IAS 38 – Intangible Assets
Why are intangible assets so important in the modern economy?
In the modern economy there are many situations in which most of a firm’s value derives from intangible assets such as patents, know-how and brands. This fact by itself highlights the importance of the accounting treatment of intangible assets. Entities often invest substantial resources to acquire, develop, or maintain intangible resources such as technological or scientific knowledge, design and implementation of a new process, licenses, commercial know-how and trademarks. Common examples of items included within such intangible resources are computer software, patents, copyrights, films, customer lists, franchises, customer relationships or supplier relationships, customer loyalty, market share and marketing rights. Costs may arise from advertising, research and development and other activities. The central accounting question, therefore, is whether such costs should be recognised as assets in the reporting entity’s financial statements.
When can costs relating to intangible items be recognised as assets?
It should be emphasised at the outset that not all the above items meet the definition and the recognition criteria of an asset. An asset is generally recognised when it represents economic benefits that are expected to be received in the future, obtained or controlled by the reporting entity as a result of past transactions or events, and its value can be measured reliably. The costs of acquiring or developing an item that does not meet the asset definition and/or the recognition criteria are recognised as an expense when incurred, unless the item is acquired in a business combination. Thus, the accounting for intangible assets often places accounting and economics on opposite sides. From an accounting perspective, recognition of assets is subject to criteria that frequently may not be met, leading the reporting entity to recognise substantial expenses in profit or loss, even though economically, in many cases, the costs borne by the reporting entity enhance its value.
Why does accounting struggle to reflect the value of intangible assets?
There is no dispute that accounting was originally created for the traditional economy, and hence its weakness in dealing with the new economy. Broadly speaking, current accounting “misses” most of the intangible assets of modern companies, a situation that often creates a considerable gap between the “accounting value” of the reporting entity as presented in the financial statements and its economic value. In many cases, the difficulty in recognising these items as assets arises from the challenge of identifying direct future economic benefits, as well as, at times, from the lack of physical substance. The Conceptual Framework for Financial Reporting maintains that uncertainty sometimes leads to certain costs being recognised as expenses or losses, although those costs clearly arise from transactions or other events intended to obtain (or increase) future economic benefits. Such uncertainty may exist, for example, with respect to research and development costs, advertising costs and costs of establishing a brand.
What are the main difficulties in recognising internally generated intangible assets?
The main difficulties in recognising the costs incurred in connection with intangible assets arise on two levels:
Level A – Degree of certainty of future economic benefits
Frequently there is a high degree of uncertainty regarding the existence of future economic benefits associated with costs incurred for intangible assets and/or uncertainty regarding the amount of those benefits and how to identify them. For this reason, for example, advertising costs are recognised as an expense rather than as an asset. Another example is the high uncertainty in assessing whether a single research and development project represents future economic benefits. Empirical data indicates that most research and development projects that have begun ultimately failed. However, in this case the uncertainty may decrease as the project progresses. Estimates of the probability of success of an R&D project are highly problematic, since they can vary widely; and even if it is possible to assess that the reporting entity will derive future economic benefits from a particular project, determining the timing and extent of those benefits is especially difficult.
Level B – Identification of costs
When it comes to internally generated intangible assets such as goodwill and brand names, it is generally not possible to identify and measure reliably the costs incurred to create them. That is, it is difficult to separate the cost of the specific asset from other costs the entity incurs in the ordinary operation of the business. Consequently, costs for internally generated intangibles are not recognised as assets, while intangibles that are acquired separately are generally recognised as assets.
Why is human capital generally not recognised as an intangible asset?
In addition, human capital, which is one of the principal resources of modern companies, is not recognised as an asset because the reporting entity typically does not have sufficient control over the future economic benefits related to that resource, such as the benefits arising from having a skilled workforce. Therefore, managerial or technological talent is generally not recognised as an intangible asset unless it is protected by a legal right and meets the other elements of the asset definition and recognition criteria.
What are the recognition and measurement principles under IAS 38?
IAS 38 sets out the accounting for intangible assets and requires recognition of an intangible asset that meets the definition and the recognition criteria, i.e., it is probable that the expected future economic benefits attributable to the asset will flow to the reporting entity and the cost of the asset can be measured reliably. The measurement basis for intangible assets established by the Standard is generally the cost model.
How does IAS 38 interpret the concept of control over intangible assets?
For assessing the “control” element over economic benefits in the asset definition under the Conceptual Framework for Financial Reporting, the Standard adopts the view that identifiability is sufficient to establish control. Accordingly, the Standard defines an intangible asset as a non-monetary, identifiable asset without physical substance. The identifiability criterion is met when the asset is separable (for example, it can be sold) or when it arises from contractual or other legal rights. For illustration, the purchase of a customer list or customer relationships meets the definition of an intangible asset. The underlying concept of this approach, as adopted by the Standard, is in effect a fair value notion: it is sufficient that the company can sell the customer list to demonstrate control over its fair value.
How did changes in goodwill accounting affect IAS 38?
It should be noted that this approach has changed the guidance that such assets (e.g., customer relationships) are not intangible assets due to the absence of control. The change in approach in 2004 stemmed from a decision to prohibit systematic amortisation of goodwill arising in a business combination. Consequently, it became necessary to expand the number of items that meet the definition of identifiable intangible assets. Likewise, following the change in the accounting treatment of goodwill, the Standard states that intangible assets with indefinite useful lives are not amortised on a systematic basis.
How does IAS 38 treat research and development activities?
The Standard’s view is that research and development projects are distinct in nature from the development of the business as a whole, e.g., goodwill and internally generated brand names and trademarks. Consequently, the recognition criteria, primarily the expectation of future economic benefits, may be met for such projects, requiring recognition of an intangible asset. For this purpose, the Standard distinguishes between the research and the development phases. While costs incurred in the research phase are expensed due to the high uncertainty characteristic of that phase, certain development phase costs are capitalised as an intangible asset when specific conditions are met, mainly concerning the forecast of the expected economic benefits once the development is complete.
Which types of costs are explicitly prohibited from capitalisation under IAS 38?
One of the Standard’s key provisions is that it does not permit recognition of an intangible asset for costs of start–up activities, employee training, costs related to a new location or reorganisation, and advertising and promotion costs, even if those costs can be measured separately and reliably. The Standard’s view is that for such costs it is not possible to determine that the definition of an intangible asset is met and/or that the expected future economic benefits attributable to the asset will flow to the reporting entity. As a result, advertising, marketing and rebranding costs are recognised as an expense when incurred.
When are advertising and promotion costs recognised as an expense?
It should be noted that advertising and promotion costs, including the costs of materials, are recognised as an expense when the reporting entity has access to those goods or has received the services, rather than when the advertisement or promotion is delivered to the entity’s customers. Also, if the reporting entity pays in advance for advertising goods or services but has not yet received them, it may recognise the advance payment as an asset.