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IAS 38 Intangible assets

Solutions

Instituut van de Bedrijfsrevisoren 1

December 12, 2008


Solutions

Véronique Weets


Solutions


December 12, 2008

TABLE OF CONTENT

Table of content ............................................................................................................................................. 2

IAS 38 Intangible assets .................................................................................................................................. 3

Purchased intangible assets ....................................................................................................................... 3

Research and development ........................................................................................................................ 4

Cost of an internally generated intangible asset ........................................................................................ 9

Intangible assets acquired in a business combination ............................................................................. 14

Assessing the useful lives of intangible assets .......................................................................................... 20

Amortization of Intangible assets ............................................................................................................. 23

Impairment of intangible assets ............................................................................................................... 26

Subsequent costs ...................................................................................................................................... 28

Comprehensive case ................................................................................................................................. 31

Annual improvements 2007 ......................................................................................................................... 33

IFRIC 12 – Service concession arrangements ............................................................................................... 34

Scope ........................................................................................................................................................ 34

Financial asset/Intangible asset ................................................................................................................ 36

AccountIng for service concession arrangements .................................................................................... 37


Purchased intangible assets


December 12, 2008

IAS 38 INTANGIBLE ASSETS

PURCHASED INTANGIBLE ASSETS

1. Operator F pays commissions of 175 to a third party dealer for the acquisition of a subscriber

that has passed the usual credit check. The subscriber signs a 12‐month contract with a minimum revenue

guarantee. Operator F has estimated that the expected margin from the minimum contracted revenues

will be 250. The subscriber acquisition costs are expected to be recovered in full within the initial contract

term. Operator F tracks subscriber acquisition costs by subscriber (PWC, Telecom, 122.39).

Should subscriber acquisition costs be capitalised as an intangible asset ?

Operator F should record the payment of 175 as an intangible asset. Operator F has acquired an

identifiable benefit, namely the minimum contractual net cash flows from the subscriber. Operator F has a

legally enforceable contractual right to receive the minimum net cash flows. It is probable that the

economic benefits of the contract will flow to F.

Each subscriber acquired is identifiable because F's systems can track each acquisition payment by

subscriber. This also enables F to

Assess the recoverability of each intangible asset; and

Identify any assets which are impaired within the contract term.

2. When a customer connects to its network on tariff AAA, Operator B agrees to make payments to

dealers of 12% of the gross billings to the customer over the life of the contract. Typically, the revenue

share payments are calculated monthly and paid quarterly in arrears. The subscriber signs a 12‐month

contract. Operator B expects that each AAA customer will generate gross billings of 1 000 over the

contract period. The dealer has no further service to render to the operator (such as billings, customer

care etc). Therefore, the contract between the dealer and operator B is not an executory contract (PWC,

Telecom 122.41).

How should an operator account for commitments to share customer revenues with dealers ?

The contract represents a financial liability for Operator B. Operator B should recognise a financial liability

of 120 when the customer is connected, being the fair value of the expected cash outflows to the dealer

which are independent on future gross billings. The estimated costs are directly related to the acquisition

of the customer, so Operator B should record subscriber acquisition costs of 120 as an intangible asset. The

financial liability will be re‐measured each month when the revenue share payments are calculated and as

the expected gross billings vary.

The intangible asset is not re‐measured but is amortised over the life of the contact and reviewed for

impairment when necessary. The asset is measured at the amount that management estimates as its

expected cost per customer.


Research and development


December 12, 2008

RESEARCH AND DEVELOPMENT

1. Consider the development of new technology to be used in a manufacturing plant. The process could

be split into the following stages (PWC, pg 15027‐15028):

Stage 1: Identify a need for/benefit of new technology

Stage 2: Board commissions a project to investigate the new technology

Stage 3: Investigate other technologies available in the market

Stage 4: Investigate competitors’ use of other technology

Stage 5: Commission the design of alternative types of new technology and get input from the

manufacturing floor for feasibility

Stage 6: Prepare a shortlist of five alternatives from stage 5 and prepare costing

Stage 7: Board prepares a budget for the new technology and agrees to the shortlist and the

replacement of technology

Stage 8: Send the shortlist to line managers for input and list three based on feedback

Stage 9: Present the final three to the board for final selection

Stage 10: Finalize a development plan for the final selection

Stage 11: Develop new technology

Stage 12: Test new technology

Stage 13: Train staff on new technology

Stage 14: Roll out new technology to the production line

Determine at what stage the entity should start to capitalize the costs of the project.

Stage 5: criteria (a) and (c) have been met because the feasibility of completing the intangible asset for use and

the entity’s ability to use it have been confirmed

Stage 7: Criteria (a), (c), (d) and (e) have been met at the end of this stage as a budget has been produced, it

has been agreed to proceed with replacing the technology and adequate resources exist to complete the

development.

Stage 10: All the criteria have been met at this stage as, in addition to the above, the board has approved the

project (evidence of the entity’s intention to complete the asset – criterion (b)) and the development plan,

based on the budgets, evidences the entity’s ability to measure the expenditure reliably (criterion f).

Note that the training of the staff should be expensed.

2. Stellenbosch Laboratories Ltd manufactures and distributes a wide range of general pharmaceutical

products. Selected audited data for the financial year ended 31 December 20X5 are as follows (Alfredson et

al.(2007), pg. 476, problem 11.2):

CU

Gross Profit 17 600 000

Profit before income tax 1 700 000

Income tax expense 500 000

Profit for the period 1 200 000

Total assets:

Current 7 300 000

Non‐current 11 500 000




December 12, 2008

The company uses a standard mark‐up on cost. From your audit files, you ascertain that total research and

development expenditure for the year amounted to 4 700 000 CU. This amount is substantially higher than in

previous years and has eroded the profitability of the company. M. Bosch, the company's finance director, has

asked for your firm's advice on whether it is acceptable accounting practice for the company to carry forward

any of its expenditure to a future accounting period.

Your audit files disclose that the main reason for the significant increase in research and development costs

was the introduction of a planned five‐year laboratory program to attempt to find an antidote for the common

cold. Salaries and identifiable equipment costs associated with this program amounted to 2 350 000 for the

current year.

The following additional items were included in research and development costs for the year:

• Costs to test a new tamper‐proof dispenser pack for the company's major selling line (20% of sales) of

antibiotic capsules ‐ 760 000 CU. The new packs are to be introduced in the 20X6 financial year.

• Experimental costs to convert a line of headache powders to liquid form ‐ 590 000 CU. The company

hopes to phase out the powder form if the tests to convert to the stronger and better handling liquid form

prove successful.

• Quality control required by stringent company policy and by law on all items of production for the

year ‐ 750 000 CU.

• Costs of a time and motion study aimed at improving production efficiency by redesigning plan layout

of existing equipment ‐ 50 000 CU

• Construction and testing of a new prototype machine for producing hypodermic needles ‐ 200 000

CU. Testing has been successful to date and is nearing completion. Hypodermic needles accounted for 1% of

the company's sales in the current year, but it is expected that the company's market share will increase

following introduction of this new machine.

Respond to M. Bosch's question for each item above.

The outlays must be analyzed using IAS 38.57:

• Technical feasibility:

• Intention to complete and sell:

• Ability to use or sell:

• Existence of a market:

• Availability of resources:

• Ability to measure costs reliably:

Dispenser pack: As the dispenser pack was a new product, costs incurred until the pack developed met the

IAS18.57 tests are expensed. In this case, determining the technical feasibility of the pack and developing a cost

effective product would have been two key issues.

Converting powders to liquid form: The tests have not yet proven successful, therefore the technical feasibility

test would not be met and the 590 000 CU must be expensed.

Costs of quality control: These costs relate to products being produced and hence can be capitalized into the

products produced. No separate intangible such as “Superior Quality” could be raised as such an asset is not

identifiable.




December 12, 2008

Costs of time and motion study: As the equipment is being used in current production, the costs could be

capitalized into the cost of the equipment.

New prototype machine: This is a difficult one to classify. The question hinges on the “nearing completion”

statement. It is a question of what has yet to be done. Questions relating to the IAS 18.57 criteria need to be

asked. For example: has technical feasibility been established, and is it only minor adjustments that are being

made? Do any minor adjustments have a material effect on the determination of the costs of the machine?

3. a. A pharmaceutical entity has obtained scientific regulatory approval for a new respiratory drug in

Country Agara. It is now progressing through the additional development procedures necessary to gain

approval in Country Belan. Management believes that achieving regulatory approval in this secondary market

is a formality. Mutual recognition treaties and past experience show that Belan's authorities rarely refuse

approval for a new drug that has been approved in Agara.

b. A pharmaceutical entity has obtained scientific regulatory approval for a new AIDS drug in Country

Spartek and is progressing through the additional development procedures necessary to gain approval in

Country Oceana. Experience shows that significant additional clinical trials will be necessary to meet the

Oceanese scientific regulatory approval requirements. Some drugs accepted in Spartek have not been

accepted for sale in Oceana, even after additional clinical trials (PWC, Pharma, 2).

