ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)
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Chapter 10: Non-current assets
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It must be probable that expected future benefits will flow to the entity from the
asset.
The cost of the asset can be measured reliably.
An intangible asset must initially be recorded at cost. In subsequent periods, the
entity can choose from one of two valuation models:
cost model, or
revaluation model
If an intangible asset is accounted for using the revaluation model, all other
intangible assets in its class must also be re-valued.
In practice, the revaluation model is rarely used for intangibles, because IAS 38
requires that revaluation to fair value should be determined by an active market.
Given the unique characteristics of most intangible assets, an active market is
unlikely to exist – except perhaps for intangibles such as taxi licenses, fishing
licenses or production quotas.
3.3 Sources of intangibles
The recognition of intangible assets and measuring their cost can lead to some
accounting problems.
Separate acquisition
When an intangible asset is purchased as a separate item, the accounting treatment
is not controversial. The three requirements for recognition are always met. There is
a separate and identifiable asset, and a recognisable purchase cost. There has been a
transaction to acquire the intangible and so clearly it is expected that the transaction
will generate future economic benefits.
Note: When an intangible asset is acquired by purchase, its cost can usually be
measured reliably. The cost of a separately-acquired intangible, such as patent rights
or rights to ownership of a trademark, should comprise:
the purchase price, including import duties and non-refundable purchase tax,
plus
any directly attributable costs of preparing the asset for its intended use.
Acquisition as part of a business combination
An intangible asset may be acquired as part of the acquisition of a new subsidiary.
As a result of a business combination, the acquirer may pay more than the sum of
the fair value of the net assets of the subsidiary that is acquired. This may be
because the acquirer is gaining access to the goodwill (reputation) of the acquired
subsidiary, but it could also be to recognise the existence of intangibles that are not
reflected in the statement of financial position of the acquired subsidiary.
Examples might include customer lists, orders waiting to be fulfilled, established
customer relationships and non-competition agreements.
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On acquisition of a subsidiary, these intangibles must be recognised separately from
the purchased goodwill, but only if the asset’s fair value can be measured reliably.
(The requirement that the intangible should probably provide future economic
benefits for recognition is always considered to be satisfied, because this probability
will be reflected in the fair value measurement of the intangible.)
IAS 38 argues that the fair value of intangibles acquired in this way can normally be
measured reliably. The only exception would be where the intangible arises from a
legal right or a contractual right, and either:
it is not separable (for example, it is a licence restricted to use by the entity only,
so that it cannot be sold as a separate item), or
it is separable, but there is no history or evidence of the exchange of similar
assets (in other words, it is a unique licence whose value cannot be measured
reliably).
Internally-generated intangible assets
Internally-generated goodwill must not be recognised as an asset. This is because it
is not identifiable (it is not separable from the entity) and reliable measurement
would not be possible.
However, development costs might be recognised as an internally-generated
intangible asset. Development costs are incurred at the end of a research and
development process, which happens in two phases:
a research phase, and
a development phase.
3.4 Research and development expenditure
Definitions
The term ‘research and development’ is commonly used to describe work on the
innovation, design, development and testing of new products, processes and
systems. IAS 38 makes a clear distinction between ‘research’ and ‘development’.
Research is defined as original and planned investigation undertaken to gain
new scientific knowledge and understanding.
Development is the application of research findings or other knowledge to a
plan or design for the production of new or substantially improved products,
processes, systems or services before the start of commercial production or use.
Accounting treatment of research costs
Expenditure on research should be recognised as an expense in profit or loss as it is
incurred. Research costs cannot be an intangible asset. (Any property, plant and
equipment used in research or on a research phase, such as laboratory equipment,
could be capitalised in accordance with IAS 16 and depreciated. The depreciation
charge is a revenue expense.)
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Accounting treatment of development costs
Development costs should be recognised as an asset, but only if all the following
conditions
can be demonstrated:
It is technically feasible to complete the development project.
The entity intends to complete the development of the asset and then use or sell it.
