Topic 5: Accounting for Intangibles

• Understand what types of assets can be considered intangible assets and understand the differences between intangible and tangible assets

• Understand when expenditure on intangible assets should be recognised as an asset

• Understand when expenditure on intangible assets must be expensed

• Understand that intangible assets will either need to be systematically amortised or be the subject of impairment testing and that this choice will depend upon whether the asset is expected to have a limited useful life or an indefinite life

• Know how and when to revalue an intangible asset

• Understand how to account for research and development expenditure

• Be able to describe some empirical research that has been undertaken on corporate accounting practices relating to research and development

• Be able to define goodwill and explain how it is calculated for accounting purposes

Definition of intangible assets

• Non-monetary assets without physical substance

• Intangible assets, as a category, must be separately disclosed in the statement of financial position

• Identifiable intangible assets

• Unidentifiable intangible assets

• Greater value nowadays being placed on intangible assets for many companies—valuation is therefore an important issue

Which intangible assets can be recognised in the statement of financial position?

AASB 138 Intangible Assets

• Internally generated intangible assets (except internally generated development expenditure) are not to be carried forward as assets

• Specifically, paragraph 63 states:

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Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance shall not be recognised as intangible assets

• Recognition

• Separable

What is the initial basis of measurement of intangible assets?

AASB 138 Intangible Assets

• With the exception of expenditure incurred on development activities, only acquired intangibles may be recognised for balance sheet purposes

• Expenditure on internally generated intangibles does not qualify for deferral and must be expensed

• Cost of an asset to include the cost of acquiring the asset and preparing it for use

• Acquired intangible assets may be revalued to fair value only where there is an ‘active market’

Example 8.1

General amortisation requirements for intangible assets

• Intangible assets (other than goodwill) that are considered to have a limited useful life are required to be depreciated/amortised over their useful lives

• Useful life of an intangible asset under AASB 138:

The period of time over which the asset is expected to be used by the entity, or the number of production or similar units expected to be obtained from the asset by the entity

• Consider the expected residual value of the asset

• Under AASB 138 the residual value of intangible assets with finite lives is generally considered to be zero

• Useful life, residual value and amortisation method to be reviewed annually

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• Amortisation method should reflect the pattern in which the economic benefits are derived

• Intangible assets may have an ‘indefinite life’

• If the asset has an indefinite life there is no requirement to amortise

• If there is an impairment in the value of the asset it is to be shown as an expense

Example 8.2

Revaluation of intangible assets

• AASB 138—intangible assets may be revalued only if there is an ‘active market’

• Only assets that have been acquired at cost can subsequently be revalued

• Where revaluation occurs it must be to fair value of asset

• Revaluations to be done regularly

• Subsequent to a revaluation, any amortisation charges are to be based revalued amount

• Revaluations of goodwill are not permitted in Australia

Example 8.3

Required disclosures in relation to intangible assets

Numerous disclosures are required by AASB 138

Financial statements are to disclose the following for each class of intangible assets, distinguishing between internally generated and other intangible assets:

(a) Whether the useful lives are indefinite or finite and, if finite, the useful lives or the amortisation rates used

(b) The amortisation methods used for intangible assets with finite useful lives

(c) The gross carrying amount and any accumulated amortisation (aggregated with accumulated impairment losses) at the beginning and end of the period

(d) The line item(s) of the statement of comprehensive income in which any amortisation of intangible assets is included

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(e) A reconciliation of the carrying amount at the beginning and end of the period

Financial statements are also to disclose:

(a) if assessed as having an indefinite useful life, the carrying amount of that asset and the reasons supporting the assessment of an indefinite useful life.

(b) a description, the carrying amount and remaining amortisation period of any individual intangible asset that is material to the financial statements of the entity as a whole

(c) for intangible assets acquired by way of a government grant and initially recognised at fair value

(d) where title is restricted and the carrying amounts of intangible assets pledged as security for liabilities

(e) the amount of contractual commitments for the acquisition of intangible assets

Research and development

Introduction

• AASB 138 applies to intangible assets generally—however, there are a number of paragraphs dealing specifically with research and development

Research and development

• May account for a large proportion of expenditure for some entities

• Accounting problem: will the expenditure, with reasonable probability, provide future benefits?

