Treatment of Intangible Assets Has Varied over Time under a Number of Accounting Standards - Essay Example

The Classification and Treatment of Intangible Assets Has Varied Over Time under a Number of Accounting Standards Accounting for intangibles has been the subject of a long debate among scholars and practitioners. For accounting, the principal problem arising from the intangible elements is that of their capitalisation as intangible assets, i.e. as an integral part of the balance sheet and therefore subject to amortisation. The share taken by intangibles in industrial companies, but also in services - take for example software firms, or companies leading in research on contract - poses necessarily important problems for an evaluation of these companies, and, in fine, of the measurement of their performance and that of their company heads. Depending on the use of one method or another, more or less open to the capitalisation of specific components of intangibles, the accounting and financial configuration of a given company might change. This point is all the more worthy of note as there exists a multitude of different methods and practices at the international level, with regard to the capitalisation of intangibles. The stakes here are threefold: • There is a need to integrate the various dimensions of the value of the company. • There is a need to standardise for accounting practices and rules. • There is a need to inform external stakeholders, such as financial analysts and potential partners and investors (e.g. pension funds) on the real value of companies, especially those with high intensive-knowledge. The assets recorded in the balance sheets are economic assets. Economic assets are entities functioning as a store of value over which ownership rights are enforced by institutional units, individually or collectively, and from which economic benefits may be derived by their owners by holding them or using them over a period of time. The economic benefits consist of primary incomes (operating surplus by using, property income by letting others use) derived from the use of asset and value, including possible holding gains/losses that could be realised by disposing of the asset or terminating it. Excluded from the asset boundary are: • human capital; • natural assets that are not economic assets (e.g. air, river water); • contingent assets, which are not financial assets. Three categories of assets are distinguished: 1 non-financial produced assets; 2 non-financial non-produced assets; 3 financial assets. Non-financial produced assets Produced assets (AN.1) are non-financial assets that have come into existence as outputs from production processes. The classification of produced assets is designed to distinguish among assets on the basis of their role in production. It consists of: • fixed assets which are used repeatedly or continuously in production for more than one year; • inventories which are used up in production as intermediate consumption, sold or otherwise disposed of; • and valuables. The latter are not used primarily for production or consumption, but are acquired and held primarily as stores of value. Non-financial non-produced assets (AN.2) Non-produced assets (AN.2) are economic assets that come into existence other than through processes of production. They consist of tangible assets and intangible assets as defined below. The classification is designed to distinguish assets on the basis of the way they come into existence. Some of these assets occur in nature, others, which may be referred to as constructs devised by society, come into existence by legal or accounting actions. All tangible non-produced assets are natural assets Which natural assets are included is determined, in compliance with the general definition of an economic asset, by whether the assets are subject to effective ownership and are capable of bringing economic benefits to their owners, given the existing technology, knowledge, economic opportunities, available resources, and set of relative prices. Moreover, natural assets over which ownership rights have not, or cannot, be established, such as open seas or air, are excluded. Intangible non-produced assets include patented entities, transferable contracts, purchased contracts, purchased goodwill, etc. Entities not evidenced by legal or accounting actions - that is, such actions as the granting of a patent or the conveyance of some economic benefit to a third party - are excluded. Financial assets and liabilities (AF) Financial assets are economic assets, comprising means of payment, financial claims and economic assets which are close to financial claims in nature. Means of payment consist of monetary gold, special drawing rights, currency and transferable deposits. Financial claims entitle their owners, the creditors, to receive a payment or series of payments without any counter-performance from other institutional units, the debtors, who have incurred the counterpart liabilities. Examples of economic assets which are close to financial claims in nature are shares and other equity and partly contingent assets. The institutional unit issuing such a financial asset is considered to have incurred a 'counterpart liability'. Intangible investments, intangible assets We have already underlined the semantic diversity with regard to names relating to intangible items. We must also underline from the start the need to make a distinction between intangible assets and intangible investment. As (Addison and Belfield, 2004) pointed out - at least from the accounting point of view, 'an investment is a financial transaction, while an asset is an element of patrimony'. However, ex ante, this differentiation is not always very operational from the point of view of the decision-making process. For example, an investment in R&D - development of a new standard software by a firm specialising in data processing - is an operation which may have not only a financial goal, but beyond this, a patrimonial one for the company. This differentiation, from a basic accounting point of view, underestimates the difficulties related to the definition of the finalities of the decision, since it is a question of engaging an intangible resource. However, one can only agree with the authors that there is no systematic connection between the engagement of an expenditure of the intangible type and the creation of a related asset. Putting it simply, a company can spend all its resources in R&D, without any assurance