Accounting for intangibles
The accounting for fixed assets is, in many cases, a straightforward exercise, but it isn’t always so when it comes to the issue of intangible fixed assets and recognising such assets on the balance sheet, explains Steve Collings.
There have also been challenges by external regulators concerning the issue of capitalising intangible assets where inspectors have challenged the appropriateness of capitalising such assets (particularly internally-developed intangible assets). This article will briefly recap on some of the more common features contained within FRS 10 Goodwill and Intangible Assets which may help in alleviating some of the problems encountered by practitioners.
The (now defunct) Accounting Standards Board (ASB) was responsible for the publication of FRS 10 and a notable feature of this standard is that it deals with both goodwill and intangible assets. The IFRS regime deals with goodwill arising through a business combination in IFRS 3 Business Combinations and intangible assets are dealt with in a separate standard, that of IAS 38 Intangible Assets. The ASB took the approach of combining both goodwill and intangible assets into one standard on the grounds that they are so closely related and to avoid accounting arbitrage that would arise as a result of giving similar items on the balance sheet different names.
Companies Act 2006
The Companies Act 2006 permits the recognition of intangible assets in Schedule 1 to the SI 2008/410 The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008. Under these requirements, there are four separate sub-headings under the heading ‘Intangible Assets’ for:
- Concessions, patents, licences, trademarks, and similar rights and assets
- Development costs
- Payments on account
Where concessions, patents, licences, trademarks, and similar rights and assets are concerned, care must be taken. There are two conditions that must be satisfied before recognition of these items on the balance sheet can take place:
- They were acquired for valuable consideration in circumstances that do not qualify them to be shown as goodwill
- They were created by the company itself. But be careful here - FRS 10 restricts the circumstances in which the costs of internally-developed intangible assets can be capitalised on the balance sheet
In addition, while the Companies Act 2006 allows intangible assets to be included in the financial statements at current cost, FRS 10 is quite restrictive. The Companies Act specifically prohibits goodwill being revalued [SI 2008/410 1 Sch 32(1)].
If the alternative accounting rules are applied to any intangible asset, Companies Act 2006 [SI 2008/410 1 Sch 52] requires the following disclosures:
- The years (so far as they are known to the directors) in which the assets were severally valued and the several values
- In the case of assets that have been valued during the financial year, the names of the persons who valued them or particulars of their qualifications for doing so and (whichever is stated) the bases of valuation used by them
It is important to emphasise at this point that FRS 10 limits the circumstances where intangible assets may be revalued which are covered later in the article.
The scope of FRS 10 covers the following:
- Recognition rules
- Internally-developed intangible assets
- Intangible assets that have been purchased separately
- Intangible assets acquired as part of the acquisition of a new business
- Valuation rules
- Amortisation and impairment rules
- Disclosures within the financial statements
FRS 10 at paragraph 2 defines an intangible asset as:
“non-financial fixed assets that do not have physical substance but are identifiable and are controlled by the entity through custody or legal rights.”
The principle involved in this definition is twofold. First to enable the distinction to be made between tangible and intangible assets and second to distinguish between intangible assets and goodwill. While this may seem obvious to many, there is clear water between the accounting standard that deals with tangible fixed assets (FRS 15 Tangible Fixed Assets) and FRS 10, particularly concerning the rules governing capitalisation and revaluation.
A company has incurred software development costs that fit the criteria for capitalisation on a company’s balance sheet. The financial controller has classified these costs as an intangible asset on the company’s balance sheet.
FRS 10 recognises that such costs present problems in today’s electronic age. Paragraph 2 to FRS 10 explains that software development costs should be treated as part of the cost of the related hardware where they are:
“directly attributable to bringing a computer system or other computer-operated machinery into working condition for its intended use within the business.”
As a consequence, the financial controller should treat the software development costs as a tangible, rather than intangible asset.
