely, the predicting of future economic performance (both in terms of earnings and cash flows) of the reporting entity. While all can agree that predicting the useful economic lives of certain intangibles is exceptionally challenging, the need to honor the matching principle and to provide relevant information for use by investors, creditors and others has driven most standard setters to impose rather stringent requirements on the recognition and measurement of intangible assets.

International accounting standards first addressed accounting for intangibles in a thorough way with IAS 38, which was promulgated after a rather long and contentious gestation period that included the issuance of two Exposure Drafts. IAS 38 is a comprehensive standard which superseded an earlier standard dealing solely with research and development expenditures. It establishes recognition criteria, measurement bases, and disclosure requirements for intangible assets. The standard also prescribes impairment testing for intangible assets, to be undertaken on a regular basis. This is to ensure that only assets having recoverable values are capitalized and carried forward to future periods.

It is interesting to note that in prescribing the amortization period, IAS 38 has ruled out the concept of intangible assets having infinite or indefinite lives. In fact, by imposing additional burdens on those who would assign lives greater than twenty years to such assets, the standard set a rather conservative approach to recognition and measurement of intangibles. However, the IASB is currently weighing revisions that would remove the refutable presumption of a twenty-year maximum economic life and would further acknowledge the existence of indefinite-life intangibles, not subject to amortization at all (at least, until a finite life was determinable). These potential revisions are being pondered largely as part of IASB's effort to "converge" its standards, in this case to the recently revised US GAAP standards on business combinations and intangibles. (See further discussion in Chapter 11.)

Also, by simultaneously withdrawing the existing standard on research and development costs (the former IAS 9) and revising the standard on business combinations (IAS 22), the former IASC considerably streamlined and rationalized the accounting standards relating to accounting for intangible assets. As the rules presently exist, therefore, they do form a coherent and consistent set of requirements for the financial reporting on all such assets.

Scope of the standard.

The standard applies to all enterprises. It prescribes the accounting treatment for intangible assets, including development costs. However, it does not apply to intangible assets covered by other IAS; for instance, deferred tax assets covered under IAS 12, leases that fall within the purview of IAS 17, goodwill arising on a business combination and dealt with by IAS 22, assets arising from employee benefits that are covered by IAS 19, and financial assets as defined by IAS 32 and covered by IAS 27, 28, 31, and 39. This standard does not apply to intangible assets arising in insurance companies from contracts with policyholders, nor to mineral rights and the costs of exploration for, or development and extraction of, minerals, oil, natural gas, and similar nonregenerative resources. However, the standard does apply to intangible assets that are used to develop or maintain these activities.

Identifiable intangible assets include patents, copyrights, licenses, customer lists, brand names, import quotas, computer software, leasehold improvements, marketing rights, and specialized know-how. These items have in common the fact that there is little or no tangible substance to them, they have an economic life of greater than one year, and they have a decline in utility over that period which can be measured or reasonably assumed. In many but not all cases, the asset is separable; that is, it could be sold or otherwise disposed of without simultaneously disposing of or diminishing the value of other assets held.

Intangible assets are, by definition, assets that have no physical substance. However, there may be instances where intangibles also have some physical form. For example

There may be tangible evidence of an asset's existence, such as a certificate indicating that a patent had been granted, but this does constitute the asset itself;
Some intangible assets may be contained in or on a physical substance such as a compact disc (in the case of computer software); and
Identifiable assets that result from research and development activities are intangible assets because the tangible prototype or model is secondary to the knowledge that is the primary outcome of those activities.

In the case of assets that have both tangible and intangible elements, there may be some confusion about whether to classify them as tangible or intangible assets. Considerable judgment is required in properly classifying such assets as either intangible or tangible assets. As a rule of thumb, the asset should be classified as either an intangible asset or a tangible asset based on the relative or comparative dominance or significance of the tangible or the intangible component (or element) of the asset. For instance, computer software that is not an integral part of the related hardware equipment is treated as software (i.e., as an intangible asset). Conversely, certain computer software, such as the operating system, that is essential and an integral part of a computer, is treated as part of the hardware equipment (i.e., as property, plant, and equipment as opposed to an intangible asset).

The concept embodied in this standard is somewhat controversial, and in some respects also vague and unclear, being subjective and open to interpretation. In various attempts to explain this concept, different techniques have been used by commentators. Some have restricted themselves to detailed examples, while others (perhaps exhibiting over enthusiasm to clarify the concept) have gone further, even so far as to argue that IAS 38 draws a distinction between an "intangible asset" and an "intangible resource." In this typology, the latter expression has been conceived of a broader concept that includes intangible assets (as defined by IAS 38), as well as other hypothetical assets. For example, intangible resources would include not only items such as patents and copyrights (which would meet the qualifying criteria set forth for intangible assets in IAS 38), but also items such as customer lists and internally generated brands (which do not meet the definition of intangible assets). While this may serve some useful purpose, the coining of a phrase such as "intangible resources" (which is found neither in the IASC Framework nor in IAS 38) to be used in distinction from the term "intangible asset," is ill-advised. Given the fact that IAS 38 (paragraph 7) has defined an asset as a "resource... controlled by the enterprise...", the creation of alternative definitions and concepts is probably not appropriate.

Recognition Criteria

Identifiable intangible assets have much similarity to tangible long-lived assets (property, plant, and equipment), and the accounting for them is accordingly very similar. The key criteria for determining whether intangible assets are to be recognized are

Whether the intangible asset has an identity separate from other aspects of the business enterprise;
Whether the use of the intangible asset is controlled by the enterprise as a result of its past actions and events;
Whether future economic benefits can be expected to flow to the enterprise; and
Whether the cost of the asset can be measured reliably.

Identifiability.

As to the first issue, the principal concern is to distinguish these intangibles from goodwill arising from a business combination, the accounting for which is addressed by IAS 22. Goodwill is the residual cost of a business acquisition that cannot be assigned either to tangible assets, net of any liabilities assumed, or to identifiable intangibles. Unlike identifiable intangibles, goodwill cannot be separated from the assets (the physical as well as the identifiable intangible) it was acquired with. Since goodwill cannot be severed and sold, its real value is often questioned and the period over which it can be amortized is, accordingly, often made as brief as possible. (But note that goodwill may become a nonamortizing, impairment-tested asset under a revised or superseded IAS 22; see Chapter 11 for a discussion.)