Should the development costs in each scenario be capitalized ?

The company in scenario 1 should capitalize any additional development costs. The criterion of technical

feasibility in Country Belan appears to have been met, as registration is highly probable and there are likely to

below barriers to obtaining regulatory approval.

Conversely, the company in scenario 2 should not capitalize additional development expenditure. It cannot

show that it has met the criterion of technical feasibility, if registration in another market requires significant

effort and approval in one market does not necessarily predict approval in the other.

4. A Pharmaceutical entity is developing a generic version of a painkiller that has been sold in the market

by another company for many years. The technical feasibility of the asset has already been established

because it is a generic version of a product that has already been approved, and its chemical equivalence has

been demonstrated. The lawyers advising the entity do not anticipate that any significant difficulties will delay

the process of obtaining commercial regulatory approval (PWC, Pharma, 3).

Should management capitalize the development costs at this point ?

It is probable that commercial regulatory approval will be achieved and, since the remaining criteria have been

met, management should start capitalizing internal development costs.

5. Pharmaceutical entity MagicCure has obtained scientific regulatory approval for a new respiratory

drug and is now incurring expenditure to educate its sales force and perform market research (PWC, Pharma,

4).

Should it capitalize these costs ?

MagicCure should expense sales and marketing expenditure such as training a sales force or performing market

research. This type of expenditure does not create, produce or prepare the asset for its intended use.

Expenditure on training staff, selling and administration should not be capitalized.




December 12, 2008

6. Pharmaceutical entity Astro engages a contract research organisation (CRO) to perform research

activities for a period of 2 years in order to obtain know‐how and try to discover a cure for AIDS. The CRO is

well known in the industry for having modern facilities and good practitioners dedicated to investigation. The

CRO receives a non‐refundable, upfront payment of CU 3 million in order to carry out the research under the

agreement. It will have to present a quarterly report to Astro with the results of its research. Astro has full

rights of access to all the research performed, including control of the research undertaken on the potential

cure for AIDS. The CRO has no rights to use the results of the research for its own purposes (PWC, Pharma, 16).

How should Astro account for upfront payments made to third parties to conduct research ?

Astro will have access to the research being carried out over a two‐year period. The upfront payment should

therefore be deferred as a pre‐payment and recognized in the income statement over the life of the research. If

the research terminates early, Astro should write off the remainder of the pre‐payment immediately. The costs

of carrying out the research should be classified as research and development expenditure in the income

statement.

7. Van Gogh Ltd. Has obtained regulatory approval for its new antidepressant drug and has started

commercialization. Van Gogh is now undertaking studies to verify the advantages of its drug over competing

drugs already on the market. These studies will support Van Gogh's sales efforts (PWC, Pharma, 38).

Should costs incurred to compare various drugs with the intent of determining relative performance for

certain indications, be capitalized as development costs ?

The expenditure incurred for studies to identify performance features should not be capitalized as part of the

development cost as it does not qualify for capitalization. The studies are directed at providing marketing

support and the nature of the amounts spent is that of selling ad distribution expense. This expense should be

included in the appropriate income statement classification.

8. Da Vinci Pharma is currently developing a drug that will be used in the treatment of a very specific

ailment affecting a small group of patients. Generally, Da Vinci pursues development of a drug if the market

potential is sufficient to obtain future economic benefits. However, Da Vinci has decided to pursue with this

drug for reputation reasons. Da Vinci has filed for initial regulatory approval, and believes that all other

capitalization criteria have been met except for concerns about its market potential (PWC, Pharma, 39).

Do limits to potential sales markets prevent management from capitalizing development costs related to

this drug ?

Da Vinci should capitalize development costs for this drug, beginning no later than final submission for

regulatory approval but limited to the amount recoverable following commercialization. Da Vici will need to

assess the capitalized costs for any indication of impairment at each reporting date and test for impairment

annually as long as the asset is not available for use.

9. Sisley Pharma contracts with Wright Pharma to research possible candidates for further development

in its anti‐hypertension program. Sisley pays Wright on a cost‐plus basis for the research, plus CU 100 000 per

development candidate which Sisley elects to pursue further. Sisley will own the rights to any such

development candidates. After two years, Wright succeeds in confirming 10 candidates that will be used by

Sisley (PWC, Pharma, 43).

How should payments for pharmaceutical research that subsequently becomes development be accounted

for ?




December 12, 2008

Costs incurred for research should not be capitalized. Accordingly, Sisley’s payments relating to the cost‐plus

portion of the contract should be expensed. Sisley’s payments relating to the successful development

candidates should also be expensed. The development candidates were previously identified by Sisley, so no

separate intangible has been acquired and the technological feasibility criterion is not met. The research costs

previously expensed cannot be reversed and capitalized with these rights.


Cost of an internally generated intangible asset


December 12, 2008

COST OF AN INTERNALLY GENERATED INTANGIBLE ASSET

1. Operator A is considering upgrading its billing system. A completed a feasibility study that

considered several software systems before deciding whether to go ahead with the upgrade. A

subsequently decided to upgrade its billing system. The development will take six months to complete. A

will use internal resources to customize the software. The total cost is expected to be 250 000, including

10 000 for the feasibility study, 25 000 to train the personnel who will be using the billing system and 215

000 of labour time for those personnel who were dedicated to the customization and upgrade of the

billing system (PWC, Telecom, 122.1).

When should an operator capitalize internally‐developed software ?

Operator A should expense the costs of 10 000 associated with the feasibility study and the training costs

of 25 000 as incurred. The direct personnel costs of 215 000 should be capitalized as part of the cost of the

new billing system.

A must capitalize the cost of customizing the software as part of the cost of the software, provided:

it has the resources to complete the project;

the software will be used in operating the business; and

it is probable the system will generate future economic benefits.

The costs that may be capitalized are those directly attributable to the project, including the salaries of

personnel directly engaged on the project. Costs that are not necessary for the development of the

software, such as the feasibility study are expensed as incurred. Training costs are never capitalized,

because employees do not represent a resource controlled by the organization.

2. Pharmaceutical entity Pilax has obtained a loan from Qula, another pharmaceutical company, to

finance the late‐stage development of a drug to treat cancer. Qula will have co‐marketing rights over any

product that is developed. Pilax's management has decided to capitalize all the development costs

incurred after filing for scientific regulatory approval (PWC, Pharma, 23).

Should Pilax capitalize the interest incurred for borrowings obtained to finance R&D activities ?

Borrowing costs incurred before capitalization of development costs are expensed. Borrowing costs should

be capitalized for qualifying assets once development costs are being capitalized. Capitalization of

borrowing costs should cease once the drug has been fully developed and is available for sale.

3. Coupono plc has incurred 1200000 CU in capital expenditure for the development of new

software during the year, for its time recording and link with invoicing. At year‐end, 120 000 CU related to

the construction of the software is included in creditors. The software is considered to be a qualifying

asset under IAS 23 ‐ Borrowing Costs.

Coupono plc has the following borrowings outstanding:

• Bank overdraft: 120 000 CU at 16% • Long‐term loan: 300 000 CU at 5,1% (nominal interest rate) • Debentures: 1 100 000 CU at 6,8%




December 12, 2008

Ancillary costs of 5000 CU have been incurred in connection with the arrangement of the long‐term loan,

which has the following characteristics:

• Issuing date: 1 January of year 1 • Maturity date: 3 years • Repayment schedule: 300000 CU at maturity date

a. Determine the interest rate on the long‐term loan using the effective interest rate method.

IRR(‐295000(*);15300(**);15300(**);315300(***)) = 5,72%

(*) 300000‐5000

(**) 5,1%*300000

(***) 300000+15300

b. Account for the long‐term loan.

1 January of year 1

Dr Cash 295 000

Cr Long term loan 295 000

31 December of year 1

Dr Interest expense 16 875 (*)

Cr Cash 15 300 (**)

Cr Long term loan 1 575

(*)5,72%*295000

(**)5,1%*300000


Dr Interest expense 16 965

Cr Cash 15 300

Cr Long‐term loan 1 665


Dr Interest expense 17 060

Cr Cash 15 300

Cr Long‐term loan 1760

Dr Long term loan 300 000

Cr Cash 300 000




December 12, 2008

c. Calculate the amount of borrowing costs to be capitalized, assuming that Coupono plc has a 31

December year‐end and that the expenditures took place on the following dates:

• 1 February 600000 CU • 1 July 400000 CU • 1 November 200000 CU

The weighted average interest rate is:

(120000*16%)+(295000*5,72%)+(1100000*6,8%) /(120000+295000+1100000) = 7,32%

Given the uneven nature of the capital expenditure during the year, it is appropriate to apply the

capitalization rate to the weighted average capital expenditure incurred in the year.

