Intangible Assets - Coursework Example

INTANGIBLE ASSETS The world economic system has undergone a radical change. It has grown from being industrial in nature, to openly favouring knowledge and services [Value Based Management]. This has resulted in a principal change in the fundamental principles of accounting, moving from a traditional cost-based set of procedures to a system based on the principle of fair value of acquired assets and adopted liabilities [Osburn]. As a result of this fundamental change, accounting of intangible assets has also changed – a fact that is very important to understand, regulate and control for the simple reason that while they accounted for just 5% of all accounting assets in the year 1978, intangible assets now cover a massive 75 to 80% of total assets [Valued Based Management]. An intangible asset is defined as an asset that comes into existence as a result of time and effort spent on it. It is a non-monetary asset that is not possible to see, feel or physically evaluate or compare against a given standard [Wikipedia]. It has certain upside, value-increasing features, namely, it is not scarce (multiple uses are simultaneously possible), it possesses the quality of scalability (it increases in value when used), it has strong network effects (it is the nucleus of networks), and it precipitates future economic benefits. An intangible asset has distinctive downside, value-decreasing characteristics as well, such as it is problematic to manage, control, trade, measure or value, it represents a riskier investment, and unlike its tangible counterpart, it is not a financially proven asset [Value Based Management]. The high-profile collapse of Enron in 2001 suddenly brought into international focus seemingly innocuous accounting headlines in the U.S and Europe that appeared much before Enron, involving restatement of earnings, increasing employment of “proforma” earnings, and quick, unexpected write downs of intangible assets involving massive values. Led by the International Accounting Standards Board (IASB), international accounting standard setters like the U.S Generally Accepted Accounting Principles (GAAP) and the U.K Accounting Standards Board (ASB) who (particularly the U.S) were complacently certain that their standards were the best in the world, were shocked out of their lethargy by the Enron debacle as they realised a completely new breed of financial engineering had surfaced, whose sole aim was to find unique ways to circumvent established accounting standards [Volcker]. Accounting standard setters were forced to urgently seek reforms to adapt existing accounting standards to the sudden new business developments and needs. Non-U.S standard setters realised that adopting an “it can’t happen to us” attitude was foolish and impractical, as the suddenly apparent problem was not limited to the U.S alone but could happen anywhere. One of the most unpleasant details of the Enron disaster was the way company auditors Arthur Andersen connived with Enron to unnaturally minimise accounting costs and unnaturally enhance asset value: intangible assets widely featured in this dishonest manipulation [Volcker]. Intangible assets represent one of the most complex accounting concepts as enterprises do not tend to trade, for example, new drugs, brands or software programmes, in organised markets as there is more risk involved as compared to tangible assets. Many enterprises that are young and intangible-sensitive, report a large increase in Research and Development (R&D) spending, but a low increase in rate of earnings. The preclusion of intangibles as assets, the unclear matching of revenues by expenses as a result of immediately expensing intangibles while showing revenue in later periods free from such costs, detracts from the quality of information provided in the enterprise’s financial statements [Daum]. The fact that the value of intangibles has soared to cover over 75% of all assets (1998 figures) meant that reforms in the shape of better quality accounting standards, improved auditing practices and a stronger enforcement mechanism had to be put in place quickly [Value Based Management]. In a bid to rectify accounting treatment of intangible assets, the U.K. implemented the IAS 38 on 31 March 2004. Clauses 8 and 12 of IAS 38 define an intangible asset as one that possesses certain specific characteristics. Firstly, it is non-monetary and does not have physical reality that can be touched or felt. Secondly, it is subject to the power and authority of the enterprise. Thirdly, it has the potential to bring economic advantages to the enterprise in future. And fourthly, it is identifiable as it has not only originated from rights emanating from contracts or the law, but it can be categorised and subjected to sale, transfer, licence, rent or exchange either by itself or as part of a package deal [Iasplus.com]. IAS 38 goes on to designate ‘Recognition’ as the test for intangible status. An enterprise must prove that the cost was determined in a reliable manner and that it is expected to bring economic advantages to it in future. If this cannot be proved conclusively, then the enterprise is not permitted to capitalise the cost as an intangible asset in its Balance Sheet, but