The asset that is being developed is capable of being used or sold.
Future economic benefits can be generated. This might be proved by the
existence of a market for the asset’s output or the usefulness of the asset within
the entity itself.
Resources are available to complete the development project.
The development expenditure can be measured reliably (for example, via costing
records).
If any of these conditions are not met, the development expenditure should be
recognised as a revenue expense in profit or loss, and cannot be treated as an
intangible asset. Once such expenditure has been written off as an expense, it cannot
subsequently be reinstated as an intangible asset (for example, if all the conditions
are subsequently met for recognising the costs of the development work as an
intangible asset). Development costs must be capitalised, but only development
costs incurred after all the conditions for capitalisation as an intangible asset are met
Example
Entity Q has undertaken the following activities during Year 1:
(1) Training of sales staff at a cost of $50,000. Additional revenue as a result of
training the staff to a higher level of skill is expected to be in the region of
$500,000.
(2) Development of a new product. Total expenditure on development of the
product has been $800,000. All of the conditions for recognising the
development costs as an intangible asset have now been met. However,
$200,000 of the $800,000 was spent before it became clear that the project was
technically feasible, could be resourced and the developed product would be
saleable and profitable.
Required
Consider how the above amounts will be dealt with in the financial statements of
Entity Q for Year 1.
Answer
Training costs
. These must be written off as an expense in profit or loss as incurred.
The ‘asset’ (the training costs) is not controlled by Entity Q. The cost is controlled by
the staff who could leave at any time.
Development costs. The $200,000 must be written off as an expense in profit or loss.
The remaining $600,000 must be capitalised and recognised as an intangible asset
(development costs).
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Measurement of internally-generated intangibles
Intangible assets should be measured initially at their cost.
The cost of a purchased intangible asset is its purchase price.
The cost of an internally-generated intangible asset (such as development
expenditure) is the expenditure incurred from the date when the asset first meets
the recognition criteria. It should not include:
selling, administrative and other general overheads
training costs
advertising expenditure.
Measurement after initial recognition
As with IAS 16 and tangible non-current assets, having recognised an intangible
asset, the entity should then choose between:
the cost model, or
the revaluation model.
This is an accounting policy choice and the selected policy must be applied
consistently across each class of intangible assets.
Under the
cost model, assets are carried at cost minus any accumulated
amortisation and any accumulated impairment losses. Costs that may be capitalised
if they meet the above development criteria include:
costs of materials and services used
costs of employee benefits
fees to register a legal right, and
amortisation of patents and licenses that are used to generate the intangible
asset.
Under the
revaluation model assets are carried at fair value, minus any
accumulated amortisation and any accumulated impairment losses. Fair value must
be determined by reference to an
active market. Revaluations must be carried out
regularly, so that for any reporting period the carrying amount of the asset in the
statement of financial position is not materially different from its fair value.
An active market is defined as one where:
the items traded are homogenous
willing buyers and sellers can be found at any time, and
prices are available to the public.
If no such market exists for the intangible asset (and in practice, due to the unique
nature of intangibles, it rarely will exist) then the cost model must be adopted.
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Website development costs and software development costs
SIC Interpretation 32 Intangible assets – website costs considers the accounting
treatment of development costs for a web site. The Interpretation states that the
development by an entity of its own website for internal or external access is an
internally-generated asset and should be accounted for in accordance with IAS 38.
This means that capitalisation should only occur if the development meets the
requirements for recognition listed above.
The most difficult item to ‘prove’ for the purpose of recognising the development
cost as an asset is the requirement that it will generate future economic benefits
from the website. A website that simply promotes and advertises its own products
and services does not meet this requirement, so the costs of developing the website
would have to be ‘expensed’ and written of to profit or loss as incurred. However a
website that allows customers to place orders will generate future benefits and so
the costs of its development should be capitalised.