(600000*11/12+400000*6/12+80000*2/12) = 763333

Note that the 120000 not yet paid at year‐end is excluded.

763333*7,32% = 55876

Dr Work in process 55 876

Cr Interest expense 55 876

d. Calculate the amount of borrowing costs to be capitalized, assuming that the debentures were

not in existence. The entity applies the same method as in d)

The weighted average interest rate: (120000*16%)+(295000*5,72%)/ (120000+295000) = 8,69%

Amount of borrowing costs to be capitalized: 763 333 *8,69% = 66333,64

However, borrowing costs actually incurred on the two borrowings during the year are only 36074.

(=16%*120000+5.72%*295000). So only 36074 can be capitalized.

Dr Work in process 36 074

Cr Interest expense 36 047

4. Tiepolo Pharma has appointed Tintoretto Laboratories, a third party, to develop an existing

compound owned by Tiepolo on its behalf. Tintoretto will act purely as a service provider without taking

any risks during the development phase and will have no further involvement after regulatory approval.

Tiepolo will retain full ownership of the compound. Tintoretto will not participate in any marketing and

production arrangements. A milestone plan is included in the contract. Tiepolo agrees to make the

following non‐refundable payments to Tintoretto (PWC, Pharma, 44):

CU 2 million on signing the agreement

CU 3 million on successful completion of phase 2

How should pharmaceutical entities account for upfront payments and subsequent milestone payments

in a long‐term research and development arrangement in which a third party develops their intellectual

property ?




December 12, 2008

Tiepolo owns the compound. Tintoretto performs development on Tiepolo’s behalf. No risks and rewards

of ownership are transferred between the parties. By making the initial upfront payment and the

subsequent milestone payment to Tintoretto, Tiepolo does not acquire a separate intangible asset, which

could be capitalized. The payments represent funding for development by a third party, which needs to be

expensed over the development period provided that the recognition criteria for internally generated

intangible assets are not met.

5. Tiepolo Pharma has appointed Tintoretto Laboratories, a third party, to develop an existing

compound owned by Tiepolo on its behalf. The agreement effectively out‐licenses Tiepolo's compound to

Tintoretto. Tiepolo and Tintoretto will set up a development steering committee to jointly perform the

development and will participate in the funding of the development costs according to specific terms.

Tiepolo agrees to make the following payments to Tintoretto:

CU 5 million on signing the agreement as an advance payment. Tintoretto has to refund the entire payment in the event of failure in development

50% of total development costs on successful completion of phase 2 (after deducting the advance payment)

In the case of successful completion of development and commercialization, Tintoretto will receive milestone payments and royalty streams (PWC, Pharma, 45).

How should pharmaceutical entities account for upfront payments and subsequent milestone payments

in a long‐term research and development arrangement in which a third party develops their intellectual

property ?

Tintoretto becomes party to substantial risks in the development of Tiepolo’s compound, as it is only partly

compensated for its development activities if the development succeeds (thereby buying into the potential

success of the future product). Tiepolo effectively reduces its exposure to ongoing development costs and

to potential failure of the development of its compound. However, by paying the refundable advance

payment and the subsequent milestone payment (determined to be 50% of total development costs),

Tiepolo does not acquire a separate intangible asset which could be capitalized. The payment and the

milestone payment should be expensed as incurred. Tiepolo should expense the refundable advance

payment once successful completion of phase 2 is probable.

6. Sargent and Chagall enter into a collaboration deal in which Sargent will pay Chagall for

developing and manufacturing a new antibiotic originally discovered by Chagall. Sargent will have

exclusive marketing rights of the antibiotic if it is approved. The contract terms require the following

payments:

Upfront payment of CU 5 million on signing of the contract

Milestone payment of CU 5 million on filing for stage 3 clinical trial approval

Milestone payment of CU 7 million on securing final regulatory approval, and

CU 11.5 per unit, which equals the estimated cost plus 15% once commercial production begins

The cost‐plus 15% is consistent with Sargent's other recently negotiated supply arrangements for drugs

with comparable manufacturing complexity (PWC, Pharma, 47).

How should pharmaceutical entities account for collaboration agreements to develop a new drug

compound ?




December 12, 2008

There is no indication that the agreed prices for the various elements are not at fair value. In particular,

the terms for product supply at cost plus 15% are consistent with Sargent’s other supply arrangements.

Therefore, Sargent should capitalize the upfront purchase of the compound and subsequent milestone

payments as incurred, and consider impairment at each financial reporting date. Amortization should

begin once regulatory approval has been obtained. Costs for the products have to be accounted for as

inventory and then expensed as costs of goods sold as incurred.

If the contract terms did not represent fair value, the payments would have to be allocated to the

development and production supply components of the arrangement using fair value as the allocation key.


Intangible assets acquired in a business combination


December 12, 2008

INTANGIBLE ASSETS ACQUIRED IN A BUSINESS COMBINATION

1. The following are examples of identifiable intangible assets acquired in a business combination. Some

of the examples may have characteristics of assets other than intangible assets.

Intangible assets are identifiable if they have a contractual basis or if they are separable. Intangible assets

identified as having a contractual basis might also be separable but separability is not a necessary condition for

an asset to meet the contractual‐legal criterion.

Explain for the following intangible assets why they meet the definition of an identifiable asset.

Marketing‐related intangible assets

Trademarks, trade names, service

marks, collective marks and

certification marks

Trademarks, trade names, service marks, collective marks and

certification marks may be protected legally through registration with

governmental agencies, continuous use in commerce or by other

means. If it is protected legally through registration or other means, a

trademark or other mark acquired in a business combination is an

intangible asset that meets the contractual‐legal criterion. Otherwise, a

trademark or other mark acquired in a business combination can be

recognised separately from goodwill if the separability criterion is met,

which normally it would be.

Internet domain names An Internet domain name is a unique alphanumeric name that is used

to identify a particular numeric Internet address. Registration of a

domain name creates an association between that name and a

designated computer on the Internet for the period of the registration.

Those registrations are renewable. A registered domain name acquired

in a business combination meets the contractual‐legal criterion.

Customer‐related intangible assets

Customer lists A customer list consists of information about customers, such as their

names and contact information. A customer list also may be in the form

of a database that includes other information about the customers,

such as their order histories and demographic information. A customer

list does not usually arise from contractual or other legal rights.

However, customer lists are often leased or exchanged. Therefore, a

customer list acquired in a business combination normally meets the

separability criterion.




December 12, 2008

Order or production backlog An order or production backlog arises from contracts such as purchase

or sales orders. An order or production backlog acquired in a business

combination meets the contractual‐legal criterion even if the purchase

or sales orders can be cancelled.

Customer contracts and the related

customer relationships

If an entity establishes relationships with its customers through

contracts, those customer relationships arise from contractual rights.

Therefore, customer contracts and the related customer relationships

acquired in a business combination meet the contractual‐legal

criterion, even if confidentiality or other contractual terms prohibit the

sale or transfer of a contract separately from the acquiree.

A customer contract and the related customer relationship may

represent two distinct intangible assets. Both the useful lives and the

pattern in which the economic benefits of the two assets are consumed

may differ.

A customer relationship exists between an entity and its customer if (a)

the entity has information about the customer and has regular contact

with the customer and (b) the customer has the ability to make direct

contact with the entity. Customer relationships meet the contractual‐

legal criterion if an entity has a practice of establishing contracts with

its customers, regardless of whether a contract exists at the acquisition

date. Customer relationships may also arise through means other than

contracts, such as through regular contact by sales or service

representatives.

Non‐contractual customer

relationships

A customer relationship acquired in a business combination that does

not arise from a contract may nevertheless be identifiable because the

relationship is separable. Exchange transactions for the same asset or a

similar asset that indicate that other entities have sold or otherwise

transferred a particular type of non‐contractual customer relationship

would provide evidence that the relationship is separable.

Artistic‐related intangible assets

Plays, operas and ballets

Books, magazines, newspapers and

other literary works

Musical works such as compositions,

song lyrics and advertising jingles

Pictures and photographs

Artistic‐related assets acquired in a business combination are

identifiable if they arise from contractual or legal rights such as those

provided by copyright. The holder can transfer a copyright, either in

whole through an assignment or in part through a licensing agreement.

An acquirer is not precluded from recognising a copyright intangible

asset and any related assignments or licence agreements as a single

asset, provided they have similar useful lives.