To capitalize the cost of an intangible asset other than goodwill, it must have an independently observable existence and a cost that can be assigned to it. Independently observable existence can be established if the enterprise can rent, sell, exchange, or distribute the future economic benefits from the assets without also disposing of other assets; that is, that an owner can convey them without necessarily also transferring related physical assets. Goodwill, on the other hand, cannot be meaningfully transferred to a new owner without also selling other assets, and hence, will not meet the recognition criteria for intangible assets as defined by IAS 38.

Identifiability can be demonstrated by a legal right over an asset or by the fact that the asset is separable from the rest of the business. It is worth noting that while IAS 38 does not regard "separability" as an additional recognition criterion, some national standards (UK GAAP, for instance) still retain it as one of the qualifying criteria for recognition. At the time it adopted IAS 38, the IASC Board rejected the views of commentators on the antecedent Exposure Drafts who had advocated the inclusion of "separability" as an additional recognition criterion. In setting forth the basis for its conclusions, the Board cited several reasons for this rejection. Among these, perhaps the most noteworthy is the following:

...if a "separability" criterion was applicable to all intangible assets, many intangible assets (for example, a license to operate a radio station) would not be shown separately in the financial statements even if they meet the (IASC) Framework's definition of, and recognition criteria for, an asset.

While not supportive of imposing separability as a threshold criterion for intangible assets, IASC supported the view that

Demonstration of the separability of an asset can assist an enterprise in identifying an intangible asset; and
The inability of an enterprise to demonstrate the separability of an asset will make it harder to demonstrate that there is an identifiable intangible asset.

Currently, IASB is embarked upon a thorough review of accounting for business combinations, a corollary of which is the accounting for intangibles (including goodwill and in-process research and development) acquired in such combinations. Based on deliberations to mid-2002, it appears that the existing philosophy for intangible asset recognition will be essentially continued. A replacement for IAS 22 will likely stipulate that intangible assets acquired in a business combination should be recognized separately from goodwill if they arise as a result of contractual or legal rights or are separable from the business. The existence of contractual or legal rights and separability will not, however, form part of the definition of an asset, but rather, will serve as indicators that an entity controls the future economic benefits embodied in the item. It would appear, therefore, that neither of these characteristics are intended to be absolute requirements, which would continue current practice in this area.

Control.

The provisions of IAS 38 require that an enterprise should be in a position to control the use of the intangible asset. Control implies the power to both obtain future economic benefits from the asset as well as restrict the access of others to those benefits. Normally enterprises register patents, copyrights, etc. to ensure its control over an intangible asset. A patent gives the holder the exclusive right to use the underlying product or process without any interference or infringement from others. Intangible assets arising from technical knowledge of staff, customer loyalty, long-term training benefits, etc., will have difficulty meeting this recognition criteria in spite of expected future economic benefits from them. This is due to the fact that the enterprise would find it impossible to fully control these resources or to prevent others from controlling them.

For instance, even if an enterprise incurs considerable expenditure on training that will supposedly increase staff skills, the economic benefits from skilled staff cannot be controlled, since trained employees could leave their current employment and move on in their career to other employers. Hence, staff training expenditures, no matter how material in amount, do not qualify as an intangible asset. In other words, the practice of deferring training costs based on the reasoning that future economic benefits from enhanced staff skills will flow to the enterprise can no longer be justified, after the promulgation of the IAS on Intangible Assets. Other often-quoted examples of expenses that do not qualify as intangible assets based on the criterion of control are market share, customer relationships, customer loyalty (unless protected by enforceable legal rights), and portfolio of clients.

Future economic benefits.

Under IAS 38, it is mandated that an intangible asset be recognized only if it is probable that future economic benefits specifically associated therewith will flow to the reporting entity, and the cost of the asset can be measured reliably. The recognition criteria for intangible assets are derived from the (IASC) Framework and are similar to the recognition criteria for tangible assets (property, plant, and equipment).

The future economic benefits envisaged by the standard may take the form of revenue from the sale of products or services, cost savings, or other benefits resulting from the use of the intangible asset by the enterprise. A good example of other benefits resulting from the use of the intangible asset is the use by an enterprise of a secret formula (which the enterprise has protected legally) that leads to reduced future production costs (as opposed to increased future revenue).

Measurement of Cost of Intangibles

The conditions under which the intangible asset has been acquired will determine the measurement of cost.

The cost of an intangible asset acquired separately is determined in the same manner used for tangible assets as described in Chapter 8. Cost comprises the purchase price itself and any directly attributable costs of preparing the asset for its intended use.

In some situations, identifiable intangibles are acquired as part of a business combination or other bulk purchase transaction. According to the provisions of IAS 38, the cost of an intangible asset acquired as part of a business combination is its fair value as at the date of acquisition. If the intangible asset can be freely traded in an active market, then the quoted market price is the best measurement of cost. If the intangible asset has no active market, then cost is determined based on the amount that the enterprise would have paid for the asset in an arm's-length transaction at the date of acquisition. If the cost of an intangible asset acquired as part of a business combination cannot be measured reliably, then that asset is not recognized, but rather, is included in goodwill.

Under US GAAP, the aggregate purchase cost is to be allocated to assets acquired and liabilities assumed. If one or more of the assets are intangibles, the extent of judgment required in the allocation process becomes somewhat greater than would otherwise be the case; in extreme situations it may be impossible to determine how much, if any, of the aggregate cost should be allocated to intangibles. It is most likely to be determinable when the intangibles were actually negotiated for in the transaction rather than being thrown in to the deal. Furthermore, if the allocation of the purchase price to individual assets is accomplished by applying discounted present value measures to future revenue streams, unless this same process is usable with regard to the intangibles, it is likely that any unallocated purchase price will have to be assigned to goodwill.

