There are concerns that financial statements no longer reflect the underpinning drivers of value in modern business. Such concerns are particularly relevant to accounting for internally generated intangible assets and intangibles in general.
International Accounting Standard (IAS) 38 Intangible Assets, which governs the treatment of the capitalisation of development costs, has been characterised as a standard reflecting prudence and conservatism with a corresponding prevalence of expensing. Nonetheless, there is significant lack of evidence about the extent to which companies capitalise other internally generated intangible assets, especially those that fall outside the scope of IAS 38.
According to IAS 38, Expenditure for an intangible item is recognised as an expense, unless the item meets the definition of an intangible asset, and:
- it is probable that there will be future economic benefits from the asset; and
- the cost of the asset can be reliably measured.
The cost of generating an intangible asset internally is often difficult to distinguish from the cost of maintaining or enhancing the entity’s operations or goodwill. For this reason, internally generated brands, mastheads, publishing titles, customer lists and similar items are not recognised as intangible assets. The costs of generating other internally generated intangible assets are classified into whether they arise in a research phase or a development phase.
Research expenditure is recognised as an expense. Development expenditure that meets specified criteria is recognised as the cost of an intangible asset.
Intangible assets are measured initially at cost. After initial recognition, an entity usually measures an intangible asset at cost less accumulated amortisation. It may choose to measure the asset at fair value in rare cases when fair value can be determined by reference to an active market.
An intangible asset with a finite useful life is amortised and is subject to impairment testing. An intangible asset with an indefinite useful life is not amortised, but is tested annually for impairment. When an intangible asset is disposed of, the gain or loss on disposal is included in profit or loss.
Software Development Costs
Under IFRS reporting regime, accounting for Software Development Costs and associated capitalisation of relevant expenditure is governed primarily by IAS 38 Intangible Assets and less so by IFRS 3 Business Combinations. IAS 38 prescribes that an intangible asset shall be recognised if, and only if: a. it is probable that the expected future economic benefits that are attributable to the asset will flow to the entity; and b. the cost of the asset can be measured reliably. Second ‘the probability recognition criterion is always considered to be satisfied for separately acquired intangible assets’ and ‘the cost of a separately acquired intangible asset can usually be measured reliably’.
IAS 38 further covers the accounting for internally generated intangible assets, including R&D costs, of which Software Development Costs form a constituent element. All research costs are expensed. Development costs must be capitalised on meeting the six conditions specified in IAS 38; all other costs are expensed. The six conditions can be applied to cover those costs incurred in relation to the internal development and use of software or its development for sale, as set out below
An intangible asset arising from development (or from the development phase of an internal project) shall be recognised if, and only if, an entity can demonstrate all of the following:
- the 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 use or sell it;
- its ability to use or sell the intangible asset;
- how the intangible asset will generate probable future economic benefits. Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset;
- the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset;
- its ability to measure reliably the expenditure attributable to the intangible asset during its development”.
Within IAS 38, specific guidance is also provided in relation to software (including that developed internally) that is integral to the use of property, plant and equipment. Specifically, ‘computer software for a computer-controlled machine tool that cannot operate without that specific software is an integral part of the related hardware and it is treated as property, plant and equipment. The same applies to the operating system of a computer. When the software is not an integral part of the related hardware, computer software is treated as an intangible asset’ (IAS 38, para 4)
For internally generated intangible assets, it’s not possible to capitalise them. The result is that these financial statements do not reflect the underpinning drivers of valuable intangible-intensive businesses. So, yes, there is in IAS 38 a suggestion, but not a requirement, to provide a brief description of the significant intangible assets controlled but not recognized
Other issues are the fact that the return on assets ratio does not provide useful information, as the asset part is not properly reflected, and the costs incurred when the intangible is built are not capitalised. So the income of a period cannot be correctly matched. As a consequence, the profit or loss is hit twice: first by the cost when they are incurred, and then when they are replaced by internally generated intangibles. So comparability is also adversely affected. You cannot compare entities that grow organically with entities that grow through acquisition. Therefore, the wider topic of intangible assets and their accounting treatment and disclosure have been on the agenda of standard setters and regulators for some time.
To learn more about the accounting for Intangible Assets, please contact us.