December 12, 2008

Video and audiovisual material,

including motion pictures or films,

music videos and television

programmes

Contract based intangible assets

Servicing contracts, such as

mortgage servicing contracts

Contracts to service financial assets are one type of contract‐based

intangible asset. Although servicing is inherent in all financial assets, it

becomes a distinct asset (or liability) by one of the following:

(a) when contractually separated from the underlying financial

asset by sale or securitization of the assets with servicing retained;

(b) through the separate purchase and assumption of the

servicing.

If mortgage loans, credit card receivables or other financial assets are

acquired in a business combination with servicing retained, the

inherent servicing rights are not a separate intangible asset because

the fair value of those servicing rights is included in the measurement

of the fair value of the acquired financial asset.

Employment contracts Employment contracts that are beneficial contracts from the

perspective of the employer because the pricing of those contracts is

favorable relative to market terms are one type of contract‐based

intangible asset.

Use rights, such as drilling, water,

air, timber cutting and route

authorities

Use rights include rights for drilling, water, air, timber cutting and

route authorities. Some use rights are contract‐based intangible assets

to be accounted for separately from goodwill. Other use rights may

have characteristics of tangible assets rather than of intangible assets.

An acquirer should account for use rights on the basis of their nature.

Computer software and mask works Computer software and program formats acquired in a business

combination that are protected legally, such as by patent or copyright,

meet the contractual‐legal criterion for identification as intangible

assets.

Mask works are software permanently stored on a read‐only memory

chip as a series of stencils or integrated circuitry. Mask works may have

legal protection. Mask works with legal protection that are acquired in

a business combination meet the contractual‐legal criterion for

identification as intangible assets.




December 12, 2008

Databases, including title plants Databases are collections of information, often stored in electronic

form (such as on computer disks or files). A database that includes

original works of authorship may be entitled to copyright protection. A

database acquired in a business combination and protected by

copyright meets the contractual‐legal criterion. However, a database

typically includes information created as a consequence of an entity's

normal operations, such as customer lists, or specialized information,

such as scientific data or credit information. Databases that are not

protected by copyright can be, and often are, exchanged, licensed or

leased to others in their entirety or in part. Therefore, even if the future

economic benefits from a database do not arise from legal rights, a

database acquired in a business combination meets the separability

criterion.

Title plants constitute a historical record of all matters affecting title to

parcels of land in a particular geographical area. Title plant assets are

bought and sold, either in whole or in part, in exchange transactions or

are licensed. Therefore, title plant assets acquired in a business

combination meet the separability criterion.

Trade secrets such as secret

formulas, processes and recipes

A trade secret is 'information, including a formula, pattern, recipe,

compilation, program, device, method, technique, or process that (a)

derives independent economic value, actual or potential, from not

being generally known and (b) is the subject of efforts that are

reasonable under the circumstances to maintain its secrecy.'1 If the

future economic benefits from a trade secret acquired in a business

combination are legally protected, that asset meets the contractual‐

legal criterion. Otherwise, trade secrets acquired in a business

combination are identifiable only if the separability criterion is met,

which is likely to be the case.




December 12, 2008

2. Determine for the following situations whether an intangible assets should be recognised

2.1 Acquirer Company (AC) acquires Target Company (TC) in a business combination on 31 December 20X5. TC

has a five‐year agreement to supply goods to Customer. Both TC and AC believe that Customer will renew the

agreement at the end of the current contract. The agreement is not separable.

The agreement, whether cancellable or not, meets the contractual‐legal criterion. Additionally, because TC

establishes its relationship with Customer through a contract, not only the agreement itself but also TC's

customer relationship with Customer meet the contractual‐legal criterion.

2.2. AC acquires TC in a business combination on 31 December 20X5. TC manufactures goods in two

distinct lines of business: sporting goods and electronics. Customer purchases both sporting goods and

electronics from TC. TC has a contract with Customer to be its exclusive provider of sporting goods but has no

contract for the supply of electronics to Customer. Both TC and AC believe that only one overall customer

relationship exists between TC and Customer.

The contract to be Customer's exclusive supplier of sporting goods, whether cancellable or not, meets the

contractual‐legal criterion. Additionally, because TC establishes its relationship with Customer through a

contract, the customer relationship with Customer meets the contractual‐legal criterion. Because TC has only

one customer relationship with Customer, the fair value of that relationship incorporates assumptions about

TC's relationship with Customer related to both sporting goods and electronics. However, if AC determines that

the customer relationships with Customer for sporting goods and for electronics are separate from each other,

AC would assess whether the customer relationship for electronics meets the separability criterion for

identification as an intangible asset.

2.3. AC acquires TC in a business combination on 31 December 20X5. TC does business with its customers

solely through purchase and sales orders. At 31 December 20X5, TC has a backlog of customer purchase orders

from 60 % of its customers, all of whom are recurring customers. The other 40 % of TC's customers are also

recurring customers. However, as of 31 December 20X5, TC has no open purchase orders or other contracts

with those customers.

Regardless of whether they are cancellable or not, the purchase orders from 60 % of TC's customers meet the

contractual‐legal criterion. Additionally, because TC has established its relationship with 60 % of its customers

through contracts, not only the purchase orders but also TC's customer relationships meet the contractual‐legal

criterion. Because TC has a practice of establishing contracts with the remaining 40 % of its customers, its

relationship with those customers also arises through contractual rights and therefore meets the contractual‐

legal criterion even though TC does not have contracts with those customers at 31 December 20X5.

2.4. AC acquires TC, an insurer, in a business combination on 31 December 20X5. TC has a portfolio of one‐

year motor insurance contracts that are cancellable by policyholders.

Because TC establishes its relationships with policyholders through insurance contracts, the customer

relationship with policyholders meets the contractual‐legal criterion. IAS 36 Impairment of Assets and IAS 38

Intangible Assets apply to the customer relationship intangible asset.




December 12, 2008

3. Olegna acquires Enile on 30 December 20X8. In the balance sheet of Enile there is amount recognized

for goodwill in relation to an acquisition on 1 February 2008 of Siabot.

Is this goodwill part of the identifiable assets acquired an liabilities assumed in the business combination on

30 December 20X8 ?

No, goodwill is defined as an asset representing the future economic benefits arising from other assets acquired

in a business combination that are not individually identified and separately recognized.


Assessing the useful lives of intangible assets


December 12, 2008

ASSESSING THE USEFUL LIVES OF INTANGIBLE ASSETS

Determine the useful life and the subsequent accounting for each of the following examples of acquired

intangible assets.

1. A direct‐mail marketing company acquires a customer list and expects that it will be able to derive

benefit from the information on the list for at least one year, but no more than three years.

The customer list would be amortized over management's best estimate of its useful life, say 18 months.

Although the direct‐mail marketing company may intend to add customer names and other information to the

list in the future, the expected benefits of the acquired customer list relate only to the customers on that list at

the date it was acquired. The customer list also would be reviewed for impairment in accordance with IAS 36 ‐

Impairment of assets by assessing at the end of each reporting period whether there is any indication that the

customer list may be impaired.

2. An entity acquires a patent that expires in 15 years. The product protected by the patented

technology is expected to be a source of net cash inflows for at least 15 years. The entity has a commitment

from a third party to purchase that patent in five years for 60 % of the fair value of the patent at the date it

was acquired, and the entity intends to sell the patent in five years.

The patent would be amortized over its five‐year useful life to the entity, with a residual value equal to the

present value of 60 % of the patent's fair value at the date it was acquired. The patent would also be reviewed

for impairment in accordance with IAS 36 by assessing at the end of each reporting period whether there is any

indication that it may be impaired.

3. An acquired copyright has a remaining legal life of 50 years. An analysis of consumer habits and

market trends provides evidence that the copyrighted material will generate net cash inflows for only 30 more

years.

The copyright would be amortized over its 30‐year estimated useful life . The copyright also would be reviewed

for impairment in accordance with IAS 36 by assessing at the end of each reporting period whether there is any


4. A broadcasting company acquires a broadcasting license that expires in five years. The broadcasting

license is renewable every 10 years if the entity provides at least an average level of service to its customers

and complies with the relevant legislative requirements. The license may be renewed indefinitely at little cost

and has been renewed twice before the most recent acquisition. The acquiring entity intends to renew the

license indefinitely and evidence supports its ability to do so. Historically, there has been no compelling

challenge to the license renewal. The technology used in broadcasting is not expected to be replaced by

another technology at any time in the foreseeable future. Therefore, the license is expected to contribute to

the entity's net cash inflows indefinitely.

The broadcasting license would be treated as having an indefinite useful life because it is expected to

contribute to the entity's net cash inflows indefinitely. Therefore, the license would not be amortized until its

useful life is determined to be finite. The license would be tested for impairment in accordance with IAS 36

annually and whenever there is an indication that it may be impaired.

