Certificate in Accounting and Finance

Financial accounting and reporting II

CHAPTER
8
IAS 36: Impairment of assets

Contents
1 Impairment of assets
2 Cash generating units

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Financial accounting and reporting II

INTRODUCTION
Objective
To broaden the knowledge base of basic accounting acquired in earlier modules with emphasis on
International Financial Reporting Standards.

Learning outcomes
LO 2 Account for transactions relating to tangible and intangible assets including
transactions relating to their common financing matters and their impairment

LO2.4.1: IAS 36: Impairment of Assets: Identify and assess the circumstances when the assets may be
impaired.
LO2.4.2: IAS 36: Impairment of Assets: Discuss the measurement of recoverable amount.
LO2.4.3: IAS 36: Impairment of Assets: Identify a cash-generating unit and assess its recoverable
amount, including its components.
LO2.4.4: IAS 36: Impairment of Assets: Account for the related impairment expenses (excluding
accounting for reversal of impairment).

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 Chapter 8: IAS 36: Impairment of assets

1 IMPAIRMENT OF ASSETS

Section overview

„ Objective and scope of IAS 36

„ Identifying impairment or possible impairment
„ Measuring recoverable amount
„ Accounting for impairment
„ Summary of the approach

1.1 Objective and scope of IAS 36

An asset is said to be impaired when its recoverable amount is less than its carrying amount in
the statement of financial position.
From time to time an asset may have a carrying value that is greater than its fair value but this is
not necessarily impairment as the situation might change in the future. Impairment means that
the asset has suffered a permanent loss in value.
The objective of IAS 36 Impairment of assets is to ensure that assets are ‘carried’ (valued) in
the financial statements at no more than their recoverable amount.
Scope of IAS 36
IAS 36 applies to accounting for impairment of all assets except the following:
‰ inventories (IAS 2: Inventories);
‰ assets arising from contracts with customers that are recognised in accordance with IFRS
15: Revenue from contracts with customers.
‰ deferred tax assets (IAS 12: Income taxes);
‰ assets arising from employee benefits (IAS 19: Employee Benefits);
‰ financial assets (IAS 39: Financial assets: recognition and measurement; IFRS 9: Financial
instruments);
‰ Financial assets recognised and measured in accordance with IFRS 10: Consolidated
financial statements, IAS 27: Separate financial statements and IAS 28: Investments in
associates and joint ventures;
‰ investment property that is measured at fair value (IAS 40: Investment property);
‰ biological assets related to agricultural activity within the scope of IAS 41: Agriculture that
are measured at fair value less costs to sell;
‰ deferred acquisition costs, and intangible assets, arising from an insurer’s contractual
rights under insurance contracts within the scope of IFRS 4: Insurance contracts (but note
that the IAS 38 disclosure requirements do apply to those intangible assets); and
‰ non-current assets classified as held for sale (or included in a disposal group that is
classified as held for sale) (IFRS 5: Non-current assets held for sale and discontinued
operations).
IAS 36 does apply to financial assets classified as:
‰ subsidiaries (IFRS 10: Consolidated financial statements);
‰ associates (IAS 28: Investments in associates and joint ventures); and
‰ joint ventures (IFRS 11: Joint arrangements).

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Financial accounting and reporting II

Recoverable amount of assets

Definitions
The recoverable amount of an asset is defined as the higher of its fair value minus costs of
disposal, and its value in use.
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.
Value in use is the present value of future cash flows from using an asset, including its eventual
disposal.
Impairment loss is the amount by which the carrying amount of an asset (or a cash-generating
unit) exceeds its recoverable amount.

Cash-generating units will be explained later.

Stages in accounting for an impairment loss
There are various stages in accounting for an impairment loss:
Stage 1: Establish whether there is an indication of impairment.
Stage 2: If so, assess the recoverable amount.
Stage 3: Write down the affected asset (by the amount of the impairment) to its recoverable
amount.
Each of these stages will be considered in turn.

