Intangible Assets

Intangible Assets

Intangible assets, from its name, are assets that lack physical substance. Intangible assets encompass items with exclusive rights like patents, copyrights, trademarks, and franchises.

According to IFRS, identifiable intangible assets must meet three definitional criteria:

  1. it must be separable or arise from contractual or legal rights,
  2. it must be under the company’s control and
  3. it should be expected to provide future economic benefits.

Additionally, identifiable intangible assets must meet two recognition criteria:

  1. the asset will likely bring future economic benefits to the company and
  2. the asset’s cost can be reliably measured.

An example of an unidentifiable intangible asset is goodwill. Goodwill arises during the acquisition of a company when the purchase price exceeds the fair value of the net identifiable assets acquired.

The accounting treatment for intangible assets depends on the method of acquisition. Intangible assets may be acquired in three primary ways: purchased in situations other than business combinations, developed internally, and acquired in business combinations. The accounting treatment accorded to an asset depends on which of these methods is used in its acquisition.

Financial Reporting for Intangible Assets

Intangible Assets Purchased in Situations Other Than Business Combinations

Intangible assets, such as patents purchased outside of business combinations, are recorded at their fair value, which is usually the purchase price. When multiple intangible assets are acquired together, the purchase price is allocated to each asset based on its fair value.

Analysts focus more on understanding the types of intangible assets acquired rather than the exact value assigned to each asset. This approach provides insights into the company’s strategic direction and future potential.

Intangible Assets Developed Internally

The costs of internally developed intangible assets are generally expensed when incurred, contrasting with the treatment of construction costs for tangible assets. In some cases, the costs incurred to develop an intangible asset internally are capitalized. This brings up key analytical issues, such as comparability across companies and the impact on a company’s trend analysis.

The requirement to expense the costs of internally developed intangible assets should be compared to capitalizing the costs of acquiring intangible assets in non-business combination situations. Since internally developed intangible assets are typically expensed, a company developing assets like patents, copyrights, or brands through R&D or advertising will show fewer assets compared to a company purchasing such assets. On the statement of cash flows, costs for internally developing intangible assets are considered operating cash outflows, whereas acquisition costs are classified as investing cash outflows. Therefore, developing versus acquiring intangible assets can affect financial ratios.

IFRS Treatment

IFRS mandates that expenditures on research (or during the research phase of an internal project) be expensed and not capitalized as an intangible asset. According to IAS 38, Intangible Assets, research is defined as “original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.” The research phase of an internal project refers to the period when a company cannot demonstrate that an intangible asset is being created, such as the search for alternative materials or systems for production processes.

However, IFRS allows companies to recognize an intangible asset from development expenditures or during the development phase of an internal project if certain criteria are met, such as demonstrating the technical feasibility of completing the intangible asset and the intent to use or sell it.

According to 4 IAS 38, Intangible Assets, paragraph 8, Definitions, development is “the application of research findings or other knowledge to a plan or design for producing new or substantially improved materials, devices, products, processes, systems, or services before the start of commercial production or use.”

US GAAP Treatment

Under US GAAP, both research and development costs are generally expensed when incurred. However, certain costs related to software development must be capitalized. Costs to develop software for sale are expensed until the product’s technological feasibility is established and capitalized thereafter. Similarly, for software developed for internal use, costs are expensed until it is probable that the project will be completed and the software used as intended, after which development costs are capitalized. The criteria for capitalization of software development costs are similar to those for all internally developed intangible assets under IFRS, including the costs of employees who build and test the software.

Intangible Assets Acquired in a Business Combination

When a company purchases another, the acquisition method of accounting is used. This involves the acquiring company allocating the purchase price to the acquired assets and assumed liabilities at their fair values. Any excess amount over the identifiable net assets’ value is recorded as goodwill, which is inseparable from the business itself.

Under IFRS, acquired assets include identifiable intangible assets that meet specific criteria. If an item from a business combination does not qualify as a tangible or identifiable intangible asset, it is classified as goodwill.

According to US GAAP, two conditions must be considered when assessing whether an intangible asset acquired in a business combination should be recognized separately from goodwill. The asset must either arise from contractual or legal rights or be capable of being separated from the acquired company. Such intangible assets include patents, copyrights, franchises, licenses, internet domain names, and audiovisual materials.

Question 1

Which of the following statements is most accurate?

  1. A company that has developed intangible assets internally will recognize fewer assets than one that has obtained intangible assets through an external purchase.
  2. A company that has developed intangible assets internally will recognize a higher amount of assets than a company that has obtained intangible assets through an external purchase.
  3. A company that has developed intangible assets internally will report an amount of assets that is equivalent to that of a company that has obtained intangible assets through an external purchase.

Solution

The correct answer is A.

Under most accounting standards, such as the International Financial Reporting Standards (IFRS) and the US Generally Accepted Accounting Principles (GAAP), companies are not allowed to capitalize (i.e., recognize as assets) expenses related to the internal development of most intangible assets (e.g., research and development costs). These costs are usually expensed as they are incurred. On the other hand, when a company buys intangible assets from an external party, it can recognize them as assets on the balance sheet at the purchase price.

Therefore, a company that has developed intangible assets internally will typically have fewer intangible assets on its balance sheet than a company that has acquired similar assets through an external purchase.

Question 2

Compared to a company that develops an intangible asset internally, a company that purchases the same asset would exhibit:

  1. Higher cash flow from operations.
  2. Higher cash flow from investing activities.
  3. Higher cash flow from financing activities.

Solution

The correct answer is B.

The company that develops the asset internally would typically expense related costs, such as research and development costs, which would be reflected as a reduction in the cash flow from operations. The company that purchases the asset would record the purchase as a cash outflow in the investing activities section of the cash flow statement. This means that the company that purchases the intangible asset would exhibit a higher (in absolute terms, more negative) cash outflow in the investing activities section of its cash flow statement than the company that develops the asset internally.

Here is an example:

Company A develops a new software program internally. The company incurs $1 million in research and development expenses over the course of the project. Company B purchases the same software program for $2 million from another company.

Company A’s cash flow from investing activities for the period would be $0 because it did not incur any cash outflows for the software program. Company B’s cash flow from investing activities for the period would be -$2 million because it paid $2 million to purchase the software program.

Even though Company A incurred $1 million in research and development expenses, these expenses were expensed in the period they were incurred, so they do not directly impact cash flow from investing activities.

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