The Requirements of the International Accounting Standard 38 - Essay Example

? Essay, Finance and Accounting Introduction The international accounting standard 38 (IAS 38) specifies the accounting rules for intangible assets that are not dealt with in other standards. The regulations specified under this standard are for entities to recognize an intangible asset only if certain criteria are fulfilled. IAS 38 also outlines the methods to measure the amount required to carry the intangible assets and also, specifies the disclosure rules of intangible assets (Europa, 2010). According to the regulations specified under the standard, an intangible asset arising from a research and development activity shall be recognized, if: The entity can demonstrate the technical viability of the intangible asset in order to make it available for use or sale. The entity intends to complete the intangible asset and thereafter, use and sell it. The entity has the ability to use or sell the asset. The entity can explain the ways of generating future economic benefits by means of these intangible assets. The entity has adequate financial, technical and other utilities and resources in order to use and sell the intangible asset. The entity can demonstrate its ability to determine and measure the expenditure that can be attributed to the intangible asset during its development (IFRS, 2012). However, in the recent past, the implementation of IAS 38 in respect of research and development expenditure has been under some sort of controversy. Leaders and researchers all around the world have regarded the implementation of IAS 38 in this field as being dubious and practically unnecessary. They believe that research and development expenditures should be treated as an expense and should be recorded in the income statement and its amounts should be disclosed in accordance with the accounts. This idea has formed the basis of research for this study and the following section will involve a critical evaluation of the idea explained above and its feasibility. Evaluation Over the last few years, the fact explains that, the relation between accounting and the extent of investment in activities giving rise to intangible assets has been an area of constant debates. One example of such activity includes the expenditures that arise from a research and development. The general concern that people have shown regarding this particular activity and its link with accounting is the fact that some of the expenditures create economic assets and that the extent of mandated disclosure of these expenditures within the financial statement is limited. IAS 38 requires entities to recognize expenditures on intangible assets, only if they fulfil the abovementioned criteria. The compulsory disclosure of these expenditures within the financial statements is limited. However, authors and leaders have severely discouraged this aspect of IAS 38, as they believe that these expenditures should be treated as proper expenses and should be fully disclosed in the accounting reports. This is primarily because, inappropriate accounting measurement practices characterized by the inadequate disclosure of expenditures arising from research and development activities, may lead to the failure of stock markets in fully reflecting the benefits of the R&D activities in the market value of firm (Dedman et al., 2009). The author also stated that stock markets have sometimes underestimated the value of R&D activities and thus, a proper disclosure of information related to R&D expenditures is of utmost importance. On the contrary, Lev (2008) cites Skinner’s summary which contradicts various theories suggesting the negativities associated with accounting for intangibles. The author quotes that, “there is no evidence that the accounting or disclosure treatment of intangibles in and of itself results in systematically lower valuations for these firms” (Lev, 2008, p. 209). However, the author simultaneously highlights the importance of proper disclosure of R&D expenditures in the firm’s income statement. The author explains that, firms that specialize in R&D activities have reasonably high bid-ask spreads and low depth. This in return gives rise to excessive cost of capital. This suggests the fact that expenditures on intangibles are comparatively riskier than any other area of investment. Thus, this highlights the importance of disclosing such information in the income statement with absolute transparency, thereby helping the investors who are investing in those firms to assess their level of exposure to the risk. Inadequate disclosure of such crucial information leads to ambiguity. Empirical researches have also highlighted the importance of reforming the accounting methods as far as recognizing expenditures from R&D activities are concerned. The economy has changed in fundamental ways over the past few years. Businesses have now become knowledge based and the intangibles arising from their activities are the new stimulants of economic activity and growth. Considering the fact mentioned above, it can be said that the traditional accounting approach such as, the IAS 38, which does not involve proper disclosure of R&D expenditures, have outlived its usefulness. It is primarily because there are certain issues associated with financial reporting as far as the traditional accounting standards are concerned. The problem is that financial statements which are prepared according to the IAS 38 fails to identify or rather recognize most of the knowledge-based intangibles such as, intellectual capital (Skinner, 2008). An improper assessment of such an important factor has adverse effects as far as investing in intangibles is concerned. It is times like these when the value of intangibles are either underestimated or overestimated. These factors highlight the necessity of bringing about a change in the accounting standards. With more and more intangible-intensive companies emerging within the economy, disclosing information related to such intangibles is of paramount importance. Researchers and policy-makers around the world have highlighted the deficiencies in the accounting standards such as, IAS 38, related to the disclosure of expenses arising from investments in R&D activities. Given the strong existence of corporation with a significant proportion of intangible assets, the significance of pertinent and timely disclosure of information related to such assets and the expenditures in the capital market, policy-makers, researchers and standard setting authorities are seriously considering the proposals of bringing about an enhancement in the amount of disclosed information in corporate financial reports (Amir, Lev and Sougiannis, 2003). Disclosing expenditures on intangibles such as, research and development activities, in income statements is essential as these intangibles are associated with the generation of future benefits and cash flows. In such a context, they are considered as assets by investors and based upon that, the market sets prices of the stock (Ballester, Garcia-Ayuso and Livnat, 2003). IAS 38 should be modified in such a way that it specifies the accounting for intangibles in order to reduce the discrepancies between the book value and market value of such assets. A proper disclosure of such expenditures within the income statement of a firm would help the managers to assess the status of their company as