HUANG HUAI UNIVERSITYFINANCIAL ACCOUNTING

Lecture 5Intangible Assets

(R &D, Goodwill, Patent, Brands)

Dr Aziz Jaafar

Coverage

Intangible assets Research and Development Goodwill

Internally Generated Purchased Goodwill (Goodwill on

Consolidation) Other intangible assets

Patent, trademark, copyright etc.

Accounting Standards

IAS 38 (1998/revised 2003) – Intangible assets

IAS 36, Impairment of Assets

IFRS 3 – Business Combinations Goodwill on consolidation

Intangible Assets An identifiable nonmonetary asset without physical

substance.

Three critical attributes of an intangible asset are: Identifiability (Separable) control (power to obtain benefits from the asset) future economic benefits (such as revenues or reduced future

costs)

Examples of intangible assets include R & D computer software, licences, patents, brands and copyrights

Initial Measurement

All intangible assets that meet the recognition criteria should be measured at cost [IAS38R.24]. The cost of an intangible asset is the fair value of the consideration given to acquire the asset.

Measurement subsequent to initial recognition

Finite Useful Life - two options for subsequent measurement, cost or revaluation.

Infinite Useful Life (No foreseeable limit to future expected economic benefits or service potential) - test of impairment review annually or when indication exists

Measurement subsequent to initial recognition

Finite Useful Life: Revaluation Model

Fair value determined by referring to active market (If no active market, use cost model)

Cost Model Useful Life Residual Value Amortisation method Review above annually

Research and Development

Growth in R&D expenditure by sector

across UK850 (2002-2006)

Source: Department for Innovation, Universities & Skills, UK

The top five UK companies in the pharmaceuticals & biotechnology sector

Source: Department for Innovation, Universities & Skills, UK

The top five global companies in the pharmaceuticals & biotechnology sector

Source: Department for Innovation, Universities & Skills, UK

Research defined

IAS 38: Research is ‘original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding’

Obtaining new knowledge Search for alternatives

Materials Products Processes

Evaluation of alternatives Not related directly to any of the company’s products or processes

Expense in the year in which incurred Not to be carried forward in balance sheet

Development defined

• IAS 38 –Recognised as development if the entity can identify an intangible asset and demonstrate that the asset will generate probable future economic benefits.

• Application of research findings to a plan for production of new or substantially improved

Products Processes Systems

• Prior to commencement of commercial production

IAS 38 – Development recognition criteria

Capitalised if meet ALL the following conditions: Technical feasibility Intention to complete and use or sell Generate future economic benefits

Existence of market for asset or output Availability of adequate resources to complete

Technical Financial Reliable measurement of costs possible

Expense if not recoverable from future revenue

Research & Development IFRS vs FASB

IFRS Development costs must be

capitalized and amortize if criteria are met

Cost to develop websites must be capitalized if criteria are met, including probably future economic benefit

In-process R&D acquired as part of business combination is capitalized

Revaluation is allowed although rare

US GAAP Expense R&D as incurred

Website cost capitalization depends on phase of spending based on SOP 98-1 and/or FAS86

IPR&D acquired as part of business combination is expensed immediately

Revaluation is not allowed

Goodwill

Intangible assets Goodwill (premium) is created by good relationships between a

business and its customers (internally generated): By reputation, i.e., high quality products, high standards of

service By responding promptly and helpfully to queries and

complaints Through the personality of staff and attitudes to customers

Internally generated goodwill is based on Directors’ valuation of internal goodwill by valuing

Business as a whole Separable assets

Goodwill

Value of goodwill to a business might be extremely significant. However, goodwill (Internally generated), is not recognised in the accounts of a business at all! due to: Goodwill is inherent, it has not been paid for,

and it does not have an ‘objective’ value. Goodwill changes from day to day, e.g., bad

customer relations, retirement/resignation of good staff, etc.

Purchased Goodwill (Goodwill on Consolidation)

Goodwill has an objective valuation when a business is sold. Purchased goodwill is based on transaction with third party at

arm’s length Goodwill is recognised by the acquirer as an asset from the

acquisition date and is initially measured as the excess of the cost of the business combination over the acquirer's share of the net fair values of the acquiree's identifiable assets, liabilities and contingent liabilities.