Internally generated goodwill is not recognized as an intangible asset because it fails to meet the recognition criteria of

Reliable measurement at cost,
Lack of an identity separate from other resources, and
Control by the reporting enterprise.

In practice, accountants are usually confronted with the desire to recognize internally generated goodwill based on the premise that at a certain point in time the market value of an enterprise exceeds the carrying value of its identifiable net assets. However, as IAS 38 categorically points out, such differences cannot be considered to represent the cost of intangible assets controlled by the enterprise, and hence, would not meet the criteria for recognition (i.e., capitalization) of such an asset on the books of the enterprise.

Intangibles acquired by means of government grants.

If the intangible is acquired free of charge or by payment of nominal consideration, as by means of a government grant (e.g., when the government grants the right to operate a radio station) or similar program, and assuming the benchmark accounting treatment (historical cost) is employed, obviously there will be little or no amount reflected as an asset. If the asset is important to the reporting entity's operations, however, it must be adequately disclosed in the notes to the financial statements. If the allowed alternative (fair value) method is used, the fair value should be determined by reference to an active market. However, given the probable lack of an active market, since government grants are generally not transferable, it is unlikely that this situation will be encountered. If an active market does not exist for this type of an intangible asset, the enterprise must recognize the asset at cost. Cost would include those that are directly attributable to preparing the asset for its intended use.

Intangibles Acquired through an Exchange of Assets

If an intangible asset is acquired in exchange or partial exchange for a dissimilar intangible or other asset, then the cost of the asset is measured at its fair value. This amount is to be ascertained by reference to the fair value of the asset received, which is equivalent to the fair value of the asset given up in the exchange, adjusted for any cash or cash equivalents transferred.

If the exchange involves similar assets to be used by the enterprise in essentially the same manner and for the same purpose as the item given up in the exchange, the exchange is not deemed to be the culmination of an earnings process, and accordingly, no gain or loss is recognized. The new asset will be recorded at the carrying amount of the asset given up, adjusted for any cash or cash equivalent (often called "boot") given or received.

Internally Generated Intangibles other than Goodwill

In many instances, intangibles are generated internally by an entity, rather than being acquired via a business combination or some other purchase transaction. Because of the nature of intangibles, the actual measurement of the cost (i.e., the initial amounts at which these could be recognized as assets) can prove to be rather challenging in practice, and for that reason, historically there was somewhat of a bias against recognition of internally generated intangible assets. However, a failure to recognize such assets would not only cause the entity's balance sheet to underreport its economic resources, but would also result in a mismatching of income and expense in both the period of expenditure and later periods when the related benefits would be reaped. Accordingly, IAS 38 provides that internally generated intangible assets, provided certain criteria are met, are to be capitalized and amortized over the projected period of economic utility.

Under the now-superseded IAS 9, it was established that research costs were to be expensed as incurred, but that development costs were to be deferred (i.e., capitalized) and expensed over the periods of expected benefit. IAS 38 absorbed the guidance formerly found in IAS 9 and expanded it to cover other internally generated intangible assets. Thus, expenditures pertaining to the creation of intangible assets are to be classified alternatively as being indicative of, or analogous to, research activity or development activity. The former costs are expensed as incurred; the latter are capitalized, if future economic benefits are reasonably likely to be received by the reporting entity. Per IAS 38,

Costs incurred in the research phase are expensed immediately; and
If costs incurred in the development phase meet the recognition criteria for an intangible asset, such costs should be capitalized. However, once costs have been expensed during the development phase, they cannot later be capitalized.

In practice, distinguishing research-like expenditures from development-like expenditures may not be easily accomplished. This would be especially true in the case of intangibles for which the measurement of economic benefits cannot be performed in anything approximating a direct manner. Assets such as brand names, mastheads, and customer lists can prove quite resistant to such direct observation of value (although in many industries there are benchmark monetary amounts commonly associated with such items, such as the oft-expressed notion that a customer list in the securities brokerage business is worth $1,500 per name, implying the amount of avoidable promotional costs each qualified name is worth).

Thus, entities may incur certain expenditures in order to enhance brand names, such as engaging in image-advertising campaigns, but these costs will also have ancillary benefits, such as promoting specific products that are being sold currently, and possibly even enhancing employee morale and performance. While it may be argued that the expenditures create or add to an intangible asset, as a practical matter it would be difficult to determine what portion of the expenditures relate to which achievement, and to ascertain how much, if any, of the cost may be capitalized as part of brand names. Thus, it is considered to be unlikely that threshold criteria for recognition can be met in such a case. For this reason the standard has specifically disallowed the capitalization of internally generated assets like brands, mastheads, publishing titles, customer lists, and items similar to these in substance.

Apart from the prohibited items, however, IAS 38 permits recognition of internally created intangible assets to the extent the expenditures can be analogized to the development phase of a research and development program. Thus, internally developed patents, copyrights, trademarks, franchises, and other assets will be recognized at the cost of creation, exclusive of costs which would be analogous to research, as further explained in the following paragraphs.

At the time IAS 38 was issued, IAS 9 was withdrawn to avoid having two mostly, but not completely, similar standards effective simultaneously. Had this not been done, there was the risk that the accounting for certain internally generated assets that would have met the criteria of both standards would have been unclear. For example, software programs developed in-house as a result of research and development activities would be covered under IAS 9, while patented software programs developed in-house would meet the recognition criteria of IAS 38 also. In order to avoid confusion caused by the modest differences in accounting treatments prescribed by the two standards, the provisions of the two standards were combined into one.

When an internally generated intangible asset meets the recognition criteria, the cost is determined using the same principles as for an acquired tangible asset. Thus, cost comprises all costs directly attributable to creating, producing, and preparing the asset for its intended use. IAS 38 closely follows IAS 16 with regard to elements of cost that may be considered as part of the asset, and the need to recognize the cash equivalent price when the acquisition transaction provides for deferred payment terms. As with self-constructed tangible assets, elements of profit must be eliminated from amounts capitalized, but incremental administrative and other overhead costs can be allocated to the intangible and included in the asset's cost. Initial operating losses, on the other hand, cannot be deferred by being added to the cost of the intangible, but must be expensed as incurred.