5. The licensing authority for the broadcasting license in the previous example subsequently decides

that it will no longer renew broadcasting licenses, but rather will auction the licenses. At the time the licensing

authority's decision is made, the entity's broadcasting license has three years until it expires. The entity

expects that the license will continue to contribute to net cash inflows until the license expires.




December 12, 2008

Because the broadcasting license can no longer be renewed, its useful life is no longer indefinite. Thus, the

acquired license would be amortized over its remaining three‐year useful life and immediately tested for

impairment in accordance with IAS 36.

6. An acquired airline route authority between two European cities that expires in three years. The route

authority may be renewed every five years, and the acquiring entity intends to comply with the applicable

rules and regulations surrounding renewal. Route authority renewals are routinely granted at a minimal cost

and historically have been renewed when the airline has complied with the applicable rules and regulations.

The acquiring entity expects to provide service indefinitely between the two cities from its hub airports and

expects that the related supporting infrastructure (airport gates, slots, and terminal facility leases) will remain

in place at those airports for as long as it has the route authority. An analysis of demand and cash flows

supports those assumptions.

Because the facts and circumstances support the acquiring entity's ability to continue providing air service

indefinitely between the two cities, the intangible asset related to the route authority is treated as having an

indefinite useful life. Therefore, the route authority would not be amortized until its useful life is determined to

be finite. It would be tested for impairment in accordance with IAS 36 annually and whenever there is an


7. An entity acquired a trademark used to identify and distinguish a leading consumer product that has

been a market‐share leader for the past eight years. The trademark has a remaining legal life of five years but

is renewable every 10 years at little cost. The acquiring entity intends to renew the trademark continuously

and evidence supports its ability to do so. An analysis of (1) product life cycle studies, (2) market, competitive

and environmental trends, and (3) brand extension opportunities provides evidence that the trademarked

product will generate net cash inflows for the acquiring entity for an indefinite period.

The trademark would be treated as having an indefinite useful life because it is expected to contribute to net

cash inflows indefinitely. Therefore, the trademark would not be amortized until its useful life is determined to

be finite. It would be tested for impairment in accordance with IAS 36 annually and whenever there is an


8. An entity acquired a trademark acquired 10 years ago that distinguishes a leading consumer product.

The trademark was regarded as having an indefinite useful life when it was acquired because the trademarked

product was expected to generate net cash inflows indefinitely. However, unexpected competition has

recently entered the market and will reduce future sales of the product. Management estimates that net cash

inflows generated by the product will be 20 % less for the foreseeable future. However, management expects

that the product will continue to generate net cash inflows indefinitely at those reduced amounts.

As a result of the projected decrease in future net cash inflows, the entity determines that the estimated

recoverable amount of the trademark is less than its carrying amount, and an impairment loss is recognized.

Because it is still regarded as having an indefinite useful life, the trademark would continue not to be amortized

but would be tested for impairment in accordance with IAS 36 annually and whenever there is an indication

that it may be impaired.

9. An entity acquired a trademark for a line of products that was acquired several years ago in a business

combination. At the time of the business combination the acquiree had been producing the line of products

for 35 years with many new models developed under the trademark. At the acquisition date the acquirer

expected to continue producing the line, and an analysis of various economic factors indicated there was no

limit to the period the trademark would contribute to net cash inflows. Consequently, the trademark was not

amortized by the acquirer. However, management has recently decided that production of the product line

will be discontinued over the next four years.




December 12, 2008

Because the useful life of the acquired trademark is no longer regarded as indefinite, the carrying amount of

the trademark would be tested for impairment in accordance with IAS 36 and amortized over its remaining

four‐year useful life.


Amortization of intangible assets


December 12, 2008

AMORTIZATION OF INTANGIBLE ASSETS

1. Operator D pays commissions of 175 to a third party dealer for the acquisition of a subscriber

that has passed the usual credit check. The subscriber signs a 12‐month contract. The average life of D's

subscribers is 24 months. Operator D can reliably establish the recoverability of the 175 and has the

systems to track the payment for each subscriber acquired separately (PWC, Telecom, 122.40).

Over what period should an operator amortize subscriber acquisition costs ?

Operator D should record the payment of 175 as an intangible asset. Operator D should amortize the 175

on a straight line basis over the 12 month life of the contract. The fact that the average life of D's

subscribers is 24 month is not relevant in considering the initial useful life because D is not able to control

whether or not the subscriber renews the contract.

2. Operator B purchases a telecom license in 1999 for 1 million. The license has a term of 12 years.

B then constructs its telecom network. The telecom network is capable of delivering service in 20X1, two

years after the license was initially purchased. The license has a remaining term of 10 years. C expects its

subscriber base to grow over the next few years and reach a critical mass in four years' time ‐ that is, 20X5

(PWC , Telecom, 122.2 and 122.3).

When should an operator commence the amortization of its telecom license ?

Operator B should commence amortizing its telecom license from the date the network, and hence the

license, is available for use ‐ that is, in 20X1. B should undertake an annual impairment review in the years

when the license is not being amortized.

The depreciable amount of an intangible asset is allocated over the best estimate of its useful life. An

asset's useful life is defined as "the period of time over which the asset is expected to be used by an

entity."

The telecom license is capable of being used on the date it is purchased, but cannot be used until the

associated network assets necessary are available for use. Amortization of the license should commence

when the associated network assets are available for use.

Which basis of amortization should an operator adopt in respect of its telecom licenses ?

Operator C should amortize the full value of the license on a straight‐line basis over its remaining term of

10 years.

The amortization method should reflect the pattern in which the entity consumes the asset's economic

benefits. The license does not suffer wear and tear from usage (i.e. the number of customers using the

service). The economic benefits of a license relate to C's ability to benefit from the use of the license. The

economic benefit consumed relates to the fact that a period of time has passed and that the useful life of

the license is now shorter by that period. Accordingly the asset depletes on a time basis and the straight‐

line basis of amortization is the most appropriate one. The presumption for intangible assets is that

straight‐line is the most appropriate basis of amortization.




December 12, 2008

3. Operator D purchased a telecom license in 20C for 1 billion. The license has an initial term of 10

years. The license agreement is silent about D's right to renew the license. While D expects to be able to

renew its license at the end of its initial term, it is not known what charge, if any, the government would

make for such a renewal (PWC, Telecom, 122.4).

Over what period should an operator amortize its telecom license ?

Operator D should amortize the full value of the license on a straight‐line basis over 10 years. D plans to

renew the license, but it has no experience of the government renewing telecom licenses. It cannot reliably

determine what amount, if any, would be payable to the government for the renewal of the license, the

likelihood of renewal or any related costs.

4. Operator E purchased a telecom license in 20X0 for 1 billion. The license has an initial term of 10

years. Te license agreement is silent about E's right to renew the license. There is an established practice

of the regulator granting a single renewal of telecom licenses at no additional cost provided operators

adhere to the requirements of the license. The license requires E to meet certain network build

milestones, to provide service to a fixed percentage of the population and to adhere to any new

regulations issued. E has already met the first two criteria and management intends to comply with new

regulations as and when they are issued (PWC, Telecom, 122.5).

Over what period should an operator amortize its telecom license ?

Operator E should amortize the full value of the license on a straight‐line basis over 20 years. There is

experience in E's country of the regulator renewing licenses for one additional term at no cost to the

operator. E has met the conditions of the license and intends to continue to adhere to any additional

requirements the regulator sets out.1.

5. A pharmaceutical entity acquired a compound in development for CU5 million on 1 January

20X3. The entity amortizes its intangible assets on a straight‐line basis over the estimated useful life of the

asset. The entity receives regulatory and marketing approval on 1 March 20 and starts using the

compound in its production process on 1 June 20X4 (PWC, Pharma, 7).

When should it begin amortizing its intangible assets ?

Amortization should begin from 1 March 20X4, because this is the date from which the asset is available

for use. Prior to that date, the intangible asset should be tested for impairment at least annually,

irrespective of whether any indication of impairment exists.

6. Picasso Pharma has acquired a new drug compound, which is currently in phase I clinical

development. Picasso has capitalized the costs for acquiring the new drug compound as an intangible

asset. Subsequently, Picasso's scientists detect that the new drug substance is much more effective when

used in a combination therapy with another drug. Management stops the current development activities

for the new drug. New phase I clinical trials are started for the combination therapy (PWC, Pharma, 49).

How should a pharmaceutical entity amortize an intangible asset related to an acquired early‐stage

project when utilizing the results for development of a drug other than the drug for which the project

was originally acquired ?




December 12, 2008

Picasso should not amortize the intangible asset subsequent to its acquisition, as it is not yet available for

use. Picasso should start amortizing the intangible asset when the combination therapy obtains regulatory

approval and is available for use.