• AASB 138 applies the simplifying assumption that all expenditure undertaken on the research component of research and development is to be expensed

Research expenditure—to be written off as incurred

AASB 138, par. 54

No intangible asset arising from research (or from the research phase of an internal project) shall be recognised. Expenditure on research shall be recognised as an expense when incurred

In justifying the above requirement

AASB 138 (par. 55)

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In the research phase of an internal project, an entity cannot demonstrate that an intangible asset exists that will generate probable future economic benefits. Therefore, this expenditure is recognised as an expense when it is incurred

Development expenditure can be deferred only if the entity can show all of the following (AASB 138, par. 57):

– The technical feasibility of completing the intangible asset

– 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, including the existence of a market for the intangible asset or, where the intangible asset is to be used internally, its usefulness

– The availability of adequate technical, financial and other resources to complete the development

– The ability to measure reliably expenditure on the intangible asset during its development

Additional key issues

• Where the total of the deferred development costs exceeds the expected recoverable amount, the deferred costs must be written down to the recoverable amount

• If the expenditure is initially expensed in one period then it may not subsequently be written back to the statement of financial position. General principle (AASB 138, par. 71):

Expenditure on an intangible item that was initially recognised as an expense shall not be recognised as part of the cost of an intangible asset at a later date

AASB 138 is inconsistent with Conceptual Framework—however, accounting standard takes precedence.

The requirement to write off all research expenditure as incurred:

• will result in much research activity that in fact does lead to subsequent economic benefits nonetheless having to be written off

• will have major implications for reported profits of entities that are heavily involved in R&D

• is less conservative than US position, where all research and development expenditure must be expensed as incurred

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Costs included as part of research and development

• Costs of internally generated assets (e.g. research and development) are all directly attributable costs necessary to create, produce and prepare the asset to be capable of operating in the manner intended by management (AASB 138, par. 66)

Example 8.4

Amortisation of deferred development costs

AASB 138 provides a number of requirements for the amortisation of intangibles, which also apply to any development expenditure that has been capitalised and deferred to future periods

Amortisation can be based on (whichever is appropriate):

• output levels

• expiration of time

Goodwill

What is goodwill?

• Arises when one entity acquires another entity, or part thereof

• An unidentifiable intangible asset

• Cannot be purchased or sold separately

• Represents the future economic benefits associated with an existing customer base, efficient management, reliable suppliers, etc.

• Could be built up over a number periods

• The relevant accounting standard is AASB 3 Business Combinations

Internally generated versus purchased goodwill

• Goodwill may be internally generated or acquired by purchasing an existing business

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• Only purchased goodwill is permitted to be recorded.

• Internally generated goodwill cannot be brought to account

• Measurement of purchased goodwill

Example 8.7

Impairment of goodwill

Impairment testing

Requirement to amortise goodwill was removed in 2005 and replaced with requirement to undertake annual ‘impairment testing’

AASB 3 (par. 55)

Goodwill acquired in a business combination shall not be amortised. Instead, the acquirer shall test it for impairment annually, or more frequently if events or changes in circumstances indicate that it might be impaired, in accordance with AASB 136 ‘mpairment of Assets

AASB 136 (par. 124)

– An impairment loss recognised for goodwill shall not be reversed in a subsequent period

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IN CLASS

Problem1

Singh Ltd involved in the research and development of a new type of three-finned surfboard. For this R & D it has incurred the following expenditure:

$50,000 obtaining a general understanding of water flow dynamics

$30,000 on understanding what local surfers expect from a surfboard

$90,000 on testing and refining a certain type of fin

$190,000 on developing and testing a full prototype of the three-finned board, to be called the ‘thruster’.

There is expected to be a very large market for the product, which will generate many millions of dollars in revenue.

Required:

Determine how the above expenditure would be treated for accounting purposes

Answer

Subject to certain tests for deferral, expenditure on development activity can be deferred to future periods and disclosed as an asset. Expenditure on research activities is to be written off as an expense as incurred. Paragraph 59 of AASB 138 provides examples of development activities. These are:

(a) the design, construction and testing of pre-production or pre-use prototypes and models;

(b) the design of tools, jigs, moulds and dies involving new technology;

(c) the design, construction and operation of a pilot plant that is not of a scale economically feasible for commercial production; and

(d) the design, construction and testing of a chosen alternative for new or improved materials, devices, products, processes, systems or services.

The $50 000 spent on developing a general understanding of water flow dynamics would be considered as research and would be expensed as incurred.

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The $30 000 spent on understanding what local surfers expect from a surfboard would be research and would be expensed as incurred

The $90 000 spent on testing and refining a certain type of fin and the $190 000 spent on the prototype would be construed as development expenditure and to the extent that the expenditure satisfies the tests for deferral then the expenditures will be capitalised.

Testing your thinking: Glass 4 Windows is involved in a research and development project to create a filtering window that removes the need for curtains. For the current year ended 30 June 2011 expenditure on the project is as follows:

Research $235,000Development costs $350,000

The window is expected to earn revenues of $70 000 per year for the 10 years commencing 1 July 2011. Assuming straight-line amortisation, how much of the research and development cost should be expensed this period and what amount should be amortised in the year ended 30 June 2014?