1.2 Identifying impairment or possible impairment

An entity must carry out an impairment review when there is evidence or an indication that
impairment may have occurred. At the end of each reporting period, an entity should assess
whether there is any indication that impairment might have occurred. If such an indication exists,
the entity must estimate the recoverable amount of the asset, in order to establish whether
impairment has occurred and if so, the amount of the impairment.
Indicators of impairment
The following are given by IAS 36 as possible indicators of impairment. These may be
indicators outside the entity itself (external indicators), such as market factors and changes in the
market. Alternatively, they may be internal indicators relating to the actual condition of the asset
or the conditions of the entity’s business operations.
When assessing whether there is an indication of impairment, IAS 36 requires that, at a
minimum, the following sources are considered:

External sources Internal sources

An unexpected decline in the asset’s market Evidence that the asset is damaged or no
value. longer of use to the entity.
Significant changes in technology, markets, There are plans to discontinue or restructure
economic factors or laws and regulations that the operation for which the asset is currently
have an adverse effect on the company. used.
An increase in interest rates, affecting the There is a reduction in the asset’s expected
value in use of the asset. remaining useful life.
The company’s net assets have a higher There is evidence that the entity’s expected
carrying value than the company’s market performance is worse than expected.
capitalisation (which suggests that the assets
are over-valued in the statement of financial
position).

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 Chapter 8: IAS 36: Impairment of assets

Internal indicators for impairment are generally refers to items under control of management
while external indicators are outside the control of management.
If there is an indication that an asset (or cash-generating unit) is impaired then it is tested for
impairment. This involves the calculating the recoverable amount of the item in question and
comparing this to its carrying amount.
Additional requirements for testing for impairment
The following assets must be reviewed for impairment at least annually, even when there is no
evidence of impairment:
‰ an intangible asset with an indefinite useful life; and
‰ goodwill acquired in a business combination.

1.3 Measuring recoverable amount

It has been explained that recoverable amount is the higher of an asset’s:
‰ fair value less costs of disposal; and
‰ its value in use.
If either of these amounts is higher than the carrying value of the asset, there has been no
impairment.
IAS 36 sets out the requirements for measuring ‘fair value less costs of disposal’ and ‘value in
use’.
Measuring fair value less costs of disposal
Fair value is normally market value. If no active market exists, it may be possible to estimate the
amount that the entity could obtain from the disposal.
Direct selling costs normally include legal costs, taxes and costs necessary to bring the asset into
a condition to be sold. However, redundancy and similar costs (for example, where a business is
reorganised following the disposal of an asset) are not direct selling costs.
Calculating value in use
Value in use represents the present value of the expected future cash flows from use of the
asset, discounted at a suitable discount rate or cost of capital.
The following elements should be reflected in the calculation of an asset’s value in use:
x An estimate of the future cash flows the entity expects to derive from the asset
x Expectations about possible variations in the amount or timing of those future cash flows
x The time value of money (represented by the current market risk-free rate of interest)
x The price for bearing the uncertainty inherent in the asset
x Other factors that market participants would reflect in pricing the future cash flows the entity
expects to derive from the asset.
Estimates of future cash flows should be based on reasonable and supportable assumptions that
represent management’s best estimate of the economic conditions that will exist over the
remaining useful life of the asset.
Estimates of future cash flows must include:
‰ cash inflows from the continuing use of the asset;
‰ cash outflows that will be necessarily incurred to generate the cash inflows from continuing
use of the asset; and

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Financial accounting and reporting II

‰ net disposal proceeds at the end of the asset’s useful life.

Estimates of future cash flows must not include:
‰ cash inflows or outflows from financing activities; or
‰ income tax receipts or payments.
Also note that future cash flows are estimated for the asset in its current condition. Therefore,
any estimate of future cash flows should not include estimated future cash flows that are
expected to arise from:
‰ a future restructuring to which an entity is not yet committed; or
‰ improving or enhancing the asset’s performance.
The discount rate must be a pre-tax rate that reflects current market assessments of:
‰ the time value of money; and
‰ the risks specific to the asset for which the future cash flow estimates have not been
adjusted.
However, both the expected future cash flows and the discount rate might be adjusted to allow
for uncertainty about the future – such as the business risk associated with the asset and
expectations of possible variations in the amount or timing of expected future cash benefits from
using the asset.