The intangible asset is not impaired by cessation of development of the initial drug compound as a stand‐

alone product. The intangible asset continues to be developed by Picasso, which expects to create more

value with it by using the new drug compound as part of a combination therapy.

7. Raphael & Co has begun commercial production and marketing of an approved product.

Development costs for this product were capitalized in accordance with the criteria specified in IAS 38.

The patent underlying the new product will expire in 10 years (PWC, Pharma, 66).

Once a drug is being used as intended, what is the appropriate method of amortizing the capitalized

development costs ?

Raphael should amortize the capitalized development costs on a straight‐line basis over the patent’s 10‐

year life, unless the business plan indicates use of the patent over a shorter period. Use of the straight‐line

method reflects consumption of benefits available from the patent, which is based upon the passage of

time. If the time over which the patent will generate economic benefits decreases, Raphael should perform

impairment test and a systematic and rational amortization method should be utilized over this shortened

remaining useful life.

8. Raphael & Co has begun commercial production and marketing of an approved product.

Development costs for this product were capitalized in accordance with the criteria specified in IAS 38.

The patent underlying the new product will expire in 10 years; however, Raphael's business plan is to use

the compound in an over‐the‐counter drug after nine years to establish market presence. The business

plan indicates a future economic useful life for the compound of 10 years after patent expiry and supports

separate attribution of the intangible cost to the patent and the compound (PWC, Pharma 67).

Once a drug is being used as intended, what is the appropriate method of amortizing the capitalized

development costs ?

The intangible asset cost should be separately attributed to the patent and the compound. Each of these

intangibles should be amortized on a straight‐line basis. The intangible asset attributable to the paten

should be amortized over its nine‐year expected useful life. The intangible asset attributable to the

compound should be amortized over the full 20‐year life (10 years under patent plus 10years thereafter).

Amortization of both intangibles should be recorded during the first nine years, as both intangible assets

are available for use. Use of the straight‐line method reflects consumption of benefits available from the

patent, which is based upon the passage of time. If the time over which the patent will generate economic

benefits decreases, Raphael should perform impairment testing and a systematic and rational

amortization method should be utilized over this shortened remaining useful life.


Impairment of intangible assets


December 12, 2008

IMPAIRMENT OF INTANGIBLE ASSETS

1. Dali Pharmaceuticals has capitalized external development costs as an intangible asset relating to

a compound that has not been approved. Subsequently, Dali identified side effects associated with the

compound that indicate its value is severely diminished and an impairment charge must be recognized

(PWC, Pharma, 60).

Where should pharmaceutical entities classify impairment charges on development intangible assets

before such assets are available for use ?

Dali should classify the impairment charge relating to the unapproved drug as a component of R&D

expense, if presenting the income statement by function. If presenting the income statement by nature of

expense, Dali should classify the charge as an impairment charge.

2. Dali Pharmaceuticals has capitalized development costs as an intangible asset relating to a drug

that has been approved and is being marketed. Competitive pricing pressure from the early introduction

of generic drugs causes Dali to recognize an impairment of the intangible asset (PWC, Pharma 61).

Where should pharmaceutical entities classify impairment charges on development intangible assets

which are currently marketed ?

The impairment of a marketed product represents the acceleration of amortization. Accordingly, Dali

should classify the impairment consistently with the amortization expense, which is in cost of goods sold if

presenting the income statement by function. If presenting the income statement by nature of expense,

Dali should classify the charge as an impairment charge.

3. By way of a collaboration agreement, Veronese SpA acquired the rights to market a topical

fungicide cream in the Eastern Hemisphere. The acquired rights apply broadly to the entire territory. For

unknown reasons, patients in Greece prove far more likely to develop blisters from use of the cream,

causing Veronese to withdraw the product from that country. As fungicide sales in Greece were not

expected to be significant, loss of the territory, taken in isolation, does not cause the overall net present

value from sales of the drug to be less than its carrying value (PWC, Pharma, 62).

How should pharmaceutical companies account for the rescission of a drug's marketing approval in a

specific territory ?

The cash‐generating unit for the acquired marketing right should be viewed as sales from the entire

Eastern Hemisphere. Accordingly, withdrawal from one territory does not cause the asset’s value in use to

be less than its carrying value and no impairment loss should be recognized.

If Veronese has capitalized any additional development costs specifically for achieving regulatory approval

in Greece, these capitalized development costs must be written off with the withdrawal of the product

from the territory.


Impairment of intangible assets


December 12, 2008

However, Veronese’s management should carefully consider whether the blistering in one jurisdiction is

indicative of potential problems in other territories. If the issue cannot be isolated, a broader impairment

analysis should be performed, including the potential for more wide‐ranging sales losses.

4. Seurat Pharmaceutical acquired a new drug compound, which is currently in phase I clinical

development. Seurat capitalized the costs for acquiring the drug as an intangible asset. Soon after

acquisition of the drug, the results of the clinical trials show that the drug is not likely to be effective for

the intended therapy. Management terminates development of the drug. Seurat's scientists will use

technology directly related to the acquired intangible in developing one of Seurat's other drugs (PWC,

Pharma, 63).

How should a pharmaceutical entity amortise an intangible asset related to an acquired early‐stage

project when utilising the results for development of a drug other than the drug for which the project

was originally acquired ?

Seurat should not start to amortize the intangible asset when it is acquired, as it is not ready for use. The

poor results of the clinical trials indicate that the intangible asset may be impaired. Management must

perform an impairment test on the intangible asset and may have to write it down to the higher of the

compound’s fair value less cost to sell or the value in use of the directly related technology. Amortization

of any remaining carrying value of the intangible asset should occur over the estimated development

period of Seurat’s other drug, as the intangible is linked to the technology being used in the development

of a new drug.

5. Rubens Corp. markets a weight‐loss drug for which development costs have been capitalized. A

competing drug was launched on the market with much lower pricing. Rubens recorded an impairment of

the capitalized development intangible asset due to a reduction in the amounts it estimated that it could

recover as a result of this rival drug. Subsequently, the competing drug was removed from the market

because of safety concerns. The market share and forecast cash flows generated by Ruben's drug

significantly increased (PWC, Pharma, 64).

How should pharmaceutical entities account for reversals of impairment losses for intangible assets

accounted for under the cost model ?

The value in use calculation resulting in the impairment loss included an estimate of market share. An

identifiable change in estimate exists and the previously recorded impairment should be reversed. Rubens

should recalculate the value in use of the drug. The revised carrying value of the intangible asset cannot

exceed the amount, net of amortization, that would have been recognized if no impairment charge had

been recognized.


Subsequent costs


December 12, 2008

SUBSEQUENT COSTS

1. Velazquez Pharma has a registered patent on a currently marketed drug. Uccello Medicines Ltd.

copies the drug's active ingredient and sells the drug during the patent protection period. Velazquez goes

to trial and is likely to win the case, but has to pay costs for its lawyers and other legal charges (PWC,

Pharma, 42).

Should legal costs relating to the defense of pharmaceutical patents be capitalized ?

Velazquez should not capitalize patent defense costs as they maintain rather than increase the expected

future economic benefits from an intangible asset. They therefore do not meet the recognition criteria.

Therefore, patent defense costs have t be expensed as incurred.

2. The Hy‐Tech Services Corporation employs researchers based in countries around the world.

Employee time is the basis upon which charges to many customers are made. The geographically

dispersed nature of its operations makes it extremely difficult for the payroll staff to collect time records,

so the management team authorized the design of an in‐house, Web‐based timekeeping system (Epstein,

pg 303).

a. Determine for the following costs incurred by the project team whether they should be

expensed or capitalized

Cost type Amount Expensed Capitalized

Concept design 2500 X

Evaluation of design alternatives 3 700 X

Determination of required technology 8 100 X

Final selection of alternatives 1 400 X

Software design 28 000 X

Software coding 42 000 X

Quality assurance testing 30 000 X

Data conversion costs 3900 X

Training 14 000 X

Overhead allocation 6 900 X

General and administrative costs 11 200 X

Ongoing maintenance costs 6 000 X

b. Determine the amortization charge to be recognized as soon as all testing is completed. The

estimated useful life of the timekeeping system is five years.

100 000/60 months = 1 666.67


Subsequent costs


December 12, 2008

c. Once operational, management elects to construct another module for the system that issues an

e‐mail reminder for employees to complete their timesheets. This represents significant added

functionality. The following costs are incurred:

Labor type Labor cost Payroll taxes Benefits Total cost

Software developers 11 000 842 1 870 13 712

Quality assurance testers 7 000 536 1 190 8 726

Total 18 000 1 378 3 060 22 438

By the time this additional work is completed, the original system has been in operation for one year.

Should the company capitalize these costs ? If yes, what would be amortization charge ?

