Accounting Problems of Intangibles - Term Paper Example

 Accounting problems of Intangibles Intangible assets are non-physical assets but contribute to production of goods or help in providing services for augment of businesses or professions similar to physical assets and in most of the cases are reasons for procuring profitable business for the entity. That is the reason that corporate economic growth is rapidly shifting from employment of material resources to knowledge based resources where wealth creation is the result of exploitation of intangible elements associated with generic term knowledge. What are these intangible elements or assets that help in generation of corporate value over and above their book value? As per John Barry (page 17)1 intangible assets are defined as “assets that cannot be touched, have no independent market value (as opposed to physical hard assets, like a building or a tractor, which do have value), and are not treated as assets at all in financial statements (except for IT). Most assets that are deemed intangibles find their way onto company’s income statement, where they are expensed, as opposed to being placed on balance sheet, where they would be capitalized.” The later part of definition provided by John Barry has described the subject matter of this essay. That is despite the growing role of intangibles, these unseen assets do not find the recognition they deserve in with modern formulators of regulations, standards, and procedures of financial accounting. The accounting approach towards recognition of intangibles is lopsided. For example in cases of mergers and takeovers whatever intangibles remain un- identified are treated as goodwill, as if goodwill is a dumping ground of listless or un- identifiable intangibles. The approach of accounting profession towards intangibles basically suffers the following limitations: Till recently intangibles were considered only those assets that play a sort of secondary role to tangible assets in augmenting the value of entities. Physical appearance of assets is of prime importance so far as presentation in balance sheet is concerned. Balance sheet lists the assets both as current and non- current assets and the term intangible remaining obscured as something not very relevant. Intangibles are defined or stated under conventional headings like Goodwill, copyrights etc., but those developing with changing times like human capital etc are not even considered or clubbed, as most of physical assets find their way under broad classification of ‘properties, plant, and equipment.’ Rules and regulations have so not established or standardized to measure and evaluate intangibles. Mere stating that intangible assets be tested for impairment does not serve the purpose, unless there is proper methodology to evaluate fair values at reporting dates. There should be a proper standardized evaluation process at least in respect of broader categories of intangibles. For a long period of time now the valuation process adopted for valuing intangibles is ‘controversial and source of debate mainly because it is very difficult to objectively define and value future economic benefits derived from such assets. How can one establish an objective value for a brand especially if the brand was developed by the firm itself and not purchased from someone else in an arms length transaction? Unlike with physical assets where value is linked to ownership, it is quality of usage made of the intangible by a management team that creates the stream of future economic benefits.’(Herve Stolowy and Michel Lebas, page 269)2 Intangibles have gained prominence only recently in the wake of globalization of businesses, particularly in the case of service industry where knowledge based intangibles like human intelligence have become the source of innovations. But ‘despite such evolution and improvement, there is some concern that accounting systems and practices have not kept pace with rapid economic changes and that statements may no longer be providing the information required. The accounting treatment of intangible assets, which generally requires immediate expensing of all investments into intangibles, such as research and development, human resources, and investments into trade marks and brand names, is another concern.”(Gordon V Smith and Russell L Parr, page 90)3 There are two types of intangibles. One those are internally developed by the entities and others those are externally acquired in merger or acquisition deals. Internally developed intangibles are not recognized as assets by the accountants mainly because of difficulty of ascertaining the expenditure incurred in developing intangibles. Secondly it is not said with certainty that they would be providing future economic benefits. The accounting process of intangibles particularly that for internally developed intangibles through research and development, is quite controversial. IASB seeks research and development costs that are initial stage expenses in process to develop an intangible to be expensed with. Expenditures at development stage are not capitalized. IAS 384 states as under in this regard: ‘Charge all research cost to expense.