A. Expensed in 2011: $58 500; amortisation in 2014: $58 500

B. Expensed in 2011: $235 000; amortisation in 2014: $35 000

C. Expensed in 2011: $235 000; amortisation in 2014: $28 000

D. Expensed in 2011: $350 000; amortisation in 2014: $23 500

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Problem 2

Suparna Ltd acquires 100 per cent of Arora Ltd on 1 July 2013. Suparna Ltd pays the shareholders of Arora Ltd the following consideration:

Cash $70,000

Plant and equipment fair value $250,000; carrying amount in the books of Suparna Ltd $170,000

Land fair value $300,000; carrying amount in the books of Suparna Ltd $200,000

There are also legal fees of $35,000 involved in acquiring Arora Ltd.

On 1 July 2013 Arora Ltd’ s statement of financial position shows total assets of $700,000 and liabilities of $300,000. The fair value of the assets is $800,000

Required:

Has any goodwill been acquired and, if so, how much?

Answer

Fair value of consideration

Cash $70 000

Plant and equipment $250 000

Land $300 000 $620 000

Fair value of net assets acquired

Asset $800 000

less Liabilities $300 000 $500 000

Goodwill $120 000

In relation to the legal fees of $35 000, these have been excluded when calculating goodwill. Although the acquisition cost of assets would normally include associated legal fees, AASB3, paragraph 53, specifically notes that in a business combination, acquisition-related costs, such as legal fees, are to be treated as expenses. Specifically paragraph 53 states:

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Acquisition-related costs are costs the acquirer incurs to effect a business combination. Those costs include finder’s fees; advisory, legal, accounting, valuation and other professional or consulting fees; general administrative costs, including the costs of maintaining an internal acquisitions department; and costs of registering and issuing debt and equity securities. The acquirer shall account for acquisition related costs as expenses in the periods in which the costs are incurred and the services are received.

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Problem 3

Nat Ltd purchases a 100 per cent interest in Rashmi Ltd, the cost of the acquisition is $1,400,000 plus associated legal costs of $70,000. As at the date of acquisition, the statement of financial position of Rashmi Ltd shows:

Assets

Current assets

Cash 20,000

Accounts receivable 80,000

Provision for doubtful debts (10,000) 70,000

Inventory 100,000

Total current assets 190,000

Non-current assets

Land and building, at cost 850,000

Accumulated depreciation (150,000) 700,000

Plant and equipment 510,000

Accumulated depreciation (100,000) 410,000

Total non-current assets 1,110,000

Total assets 1,300,000

Liabilities

Current liabilities

Accounts payable 90,000

Bank overdraft 20,000

Total current liabilities 110,000

Non-current liabilities

Bank Loan 190,000

Total liabilities 300,000

Net assets 1,000,000

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Additional information

The assets and liabilities of Rashmi Ltd are fairly stated except for land and buildings, which have a fair value of $800,000

Rashmi Ltd has brand name that is not recognised on the statement of financial position and that has a fair value of $50,000

Required:

(a) Determine, for accounting purposes, the amount of goodwill that has been acquired by Nat Ltd

(b) Why do you think that Nat Ltd would have been prepared to pay for goodwill?(c) Can Nat Ltd revalue the goodwill upwards in a subsequent period?

Answer

(a)

Fair value of consideration

Direct cost of acquisition $1 400 000

Fair value of net assets acquired

Carrying amount of net assets $1 000 000

Fair value of brand name $50 000

Fair value adjustment for land and buildings $100 000 $1 150 000

Goodwill $250 000

As can be seen from the above calculation, an adjustment was made for the fair value of the brand name. The brand name was not shown on the statement of financial position of the acquired company (perhaps because it was internally developed). Paragraph 63 of AASB 138 states that internally generated brands, mastheads, publishing titles, customer lists and items similar in substance shall not be recognised as intangible assets. This is explained by paragraph 64 which states that expenditure on internally generated brands, mastheads, publishing titles, customer lists and items similar in substance cannot be distinguished from the cost of developing the business as a whole. Therefore, such items are not recognised as intangible assets.

If the acquiring entity has clearly included a payment of $50 000 for the brand name (as part of the total payment) and this is quite explicit in the purchase agreement, then the amount of goodwill can be reduced to $250 000 and a $50 000 brand name could also be disclosed within the statement of financial position.

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(b) Nat Ltd would have been prepared to pay for the goodwill because of the economic benefits that the goodwill is expected to generate. Further, Nat Ltd must believe that it is more efficient to acquire existing goodwill rather than trying to create the goodwill itself.

(c) Because only purchased goodwill is allowed to be disclosed in the financial statements, there is a general prohibition on the subsequent revaluation of goodwill.

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