Purchased goodwill should be capitalised as assets

Accounting for Goodwill

Five alternative approaches: Permanent capitalisation: keeping the goodwill in the

balance sheet unchanged (i.e., no amortisation and no impairment)

Capitalisation with annual impairment Writing off directly to reserves in the year of acquisition Writing off directly to the income statement in the year of

acquisition Amortising the goodwill over its expected life

IFRS 3 prohibits the amortisation of goodwill. Instead goodwill must be tested for impairment at least annually in accordance with IAS 36 Impairment of Assets

Purchased goodwill: amortise vs. write off

Figure 17.1 Comparison of immediate write-off with amortisation of goodwill

Purchased goodwill

Comparison of immediate write-off with amortisation of goodwill

• Effect on reserves

Goodwill Treatment in the UK

SSAP 22 (1984) – allows two alternatives:1. Write-off immediately to reserves2. Amortise over useful life

Almost all UK companies used the first alternative, as it had no effect on reported profit. However, it reduced shareholders’ funds which could become negative.

FRS 10 (1998) - requires goodwill to be capitalised and amortised over its useful life (20 years)

IFRS 3 (2004) – treats goodwill as if it has an indefinite life. So, it tests goodwill annually for impairment.

Rolls-Royce annual reports in 1995 and 1999:

“Goodwill, which represents the excess of the value of the purchase consideration for shares in subsidiary and associated undertakings over the fair value to the Group of the net assets acquired, is written off to reserves in the year of acquisition.”(Rolls-Royce plc, Annual Report 1995, p. 37).

“Goodwill represents the excess of the fair value of the purchase consideration for shares in subsidiary undertakings and joint ventures over the fair value to the Group of the net assets acquired. From January 1, 1998, goodwill has been recognised within fixed assets in the year which it arises and amortised on a straight-line basis over its useful economic life, up to a maximum of 20 years.” (Rolls-Royce plc, Annual Report 1999, p. 45)

Example: Rolls Royce plc.

Example: Rolls Royce plc.Purchased goodwillGoodwill represents the excess of the fair value of the purchase consideration for

shares in subsidiary undertakings and joint ventures over the fair value to the Group of the net identifiable assets acquired.

To December 31, 1997: Goodwill was written off to reserves in the year of acquisition.

From January 1, 1998: Goodwill was recognised within intangible assets in the year in which it arose and amortised on a straight line basis over its useful economic life, up to a maximum of 20 years.

From January 1, 2004, in accordance with IFRS 3 Business Combinations, goodwill is recognised as per (ii) above but is no longer amortised.

(Rolls Royce plc. Annual Report, 2007)

Effect of IFRS 3

The reported Royal Bank of Scotland restated basic earnings increase 10 per cent due to goodwill no longer being amortised.

Vodafone - no longer has to charge £7.3 billion for amortisation of goodwill, the main contributor to turning a pre-tax loss of £2.2 billion for the six months to September 30, 2004 into a pre-tax profit of £4.5 billion.

Which goodwill treatment is correct?

Permanent capitalisation, i.e., keeping the goodwill in the balance sheet unchanged – probably wrong as generally goodwill value will decline with time.

Writing off directly to reserves in the year of acquisition – definitely wrong as the loss in value does not occur at acquisition

Writing off directly to the income statement in the year of acquisition – wrong as (again) the loss in value of the goodwill does not occur at acquisition.

Which goodwill treatment is correct?

Amortising the goodwill over its expected life – probably the best approach but problems with (i). estimating useful life and (ii). method of amortising.

Capitalisation with annual impairment – ‘balance sheet’ approach, consistent with Framework where “Expenses are recognised in Income Statement when a decrease in future economic benefits related to a decrease in asset…”. However, not consistent with IAS 38 – amortisation.

Other Intangible Assets

Patent – a document granted by a government or an official authority bestowing on the inventor of a product or manufacturing process the exclusive right to use or sell the invention or rights to it. Duration of patent varies across countries (US – 17 years, France 20 years etc., UK must renew it every year after the 5th year for up to 20 years)

Trademark – (trade name, brand, brand name) is a distinctive identification of manufactured products and/or services that distinguishes it from similar families of products or services provided by other parties.

Other Intangible Assets

Copyright – provides the holder with exclusive rights to the publication, production, and sale of the rights for an intellectual creation, i.e., musical, artistic, literary or dramatic work. Usually, the protection is granted for the remaining life of the author plus 50 years.

Franchises, Licensing agreements, Set-up costs, Computer software costs, Football player transfer fees.

Other Intangible Assets

Accounting treatment under IAS 38 Intangible assets with finite or indefinite useful

lives: Finite useful life: amortisation over useful life Indefinite: impairment test

Impairment of non-financial assets

An asset is impaired when its carrying amount will not be recovered from its continuing use or from its sale.

Determine at each reporting date whether there is any indication that an asset is impaired

IAS36 – Indicators of impairment

Decline in market value greater than expected as a result of normal use or passage of time

Significant adverse changes affecting entity including economic, technological, legal environment

Higher interest rates which would make future cash flows less valuable

Evidence of physical damage or obsolescence Plans to discontinue use, dispose of asset, etc.