As noted above, the standard presents the concepts of the research phase and the development phase of a research and development project. IAS 38 mandates that the expenditure incurred during the research phase of an internal project should be recognized as an expense when incurred (as opposed to recognizing it as an intangible asset). The standard takes this view based on the premise that an enterprise cannot demonstrate that the expenditure incurred in the research phase will generate probable future economic benefits, and consequently, that an intangible asset exists (thus, such expenditure should be expensed). Examples of research activities include: activities aimed at obtaining new knowledge; the search for, evaluation, and final selection of applications of research findings; and the search for and formulation of alternatives for new and improved systems, etc.

The standard recognizes that the development stage is further advanced than the research stage, and that an enterprise can possibly, in certain cases, identify an intangible asset and demonstrate that this asset will probably generate future economic benefits for the organization. Thus, the standard allows recognition of an intangible asset during the development phase, provided the enterprise can demonstrate all the following:

Technical feasibility of completing the intangible asset so that it will be available for use or sale;
Its intention to complete the intangible asset and either use it or sell it;
Its ability to use or sell the intangible asset;
The mechanism by which the intangible will generate probable future economic benefits;
The availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and
The entity's ability to reliably measure the expenditure attributable to the intangible asset during its development.

Examples of development activities include: the design and testing of preproduction models; design of tools, jigs, molds, and dies; design of a pilot plant which is not otherwise commercially feasible; design and testing of a preferred alternative for new and improved systems, etc.

Recognition of internally generated computer software costs.

The recognition of computer software costs poses several questions.

In the case of a company developing software programs for sale, should the costs incurred in developing the software be expensed, or should the costs be capitalized and amortized?
Is the treatment for developing software programs different if the program is to be used for in-house applications only?
In the case of purchased software, should the cost of the software be capitalized as a tangible asset or as an intangible asset, or should it be expensed fully and immediately?

In view of the current IAS on intangible assets, the position can be clarified as follows:

In the case of a software-developing company, the costs incurred in the development of software programs are research and development costs. Accordingly, all expenses incurred in the research phase would be expensed. Thus, all expenses incurred until technological feasibility for the product has been established should be expensed. The enterprise would have to demonstrate technical feasibility and probability of its commercial success. Technological feasibility would be established if the enterprise has completed a detailed program design or working model. The enterprise should have completed the planning, designing, coding, and testing activities and established that the product can be successfully produced. Apart from being capable of production, the enterprise should demonstrate that it has the intention and ability to use or sell the program. Action taken to obtain control over the program in the form of copyrights or patents would support capitalization of these costs. At this stage the software program would be able to meet the criteria of identifiability, control, and future economic benefits, and can thus be capitalized and amortized as an intangible asset.
In the case of software internally developed for in-house use, for example, a payroll program developed by the reporting enterprise itself, the accounting approach would be different. While the program developed may have some utility to the enterprise itself, it would be difficult to demonstrate how the program would generate future economic benefits to the enterprise. Also, in the absence of any legal rights to control the program or to prevent others from using it, the recognition criteria would not be met. Further, the cost proposed to be capitalized should be recoverable. In view of the impairment test prescribed by the standard, the carrying amount of the asset may not be recoverable and would accordingly have to be adjusted. Considering the above facts, such costs may need to be expensed.
In the case of purchased software, the treatment would differ on a case-to-case basis. Software purchased for sale would be treated as inventory. However, software held for licensing or rental to others should be recognized as an intangible asset. On the other hand, cost of software purchased by an enterprise for its own use and which is integral to the hardware (because without that software the equipment cannot operate), would be treated as part of cost of the hardware and capitalized as property, plant, or equipment. Thus, the cost of an operating system purchased for an in-house computer, or cost of software purchased for computer-controlled machine tool, are treated as part of the related hardware.

Cost of other software programs should be treated as intangible assets (as opposed to being capitalized along with the related hardware), as they are not an integral part of the hardware. For example, the cost of payroll or inventory software (purchased) may be treated as an intangible asset provided it meets the capitalization criteria under IAS 38 (in practice, the conservative approach would be to expense such costs as they are incurred, since their ability to generate future economic benefits is always questionable).

Costs Not Satisfying the IAS 38 Recognition Criteria

The standard has specifically provided that expenditures incurred for nonmonetary intangible assets should be recognized as an expense unless

It relates to an intangible asset dealt with in another IAS;
The cost forms part of the cost of an intangible asset that meets the recognition criteria prescribed by IAS 38; or
It is acquired in a business combination and cannot be recognized as an identifiable intangible asset. In this case, this expenditure should form part of the amount attributable to goodwill as at the date of acquisition.

As a consequence of applying the above criteria, the following costs are expensed as they are incurred:

Research costs;
Preopening costs to open a new facility or business, and plant start-up costs incurred during a period prior to full-scale production or operation, unless these costs are capitalized as part of the cost of an item of property, plant, and equipment;
Organization costs such as legal and secretarial costs, which are typically incurred in establishing a legal entity;
Training costs involved in operating a business or a product line;
Advertising and related costs;
Relocation, restructuring, and other costs involved in organizing a business or product line;
Customer lists, brands, mastheads, and publishing titles that are internally generated.

Thus, the IASC has finally resolved the controversy regarding the potential deferral of costs like preoperating expenses. In the past, many enterprises have been known to defer setup costs and preoperating costs on the premise that benefits from them flow to the enterprise over future periods as well. Due to the unequivocal stand taken by the IASC on this contentious issue, enterprises can no longer defer such costs. Further, by adding the provision relating to annual impairment testing of all internally generated intangible assets being amortized (over a period exceeding twenty years), the IASC has ensured that all such costs capitalized in the past would need to be adjusted for impairment.