that this will lead to a patentable output, and that this will turn out to have been the right step to the creation of an asset that will ensure financial generation to the company. Expenditure, investment or asset? The observation of the practices of companies, and the analysis of the literature, show that there is a strong connection between investment and asset building in a given company. The great difficulty on this level relates to the shift from the concept of expenditure - associated with an investment, to the concept of an asset, i.e. with the appearance of the expenditure engaged in the left side of the balance sheet. The following relation must thus be kept in mind since it determines the problem of patrimony's identification and measurement within companies. It makes it possible to highlight the difficulties - as well as multiple ambiguities - of such an exercise. Let us examine the terms of each relation: • expenditure → investment; • investment → assets. The relation expenditure → investment The question of knowing if a current intangible expenditure can be apprehended as investment, i.e. likely to generate revenue for a company, poses a problem. Here the concept of investment implies the existence of a project. As has been underlined by (Allison et al. 2003), two types of criteria characterize the concept of investment: one of a legal nature, relating to property; the other of an economic nature having three characteristics: working life, the increase in the output, and the need for engagement of a certain volume (threshold of significance). The relation investment → asset That which poses the greatest problem from the point of view of the accounting of intangible assets. However on this level, accounting an investment as asset supposes a certain idea of accumulation and thus of creation of a patrimony. This transition poses specific methodological problems, the most important of which in all probability relates to the definition of criteria that will enable us to highlight which intangible expenditures potentially generate a revenue and thus potentially belong to the asset category, and which do not, the latter having to be regarded as a current running cost. Recognition of intangible assets by accounting standards in force Public accounting obeys two fundamental principles, which pose problems from the point of view of accounting of intangible elements (Cohen, et al. 2000): the principle of prudence and the principle of independence of annual accounts. The first answers two important interrelated rules: reference to historical costs, with the result that an asset cannot appear on a balance sheet for a value higher than its real (historical) value, just as it cannot be the subject of revalorisation for a value higher than its book value. In addition, it is important to take account of any event likely to deteriorate the value of the considered asset. More generally, it is important that the awaited economic advantages of an asset are sufficiently certain as for their realisation and are measurable in a sufficiently precise way. However the application of these two rules poses problems, precisely because there are uncertainties touching on the value of these elements and in particular on their capacity to generate future incomes. The second principle is that of the independence of the accounting exercises, under the terms of which revenues are attached costs, which poses the problem of the valorisation of revenues and costs to be distributed on several years accounting exercises. These generic rules have implications on the nature of intangible elements that can be potentially capitalised, examined below. Expenditure in Research & Development Among intangible activities, the activities of Research & Development are those which were the subject of precise international coding. According to the aforementioned handbook, R&D covers three distinct activities (ibid.: 31): • basic research, which 'consists of experimental or theoretical work undertaken mainly in order to acquire new knowledge on the basis of observable phenomena and facts, without considering an application or a particular use'; • applied research, which 'also consists of original work undertaken in order to acquire new knowledge. However, it is especially directed towards a goal or a practical determined objective'; • experimental development which 'consists of the systematic work based on the existing knowledge obtained by research and/or the practical experiment, for launching the manufacture of new materials, products or devices, to establish new processes, systems and services or to improve considerably those which already exist'. The expenditures relating to these activities are generally recorded during their year of engagement. This can be detailed as follows: • expenditures on fundamental research are systematically recorded as expenses; • expenditures relating to applied Research & Development can on occasion be debited on the account 203 'expenses on Research & Development', by crediting the account 72, 'Capitalised Production'. If this is to take place, two conditions are to be filled: • the projects to be considered must be clearly individualised; • each project must clearly attest, at the date of establishment of its accounting position, to its chances of economic profitability (Hall, 2000). The amounts to be integrated are those provided by the analytical accounts of the company. Their amortisation must intervene within five years maximum, according to a given plan. The expenditure on software An important distinction is made here between software created by a company and acquired software assets, as well as between the internal role of this software and its commercial role. With regard to the software internally created, a ruling of the National Accounting Council, April 1987, even authorises the registration among software assets developed by a company for its own use, provided that these are intended to be useful in a durable way. On an accounting level, it was recommended to comply with the prudential rule and to enter the expenses of development at their production cost. With regard to the acquired software, the same rules apply, provided that such software is intended to be useful in a durable way, and provided that they are of a certain amount. Expenditures related to the development of brands A brand is defined legally by characteristics of extremely precise distinction and protection. At the accounting level, in a detailed