is obliged to expense it in its Profit and Loss Account. Furthermore, the enterprise cannot, at any later date, reinstate such an expense in the form of an intangible asset. This relates to intangible assets purchased externally. It also pertains to internally generated intangibles but these are subject to 3 additional ‘Initial Recognition’ stipulations [Iasplus.com]. The first ‘Initial Recognition’ stipulation needs costs related to Research to be treated as expenses (Clause 54 of IAS 38), but costs related to the Developmental phase can be treated as an intangible asset but only after conclusive technical and commercial proof that they can generate future benefit if sold or used (Clause 57). If an enterprise is unable to separate Research costs from those involving Development, then it should treat the whole cost as if Research oriented, and is obliged to treat it as a total expense. The second ‘Initial Recognition’ stipulation needs internally generated computer software to be treated as an expense until the enterprise can successfully prove, on technical and commercial grounds, that the software can be used or sold in future at an economic benefit. The last ‘Initial Recognition’ stipulation identifies specific costs that must be treated purely as expenses only; these are internally generated goodwill (Clause 48), brands, publishing titles, mastheads, customer lists (Clause 63) and costs relating to pre-opening, pre-operating, start-up, training, advertising and relocation (Clause 69) [Iasplus.com]. IAS 38 next clarifies about measurement of intangible assets. Initially, intangible assets are measured at cost (Clause 34) [Iasplus.com]. Subsequent to acquisition, measurement can be done using the Cost model (carrying value = cost less accumulated amortisation and impairment losses {Clause 74}), or the Revaluation model (carrying value = revalued amount less subsequent amortisation and impairment losses {Clause 75}) [Ernst & Young]. If the Revaluation model measurement is used, then the asset should be further examined based on its useful life. An intangible asset having finite life is expected to generate limited economic advantage, therefore cost of such an asset less residual value should be amortised over that finite life (Clause 97) [Iasplus.com]. An intangible asset with an indefinite life does not have a predictable limit to the time over which it can generate cash flows, for example, a fishing licence due for renewal every 10 years [Ernst & Young]; while Clause 107 precludes it from amortisation, Clause 109 requires the usefulness of life to be reviewed periodically to conclude if it is worthy of retaining its indefinite life status or if it should be shifted to the finite life category [Iasplus.com]. Lastly, IAS 38 clarifies about Subsequent Expenditure and De-recognition. Clause 60 states that all costs incurred on an intangible asset following its purchase or completion should be expensed. However, such costs are permitted to be added on to the value of the related intangible asset if they can be reliably measured and can prove to bring future benefit [Iasplus.com]. Clauses 112 to 117 specify that an intangible asset is de-recognised when it is either sold (in which case resultant gains or losses should not be treated as revenue), or when it is proven that no future economic benefit may result from its use or sale [Ernst & Young]. There are many advantages associated with the IAS 38 approach. Firstly, before IAS 38, enterprises had to provide irrefutable proof that intangible assets acquired in a business combination were measured correctly and reliably. There were many difficulties associated with such measurement. IAS 38 replaced it with a refutable assumption that value is “normally” measurable with enough reliability to make it an intangible asset [Enevoldsen]. Secondly, IAS 38 assures smoother passage of deals involving intangible assets acquired in a business combination from EU based enterprises. This is because the improvement brought about in U.K. standards by IAS 38, which made it satisfy all requirements of financial connection, easy assimilation, dependability and comparability, prompted acceptance by the EU [Enevoldsen]. Thirdly, although IAS38 is mandatory for quoted companies in the U.K., small companies who are precluded may choose to adopt it due to associated new and more favourable tax rules governing acquired tangible assets [Osburn]. Fourthly, by prohibiting brands, goodwill, research and other costs from being classified as intangible assets, IAS 38 safeguards the interest of stakeholders and the general public. The former is saved from being deceived by irrationally high asset values in balance sheets, and the latter is saved from price increases which can follow such erroneously high asset evaluation (for example, prices of many beer brands were raised as a result of the Monopolies and Merger Commission (MMC) pre-31 March.2004 permission to allow beer brands as Intangible Assets)[Osburn]. Fifthly, “buildings with trading potential,” such as supermarkets, health care centres, and even airports are now allowed by IAS 38 to group tangible and intangible assets as one tangible asset upon valuation [Osburn]. Sixthly, negative goodwill arising as a result of bargain