The criteria for recognition of intangible assets as provided in IAS 38 are rather stringent, and many enterprises will find that expenditures either to acquire or to develop intangible assets will fail the test for capitalization. In such instances, all these costs must be expensed currently as incurred. Furthermore, once expensed, these costs cannot be resurrected and capitalized in a later period, even if the conditions for such treatment are later met. This is not meant, however, to preclude correction of an error made in an earlier period if the conditions for capitalization were met but interpreted incorrectly by the reporting entity at that time.)

Subsequently Incurred Costs

Under the provisions of IAS 38, the capitalization of any subsequent costs incurred on intangible assets is difficult to justify. This is because the nature of an intangible asset is such that, in many cases, it is not possible to determine whether subsequent costs are likely to enhance the specific economic benefits that will flow to the enterprise from those assets. Thus, subsequent costs incurred on an intangible asset should be recognized as an expense when they are incurred unless

It is probable that those costs will enable the asset to generate specifically attributable future economic benefits in excess of its originally assessed standard of performance; and
Those costs can be measured reliably and attributed to the asset reliably.

Thus, if the above two criteria are met, any subsequent expenditure on an intangible after its purchase or its completion should be capitalized along with its cost. The following example should help to illustrate this point better.

Example

An enterprise is developing a new product. Costs incurred by the R&D department in 2002 on the "research phase" amounted to $200,000. In 2003, technical and commercial feasibility of the product was established. Costs incurred in 2003 were $20,000 personnel costs and $15,000 legal fees to register the patent. In 2004, the enterprise incurred $30,000 to successfully defend a legal suit to protect the patent. The enterprise would account for these costs as follows:

Research and development costs incurred in 2002, amounting to $200,000, should be expensed, as they do not meet the recognition criteria for intangible assets. The costs do not result in an identifiable asset capable of generating future economic benefits.
Personnel and legal costs incurred in 2003, amounting to $35,000, would be capitalized as patents. The company has established technical and commercial feasibility of the product, as well as obtained control over the use of the asset. The standard specifically prohibits the reinstatement of costs previously recognized as an expense. Thus $200,000, recognized as an expense in the previous financial statements, cannot be reinstated and capitalized.
Legal costs of $30,000 incurred in 2004 to defend the enterprise in a patent lawsuit should be expensed. Under US GAAP, legal fees and other costs incurred in successfully defending a patent lawsuit can be capitalized in the patents account, to the extent that value is evident, because such costs are incurred to establish the legal rights of the owner of the patent. However, in view of the stringent conditions imposed by IAS 38 concerning the recognition of subsequent costs, the IASC seems to be in favor of the conservative approach of expensing such costs. Only such subsequent costs should be capitalized which would enable the asset to generate future economic benefits in excess of the originally assessed standards of performance. This represents, in most instances, a very high, possibly insurmountable hurdle. Thus, legal costs incurred in connection with defending the patent, which could be considered as expenses incurred to maintain the asset at its originally assessed standard of performance, would not meet the recognition criteria under IAS 38.
Alternatively, if the enterprise were to lose the patent lawsuit, then the useful life and the recoverable amount of the intangible asset would be in question. The enterprise would be required to provide for any impairment loss, and in all probability, even to fully write off the intangible asset. What is required must be determined by the facts of the specific situation.

Measurement subsequent to Initial Recognition

Benchmark treatment.

After initial recognition, an intangible asset should be carried at its cost less any accumulated amortization and any accumulated impairment losses.

Allowed alternative treatment—revaluation.

As with tangible assets under IAS 16, the standard for intangibles permits revaluation subsequent to original acquisition, with the asset being written up to fair value. Inasmuch as most of the particulars of IAS 38 follow IAS 16 to the letter, and were described in detail in Chapter 8, these will not be repeated here. The unique features of IAS 38 are as follows:

If the intangibles were not initially recognized (i.e., they were expensed rather than capitalized) it would not be possible to later recognize them at fair value.
Deriving fair value by applying a present value concept to projected cash flows (a technique that can be used in the case of tangible assets under IAS 16) is deemed to be too unreliable in the realm of intangibles, primarily because it would tend to commingle the impact of identifiable assets and goodwill. Accordingly, fair value of an intangible asset should only be determined by reference to an active market in that type of intangible asset. Active markets providing meaningful data are not expected to exist for such unique assets as patents and trademarks, and thus it is presumed that revaluation will not be applied to these types of assets in the normal course of business. As a consequence, the IASC has effectively restricted revaluation of intangible assets to only freely tradable intangible assets.

As with the rules pertaining to plant, property, and equipment under IAS 16, if some intangible assets in a given class are subjected to revaluation, all the assets in that class should be consistently accounted for unless fair value information is not or ceases to be available. Also in common with the requirements for tangible fixed assets, IAS 38 requires that revaluations be taken directly to equity through the use of a revaluation surplus account, except to the extent that previous impairments had been recognized by a charge against income.

Example of revaluation of intangible assets

A patent right is acquired July 1, 2002, for $250,000; while it has a legal life of 15 years, due to rapidly changing technology, management estimates a useful life of only 5 years. Straight-line amortization will be used. At January 1, 2003, management is uncertain that the process can actually be made economically feasible, and decides to write down the patent to an estimated market value of $75,000. Amortization will be taken over 3 years from that point. On January 1, 2005, having perfected the related production process, the asset is now appraised at a sound value of $300,000. Furthermore, the estimated useful life is now believed to be 6 more years. The entries to reflect these events are as follows:

7/1/02	Patent	250,000
	Cash, etc.		250,000
12/31/02	Amortization expense	25,000
	Patent		25,000
1/1/03	Loss from asset impairment	150,000
	Patent		150,000
12/31/03	Amortization expense	25,000
	Patent		25,000
12/31/04	Amortization expense	25,000
	Patent		25,000
1/1/05	Patent	275,000
	Gain on asset value recovery		100,000
	Revaluation surplus		175,000

Certain of the entries in the foregoing example will be explained further. The entry at year-end 2002 is to record amortization based on original cost, since there had been no revaluations through that time; only a half-year amortization is provided [($250,000/5) x 1/2. On January 1, 2003, the impairment is recorded by writing down the asset to the estimated value of $75,000, which necessitates a $150,000 charge to income (carrying value, $225,000, less fair value, $75,000).