report of 1992, the CNC defined in minute detail the conditions of capitalisation and amortisation of brands. The reasoning developed for brands is similar to that specified for software; it is mainly directed towards the conditions of technical and commercial success of a project aimed at developing brands. More generally, it arises from the prerequisite conditions for the integration of a tangible or intangible element in the capitalised assets, within the conceptual framework of the IASC, namely the probability of a future economic flow and the attribution of a cost or a value which can be measured reliably. The concept of uncertainty related to future incomes applies here in an undifferentiated way to tangible or intangible elements. Lastly, the concept of project is underlined here, insofar as it is a means of making it possible 'to individualise the elements developed in the company' (Hall and Kim, 2000). The concept of project is taken here in an Anglo-American sense of 'project', i.e. as 'a set of actions combined and programmed to produce results specified by respecting certain means, cost, and time constraints' (ibid.: 41). Under the recommendations of the CNC, a company which develops an internal brand can register it as an asset, under three conditions: • The project having led to the constitution of the brand must be clearly individualised: the distinctive sign of the brand is defined, but not yet The opinion of the CNC distinguishes four types of software and specifies their modes of accounting: 1 Software intended for regular commercial practice, created in the company and worked out for a single user within the framework of a commercial contract The expenditures on software generated within the framework of a single contract for a customer (application software) are to be carried as expenditures. It therefore follows that they cannot be the subject of a capitalisation. 2 Software intended for regular commercial practice, created in the company to cover several users The CNC specifies that any software created by a company can be registered as an asset, provided that it can be used in a durable way for its activity. Under the terms of the principle of prudence, the software under consideration is registered with its production costs. The assessment of production costs is carried out in reference to the various technical phases of development of the considered software. It is in particular stressed that 'in the “accounting plan”, processes of software production with regular commercial practice begin when, at the date of establishment of the accounting situations, the following conditions are met: • the project must have serious chances of technical success and commercial profitability; • the company must have concretely indicated the intention to produce the “mother-software” concerned and to make use of it durably' (p. 6). The FC method has a natural advantage for the company: delaying the recording of the expenditures of its wells without reserves. The results thus appear in a more favourable light than those of the SR method. A contrario, the adoption of this method implies the recording of higher amortising costs in the following years. But in the long term, the two methods lead to the same results. Both are currently accepted for the oil and gas sectors in the United Kingdom, as in the United States and Japan. The financial analysis of companies must thus be attentive to the method used, which impacts on certain traditional ratios. In addition, companies which choose the FC method are in general different from those which adopt the RF method, the latter being generally younger. IAS 38 specifies criteria for defining intangible assets, as previously specified, i.e. an intangible asset should be recognised initially, at cost, in financial statements, if, and only if: a the asset meets the definition of an intangible asset. Particularly, there should be an identifiable asset that is controlled and clearly distinguishable from an enterprise's goodwill; b it is probable that the future economic benefits that are attributable to the asset will flow to the enterprise; and c the cost of an asset can be measured reliably. These requirements apply whether the considered asset is acquired externally or generated internally. In case the item does not meet both the definition and the recognition criteria, then the expenditure on this item must be considered as expenditure when it is included. From the criteria of recognition, it follows that all expenditure on research, start-up, training, and advertising must be registered as expenditures. The same treatment applies to internally generated goodwill, brands, mastheads, publishing titles, customer lists and similar items in substance. However, some development expenditure, for instance on software, may be recognised as an asset. After initial recognition in financial accounting, the asset should be amortised over a useful life, which rarely exceeds 20 years. It must be submitted to an annual impairment test. Disclosure is encouraged, especially for R&D expenditures. IAS 38 was effective for accounting periods beginning on or after 1 July 1999. Works Cited 1. Addison, J.T. and Belfield, C.R. (2004), 'Unions, Training, and Firm Performance: Evidence from the British Workplace Employee Relations Survey'. International Finance and Financial Management; Institute for the Study of Labour (IZA) Discussion Paper, No. 1264. 2. Allison, J.R., Lemley, M.A., Moore, K.A. and Trunkey, R.D. (2003), 'Valuable Patents', UC Berkeley Public Law Research Paper, No. 133. 3. Cohen, W.M., Nelson, R.R. and Walsh, J.P. (2000), 'Protection their Intellectual Assets: Appropriability Conditions and Why US Manufacturing Firms Patent (or not)', National Bureau of Economic Research Working Paper 7552. 4. Hall, B.H. (2000), 'Innovation and Market Value', in Barrell, R., Mason, G. and O'Mahony, M. (eds), Productivity, Innovation and Economic Performance. National Institute of Economic and Social Research and Cambridge University Press, London and Cambridge. 5. Hall, B.H. and Kim, D. (2000), 'Valuing Intangible Assets: The Stock Market Value of R & D. Revised', Working Paper, University of California at Berkeley and Harvard University, Berkeley, CA and Cambridge, MA. 6. Posner, R.A. (2005), 'Intellectual Property: The Law and Economics Approach', Journal of Economic Perspectives, 19, 57-74. 7. Nelson, R.R. (2004), 'The Market Economy, and the Scientific Commons', Research Policy, 33, 455. Read More