Intangible Assets for Financial Reporting - Assignment Example

Intangible Assets for Financial Reporting As per IAS 38 an intangible assets has three important characteristics. First the intangible is an identifiable asset. Second the intangible is a non- monetary asset under the control of entity, and third and most important is that intangible assets do not have a physical substance. IAS 38 is applicable to those intangible that are not dealt in by other IAS. The examples of intangibles are brand names, franchises, computer software, licenses, and intangible under development. The intangible should have a separate identification and the entity should be able to sell or license it. The important characteristic of intangibles is that they lack physical substance. It is very difficult to estimate the value of intangibles and there is a high degree of uncertainty regarding the length of time over which they will provide future benefits. IAS 38 clarifies that intangibles should not be recorded as other assets. Also this standard does not apply to intangible held for sale in the normal course of business of the entity. Similarly differed tax assets, leases, assets arising from employee benefits, financial assets, mineral rights, and other exploration and evaluation assets, and most importantly goodwill arising from business combinations do not fall the preview of IAS 38. The identifiable assets should be separable. The entity is in a position to sell, transfer, and license, rent or exchanges the intangibles. It is important to note that intangibles should be clearly distinguishable and controlled separately from the goodwill. Such identifiable intangibles may have arisen from contractual or other legal rights, whether those are transferable or not, or separable from the entity or other rights and obligations. The entity should have complete control over such intangibles and the use of intangibles creates future economic benefits for the entity. 4(b) Accounting Measurement as per IFRS IFRS prescribe the rules that intangible should be recognized only when the following conditions are fulfilled: 1. There is a probability that the future economic benefits arising from the use of intangibles or attributable to assets will belong or flow to the entity. 2. The second parameter is that cost of intangibles should reliably measureable. The initial accounting for intangible is largely dependent on whether they are purchased or developed internally. When intangibles are purchased from others, they are initially recorded at their cost. The amount capitalized will include the purchase price and, like other assets, costs of preparing them for their intended uses. As a result, costs of registration or legal fees related to acquisition are also capitalized. When intangibles are purchased in a business combination, the cost to be recognized is the fair value at acquisition. When intangibles are acquired free of cost or received as a grant, the fair value or nominal value and directly attributable costs of such intangibles is recognized. All other costs of intangibles are charged to revenue. Internally generated intangibles are not recognized as assets. Also the start up costs, training costs, expenses on advertisement and promotion relating to intangibles, relocation and reorganization expenses, redundancy and other termination costs are charged to revenue and not capitalized. After the initial recognition of intangible, the entity has to choose between cost model and revaluation model as its accounting policy for accounting treatment of intangibles. Once a model is chosen it will become applicable to the entire class of intangible assets. Under cost model the carrying amount is recognized as costs of intangibles less the accumulated amortization. More over those intangibles that are held for sale are shown at lower fair value less cost to sell and the carrying amount of intangibles. Revaluation model prescribes that carrying amount is the fair value of intangible less subsequent accumulated amortization and impairment losses. Those intangibles that are held for sale are shown at the lower of fair value less cost to sell and carrying value of intangibles. The important point to note is that increase in carrying amount shall be recognized as comprehensive income and shown in equity as revaluation surplus; and the decrease will be charged to profit and loss. 4(c). Accounting treatment of Intangibles under IFRS and US GAAP IAS 38 treats research and development expenditure as a separate component of internally generated intangibles and thus costs on research and development is charged to revenue. Under US GAAP when a company acquires an asset for specific research, it is capitalized and depreciated. The depreciation is charged to research and development expense. But when such acquired assets have no alternative use to the company, the cost is charged to revenue. IAS 38 seeks revaluation of intangibles as an alternative accounting treatment. US GAAP does not allow revaluation accounting of intangibles. Intangible asset is amortized as per IFRS over its useful life. Subsequent expenditure on intangibles is expensed away unless it is probable that such expenditure will enable the asset to provide future benefits to the entity. There are no explicit criteria under US GAAP on when to capitalize expenditure on intangibles. However the common practice under US GAAP is to capitalize that expenditure that enhances the useful value of the asset. “Generally under US GAAP, internally generated costs are not capitalized unless a specific rule requires capitalization. For example, specific rule apply to costs associated with the development of software. US GAAP distinguish between software developed for sale to third party and software developed for internal use. IFRS do not contain specific guidance for software, and therefore under the international accounting the general criteria of IAS 38 are applicable. Also under US GAAP specific rules apply