In 2003 and 2004, amortization must be provided on the new lower value recorded at the beginning of 2003; furthermore, since the new estimated life was 3 years from January 2003, annual amortization will be $25,000.

As of January 1, 2005, the carrying value of the patent is $25,000; had the January 2003 revaluation not been made, the carrying value would have been $125,000 ($250,000 original cost, less 2.5 years amortization versus an original estimated life of 5 years). The new appraised value is $300,000, which will fully recover the earlier write-down and add even more asset value than the originally recognized cost. Under the guidance of IAS 38, the recovery of $100,000 that had been charged to expense should be taken into income; the excess will be credited to stockholders' equity.

Development costs pose a special problem in terms of the application of the allowed alternative method under IAS 38. The utilization of the allowed alternative method of accounting for long-lived intangibles is only permissible when stringent conditions are met concerning the availability of fair value information. In general, it will not be possible to obtain fair value data from active markets, as is required by IAS 38, and this is particularly true with regard to development costs. Accordingly, the expectation is that the benchmark (historical cost) method will be almost universally applied for development costs. The use of the available alternative method for development costs, while theoretically valid, is expected to be very unusual in practice.

Example of development cost capitalization

Assume that Creative, Incorporated incurs substantial research and development costs for the invention of new products, many of which are brought to market successfully. In particular, Creative has incurred costs during 2002 amounting to $750,000, relative to a new manufacturing process. Of these costs, $600,000 were incurred prior to December 1, 2002. As of December 31, the viability of the new process was still not known, although testing had been conducted on December 1. In fact, results were not conclusively known until February 15, 2003, after another $75,000 in costs were incurred post-January 1. Creative, Incorporated's financial statements for 2002 were issued February 10, 2003, and the full S750,000 in research and development costs were expensed, since it was not yet known whether a portion of these qualified as development costs under IAS 38. When it is learned that feasibility had, in fact, been shown as of December 1, Creative management asks to restore the $150,000 of post-December 1 costs as a development asset. Under IAS 38 this is prohibited. However, the 2003 costs ($75,000 thus far) would qualify for capitalization, in all likelihood, based on the facts known.

If, however, it is determined that fair value information derived from active markets is indeed available, and the enterprise desires to apply the allowed alternative (revaluation) method of accounting to development costs, then it will be necessary to perform revaluations on a regular basis, such that at any reporting date the carrying amounts are not materially different from the current fair values. From a mechanical perspective, the adjustment to fair value can be accomplished either by "grossing up" the cost and the accumulated amortization accounts proportionally, or by netting the accumulated amortization, prerevaluation, against the asset account and then restating the asset to the net fair value as of the revaluation date. In either case, the net effect of the upward revaluation will be recorded in stockholders' equity as revaluation surplus; the only exception would be when an upward revaluation is in effect a reversal of a previously recognized impairment which was reported as a charge against earnings or a revaluation decrease (reversal or a yet earlier upward adjustment) which was reflected in earnings.

The accounting for revaluations is illustrated as follows:

Example of accounting for revaluation of development cost

Assume Breakthrough, Inc. has accumulated development costs that meet the criteria for capitalization at December 31, 2002, amounting to $39,000. It is estimated that the useful life of this intangible asset will be 6 years; accordingly, amortization of $6,500 per year is anticipated. Breakthrough uses the allowed alternative method of accounting for its long-lived tangible and intangible assets. At December 31, 2004, it obtains market information regarding the then-current fair value of this intangible asset, which suggests a current fair value of these development costs is $40,000; the estimated useful life, however, has not changed. There are two ways to apply IAS 38: the asset and accumulated amortization can be "grossed up" to reflect the new fair value information, or the asset can be restated on a "net" basis. These are both illustrated below. For both illustrations, the book value (amortized cost) immediately prior to the revaluation is $39,000 - (2 $6,500) = $26,000. The net upward revaluation is given by the difference between fair value and book value, or $40,000 - $26,000 = $14,000.

If the "gross up" method is used: Since the fair value after 2 years of the 6-year useful life have already elapsed is found to be $40,000, the gross fair value must be 6/4 $40,000 = $60,000. The entries to record this would be as follows:

Development cost (asset)	21,000
Accumulated amortization—development cost		7,000
Revaluation surplus (stockholders' equity)		14,000

If the "netting" method is used: Under this variant, the accumulated amortization as of the date of the revaluation is eliminated against the asset account, which is then adjusted to reflect the net fair value.

Accumulated amortization—development cost	13,000
Development cost (asset)		13,000
Development cost (asset)	14,000
Revaluation surplus (stockholders' equity)		14,000

Amortization Period

As with tangible assets subject to depreciation or depletion, the cost (or revalued carrying amount) of intangible assets is subject to rational and systematic amortization. Given that the useful economic life of many intangibles would be difficult to assess, the rule is that a maximum twenty-year life is permissible, with amortization being over a shorter useful life if known. The only exceptions would occur in those instances where the legal right has a life of greater than twenty years and either of the following conditions exists:

The intangible has an existence that is not separable from a specific tangible asset, the useful life of which can be reliably determined to exceed twenty years, or
There is an active secondary market for the intangible.

The thrust of these requirements is to make the twenty-year life an upper limit for most intangibles.

If there is persuasive evidence that the useful life of an intangible asset is longer than twenty years, then the twenty-year presumption is rebutted and the enterprise must

Amortize the intangible asset over that longer period;
Estimate the recoverable amount of the intangible asset at least annually in order to identify any impairment loss; and
Disclose the reasons why the presumption has been rebutted.

Note that IAS 38 provides for amortization of all intangible assets; it does not subscribe to the view that any intangible asset can possess an infinite life. The thrust of these requirements is to make the twenty-year life an upper limit for most intangibles.

If control over the future economic benefits from an intangible asset is achieved through legal rights for a finite period, then the useful life of the intangible asset should not exceed the period of legal rights, unless the legal rights are renewable and the renewal is a virtual certainty. Thus, as a practical matter, the shorter legal life will set the upper limit for an amortization period in most cases.

