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HUANG HUAI UNIVERSITY

FINANCIAL ACCOUNTING

Lecture 5

Intangible
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 reserves

2.
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 goodwill

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 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.