If an entity has computer software that is essential to the operation of the computer
hardware (for example the operating system on a computer) the software should be
capitalised as part of the hardware cost in accordance with IAS 16. If the computer
software is a stand-alone package, it should be accounted for in accordance with
IAS 38.
3.5 Amortisation of intangible assets
An intangible asset, once recognised, should be amortised over its estimated useful
life, unless this is believed to be indefinite. When determining the useful life, it is
necessary to consider:
the expected usage by the entity
typical product life cycle for the asset
technical, technological or commercial obsolescence
the stability of the industry and changes in market demands
expected actions by competitors/ potential competitors
the level of maintenance to obtain future economic benefits
the period of control over the asset and any legal limits on its use (i.e. expiry
date of a patent agreement), and
whether the useful life of the asset is dependent on the useful life of other assets.
Given the rate of change in technology, computer software and many other
intangible assets are likely to have very short useful lives.
(Note: Purchased goodwill on the acquisition of a subsidiary is not amortised.
However, it is subject to impairment.)
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Example
A broadcasting licence is renewable every ten years, on condition that the entity
provides a suitable level of service and complies with legislative requirements. The
licence may be renewed indefinitely at little cost and has been renewed twice before.
The current licence expires in five years and the entity intends to renew it
indefinitely. Evidence supports their ability to do so.
Required
Outline an appropriate amortisation policy for this intangible, explaining what
further information is required to support your decision.
Answer
The licence should not be amortised as it appears that the useful life is indefinite
and so it is expected to contribute to the entity’s cash flows indefinitely. As a result
of not being amortised, an annual impairment review must be conducted.
Further information required to support this conclusion:
Any difficulties renewing the licence in the past, which might indicate possible
problems in the future.
Any breach of service levels and legislative requirements which may jeopardise
applications to renew in the future.
Whether technology is expected to be replaced such that this licence is no longer
required or appropriate.
Chapter 10: Non-current assets
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Impairment of assets (IAS 36)
Objective and scope of IAS 36
Identifying that an asset may have impaired
Measuring the recoverable amount
Recording the impairment
Cash generating units
4 Impairment of assets (IAS 36)
4.1 Objective and scope of IAS 36
The objective of IAS 36: Impairment of assets is to ensure that assets are ‘carried’ in
the financial statements at
no more than their recoverable amount.
The recoverable amount of an asset is defined as the higher of its:
fair value minus costs to sell, and
value in use.
Fair value less costs to sell is the amount obtainable from the sale of an asset in an
arm’s length transaction between knowledgeable, willing parties, less the costs of
disposal.
Value in use is the present value of future cash flows from using an asset, including
its eventual disposal.
IAS 36 applies to all assets, except for:
inventories (IAS 2)
deferred tax assets (IAS 12)
assets arising on a pension scheme (IAS 19)
financial instruments (IAS 39)
investment property that is measured at fair value (IAS 40)
biological assets measured at fair value (IAS 41)
assets held for sale (IFRS 5).
IAS 36 does cover impairments of property, plant and equipment and intangible
non-current assets, including purchased goodwill.
There are various stages in accounting for an impairment loss:
(1) Establish whether there is an indication of impairment.
(2) If so, assess the recoverable amount.
(3) Write down the affected asset (by the amount of the impairment) to its
recoverable amount.
Each of these stages will be considered in turn.
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4.2 Identifying that an asset may have impaired
An entity is required to assess at the end of each reporting period whether there is
an indication that an asset may be impaired. If an indication of impairment is found,
then work must continue to ascertain the recoverable amount of the asset.
In addition, a calculation of the recoverable amount must take place annually,
regardless of any indications of impairment, for the following assets:
goodwill
intangible assets with a indefinite useful life
an intangible asset not yet brought into use (development costs that have been
capitalised, but where amortisation has not yet started).
Indicators of impairment
When assessing whether there is an indication of impairment, IAS 36 requires that,
as a minimum, the following sources are considered:
Sources of information indicating impairment
External sources Internal sources
An unexpected decline in the asset’s
market value.