The amortization method used should reflect the pattern in which the economic benefits of the asset are consumed by the enterprise. Amortization should commence when the asset is available for use and the amortization charge for each period should be recognized as an expense unless it is included in the carrying amount of another asset (e.g., inventory). Intangible assets may be amortized by the same systematic and rational methods that are used to depreciate tangible fixed assets. Thus, IAS 38 would seemingly permit straight-line, diminishing balance, and units of production methods. If a method other than straight-line is used, it must accurately mirror the expiration of the asset's economic service potential.

Residual Value

Tangible assets often have a positive residual value before considering the disposal costs because tangible assets can generally be sold for scrap, or possibly be transferred to another user that has less need for or ability to afford new assets of that type. Intangibles, on the other hand, lacking the physical attributes that would make scrap value a meaningful concept, often have little or no residual worth. Accordingly, IAS 38 requires that a zero residual value be presumed unless an accurate measure of residual is possible. Thus, the residual value is presumed to be zero unless

There is a commitment by a third party to purchase the asset at the end of its useful life; or
There is an active market for that type of intangible asset, and residual value can be measured reliably by reference to that market and it is probable that such a market will exist at the end of the useful life.

Periodic review of useful life assumptions and amortization methods employed.

As for fixed assets accounted for in conformity with IAS 16, the newer standard on intangibles suggests that the amortization period be reconsidered at the end of each reporting period, and that the method of amortization also be reviewed at similar intervals. There is the expectation that due to their nature intangibles are more likely to require revisions to one or both of these judgments. In either case, a change would be accounted for as a change in estimate, affecting current and future periods' reported earnings but not requiring restatement of previously reported periods.

Impairment Losses

IAS 38 has provided that

Amortization of an asset should commence when the asset is available for use; and
The amortization period should not exceed twenty years, although this presumption is rebuttable.

In view of the above, some enterprises may be tempted to

Capitalize intangible assets and defer amortization for long periods on the grounds that the assets are not available for use; and/or
Rebut the presumption of twenty-year life and amortize assets over a longer period.

To combat the risk that either of these strategies might be employed, the standard provides that in addition to the universal provisions of IAS 36 (which require that the recoverable amount of an asset should be estimated when certain indications of impairment exist, as described in detail in Chapter 8), IAS 38 requires that an enterprise should estimate the recoverable amount of the following intangible assets at least at each financial year-end even if there is no indication of impairment:

Intangible assets that are not yet ready for use; and
Other intangible assets that are amortized over a period exceeding twenty years from the date when the asset becomes available for use.

Apart from the special case of assets not yet in use, or being amortized over greater than twenty years, the major complication arises in the context of goodwill. Unlike other intangible assets that are individually identifiable, goodwill is amorphous and cannot exist, from a financial reporting perspective, apart from the tangible and identifiable intangible assets with which it was acquired. Thus, a direct evaluation of the recoverable amount of goodwill is not actually feasible; accordingly, the standard requires that goodwill be combined with other assets which together define a cash generating unit, and that an evaluation of any potential impairment (if warranted by the facts and circumstances) be conducted on an aggregate basis. A more detailed consideration of goodwill is presented in Chapter 11.

The impairment of intangible assets other than goodwill (such as patents, copyrights, trade names, customer lists, and franchise rights) should be considered in precisely the same way that long-lived tangible assets are dealt with. Carrying amounts must be compared to the greater of net selling price or value in use when there are indications that an impairment may have been suffered. Reversals of impairment losses under defined conditions are also recognized. The effects of impairment recognitions and reversals will be reflected in current period operating results, if the intangible assets in question are being accounted for in accordance with the benchmark method set forth in IAS 38 (i.e., at historical cost). On the other hand, if the allowed alternative method (presenting intangible assets at revalued amounts) is followed, impairments will normally be charged to stockholders' equity to the extent that revaluation surplus exists, and only to the extent that the loss exceeds previously recognized valuation surplus will the impairment loss be reported as a charge against earnings. Recoveries are handled consistent with the method by which impairments were reported, in a manner entirely analogous to the explanation earlier in this chapter dealing with impairments of plant, property, and equipment.

Disposals of Intangible Assets

With regard to questions of accounting for the disposition of assets, the guidance of IAS 38 virtually mirrors that of IAS 16. Gain or loss recognition will be for the difference between carrying amount (net, if applicable, of any remaining revaluation surplus) and the net proceeds from the sale.

Year 2000 Computer Software Revisions and Similar Costs

The months leading up to the start of the year 2000 were characterized by a great deal of consternation caused by the fact that a large fraction of "mainframe" computer software was unable to differentiate the year 2000 from 1900, since only the last two digits were used in date fields during the era when computer storage costs were high. This led to the expectation that many programs would "crash" when the last century ended, causing widespread mayhem. To obviate this risk, many companies committed enormous resources to acquiring replacement software or reprogramming existing software. This gave rise to the financial reporting issue: were such costs capitalizable?

The Standing Interpretations Committee ruled in SIC 6 that costs incurred to maintain or restore the benefits originally intended when software systems were installed were to be expensed as incurred. That is, assuming the carrying values of software had not been written down for the impairment of not being able to cope with the year 2000, any costs would not add to the utility of the software, but would only maintain or preserve it at the amounts already reflected in the financial statements.

While the "Y2K" crisis passed (with surprisingly little problem, in fact), the guidance of SIC 6 remains relevant. Logically, it extends to any costs incurred to restore software to its original value. For example, the cost of any software modifications necessitated by the more recent introduction of the euro currency would also have to be expensed as incurred.

A related question is whether the cost of upgrading or repairing the software should be accrued in anticipation of engaging in this effort. It appears that accrual in anticipation of these expenses is not warranted, however, since a legal or constructive obligation to incur such costs does not exist in advance. On the other hand, if a reporting entity were not planning to make necessary modifications to software which external factors (such as the adoption of the euro) were going to cause to become obsolete, then clearly a reduction in useful life (handled prospectively) or even an impairment charge, would be warranted.