Example: Measurement of recoverable amount

A company has a machine in its statement of financial position at a carrying amount of
Rs.300,000.
The machine is used to manufacture the company’s best-selling product range, but the entry of a
new competitor to the market has severely affected sales.
As a result, the company believes that the future sales of the product over the next three years
will be only Rs.150,000, Rs.100,000 and Rs.50,000. The asset will then be sold for Rs.25,000.
An offer has been received to buy the machine immediately for Rs.240,000, but the company
would have to pay shipping costs of Rs.5,[Link] risk-free market rate of interest is 10%.
Market changes indicate that the asset may be impaired and so the recoverable amount for the
asset must be calculated.
Fair value less costs of disposal Rs.
Fair value 240,000
Costs of disposal (5,000)
235,000
Year Cash flow (Rs.000) Discount factor Present value
1 150,000 1/1.1 136,364
2 100,000 1/1.12 82,645
3 50,000 + 25,000 1/1.13 56,349
Value in use 275,358
The recoverable amount is the higher of Rs.235,000 and Rs.275,358, i.e. Rs.275,358.
The asset must be valued at the lower of carrying value and recoverable amount.
The asset has a carrying value of Rs.300,000, which is higher than the recoverable amount
from using the asset.
It must therefore be written down to the recoverable amount, and an impairment of
Rs.24,642 (Rs.300,000 – Rs.275,358) must be recognised.

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 Chapter 8: IAS 36: Impairment of assets

1.4 Accounting for impairment

The impairment loss is normally recognised immediately in profit or loss.

Example: Measurement of recoverable amount

A company has a machine in its statement of financial position at a carrying amount of
Rs.300,000.
The machine has been tested for impairment and found to have recoverable amount of
Rs.275,358 meaning that the company must recognise an impairment loss of Rs.24,642.
This is accounted for as follows:

Debit Credit
Statement of profit or loss 24,642
Accumulated impairment loss 24,642
(Property, plant and equipment would be
presented net of the balance on this
account on the face of the statement of
financial position).

Practice question 1
On 1 January Year 1 Entity Q purchased for Rs.240,000 a machine with an estimated useful
life of 20 years and an estimated zero residual value.
Depreciation is on a straight-line basis.
On 1 January Year 4 an impairment review showed the machine’s recoverable amount to be
Rs.100,000 and its remaining useful life to be 10 years.
Calculate:
a) The carrying amount of the machine on 31 December Year 3 (immediately before the
impairment).
b) The impairment loss recognised in the year to 31 December Year 4.
c) The depreciation charge in the year to 31 December Year [Link])

However, an impairment loss recognised in respect of an asset carried at a previously

recognised revaluation surplus is recognised in other comprehensive income to the extent that it
is covered by that surplus. Thus it is treated in the same way as a downward revaluation,
reducing the revaluation reserve balance relating to that asset.
Impairment not covered by a previously recognised surplus on the same asset is recognised in
profit or loss.

Example: Measurement of recoverable amount

A company has a machine in its statement of financial position at a carrying amount of
Rs.300,000 including a previously recognised surplus of Rs.20,000.
The machine has been tested for impairment and found to have recoverable amount of
Rs.275,358 meaning that the company must recognise an impairment loss of Rs.24,642.

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Financial accounting and reporting II

Example: Measurement of recoverable amount (continued)

This is accounted for as follows:

Debit Credit
Statement of profit or loss 4,642
Other comprehensive income 20,000
Property, plant and equipment 24,642

Following the recognition of the impairment, the future depreciation of the asset must be based
on the revised carrying amount, minus the residual value, over the remaining useful life.

Practice question 2
On 1 January Year 1 Entity Q purchased for Rs.240,000 a machine with an estimated useful
life of 20 years and an estimated zero residual value.
Depreciation is on a straight-line basis.
The asset had been re-valued on 1 January Year 3 to Rs.250,000, but with no change in
useful life at that date.
On 1 January Year 4 an impairment review showed the machine’s recoverable amount to be
Rs.100,000 and its remaining useful life to be 10 years.
Calculate:
a) The carrying amount of the machine on 31 December Year 2 and hence the
revaluation surplus arising on 1 January Year 3.
b) The carrying amount of the machine on 31 December Year 3 (immediately before the
impairment).
c) The impairment loss recognised in the year to 31 December Year 4.
d) The depreciation charge in the year to 31 December Year 4.

