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Recognition
Extract from FRS 102 Section 18.4-18.7
General principle for recognising intangible assets
18.4 An entity shall apply the recognition criteria in paragraph 2.27 in determining whether to recognise an intangible asset. Therefore, the entity shall recognise an intangible asset as an asset if, and only if:
(a) it is probable that the expected future economic benefits that are attributable to the asset will flow to the entity; and
(b) the cost or value of the asset can be measured reliably.
18.5 An entity shall assess the probability of expected future economic benefits using reasonable and supportable assumptions that represent management’s best estimate of the economic conditions that will exist over the useful life of the asset.
18.6 An entity uses judgement to assess the degree of certainty attached to the flow of future economic benefits that are attributable to the use of the asset on the basis of the evidence available at the time of initial recognition, giving greater weight to external evidence.
18.7 The probability recognition criterion in paragraph 18.4(a) is always considered satisfied for intangible assets that are separately acquired.
OmniPro comment
The standard makes it clear that future economic benefits must be probable. Probable means more likely than not in this particular case. Before any asset is recognised it must be probable future economic benefits will derive from it and the cost can be measured. Website development costs for example would now likely meet the definition of an intangible as opposed to PPE.
When looking at future economic benefits, the requirement that revenue will be generated from the intangible is not the only indicator, an intangible could have been developed which provide substantial cost savings for a company through a reduction in workforce. Such intangibles would meet the future economic benefit test for the recognition of an intangible.
Example of intangibles include:
– Contract related intangibles i.e. Licencing agreements, franchises, service contracts, pub licenses, liquor licenses
– Market related intangibles i.e. trademarks, quota’s, market share and non-competition agreements.
– Technological related intangibles i.e. Computer software (see further detail above), patented technology
– Artistic related intangibles i.e. musical works etc.
Exchange transactions would provide evidence of future economic benefits. When assessing future economic benefits, external factors should be given higher importance.
The section details the criteria for recognition and initial measurement of intangibles in five different instances as follows:
– Intangibles acquired in a business combination;
– Intangibles acquired by separate acquisition;
– Intangibles acquired by exchange for other non-monetary assets;
– Intangibles acquired through developing the asset internally.
The criteria for recognition is applied differently in each of the above cases.
Acquisition as part of a business combination – recognition, initial measurement
Extract from FRS 102 Section 18.8 and 18.11
18.8 An intangible asset acquired in a business combination is normally recognised as an asset because its fair value can be measured with sufficient reliability. However, an intangible asset acquired in a business combination is not recognised when it arises from legal or other contractual rights and there is no history or evidence of exchange transactions for the same or similar assets, and otherwise estimating fair value would be dependent on immeasurable variables.
18.11 If an intangible asset is acquired in a business combination, the cost of that intangible asset is its fair value at the acquisition date.
OmniPro comment
As can be seen the key thing in this instance is that there is a history or evidence of exchange of transactions for similar assets. Therefore, even though an intangible asset may have legal or contractual rights attached, it cannot be recognised if there is no history or evidence of exchange of similar assets in the market. Where this condition is met then the intangible is recognised separately from goodwill and the useful life determined, if not they stay consumed in goodwill.
For example, customer and subscriber lists are frequently licenced and therefore would meet the requirement of them having a history of exchange of similar assets, then it is likely that these will nearly always be separately identified if the reliable estimate can be determined. However, where there is a confidentiality clause etc. from selling customer information then this does not give the entity a legal right; hence they should not be recognised separately as intangibles.
The processes involved in identifying intangibles in a business combination are usually:
– Reviewing the list of items that meet the intangible definition to include; customer lists, trade names, internet domain names, non-contractual customer relationships, databases, franchise agreements and unpatented technology;
– Reviewing documents related to the acquisition and other internal documents produced to include press releases, analyst reports;
– Comparing the acquired business to similar businesses and their intangible assets.
When recognising and measuring an intangible arising from a business combination, an entity should recognise this at fair value at the date of acquisition assuming the criteria for recognition has been met. There is no further guidance provided in Section 18, therefore an entity should go to Section 11 Basic Financial instruments in determining the meaning of fair value. Section 11.27 details how fair value should be determined, the hierarchy detailed in Section 11.27 is as detailed below:
(a) The best evidence of fair value is a quoted price for an identical asset in an active market. Quoted in an active market in this context means quoted prices are readily and regularly available and those prices represent actual and regularly occurring market transactions on an arm’s length basis. The quoted price is usually the current bid price.
(b) When quoted prices are unavailable, the price of a recent transaction for an identical asset provides evidence of fair value as long as there has not been a significant change in economic circumstances or a significant lapse of time since the transaction took place. If the entity can demonstrate that the last transaction price is not a good estimate of fair value (e.g. because it reflects the amount that an entity would receive or pay in a forced transaction, involuntary liquidation or distress sale), that price is adjusted.
