Financial Reporting of Intangible Assets

Intangible assets are those assets that have no physical substance such as patents, trademarks, franchises, and copyrights.

Intangible assets can have finite lives or indefinite lives. For assets with finite lives, the cost is amortized over the life of the asset. For assets with indefinite lives, there is no amortization. Instead a test of impairment is conducted at least once a year to check if the assets are impaired. If there is impairment, then the value of the asset is reduced and the reduction is recognized as a loss in income statement.

IFRS defines intangible assets as 'identifiable non-monetary assets without physical substance'. In order to be an identifiable intangible asset, an asset must meet the following three criteria:

1. Asset must be identifiable (Capable of being separated from the firm or arise from a contractual or legal right)
2. Asset is controlled by the firm.
3. Asset is capable of generating future economic benefit.

In addition, there are two recognition criteria: 1) It is probable that the expected future economic benefits of the assets will flow to the company. 1) The cost of the asset can be reliably measured.

The intangible assets are accounted for depending on how they are acquired. Intangible assets can be:

• Purchased
• Internally developed
• Acquired in a business combination

Internally Developed Assets

All costs to create intangible assets are expensed as incurred. A few exceptions are research and development costs and software development costs. The treatment of these exceptions is summarized below:

	IFRS	US GAAP
Research Costs	Expensed	Expensed
Development Costs	Capitalized	Expensed Exception: Software development costs
Software Development (Own Use)	Costs expensed till technical feasibility is established. (Capitalization criteria) Capitalized thereon.	Capitalized
Software Development (For sale)	Costs expensed till technical feasibility is established. Capitalized thereon.	Costs expensed till technical feasibility is established. Capitalized thereon.

Let’s take an example to understand the accounting of software development cost. A firm is developing software for its own use. Initially it spends $5,000 on software development. However, till then the firm could not estimate the expected future economic benefits of the assets. After that the company is able to estimate the expected future economic benefits from the intangible asset and then spends $20,000 more to develop the software.

Under IFRS, the initial $5,000 will be expensed, and the rest $20,000 will be capitalized. Under US GAAP, the entire $25,000 will be capitalized.

Purchased Intangible Assets

If an intangible asset is purchased, it will be treated in the same way as capitalization of any other tangible asset. The cost of acquiring the intangible asset (fair value at acquisition) is recorded on the balance sheet.

The capitalization results in higher net income, higher equity, higher assets and higher operating cash flows.

An analyst will be more interested in the type of asset purchased. For example, if the firm has purchased a franchise, the analyst will have some insight into the future earning capacity of the business.

Intangible Assets Acquired in a Business Combination

When a company acquires another company, the acquisition method is used to account for the transaction. Under this method:

• The acquirer allocates the purchase price to each asset acquired on a fair value basis.
• If the total purchase price exceeds the sum of fair value amounts allocated, then the excess is recorded as goodwill.

The goodwill generated in business combination is the only asset recorded in the balance sheet. Note that goodwill is an unidentifiable indefinite asset and cannot be separated from the entity. Also note that any internally created goodwill will be expensed in the period in which it is incurred.

Under IFRS, the acquired intangible assets include assets that meet all the definitional and recognition criteria discussed earlier. Any intangible asset not meeting these criteria is recognized as goodwill.

Under US GAAP, an intangible asset acquired in a business combination is recognized separately from goodwill if it is capable of being separated from the firm or arise from a contractual or legal right.