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Feature

posted 1 Oct 1998 in Volume 2 Issue 2

The International View on How to Account for Intangibles

In July 1998, the International Accounting Standards Committee (IASC) approved accounting rules that represent a step forward towards the recognition of some intangible assets in financial statements and provide a better understanding of investments in intangible assets. Laurence Rivat outlines the story of IAS 38 - and the implications this will have for valuing knowledge.

Awareness of the importance of, and investments in, intangible assets have increased significantly in the last two decades. Around the world, there have been complaints that financial statements are becoming meaningless because they do not reflect one of the main sources of an enterprise's revenues 'its intangible assets; or provide sufficient information on them.

In July 1998, after almost 10 years of debate, the International Accounting Standards Committee (IASC) approved a new International Accounting Standard, IAS 38, Intangible Assets. IAS 38 follows two Exposure Drafts (E50, Intangible Assets, published in June 1995, and E60, Intangible Assets, published in August 1997) and a Draft Statement of Principles (published in January 1994). Its development was controversial and it raised significant emotional debates around the world, particularly on two issues - the recognition of internally generated intangible assets and the amortization of intangible assets.

Scope of the Standard

IAS 38 applies to the accounting of all intangible assets that are not specifically dealt with in other International Accounting Standards. It applies, among other things, to the accounting of expenditure on advertising, training, start-up, research and development (R&D) activities.

The current International Accounting Standard dealing with research and development expenditure (IAS 9, Research and Development Costs) has been merged with IAS 38. This is because the IASC Board (the Board) believes that an asset that results from research and development activities is an intangible asset because knowledge is the primary outcome of these activities. The Board also believes that all intangible assets should be accounted for using the same principles and, therefore, that there should be only one Standard dealing with them. IAS 38 does not change the requirements of IAS 9.

Recognition in financial statements

IAS 38 defines an intangible asset as 'an identifiable non-monetary asset without physical substance held for use in the production or supply of goods or services, for rental to others, or for administrative purposes'. Among other things, there should be a resource that is controlled by an enterprise and that is clearly distinguishable from the enterprise's goodwill.

IAS 38 requires an enterprise to recognize an intangible asset in its financial statements if, and only if:

it is probable that the future economic benefits that are attributable to the asset will flow to the enterprise; and

the cost of the asset can be measured reliably.

users of financial statements. They are usually suspicious of the types of internally generated intangible assets that are recognized in the balance sheet. They also believe that it is not possible to assess reliably the amount that can be recovered from intangible assets, unless its value can be determined by reference to an active market. Therefore, they believe that recognizing a self-constructed intangible asset for which no active market exists at an amount other than zero may mislead investors;

those who have concerns that IAS 38 s definition of, and recognition criteria for, an intangible asset - which require management and auditors to exercise judgement - are too subjective and will undermine the comparability of financial statements; and

those who believe that IAS 38 s requirements will result in very little decision-useful or predictive information when applied to internally generated intangible assets. This is because they believe that, in most cases, the cost of a self-constructed intangible asset recognized in the balance sheet will not represent the total expenditure on that asset: demonstration of technological feasibility or commercial success (required to meet the recognition criteria) will generally not be achieved until substantial expenditure has been recognized as an expense. Therefore, they believe that it is not worth recognizing only part of the cost of an internally generated intangible asset.

there is no justification not to recognize intangible assets, at cost, in the balance sheet when the criteria for recognizing an asset are met. There should not be different rules for intangible assets that are internally generated. Particularly, whether an enterprise decides to out-source the development of an intangible asset or develop it internally, the principles for recognizing it in the balance sheet should be the same; and

abuse of the requirements for recognizing internally generated intangible assets in the balance sheet instead of an immediate expense will be limited by the requirement to test for impairment an intangible asset that is not yet available for use at least at each financial year end - i.e. verification at least annually that there is no impairment loss to recognize because the book value of such an asset exceeds its recoverable amount.

benchmark treatment: cost less any amortization - i.e. the systematic allocation and recognition as an expense of the cost of an intangible asset over its useful life - and impairment losses; or

allowed alternative treatment: revalued amount - based on the fair value of the asset - less any subsequent amortization and impairment losses. Under IASC literature, an asset's fair value is defined as 'the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction'. Unlike revaluations of property, plant and equipment under IASC Standards, revaluations of intangible assets are permitted only if the fair value of the intangible asset can be determined by reference to an active market. In practice, active markets for intangible assets will be very rare because one characteristic for such a market is that the items traded on this market should be homogeneous.

test the intangible asset for impairment at least annually (this test requires, among other things, a calculation of the estimated discounted future net cash flows from the asset); and

disclose the reasons why the presumption that the useful life of an intangible asset will not exceed 20 years is rebutted, and also the factor(s) that played a significant role in determining the useful life of the intangible asset.

those who believe that, for intangible assets with a long useful life, an annual impairment test should be used instead of amortization. They see no reason why an expense should be recognized in the financial statements where the value of an intangible asset does not decrease over time; and

those who believe that all intangible assets should be amortized but reject the proposed limit of 20 years for intangible assets. They commented that IASC Standards include no arbitrary upper limit on the amortization period of tangible assets.

although there may be no physical limit to the useful life of some intangible assets and the goodwill of an acquired business if properly maintained, infinite lives do not exist. Recently, changing economic circumstances and consumer preferences and attitudes, together with technological advances and aggressive marketing campaigns by competitors have undermined the economic value and reduced the lives of many prominent long-lived intangible assets or businesses;

if the value of an intangible asset or goodwill does not decrease over time, this is because the potential for revenues that was purchased initially has been progressively replaced by the potential for revenues resulting from subsequent enhancements to these assets. Therefore, after some (unknown) time, the value of the asset initially purchased has been replaced by internally generated goodwill. IAS 38 prohibits the recognition of internally generated goodwill in the financial statements because, among other things, the cost of developing internally generated goodwill cannot be measured reliably; and

in most cases, it is impossible to determine reliably, at the date of initial recognition, that an intangible asset or the goodwill of an acquired business will have a useful life exceeding 20 years.