The full 22 438 amount of these costs should be capitalized since the work represents significant added

functionality. The additional amortization charge amounts to : 22 438/48 months = 467.46

d. After the system has been operating for two years, a Hy‐tech customer sees the timekeeping

system in action and begs management to sell it as a stand‐alone product. The customer becomes a

distributor, and lands three sales in the first year. From these sales Hy‐Tech receives revenues of 57 000

and incurs the following related expenses:

Distributor commission (25%) 14 250

Service costs 1 900

Installation costs 4 300

Total 20 450

Give the appropriate journal entries

The net proceeds from the software sale is 36 550 (57 000 – 20 450). Rather than recording these

transactions as revenue and expense, the 36 550 net proceeds are offset against the remaining

unamortized balance of the software asset with the following entry:

Dr Revenue 57 000

Cr Intangible assets – software 36 550

Cr Commission expense 14 250

Cr Service expense 1 900

Cr Installation expense 4 300

e. Immediately thereafter, Hy‐Tech’s management receives a sales call from an application service

provider who manages an Internet‐based timekeeping system. The terms offered are so attractive that

Hy‐Tech abandons its in‐house system at once and switches to the server system.

What should the entity do ?


Subsequent costs


December 12, 2008

As a result of this change, the company writes off the remaining unamortized balance of its time‐keeping

system.

Dr Accumulated depreciation 45 610

Dr Loss on asset disposal 40 278

Cr Fixed assets ‐ software 85 888

3. An entity is developing a new production process. During 20X5, expenditure incurred was CU1

000, of which CU900 was incurred before 1 December 20X5 and CU100 was incurred between 1

December 20X5 and 31 December 20X5. The entity is able to demonstrate that, at 1 December 20X5, the

production process met the criteria for recognition as an intangible asset. The recoverable amount of the

know‐how embodied in the process (including future cash outflows to complete the process before it is

available for use) is estimated to be CU500.

When should the entity recognize an intangible asset and for what amount ?

At the end of 20X5, the production process is recognized as an intangible asset at a cost of CU100

(expenditure incurred since the date when the recognition criteria were met, ie 1 December 20X5). The

CU900 expenditure incurred before 1 December 20X5 is recognized as an expense because the recognition

criteria were not met until 1 December 20X5. This expenditure does not form part of the cost of the

production process recognized in the statement of financial position.

During 20X6, expenditure incurred is CU2 000. At the end of 20X6, the recoverable amount of the know‐

how embodied in the process (including future cash outflows to complete the process before it is

available for use) is estimated to be CU1 900.

How should the entity account for the subsequent cost and the recoverable amount ?

At the end of 20X6, the cost of the production process is CU2 100 (CU100 expenditure recognized at the

end of 20X5 plus CU2 000 expenditure recognized in 20X6). The entity recognizes an impairment loss of

CU200 to adjust the carrying amount of the process before impairment loss (CU2 100) to its recoverable

amount (CU1 900). This impairment loss will be reversed in a subsequent period if the requirements for the

reversal of an impairment loss in IAS 36 are met.


Comprehensive case


December 12, 2008

COMPREHENSIVE CASE

1. Bitterfontein plc is a South African mail‐order film developer. Although the photo‐developing business

in South Africa is growing slowly, Bitterfontein plc has reported significant increases in sales and net income in

recent years. While sales increased from 50 mCU in 20X1 to 120 mCU in 20X4, profit increased from 3 mCU to

12 mCU over the same period. The stock market and analysts believe that the company’s future is very

promising. In early 20X5, the company was valued at 350 mCU, which is three times its 20X4 sales and 26 times

its estimated 20X5 profit.

What is the secret of Bitterfontein plc’s success? Company management and many investors attribute the

company’s success to its marketing flair and expertise. Instead of competing on price, Bitterfontein plc prefers

to focus on service and innovation, including

• offering customers a CD of their photos and a set of prints from the same roll of film for a set price • giving customers (at no extra charge) a “picture index” showing mini photos of every photo on the roll • giving every customer a replacement roll (at no extra charge) with every development order.

As a result of such innovations, customers accept prices that are 60% above those of competing discount‐film

developers, and Bitterfontein plc maintains a gross profit margin of around 40%.

Nevertheless, some investors have doubts about the company because they are uneasy about certain

accounting policies it has adopted. For example, Bitterfontein plc capitalizes the costs of its direct mailings to

prospective customers (4,2 mCU at 30 June 20X4) and amortizes them on a straight‐line basis over three years.

This practice is considered to be questionable as there is no guarantee that customers will be obtained and

retained from direct mailings.

In addition to the mailing lists developed by in‐house marketing staff, Bitterfontein plc purchased a customer

list from a competitor for 800 000 CU on 4 July 20X5. This list is also recognized as a non‐current asset.

Bitterfontein plc estimates that this list will generate sales for at least another two years, more likely another

three years. The company also plans to add names, obtained from a telephone survey conducted in August

20X5, to the list. These extra names are expected to extend the list’s useful life by another year.

Bitterfontein plc’s 20X4 statement of financial position also reported 7,5 mCU of marketing costs as non‐

current assets. If the company had expensed marketing costs as incurred, 20X4 net income would have been

10 mCU instead of the reported 12 mCU. The concerned investors are uneasy about this capitalization of

marketing costs, as they believe that Bitterfontein plc’s marketing practices are relatively easy to replicate.

However, Bitterfontein plc argues that its accounting is appropriate. Marketing costs are amortized at an

accelerated rate (55% in the first year, 29% in the second year, and 16% in the third year), based on 15 years

knowledge and experience of customer purchasing behaviour.

Explain how Bitterfontein plc’s costs should be accounted for under IAS 38, giving reasons for your answers

(Alfredson et al.(2007), pg. 478, problem 11.6)

Costs of direct mailings to prospective customer: Under IAS 38 internally generated customer lists and items

similar in substance shall not be recognized as intangible assets.

Accordingly, Bitterfontein plc should:

• Write off all costs capitalised to date; and

• Expense all such costs as incurred from now on.


Comprehensive case


December 12, 2008

Purchased customer list: It meets the asset definition. Bitterfontein plc has control as it has the power to obtain

the future economic benefits flowing from it and can restrict the access of others to it. Future economic

benefits exist in the form of potential sales. It also meets the intangible asset definition, as it is non‐monetary,

has no physical substance, and is identifiable as it can be sold. Assuming that it is probable that future

economic benefits will be obtained from this list, Bitterfontein plc’s treatment is correct – i.e. recognize it as an

intangible asset at cost and then, as the question indicates that Bitterfontein plc has chosen the cost model,

amortise it.

Cost of phone survey conducted after customer list purchased: Under IAS 38 subsequent expenditure on

customer lists and items similar in substance (whether externally acquired or internally generated) is always

expensed as incurred. Hence, Bitterfontein plc should expense the cost of the phone survey.

Marketing costs: They do not meet the asset definition. Bitterfontein plc cannot demonstrate control over he

future economic benefits flowing from them, as it cannot restrict the access of others to those benefits. IAS 38

states that control normally arises from legal rights (e.g. restraint of trade agreements). Without such rights it

is difficult to demonstrate control. Bitterfontein plc’s marketing practices and flair are known to competitors

and accordingly could be replicated.

Hence, Bitterfontein plc should:

• Write off all costs capitalised to date; and

• Expense all such costs as incurred from now on


Annual improvements 2007


December 12, 2008

ANNUAL IMPROVEMENTS 2007

1. Kandinsky Medical recently completed a major study comparing its Alzheimer's drug to

competing drugs. The results of the study were highly favourable and Kandinsky has invested in a

significant new marketing campaign. The campaign will be launched at the January 20X5 International

Alzheimer's Conference. Kandinsky has also paid for direct‐to‐customer (DTC) television advertising which

will appear in February 20X. Related DTC internet advertising will likewise begin in February, and will be

paid based on 'click‐through' to its Alzheimer's site (PWC, Pharma, 78).

How should the marketing campaign costs incurred be treated in its December 20X4 financial

statements ?

Advertising and promotional expenditure should be treated as an expense when incurred. All costs to

develop and to produce the marketing campaign and related materials, including the television

advertisement, internet advertisement and website, should be expensed immediately. Amounts paid to

television broadcast providers should be accounted for as a prepayment and expensed when the

advertisement airs in 20X5. Costs for hits to the company’s internet site should be expensed based upon

the click‐through rate in 20X5.

2. Goya Laboratories is eager to increase knowledge of its new generic pain medication within

hospitals. Accordingly, Goya's sales force distributes free samples of the pain medication during sales calls

and at certain hospital conventions. Additionally, Goya runs a special promotion where hospitals get 13

tablets for the price of 12 (PWC, Pharma, 80).

How should management classify, and account for, the costs of free samples distributed in order to

promote a product ?

