Lecture 5 Intangible Assets R ampD Goodwill Patent Brands Dr Aziz Jaafar Coverage Intangible assets Research and Development Goodwill Internally Generated Purchased Goodwill Goodwill on Consolidation ID: 659861
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HUANG HUAI UNIVERSITYFINANCIAL ACCOUNTING
Lecture 5
Intangible
Assets
(R &D, Goodwill, Patent, Brands)
Dr Aziz
JaafarSlide2
CoverageIntangible assetsResearch and DevelopmentGoodwill
Internally Generated
Purchased Goodwill (Goodwill on Consolidation)
Other intangible assets
Patent, trademark, copyright etc. Slide3
Accounting StandardsIAS 38 (1998/revised 2003) – Intangible assetsIAS 36, Impairment of Assets
IFRS 3 – Business Combinations
Goodwill on consolidationSlide4
Intangible AssetsAn 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
Slide5
Initial MeasurementAll 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.Slide6
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 existsSlide7
Measurement subsequent to initial recognitionFinite 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 annuallySlide8
Research and DevelopmentSlide9
Growth in R&D expenditure by sector across UK850 (2002-2006)
Source: Department for Innovation, Universities & Skills, UKSlide10
The top five UK companies in the pharmaceuticals & biotechnology sector
Source: Department for Innovation, Universities & Skills, UKSlide11
The top five global companies in the pharmaceuticals & biotechnology sector
Source: Department for Innovation, Universities & Skills, UKSlide12
Research definedIAS 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 sheetSlide13
Development definedIAS 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 productionSlide14
IAS 38 – Development recognition criteriaCapitalised 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 revenueSlide15
Research & Development IFRS vs FASBIFRS
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 allowedSlide16
GoodwillIntangible assetsGoodwill (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 assetsSlide17
GoodwillValue 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.Slide18
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 assetsSlide19
Accounting for GoodwillFive 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 AssetsSlide20
Purchased goodwill: amortise vs. write offFigure 17.1
Comparison of immediate write-off with amortisation of goodwillSlide21
Purchased goodwillComparison of immediate write-off with amortisation of goodwill
Effect on reservesSlide22
Goodwill Treatment in the UKSSAP 22 (1984) – allows two alternatives:Write-off immediately to reserves
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.
Slide23
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
.Slide24
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)Slide25
Effect of IFRS 3The 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. Slide26
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.
Slide27
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. Slide28
Other Intangible AssetsPatent – 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. Slide29
Other Intangible AssetsCopyright – 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.Slide30
Other Intangible AssetsAccounting treatment under IAS 38Intangible assets with finite or indefinite useful lives:Finite useful life: amortisation over useful lifeIndefinite: impairment testSlide31
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 Slide32
IAS36 – Indicators of impairmentDecline in market value greater than expected as a result of normal use or passage of timeSignificant 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.