to direct- response advertising costs, which are eligible for capitalization if certain specific criteria are met. Under IFRS, advertising costs are always expensed as incurred.” (McGladrey & Pullen, page 1)i 5(a) Goodwill on consolidation and its accounting treatment comparison with internally generated goodwill Goodwill can only be acquired as part of acquisition (or consolidation) of a company. In fact the only time the cost of goodwill can be capitalized is as the result of a business combination accounted for as a purchase. When a company is involved in a purchase, they will allocate the amount paid for the other company based on the fair value of underlying net identifiable assets. When the amount paid for the company exceeds the amount of fair value of underlying net identifiable assets, the excess is reported as goodwill. Such goodwill on business consolidation is recognized as an asset. In other words goodwill is the future economic benefits arising from acquired assets that are not capable of being identified separately. As per IFRS the goodwill recognized on consolidation is tested annually for impairment. It is not amortized. This is because goodwill is considered to have an indefinite life. However, when the acquirer’s interest in fair value of identifiable assets exceeds over the acquisition cost, it is a gain and such gain is recognized in profit and loss. Such gain is not treated as negative goodwill. UK GAAP seeks “purchased goodwill to be held as an asset (within fixed assets) on the balance sheet. If that goodwill has a limited useful life (as it obviously has, except in quite rare circumstances), it should be amortized systematically (in most cases on straight line bases) over that life.” (Andrew Stilton, page 283)ii Sometimes expenditure is incurred that generate future economic benefit to the entity. It is described as internally generated goodwill. Internally generated goodwill is not recognized as asset. This is because internally generated goodwill is not an identifiable source that can be measured reliably. The expenditure on internally generated goodwill is charged to profit and loss. 5 (b) Alternative financial reporting approaches for goodwill arising from consolidations There are three alternative financial reporting methods for goodwill acquired on consolidation (Besides the treatment of capitalization and testing for impairment on periodic basis as mooted under IFRS 3) The first is that of permanent capitalization of goodwill. The idea is good but not practical as though goodwill has an indefinite life but its value keeps on changing over the period of time and that is why there is need for annual testing for impairment. Impairment loss, if any, can be written off to profit and loss. The second alternative is to write it off to a reserve as has been the practice in UK before FRS 10 sought its capitalization and amortization over its useful life of 20 years. Writing off to reserve the shareholders funds get depleted and thus it has a sort of negative impact on users of financial statements. Therefore this approach of writing of goodwill to reserves has not been accepted by the international accounting standards. IFRS 3 clearly seeks capitalization of acquired goodwill and testing that for impairment annually. The third alternative is writing off the goodwill acquired to profit and loss. None of the accounting standards have accepted this approach as this has direct impact on the reduction of profits, whereas goodwill is meant to promote the business and increase the profits. However, the accounting standards have accepted the writing off of expenditure on internally generated goodwill because that cannot be measured reliably. 2 (b): Concept of ‘Control’ under IFRS 3 The concept of ‘Control’ as per IFRS 3 implies a situation where power is exerted in order to govern the financial and operating policies with the aim of getting the maximum benefits from the business of the entity. The standard states that usually this power is the result of acquiring more than 50% voting powers in the entity. Control or power to govern can also be achieved by exercising the following powers: “Power over greater than 50% of the voting control (which can be by contract). Power to govern the financial and operating policies. Power to remove the majority of directors, and Power to cast the majority of votes at a meeting.” (ACCAglobal.com, page 2)iii In defining control, the pertinent point is that “a subsidiary should be excluded from consolidation when Control is only temporary as it is expected to be disposed of in the near future (12 months); and Management is actively seeking a buyer. Such subsidiaries should be accounted for as IAS 39.” (Robert J. Kirk, page 208)iv 2 (a) (i) The parent company is clearly X as it holds more than 50% voting rights in Y. Accordingly Y is its subsidiary. As X holds 15% in Y1 and its subsidiary Y also holds 40% in Y1, the combined holding of both in Y1 is more than 50%. Therefore by virtue of such holding the X has effectively more than 50% voting powers in Y1and thus Y1 is also its subsidiary. (ii) A is the parent company as its holds more than 50% voting powers in B and thereby B becomes its subsidiary/ A also has an agreement to control the financial and operating policies of C. Therefore by virtue of this agreement to control financial and operating policies of C, A company becomes the parent of C Company as well. (iii) A is parent company even though it holds less than 50% of voting powers in B company. This is because it has majority power to appoint or remove five out of nine directors of B Company. (iv) A is not the parent company of B even though it has agreement with shareholder of 15% voting powers in B. This is because the total voting powers of A together with its holding in B of 30% voting powers is only 45% of voting powers in B and this is less than 50% of voting powers in B. Thus B is not the subsidiary of A Company. Word Count: 2009 References: Read More