purchases used to be credited to the profit and loss account, resulting in an increase in reported profits. This unrealistic profit-increasing tactic has been stopped by IAS 38 which requires negative goodwill to be immediately written off as a loss in the profit and loss account [Osburn]. Seventhly, IAS 38 has significantly trimmed executive remuneration packages that contained sizeable return-on-assets (especially R&D), by separating R&D component costs [Osburn]. Eighthly, the useful life of an intangible asset was earlier refutably presumed to not be more than 20 years. This restriction was totally removed by IAS 38. Ninthly, IAS 38 requires certain intangible assets such as trademarks acquired by independent purchase or through a business combination, to be subjected to mandatory impairment tests based on cash-flow techniques to calculate their value over time. This lends a more reliable look to balance sheets [Kaiser]. Manufacturers of Personal Protective Equipment (PPE) where an intangible asset is contained within the structure of a tangible asset (for example, software integrated into computer hardware) do not need to show them separately. Clause 4 of IAS 38 allows both to be treated as one tangible asset [Ernst & Young]. There are certain disadvantages associated with the IAS 38 approach. Firstly, IAS 38 does not at all consider that the value of trademarks (acquired through a business combination or purchased independently) may increase over a period of time. If an acquired trademark gains in monetary worth later, the difference in value is not recorded in the balance sheet [Kaiser]. Secondly, separation of R&D component expenditure requires details to be disclosed. This is a huge setback to large enterprises (especially in industries like pharmaceuticals, software and electronics), as competitors can gain crucial insights into R&D secrets by analysing such expenditure carefully [Kaiser]. Thirdly, intangible assets acquired in business combinations before 31 March 2004 cannot be subjected to IAS 38, and therefore cannot partake of its better accounting standards [Enevoldsen]. Fourthly, unlike the MMC which used to allow brands to be shown as intangible assets, IAS 38 prohibits it. This is detrimental to enterprises burdened with significant hostile minority stakes that need to have substantial assets value in their balance sheets to offset the predicament [Osburn]. Fifthly, by taking advantage of IAS 38’s “buildings with trading potential,” buildings like supermarkets and even airports are able to camouflage clearly intangible portions as tangibles and portray unrealistically high valuation of the asset [Osburn]. Sixthly, due to its intricate nature, it is often very difficult to segregate R&D expenditures convincingly, thus unfairly forcing the enterprise to show the entire cost as Research and expense it [Iasplus.com]. Lastly, enterprises are not allowed to present a healthy picture in balance sheets as costs like goodwill (negative as well as internally generated), brands, and research have to be relegated to the profit and loss account [Osburn]. Users of accounting statements include shareholders and other stakeholders like creditors, banks, employees, society and environmentalists. IAS 38 assures shareholders of a clear and reliable statement which they can analyse to determine the enterprise’s growth and profitability potential and decide whether to continue or enhance their investment in it. Creditors are confident that the enterprise is not hiding any financial irregularity, so they can continue to supply goods or services on reasonable credit terms to the enterprise. Banks are convinced that the accounting statements present a true and correct portrayal of the enterprise, making it easier to grant them loans especially for R&D activities on which millions could be spent. Employees are able to analyse the growth potential of the enterprise, and decide whether short or long term employment with it is suitable. Society is relieved that there is no Enron-like catastrophe associated with the enterprise, and its clear cut R&D expenses presentation do not allow for unfair price increases based on unrealistic projections. Environmentalists are able to clearly study the enterprise’s R&D policy and analyse if it is noncommittal, beneficial or detrimental to the environment. References used: “Annual Reports & Shareholder Value.” ValueBasedManagement.net. 2007. 9 Mar. 2007. “Characteristics of Intangible Assets.” ValueBasedManagement.net. 2007. 9 Mar. 2007. Daum, Juergen. “Interview with Baruch Lev: Accounting, Reporting & Intangible Assets.” Juergendaum.com. 2002. 9 Mar. 2007. Enevoldsen, Stig. “Adoption of Amended IAS 36 ‘Impairment of Assets’ & Amended IAS 38 ‘Intangible Assets.’” EFRAG. 2004. 9 Mar. 2007. “IAS 38 (AC 129) Revised: Intangible Assets.” Ernst & Young. 2005. 9 Mar. 2007. “Intangible Asset.” Wikipedia.org. 2007. 9 Mar. 2007. Kaiser, Alain. “IAS – IFRS: Intangible Asset Warning.” Bredema.com. 2005. 9 Mar. 2007. Osburn, Hugh. “Technical Update – The New Accounting Standards & Valuation.” Financeweek.co.uk. 2007. 9 Mar. 2007. “Summary of IAS 38.” Deloitte Touche Tohmatsu. 2007. 9 Mar. 2007. Volcker, Paul A. “Accounting in Crisis.” Iasplus.com. 2002. 9 Mar. 2007 Read More