Website development and operating costs

With the advent of the Internet and growing popularity of "e-commerce," many businesses now have their own websites. Websites have become integral to doing business and may be designed either for external or internal access. Those designed for external access are developed and maintained for the purposes of promotion and advertising of an entity's products and services to their potential consumers. On the other hand, those developed for internal access may be used for displaying company policies and storing customer details.

With substantial costs being incurred by many entities for website development and maintenance, the need for accounting guidance became evident. The recently promulgated interpretation, SIC 32, concluded that such costs represent an internally generated intangible asset that is subject to the requirements of IAS 38, and that such costs should be recognized if, and only if, an enterprise can satisfy the requirements of IAS 38, paragraph 45. Therefore, website costs have been likened to "development phase" (as opposed to "research phase") costs.

Thus the stringent qualifying conditions applicable to the development phase, such as "ability to generate future economic benefits," have to be met if such costs are to be recognized as an intangible asset. If an enterprise is not able to demonstrate how a website developed solely or primarily for promoting and advertising its own products and services will generate probable future economic benefits, all expenditure on developing such a website should be recognized as an expense when incurred.

Any internal expenditure on development and operation of the website should be accounted for in accordance with IAS 38. Comprehensive additional guidance is provided in the Appendix to the Interpretation and is summarized below.

Planning stage expenditures, such as undertaking feasibility studies, defining hardware and software specifications, evaluating alternative products and suppliers, and selecting preferences, should be expensed;
Application and infrastructure development costs pertaining to acquisition of tangible assets, such as purchasing and developing hardware, should be dealt with in accordance with IAS 16;
Other application and infrastructure development costs, such as obtaining a domain name, developing operating software, developing code for the application, installing developed applications on the web server and stress testing, should be expensed when incurred unless the conditions prescribed by IAS 38, paragraphs 19 and 45, are met;
Graphical design development costs, such as designing the appearance of web pages, should be expensed when incurred unless conditions prescribed by IAS 38, paragraphs 19 and 45, are met;
Content development costs, such as creating, purchasing, preparing, and uploading information on the website before completion of the website's development should be expensed when incurred under IAS 38, paragraph 57(c), to the extent content is developed to advertise and promote an enterprise's own products or services; otherwise, expensed when incurred, unless expenditure meets conditions prescribed by IAS 38, paragraphs 19 and 45;
Operating costs, such as updating graphics and revising content, adding new functions, registering website with search engines, backing up data, reviewing security access and analyzing usage of the website should be expensed when incurred, unless in rare circumstances these costs meet the criteria prescribed in IAS 38, paragraph 60, in which case such expenditure is capitalized as a cost of the website; and
Other costs, such as selling and administrative overhead (excluding expenditure which can be directly attributed to preparation of website for use), initial operating losses and inefficiencies incurred before the website achieves planned performance, and training costs of employees to operate the website, should be expensed when incurred.

This interpretation became effective in March 2002. The effects of adopting this Interpretation should be accounted for using the transition provisions originally established by IAS 38. For instance, when a website does not meet the requirements of this SIC but was previously recognized as an asset, the item should be derecognized at the date when this SIC becomes effective. If previously capitalized costs are written off due to the imposition of SIC 32, the expense may be handled under either the benchmark or alternative treatments specified by IAS 8.

Disclosure Requirements

The disclosure requirements set out in IAS 38 for intangible assets and those imposed by IAS 16 for property, plant, and equipment are very similar, and both demand extensive details to be disclosed in the financial statement footnotes. Another marked similarity is the exemption from disclosing "comparative information" with respect to the reconciliation of carrying amounts at the beginning and end of the period. While this may be misconstrued as a departure from the well-known principle of presenting all numerical information in comparative form, it is worth noting that it is in line with the provisions of IAS 1. IAS 1, paragraph 38, categorically states that "(u)nless an International Accounting Standard permits or requires otherwise, comparative information should be disclosed in respect of the previous period for all numerical information in the financial statements...." (Another standard that contains a similar exemption from disclosure of comparative reconciliation information is IAS 37—please refer to the relevant chapter of the book for details.)

For each class of intangible assets (distinguishing between internally generated and other intangible assets), disclosure is required of

The amortization method(s) used;
Useful lives or amortization rates used;
The gross carrying amount and accumulated amortization (including accumulated impairment losses) at both the beginning and end of the period;
A reconciliation of the carrying amount at the beginning and end of the period showing additions, retirements, disposals, acquisitions by means of business combinations, increases or decreases resulting from revaluations, reductions to recognize impairments, amounts written back to recognize recoveries of prior impairments, amortization during the period, the net effect of translation of foreign entities' financial statements, and any other material items; and
The line item of the income statement in which the amortization charge of intangible assets is included.

The standard explains the concept of "class of intangible assets" as a "grouping of assets of similar nature and use in an enterprise's operations." Examples of intangible assets that could be reported as separate classes (of intangible assets) are

Brand names;
Licenses and franchises;
Mastheads and publishing titles;
Computer software;
Copyrights, patents and other industrial property rights, service and operating right;
Recipes, formulae, models, designs and prototypes; and
Intangible assets under development.

The above list is only illustrative in nature. Intangible assets may be combined (or disaggregated) to report larger classes (or smaller classes) of intangible assets if this results in more relevant information for financial statement users.

In addition, the financial statements should also disclose the following:

If the amortization period for any intangibles exceeds twenty years, the justification therefor;
The nature, carrying amount, and remaining amortization period of any individual intangible asset that is material to the financial statements of the enterprise as a whole;
For intangible assets acquired by way of a government grant and initially recognized at fair value, the fair value initially recognized, their carrying amount, and whether they are carried under the benchmark or allowed alternative treatment for subsequent measurement;
Any restrictions on titles and any assets pledged as security for debt; and
The amount of outstanding commitments for the acquisition of intangible assets.

In addition, the financial statements should disclose the aggregate amount of research and development expenditure recognized as an expense during the period.