Evidence that the asset is damaged
or no longer of use to the entity.
Significant changes in technology,
markets, economic factors or laws
and regulations that have an
adverse effect on the company.
There are plans to discontinue or
restructure the operation for which
the asset is currently used.
An increase in interest rates,
affecting the value in use of the
asset.
There is a reduction in the asset’s
expected remaining useful life.
The company’s net assets have a
higher carrying value than the
company’s market capitalisation
(which suggests that the assets are
over-valued in the statement of
financial position).
There is evidence that the entity’s
expected performance is worse than
expected.
4.3 Measuring the recoverable amount
An asset must be carried at no more than its recoverable amount. If the carrying
value is higher than the recoverable amount, the asset has suffered impairment and
must be written down. An asset is therefore carried in the statement of financial
position at the lower of:
its current carrying value, and
its recoverable amount.
But what is the ‘recoverable amount’ of an asset?
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Recoverable amount is the higher of:
an asset’s fair value minus costs to sell, and
its value in use.
In summary:
Carrying value
Value at the lower of
Recoverable amount:
the higher of
Fair value less
costs to sell
Value in use
Fair value minus costs to sell
Fair value is normally market value. If no active market exists, it may be possible to
estimate the amount that the entity could obtain from the disposal.
Direct selling costs normally include legal costs and costs necessary to bring the
asset into a condition to be sold. However, redundancy and similar costs (for
example, where a business is reorganised following the disposal of an asset) are not
direct selling costs.
In determining fair value, the following sources should be used in descending
order:
(1) The price in a binding sales agreement between willing and unrelated parties.
(2) If (1) does not exist: the price at which someone is prepared to buy (‘bid price’)
in an active market.
(3) If (1) and (2) do not exist: an approximate value based on the most recent price
obtained in the market or based on other available information.
Value in use
Value in use is calculated by:
estimating future cash flows from the use of the asset (including those from
ultimate disposal)
discounting them to present value.
Estimates of future cash flows should be based on reasonable and supportable
assumptions that represent management’s best estimate of the economic conditions
that will exist over the remaining useful life of the asset.
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The net present value is derived by discounting back the future operating cash
flows at the risk-free market rate of interest.
Example
A company has a machine in its statement of financial position with a net book
value of $300,000. The machine is used to manufacture the company’s best-selling
product range, but the entry of a new competitor to the market has severely affected
sales. As a result, the company believes that the future sales of the product over the
next three years will be only $150,000, $100,000 and $50,000. The asset will then be
sold for $25,000. An offer has been received to buy the machine immediately for
$240,000, but the company would have to pay shipping costs of $5,000.
The risk-free market rate of interest is 10%.
Market changes indicate that the asset may be impaired and so the recoverable
amount for the asset must be calculated.
Fair value minus costs to sell is $235,000 ($240,000 fair value minus $5,000
disposal costs)
Value in use is the discounted future cash flows from keeping the asset. This is:
150,000
1.1
+
100,000
1.1
2
+
50,000
+
25,000
()
1.1
3
= $275, 357
The recoverable amount is the higher of (1) value in use and (2) fair value minus
costs to sell. In this example, this is $275,357 (the higher of
$235,000 and $275,357).
The asset has a carrying value of $300,000, which is higher than the recoverable
amount from using the asset. The asset should be valued at the lower of carrying
value and recoverable amount. It must therefore be written down to the recoverable
amount, and an impairment of $24,643 must be recorded. (Impairment = $300,000 –
$275,357.)
4.4 Recording the impairment
The impairment loss should normally be recognised immediately in profit or loss.
However, if the impairment relates to a re-valued asset, it is treated as other
comprehensive income and (as a downward revaluation) the impairment loss
should be set against the revaluation reserve balance relating to that asset. If there is
any excess impairment, this should be charged to profit or loss.
Following the recognition of the impairment, the future depreciation of the asset
should be based on the revised carrying amount, minus the residual value, over the
remaining useful life.