One of the key principles laid down in FRS 10 and in the Companies Act 2006 is that intangible assets must be separable in the context of identifiable assets and liabilities – in other words that such assets can be disposed of separately without disposing of the business separately. The definition is contained in paragraph 2 to FRS 10 and states:
“An identifiable asset is defined by companies legislation as one that can be disposed of separately without disposing of a business of the entity. If an asset can be disposed of only as part of the revenue-earning activity to which it contributes, it is regarded as indistinguishable from the goodwill relating to that activity and is accounted for as such."
If intangible assets have been developed internally then they fail to meet the recognition criteria because FRS 10 does not permit internally-developed intangible assets to be recognised on a company’s balance sheet. In contrast, purchased goodwill and purchased intangible assets must be capitalised.
The principle of separability is important to distinguish intangible assets from goodwill acquired in a business combination.
A company operates in a regulated industry and obtains a licence for it to undertake its day-to-day activities. The terms of the licence stipulate that the licence is non-transferable and hence cannot be disposed of. The financial controller is of the opinion that such licences do not meet the definition of an intangible asset and is therefore writing off the cost of the licence to the profit and loss account as legal and professional fees.
On 26 January 2000, UITF issued Information Sheet 34 which dealt with such issues. UITF noted that:
- Paragraph 2 to FRS 10 refers specifically to licences as an intangible asset and in the guidance on whether an intangible asset should be regarded as having a readily ascertainable market value
- The test of separate disposability focuses on distinguishing intangible assets from goodwill and not of determining whether, or not, certain assets fall outside the scope of FRS 10. UITF also confirmed that the circumstances in which the transfer would be uneconomic or illegal are not relevant
- FRS 10 at paragraph 9 requires an intangible asset that has been purchased separately to be capitalised at cost
UITF have concluded that licences and similar assets purchased separately met the definition of intangible assets and therefore should be accounted for as such under FRS 10.
Internally-developed and purchased intangible assets
Paragraph 14 to FRS 10 permits the recognition of internally-developed intangible assets provided such assets have a readily ascertainable market value. FRS 10 at paragraph 2 defines a readily ascertainable market value as a value that derives from:
- An asset belonging to a homogenous population of assets that are equivalent in all material respects
- An active market in those assets, evidenced by frequent transactions
If a readily ascertainable market value does not exist, the accounting treatment is the same as that for internally-developed goodwill which is that the costs are written off as incurred.
The reality is that hardly any intangible assets are likely to have a readily ascertainable market value and it’s more likely than not that those that do have a readily ascertainable market value are unlikely to have been developed internally.
Intangible assets that have been purchased separately are capitalised at cost. Intangible assets that have been acquired by way of a business combination must be separately capitalised from goodwill where values can be measured reliably on initial recognition. The interacting standard that would apply for valuing the identifiable assets in acquisition accounting is that of FRS 7 Fair Values in Acquisition Accounting and for intangible assets FRS 7 says that fair value is based on the asset’s replacement cost (normally estimated market value).
After initial recognition at cost, no intangible assets can be subjected to revaluation. There are rare exceptions which relate to intangible assets that have a readily ascertainable market value and in such cases the revaluation model is permissible, provided that all the assets within the same class are revalued and revaluation exercises are carried out on a regular basis to ensure that the carrying amount does not differ from the market value at the balance sheet date.
FRS 10 requires intangible assets to be amortised on a systematic basis. There are three possible scenarios for amortisation:
- The intangible asset has a limited useful economic life and as such it is amortised on a systematic basis over that useful economic life
- There is a rebuttable presumption that the useful economic life of the intangible asset(s) does not exceed 20 years
- Management could choose a longer useful economic life than 20 years where it can be demonstrated that the intangible asset is more durable. However, bear in mind that the intangible asset must also be capable of continued measurement in order that annual impairment tests can be carried out
The phrase useful economic life is defined in paragraph 2 to FRS 10 as ‘the period over which the entity expects to derive economic benefits from that asset.’ If management choose a useful economic life of more than 20 years, they must support non-amortisation by annual impairment reviews to ensure that the carrying amount of the intangible assets in the balance sheet is not higher than its recoverable amount. Where such a review identifies the carrying amount to be in excess of the intangible asset(s) recoverable amount, the asset should be written down to its recoverable amount.