(c) If the market for the asset is not active and recent transactions of an identical asset on their own are not a good estimate of fair value, an entity estimates the fair value by using a valuation technique. The objective of using a valuation technique is to estimate what the transaction price would have been on the measurement date in an arm’s length exchange motivated by normal business considerations.
Given that most intangibles will not have an active market and there is unlikely to be recent transaction, it is likely a lot of intangibles will fall into the valuation technique method. This valuation technique should make maximum use of market inputs and rely as little on entity determined inputs. The valuation techniques used in practice are:
– Determining the costs the entity has saved by acquiring the intangible and therefore not needing; to pay another entity licence fees or to recreate or replace this.
– Determining the future cash flows that can be derived from the asset.
Separately acquired intangible assets – recognition, and initial measurement
Extract from FRS 102 Section 18.10
18.10 The cost of a separately acquired intangible asset comprises:
(a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates; and
(b) any directly attributable cost of preparing the asset for its intended use.
OmniPro comment
The actual cost of the intangible should reflect its fair value at the date of acquisition which is in effect what was paid for the intangible assuming it was purchased on an arm’s length basis.
Section 18 does not provide examples of directly attributable costs, but examples would include:
– Professional fees arising directly from the acquisition in bringing it to its current condition;
– Cost of employees benefits arising from directly bringing the asset to its working condition;
– Cost of testing functionality of an asset where applicable.
– Costs which would not be seen as directly attributable would be; cost of advertising and promotional activities, costs in relation to staff training and any administrative overheads.
– Capitalisation should cease when the asset is ready for use and at that time amortisation should begin.
Example 1: Commencement of capitalisation
Company A purchased specialised software from a third party for CU600,000. The company incurred CU20,000 on tailoring to the company’s specific circumstances, CU10,000 in labour costs training staff on the software and a cost of CU2,000 on testing the new software.
In this example the total to be capitalised is the initial cost of CU600,000, the tailoring cost of CU20,000 and the CU2,000 on testing. The other costs are ignored as they are not directly attributable.
Internally generated intangible assets – recognition and initial measurement
Extract from FRS 102 Section 18.8A-18.8K, 18.17 and 18.10A-18.10B
18.8A To assess whether an internally generated intangible asset meets the criteria for recognition, an entity classifies the generation of the asset into:
(a) a research phase; and
(b) a development phase.
18.8B If an entity cannot distinguish the research phase from the development phase of an internal project to create an intangible asset, the entity treats the expenditure on that project as if it were incurred in the research phase only.
18.8C An entity shall recognise expenditure on the following items as an expense and shall not recognise such expenditure as intangible assets:
(a) Internally generated brands, logos, publishing titles, customer lists and items similar in substance.
(b) Start-up activities (ie start-up costs), which include establishment costs such as legal and secretarial costs incurred in establishing a legal entity, expenditure to open a new facility or business (ie pre-opening costs) and expenditure for starting new operations or launching new products or processes (ie pre-operating costs).
(c) Training activities.
(d) Advertising and promotional activities (unless it meets the definition of inventories held for distribution at no or nominal consideration (see paragraph 13.4A)).
(e) Relocating or reorganising part or all of an entity.
(f) Internally generated goodwill.
18.8D Paragraph 18.8C does not preclude recognising a prepayment as an asset when payment for goods or services has been made in advance of the delivery of the goods or the rendering of the services.
Research phase
18.8E No intangible asset arising from research (or from the research phase of an internal project) shall be recognised. Expenditure on research (or on the research phase of an internal project) shall be recognised as an expense when it is incurred.
18.8F In the research phase of an internal project, an entity cannot demonstrate that an intangible asset exists that will generate probable future economic benefits.
18.8G Examples of research activities are:
(a) Activities aimed at obtaining new knowledge.
(b) The search for, evaluation and final selection of, applications of research findings and other knowledge.
(c) The search for alternatives for materials, devices, products, processes, systems or services.
(d) The formulation, design, evaluation and final selection of possible alternatives for new or improved material, devices, projects, processes, systems or services.
Development phase
18.8H An entity may recognise an intangible asset arising from development (or from the development phase of an internal project) if, and only if, an entity can demonstrate all of the following:
(a) The technical feasibility of completing the intangible asset so that it will be available for use or sale.
(b) Its intention to complete the intangible asset and use or sell it.
(c) Its ability to use or sell the intangible asset.
(d) How the intangible asset will generate probable future economic benefits. Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset.
(e) The availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset.
