Objectives of Financial Statements
The principles provided by financial reporting standards facilitate the preparation of financial reports... Read More
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.
Intangible assets, such as patents purchased in situations other than business combinations, are recorded at their fair value (equivalent to the purchase price) when acquired. If several intangible assets are acquired as part of a group, each asset’s purchase price is allocated based on its fair value.
The costs of internally developed intangible assets are generally expensed when incurred. As a result, a company that has internally developed intangible assets such as patents, copyrights, or brands through expenditures on research and development (R&D) or advertising will recognize a lower amount of assets than one that has obtained intangible assets through an external purchase.
IFRS requires that expenditures on research (or during the research phase of internal projects) be expensed rather than capitalized as an intangible asset. IFRS also allows companies to recognize an intangible asset arising from development (or during the development phase of internal projects) once specific criteria are met.
Generally, US GAAP requires both research and development costs to be expensed as they are incurred. Further, it is a US GAAP requirement that certain costs related to software development be capitalized. The costs incurred while developing a software product for sale are expensed until the product’s technological feasibility is established. The costs are capitalized after that. Similarly, companies expense the costs related to software development for internal use until it is probable that the project will be completed and the software will be used as intended. It is then that the development costs are capitalized.
The ‘acquisition method’ of accounting is used whenever one company acquires another. Under this method, the acquiring entity allocates the purchase price to each asset acquired, and each liability is assumed based on its fair value. If the purchase price exceeds the sum of the amounts that can be allocated to individual identifiable assets and liabilities, the excess will be recorded as goodwill.
Under IFRS, the individual assets that can be acquired include identifiable intangible assets that meet certain definitional and recognition criteria. Otherwise, if the item is acquired in a business combination and cannot be recognized as a tangible or identifiable intangible asset, it will be recognized as goodwill.
Question 1
Which of the following statements is most accurate?
- A company that has developed intangible assets internally will recognize fewer assets than one that has obtained intangible assets through an external purchase.
- 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.
- 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:
- Higher cash flow from operations.
- Higher cash flow from investing activities.
- 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.