When management choose a useful economic life of 20 years or less, FRS 10 requires the cost of the intangible asset(s) to be amortised over this useful economic life. The fact that the intangible asset is being amortised does not preclude management from undertaking impairment reviews. The standard requires management to undertake an impairment review at the end of the first full financial year following the intangible asset(s) acquisition. After this first full financial year, impairment reviews will only become necessary if adverse events indicate the amortised carrying value of the asset may not be recoverable and an impairment review confirms this.
A company acquires an intangible asset and decides the asset’s useful economic life is 26 years and hence does not charge any amortisation in the first three years of ownership, but carries out annual impairment tests which do not reveal any impairment. In year four circumstances are such that management decides they no longer wish to rebut the 20-year presumption and therefore amortisation is required. The question arises as to whether this change triggers a change in accounting policy and thus resulting in a consequential prior year adjustment, or a change in estimation technique which would require the change to be applied prospectively.
On 8 December 2000, UITF issued Abstract 27 Revision to estimates of the useful economic life of goodwill and intangible assets’. Here, UITF concluded that such a change would not give rise to a change in accounting policy, but would instead be regarded as a change in the way in which the useful economic life is estimated. UITF took this view on the grounds that FRS 10 does not allow a choice of policies – goodwill and intangible assets should be amortised unless their useful economic lives are indefinite. UITF acknowledged that where FRS 10 does offer a choice is in relation to the assumptions for estimating useful lives and the scenario above would be a change in such estimations. The entity will need to amortise the remaining net book values at the date of revision over the revised remaining useful economic life of the asset [FRS 10 paragraph 33].
Tangible fixed assets may sometimes be assigned a residual value which is taken into consideration to calculate the depreciable amount of the fixed asset. The question arises as to whether an intangible asset can be assigned a residual value for the purposes of calculating the value of the asset to amortise over its estimated useful economic life. FRS 10 permits residual values being assigned to an asset at the end of the asset’s useful economic life (paragraph 28) but only if such a value can be measured reliably. It is important to emphasise that goodwill should never have a residual value placed on it as FRS 10 prohibits residual values being assigned to goodwill. The reality is that an intangible asset may only have a residual value at the end of its useful economic life where the company has a legal or contractual right to receive cash when the right to use the intangible asset expires. In addition, in rare circumstances a residual value may be assigned where there is a readily ascertainable market value.
Paragraph 30 to FRS 10 prefers the use of the straight-line method of amortisation unless another systematic method can be demonstrated to be more appropriate and reporting entities are required to disclose their chosen amortisation policy. The standard prefers the use of the straight-line method of amortisation because it recognises that measuring depletion can be complex as well as promoting comparability and goes on to explain that it is unlikely that methods that are less conservative than the straight-line method could be justified with sufficient evidence.
A company has decided not to amortise an intangible asset using straight-line method of amortisation, but instead has adopted the ‘reverse sum of digits’ method which produces a constant rate of return on the carrying value.
FRS 10 at paragraph 32 specifically prohibits amortisation methods such as these which aim to produce a constant rate of return on the carrying value and therefore management must revise its policy accordingly.
A company had decided to amortise an intangible asset using the ‘unit of production’ method but has subsequently decided to revert to the straight-line method as management feel this is a better reflection of the use of the intangible asset.
Such changes are permissible in FRS 10, but where a company does choose to change its method of amortising intangible assets, it must disclose the reason and effect (if material) in the year of change.
This article has covered some of the main issues relating to goodwill and intangible assets. The key issue to be aware of is in relation to internally-developed intangible assets (particularly internally-generated goodwill) as these are the areas that are known to cause problems. In addition, clients should also be advised of the preferred methods of amortisation and with more emphasis being placed on the carrying values of assets in the balance sheet during challenging economic times, impairment reviews may be required.
Steve Collings is the audit and technical partner at Leavitt Walmsley Associates and the author of ‘Interpretation and Application of International Standards on Auditing’. He is also the author of ‘The AccountingWEB Guide to IFRS’ and ‘IFRS For Dummies’ and was named Accounting Technician of the Year at the 2011 British Accountancy Awards.