(IAS 38.54). Development costs are capitalized only after technical and commercial feasibility of the asset for sale or use have been established. This means that enterprise must intend and be able to complete the intangible asset and either uses it or sells it and be able to demonstrate how the asset will generate future economic benefits (IAS 38.57)’ As per IAS 38 the recognition of intangible starts on finding something of commercial value, as only after that it can be assumed that future economic benefits would accrue from research and development expenditure incurred after such realization of commercial development of intangibles. Expenditures incurred prior to that stage are being ignored just for convenience sake. There is no reason why prior research and development expenses should not be capitalized. A way out could be found to deal with the situation. Those research and development stage expenses could be charged to a memorandum account instead of expensing away directly, and debited to intangible asset only after the realization that economic benefits in future would accrue to the entity. If it is realized at a later stage that project is not feasible, the management should have an option either to expense with the entire research and development at one go or treat the expense as deferred revenue expenditure to be written over a reasonable period say in five years. Otherwise, direct expensing of research and development would constitute suppression of profits. The present approach of international standards is very pessimistic and against the basic objectives of maximization of shareholders wealth. There exists controversies and differences of opinion among different accounting principles in dealing with the matter of recognition of intangibles. FAS 141 of US require intangible assets to be recognized as separate category of assets. Under purchase accounting goodwill is the resultant figure of purchase price left after the costs have been allocated to various tangible and intangible assets. The idea is to recognize other intangible assets first and then goodwill as residual purchase price. But different accounting principles favor or oppose recognition of intangible assets. For example matching principle of accountancy favors amortization of intangible assets as per economic benefits that will be derived during different accounting periods. At the same time the principles of prudence suggests that there are uncertainties about economic benefits from intangibles and therefore the costs of intangible should be expensed with in the period of its occurrence. IAS 138 has specified criteria of recognition of any asset when it is probable that expected economic benefits will accrue to the entity and the costs of asset are measured reliably. This principle does not appear to be working in purchase method of accounting of mergers and takeovers, where after identifying assets from the total purchase price the leftover is treated as goodwill. Now where this treatment or creation of goodwill is based on the criteria of recognition suggested by IAS 38? Potential of economic benefits in goodwill has not been made as the criteria of development of goodwill in purchase method. It is the left over balance of purchase price that has created the goodwill. That shows that there is no link between the establishment of an accounting principle and practically using it so far in the case of intangibles. There is another issue that needs consideration. Why only an intangible like goodwill has been created with left over purchase price and not any other assets? There is no answer to this. If accounting standards are so keen to expense the internally developed goodwill, why not the externally developed goodwill that is left over purchase price is not expensed with particularly when there are no specific criteria developed or suggested by the accounting standards to measure its future economic benefits? There is no answer even to this. It appears that is principle of simplicity is only being followed by the framers of accounting standards. No identification process of intangibles has been developed with authenticity. Accounting standards are being developed only for the sake of bringing a change and not for solving the real issues relating to intangible assets. Once intangibles are recorded there are only three ways to account for their exist reporting stated as under: The cost of intangible may be amortized over a period of its estimated useful life; The intangible may be tested for impairment and a decrease in its value, if assessed, is recognized as loss to profit and loss; and A revaluation of the intangible is done at the reporting date or at the date of balance sheet and corresponding profit or loss is recognized in income statement. At the same time the matter is dealt by IFRS 3 with rules that permit no amortization but an annual test of impairment. It does not permit reversal of impairment loss either. That means the treatment is strictly to write off the recorded value of intangibles like amortization. But ‘in the case of intangible assets with a finite useful life, amortization and impairment are not exclusive of each other. The impairment amount can be added to the predefined amortization expense if the accountant feels the environment has changed and the pattern of depreciation does not offer a fair net value of asset.”(Harve Stolowy and Michel Lebas, page 280)5. That means there is no difference between amortization and testing for impairment, particularly when reversal of loss is not permitted. It is just like serving the old wine in new bottle. The framer of accounting standards like to match intangible assets with fair market value for impairment tests, but at the same time they are not ready to provide benefit of gains on comparisons for impairments by allowing reversal of loss already written off. Are they following conservatism? If so, what was harm with amortization process, when ultimately things would remain the same even after the changing the method to impairment testing. Intangibles have become very important to businesses, but are also continuously contributing to accounting problems. The basic reason is the limitation of valuation process. It is difficult to assign historical costs to intangible like brand value and at the same time it is difficult to ascertain its fair value in absence of a scientific method to ascertain value of its future economic gains to the entity. Something concrete is required to be done to sort out this puzzle in order to provide due recognition and valuation to while measuring intangibles for accounting purposes. Revolutionary changes are required for this purpose. References Read More