far as the benefits accrued from such intangible assets are concerned. Reporting such information within the financial statements will lead to the revelation of certain private information regarding the value of R&D assets, which will be incorporated by the investors into the equity values of the company (Lev, 2008). However, contrary perspective has also been witnessed referring to the drawbacks of reporting such expenditures in the financial statements of a particular company. Basu and Waymire (2008) have argued that, accounting for intangibles is an important activity in context of the current economy and is not unique in this recent time. They were always considered to be important and thus, bringing about a change in order to assure a proper disclosure is not an absolute necessity considering the fact that they were not so important before and even then, the economy had performed well. The authors also said intangibles are omnipresent. They are ubiquitous to human economic interaction and are present in even the simplest of economies who does not stress much on the disclosure of such assets and their expenditures in the financial statements. Intangibles have been referred to as ideas that build upon other’s ideas to generate synergies and complementarities. In such a context, the resulting consequence is that the value of the idea of an individual can be distinguished autonomously by neglecting other’s ideas. Thus, if more ideas that are implemented in disclosing the information related to the intangible and their expenditures, then more complex is the financial statement, thereby compromising the verifiability and comparability of the information. Another drawback as explained by the authors is that ideas are only valuable to the extent where they would generate wealth for the company. Thus, instead of incorporating such intangibles into the financial statements, it is more important to adopt an approach of measuring income as it will serve the users of the financial statements in a much better way. The accounting requirements for considering intangible assets have been a subject of debate in the recent times. It has been witnessed quite often that entities have faced difficulty in communicating functional information to third parties regarding their investments in intangible assets. The primary reason that can be attributed to this fact is the gap in the current financial reporting standards and the inadequacies present in this system, as far as handling the economic properties of intangible assets are concerned. Given the importance of intangible assets in strengthening the global economy, its importance is always going to increase in the near future. As highlighted above, the disclosure of the expenditures of intangibles plays a crucial role in ensuring the stability in the performance of a firm. The failure to identify these assets and reporting them in the financial statements will give rise to ambiguity and imply that investors will be unable to receive relevant information regarding the status of the entity where they are investing or want to invest in (Powell, 2003). The author has explained that considering the importance of intangible assets and the crucial role that it plays in strengthening a business, there is no reason for treating intangible assets, developed internally, differently than internally developed tangible assets (Elwin and Cazenove, 2008). Rather a proper disclosure of the expenditure from the intangibles would reflect transparency and foster a stable trust relationship between the investors and the entity. Thus, IAS 38 should be modified by the standard setters taking in account the importance of disclosing R&D expenditure information within the financial statements of a company. However, it is a known fact that in practice, recognizing internally developed intangible assets at times can be very difficult. This is primarily because of a certain degree of uncertainty of the expenditure which is incurred in developing the intangible assets for generating future economic benefits for the company (Stark, 2008). It is this uncertainty that proves to be a barrier for the makers of financial statements while recognizing intangible assets. Eventually in the process, certain intangible assets get ignored and are not reported within the financial statement, thereby revealing incomplete information (Helmers, Schulte and Strauss, 2009). Current accounting methods such as, IAS 38, focus much on transaction and thus, essential information regarding the expenditure of intangible assets are not recorded within a firm’s financial statements. These reasons can be attributed to the fact that policy makers, leaders and researchers around the world consider the implementation of IAS 38 in research and development expenditure to be dubious and practically unnecessary. Conclusion Having studied the literatures in the field of accounting, which have highlighted the importance of disclosing intangible assets and the implementation of IAS 38 in such context, it can be said that expenditures arising from the development of such intangible assets needs to be reported in the financial statements irrespective of the set criteria. This is primarily because if the intangible assets are identified based upon this criteria, then some or many intangible assets will have to be ignored. This might include intangibles which are important information sources revealing the exact status of the company in terms of its performance. This helps investors to assess the extent to which a company has intangible assets and also, its ability to use and sell it in order to accrue future economic benefits. Reference List Amir, E., Lev, B., and Sougiannis, T., 2003. Do financial analysts get intangibles? European Accounting Review, 12(4), pp 635-660. Ballester, M., Garcia-Ayuso, M., and Livnat, J., 2003. The economic value of the R&D intangible asset. European Accounting Review, 12(4), pp. 605-633. Basu, S., and Waymire, G., 2008. Has the importance of intangibles really grown? And if so, why? Accounting and Business Research, 38(3), pp. 171-190. Dedman, E., Mouselli, S., Shen, Y., and Stark, A., 2009. Accounting, intangible assets, stock market activity, and measurement and disclosure policy–views from the UK. Abacus, 45(3), pp. 312-357. Elwin, P., and Cazenove, E., 2008. Discussion of ‘Accounting for intangibles – a critical review of policy recommendations. Accounting and Business Research, 38(3), pp. 205-208. Europa., 2010. International Accounting Standard 38. [pdf] Europa Available at: [Accessed 20 November 2012]. Helmers, C., Schulte, C., and Strauss, H., 2009. Business R&D expenditure and capital in Europe. EIB Papers, 14(1), pp. 36-61. IFRS., 2012. IAS 38 Intangible Assets. [pdf] IFRS Available at: [Accessed 20 November 2012]. Lev, B., 2008. A rejoinder to Douglas Skinner’s ‘Accounting for intangibles – a critical review of policy recommendation. Accounting and Business Research, 38(3), pp. 209-214. Powell, S., 2003. Accounting for intangible assets: current requirements, key players and future directions. European Accounting Review, 12(4), pp. 797-811. Skinner, D., 2008. Accounting for intangibles–a critical review of policy recommendations. Accounting and Business Research, 38(3), pp 191-204. Stark, A.W., 2008. Intangibles and research–An overview with a specific focus on the UK. Accounting and Business Research, 38(3), pp. 275-286. Read More