The cost of product distributed for free and not associated with any sale transaction should be classified as

marketing expenses. Goya should account for the sample products given away at conventions and during

sales calls as marketing expenses. The product costs should be recognized as marketing expense when the

product is packaged as sample product. The cost of the incremental 13th tablet sold under the special

promotion should be classified as cost of goods sold, as it is related to the overall sales transaction and is

not a free sample.

IFRIC 12 – Service concession arrangements

Scope


December 12, 2008

IFRIC 12 – SERVICE CONCESSION ARRANGEMENTS

SCOPE

Decide for the following scenarios whether IFRIC 12 should be applied or not

1. A construction company has an agreement with the French government to construct a tunnel

through a mountain. The tunnel is constructed on land of the French government, which means that the

French government is the legal owner of the tunnel. During a period of 15 years the company will collect

toll from drivers using the tunnel. The fare is limited to €5 by the French government. During the 15

year‐period the tunnel must be maintained by the construction company. After this period the

government will take over the maintenance.

Proposed solution: this agreement falls within the scope of IFRIC 12: transportation is considered a public

service. The service is regulated, and the residual interest in the asset, which is considered significant, is

controlled by the grantor. The company recognizes an intangible asset.

2. A power company builds a power plant. It contracts a power purchase agreement with the local

government. Through the agreement it is obliged to generate energy for the adjacent city. The

government will pay a fixed capacity payment to the company, if the plant is available, regardless of it

being dispatched. At the end of the 15‐year agreement, the power company can manage its plant at its

sole discretion. The power plant has a useful life of 30 years.

Proposed solution: this agreement does not fall within the scope of IFRIC 12: even though energy

generation is considered a public service, the residual interest in the asset, which is considered significant,

is controlled by the project company.


government. Through the agreement it is obliged to generate energy for the adjacent city. The

government will pay a fixed capacity payment to the company, if the plant is available, regardless of it

being dispatched. At the end of the 25‐year agreement, the power company can manage its plant at its

sole discretion. The power plant has a useful life of 30 years.

Proposed solution: this agreement falls within the scope of IFRIC 12: energy generation is considered a

public service, the service is regulated, and the residual interest in the asset is considered insignificant. The

company recognizes a financial asset.


government. Through the agreement it is obliged to generate energy for the adjacent city. The users will

pay a fixed price per MW acquired to the company. At the end of the 25‐year agreement, the power

company can manage its plant at its sole discretion. The power plant has a useful life of 30 years.

Proposed solution: this agreement falls within the scope of IFRIC 12: energy generation is considered a

public service, the service is regulated, and the residual interest in the asset is considered insignificant. The

company recognizes an intangible asset.


Scope


December 12, 2008


government. Through the agreement it is obliged to generate energy for the adjacent city. The users will

pay a fixed price per MW acquired to the company. At the end of the 15‐year agreement, the power

company can manage its plant at its sole discretion. The power plant has a useful life of 30 years.

Proposed solution: this agreement does not fall within the scope of IFRIC 12: even though energy

generation is considered a public service, the residual interest in the asset, which is considered significant,

is controlled by the project company.


Financial asset/intangible asset


December 12, 2008

FINANCIAL ASSET/INTANGIBLE ASSET

Decide for the following scenarios whether a financial asset or an intangible asset should be recognized

1. A waste incineration company has an agreement with the Belgian government to construct and

operate a waste incineration oven. The company can use this oven to treat any waste collected by the

Belgian municipalities for a period of 20 years. The price paid by the municipalities for waste incineration

is fixed by the government and is reviewed every year. After 20 years, the oven will become the property

of the Belgian government.

Intangible asset since the waste incineration company receives a right (a license) to charge the

municipalities for the use of the incineration oven. The amounts are contingent on the extent that the

municipalities use the service.

2. A privately owned hospital that has an arrangement with the Swiss government to construct,

maintain, and operate a division for AIDS patients for 20 years. Under the arrangement, the hospital is

paid by the patients for care but if patients cannot afford to pay for the care the Swiss government

reimburses the hospital. The payments should at least cover the cost of the infrastructure, the

maintenance of the infrastructure and the variable costs of the care. In addition, if there are not

sufficient payments by the patients to cover the fixed cost of the hospital, the government will

compensate for those costs. At the end of the concession period the infrastructure either reverts to the

government or the concession is renewed.

Financial asset since the hospital has an unconditional right to receive cash from the government if the

patients do not pay, or receipts from the patients are insufficient to cover costs.

3. A construction company has an agreement with grantor Spain to construct a road and maintain

and operate the road for twelve years. Under the contract, the company will be paid an annual amount,

with the total to be paid over the arrangement being equal to 70% of the total costs to be incurred. The

company will be able to charge users a toll, which is capped by the grantor.

Bifurcated model: The company will have to account separately for each component of the consideration.

It will recognize a financial asset and an intangible asset measured initially at the fair values of the

considerations received or receivable. The consideration to be received from the grantor will lead to a

financial asset. The excess of the costs incurred over the financial asset should be recognized as an

intangible asset


Accounting for service concession arrangements


December 12, 2008

ACCOUNTING FOR SERVICE CONCESSION ARRANGEMENTS

Arrangement terms:

Cost of construction: 100

Profit on construction: 10

Cash flows over life: 200

A. Financial Asset Model

Assume that the interest revenue to be recognized over the life of the contract (based on the effective interest

rate method in accordance with IAS 39 – Financial Instruments: Recognition and Measurement) is 10.

During construction:

Dr Financial asset 110

Cr Revenue 110

Dr Cost of construction 100

Cr Cash 100

In accordance with IAS 39, the entity recognizes a financial asset at the fair value of the construction and

recognizes the cost of the construction. Revenue of 110, costs of 100 and a profit of 10 is thus recognized

during the construction.

During operational phase:


Cr Finance revenue 10


Cr Revenue 80

Dr Cash 200

Cr Financial asset 200

Total revenue over the life of the contract: 200

Total cash flows over the life of the contract: 200

Over the life of the construction period the financial asset is measured using the effective interest method. In

this example, the finance revenue recognized under this method is 10. The excess of the total cash flows over

the life of the contract (200) over the carrying amount of the financial asset (110+10=120), is recognized as

revenue (80). When cash is received the financial asset is credited. Total Revenue of 90 is therefore

recognized during the operational phase. (NB: This is a simplified example. Concession arrangements will

normally also incorporate significant running costs during the life of the concession).

B. Intangible Asset Model


Dr Construction costs 100




December 12, 2008

Cr Cash 100

Dr Intangible asset 110

Cr Revenue 110

During the construction, the cost of the construction services provided is recognized as work in process and

then a subsequent exchange transaction of construction WIP for an intangible asset is recognized at the fair

value of the constructions services provided. This gives revenue of 110, costs of 100 and a profit of 10 during

the construction.


Dr Amortization expense 110

Cr Intangible asset 110

Dr Cash 200

Cr Revenue 200



During the life of the concession the intangible asset is amortized and the cash flows are recognized as

revenue. This means that during the operational phase of the service concession arrangement 110 of

concession costs are recognized and 200 of revenue is recognized. This leads to a profit of 90 during the

operational phase of the contract.

C. Bifurcated Model

Additional information: Cash flows guaranteed by the government are 60, which is 54% of the fair value of the

construction. Assume that the interest revenue that should be recognized over the life of the contract (based

on the effective interest rate in accordance with IAS 39 – Financial Instruments: Recognition and

Measurement) is 6.


Dr Receivable 60

Cr Revenue 60

A financial asset of 60, equal to the cash flows guaranteed by the government, is recognized as construction

services are provided.

Dr Cost (exp) 54

Dr Construction WIP 46

Cr Cash 100

Since the government guarantees 54% of the fair value of the construction, a cost of 54 related to the financial

asset is recognized during the course of construction in the income statement. The remaining part of the

construction costs (100‐54=46) are considered to be costs that are related to acquisition of the intangible

asset.

Dr Intangible asset 50

Cr Revenue 50




December 12, 2008

An intangible asset is recognized for the difference between the fair value of the construction (110) and the

value of the financial asset (60).

Dr Cost of sales 46

Cr WIP 46

The construction cost related to the construction of the intangible asset is recognized as cost of sales. During

the construction the entity recognizes revenue of 110, costs of 100 and profit of 10.



Cr Finance revenue 6

The financial asset is measured in accordance with the effective interest method.

Dr Amortization expense 50

Cr Intangible asset 50

The intangible asset is amortized.

Dr Cash 200

Cr Revenue 134

Cr Financial asset 66

The cash received is split between revenue and the reduction of the receivable (60+6).

During the operational phase of the contract the entity recognizes revenue of 140, costs of 50 and profit of 90.



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