(f) Its ability to measure reliably the expenditure attributable to the intangible asset during its development.
18.8I In the development phase of an internal project, an entity can, in some instances, identify an intangible asset and demonstrate that the asset will generate probable future economic benefits. This is because the development phase of a project is further advanced than the research phase.
18.8J Examples of development activities are:
(a) The design, construction and testing of pre-production or pre-use prototypes and models.
(b) The design of tools, jigs, moulds and dies involving new technology.
(c) The design, construction and operation of a pilot plant that is not of a scale economically feasible for commercial production.
(d) The design, construction and testing of a chosen alternative for new or improved materials, devices, products, processes, systems or services.
18.8K Where an entity adopts a policy of capitalising expenditure in the development phase that meets the conditions of paragraph 18.8H, that policy shall be applied consistently to all expenditure that meets the requirements of paragraph 18.8H. Expenditure that does not meet the conditions of paragraph 18.8H is expensed as incurred.
18.10A The cost of an internally generated intangible asset for the purpose of paragraph 18.9 is the sum of expenditure incurred from the date when the intangible asset first meets the recognition criteria in paragraphs 18.4 and 18.8H.
18.10B The cost of an internally generated intangible asset comprises all directly attributable costs necessary to create, produce and prepare the asset to be capable of operating in the manner intended by management. Examples of directly attributable costs are:
(a) costs of materials and services used or consumed in generating the intangible asset;
(b) costs of employee benefits (as defined in Section 28 Employee Benefits) arising from the generation of the intangible asset;
(c) fees to register a legal right; and
(d) amortisation of patents and licences that are used to generate the intangible asset. Section 25 Borrowing Costs specifies criteria for the recognition of interest as an element of the cost of an internally generated intangible asset.
18.17 Expenditure on an intangible item that was initially recognised as an expense shall not be recognised at a later date as part of the cost of an asset.
OmniPro Comment
It is clear from the standard that any research activities are expensed as incurred and are not capitalised. Where the distinction between development and research is not clear then it is assumed to be research and therefore expensed.
Research is defined in FRS 102, as original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge or understanding. Examples of research activities are detailed in Section 18.8G above. If a prepayment for research activity has been made an asset can be created for the prepayment so that it is charged when the product is received or the service is provided. The one exception where research activity may be capitalised is where it is acquired through a business combination as it may meet the future economic benefits test.
Development is defined as the application of research findings or technical knowledge and understanding. Examples of development activities are detailed in Section 18.8J above.
It is clear that the only internally developed intangible that can be recognised is development expenditure which meet the definition in Section 18.8H above. Therefore, internally generated goodwill, internal brands, logos, publishing titles, customer lists cannot be capitalised.
The standard gives an entity a choice as to whether they want to capitalise or expense development expenditure even where it meets the definition for capitalisation. The policy chosen should be applied consistently to all development expenditure. Where a policy of capitalisation exists, the costs can only be capitalised if they meet the criteria in Section 18.8H which is outlined above.
Once the conditions for capitalisation are met, it is at that point that all costs are capitalised. Costs which have been expensed prior to this date cannot be recognised in the cost of the asset at that time. The purchase costs to be included are all directly attributable costs. Certain costs specifically excluded are detailed in Section 18.8C above which includes, start up costs, training activities, advertising and promotion activities, relocation and reorganising part or all of an entity. Other costs excluded would include;
– selling and administrative and other general overhead costs,
– inefficiencies and initial operating losses incurred before reaching planned performance.
Example 2: Allowable costs for capitalisation
Company A has developed specific software for onward sale, it has carried out extensive advertising and promotion to attract customers as well as incurring operating losses during the start up period. Under Section 18 none of these costs can be capitalised as advertising costs are not allowed and the operating losses are just start up costs, the intangible itself is ready to use, it is just that customers now need to be found, so the operating losses are expensed.
The conditions in Section 18.18H are very onerous. Management should ensure that they maintain detailed memos and records of how they have determined that they met each of the criteria mentioned in part 18.8H (a) to (f). Type of evidence that can be used to support the criteria are:
– Business plan showing the technical feasibility, financial and other resources needed and the entities ability to secure those resources;
– Detail project information demonstrating that the entity’s costing system can measure reliably the cost of generating the intangible asset;
– Letter of offer from a bank to show that it will provide funding for the project.
If is evident that regulatory approval is not required so it is possible to capitalise before this is obtained. However, for some industries e.g. drug manufacturers, commercial success of a product cannot be guaranteed until it passes regulatory approval so for these types of entities, it is usual for capitalisation to start only when approval has been obtained.
The capitalisation costs stop once the asset is ready for use even if not put into use. See example 2 above for an example of when capitalisation should cease.
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