1.5 Summary of the approach

Impairment of an asset should be identified and accounted for as follows:
(1) At the end of each reporting period, the entity should assess whether there are any
indications that an asset may be impaired.
(2) If there are such indications, the entity should estimate the asset’s recoverable amount.
(3) When the recoverable amount is less than the carrying value of the asset, the entity should
reduce the asset’s carrying value to its recoverable amount. The amount by which the
value of the asset is written down is an impairment loss.
(4) This impairment loss is recognised as a loss for the period.
(5) However, if the impairment loss relates to an asset that has previously been re-valued
upwards, it is first offset against any remaining revaluation surplus for that asset. When
this happens it is reported as other comprehensive income for the period (a negative
value) and not charged against profit.
(6) Depreciation charges for the impaired asset in future periods should be adjusted to
allocate the asset’s revised carrying amount, minus any residual value, over its remaining
useful life (revised if necessary).

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 Chapter 8: IAS 36: Impairment of assets

2 CASH GENERATING UNITS

Section overview

„ Cash-generating units
„ Allocating an impairment loss to the assets of a cash-generating unit

2.1 Cash-generating units

It is not always possible to calculate the recoverable amount of individual assets. Value in use
often has to be calculated for groups of assets because assets may not generate cash flows in
isolation from each other. An asset that is potentially impaired may be part of a larger group of
assets which form a cash-generating unit.
IAS 36 defines a cash-generating unit (CGU) as the smallest identifiable group of assets that
generates cash inflows that are largely independent of the cash inflows from other assets or
groups of assets.
Goodwill
The existence of cash-generating units may be particularly relevant to goodwill acquired in a
business combination. Purchased goodwill must be reviewed for impairment annually, and the
value of goodwill cannot be estimated in isolation. Often, goodwill relates to a whole business.
It may be possible to allocate purchased goodwill across several cash-generating units. If
allocation is not possible, the impairment review is carried out in two stages:
1 Carry out an impairment review on each of the cash-generating units (excluding the
goodwill) and recognise any impairment losses that have arisen.
2 Then carry out an impairment review for the entity as a whole, including the goodwill.

2.2 Allocating an impairment loss to the assets of a cash-generating unit

When an impairment loss arises on a cash-generating unit, the impairment loss is allocated
across the assets of the cash-generating unit in the following order:
‰ first, to the goodwill allocated to the cash-generating unit; then
‰ to the other assets in the cash-generating unit, on a pro-rata basis (i.e. in proportion to the
carrying amount of the assets of the cash-generating unit).
However, the carrying amount of an asset cannot be reduced below the highest of:
‰ its fair value less costs of disposal (if determinable);
‰ its value in use (if determinable); and
‰ zero.

Example: Allocation of impairment loss in cash-generating unit

A cash-generating unit is made up of the following assets.

Rs.m

Property, plant and equipment 90

Goodwill 10
Other assets 60
160
The recoverable amount of the cash-generating unit has been assessed as Rs.140 million.

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Financial accounting and reporting II

Example: Allocation of impairment loss in cash-generating unit (continued)

The impairment loss would be allocated across the assets of the cash-generating unit as follows:
There is a total impairment loss of Rs.20 million (= Rs.160m – Rs.140m). Of this, Rs.10 million is
allocated to goodwill, to write down the goodwill to Rs.0. The remaining Rs.10 million is then
allocated to the other assets pro-rata.
Therefore:
Rs.6 million (= Rs.10m × 90/150) of the impairment loss is allocated to property, plant and
equipment, and
Rs.4 million (= Rs.10m × 60/150) of the loss is allocated to the other assets in the unit.
The allocation has the following result:
Before Impairment After loss
loss loss
Rs.m Rs.m Rs.m

Property, plant and equipment 90 (6) 84

Goodwill 10 (10) 
Other assets 60 (4) 56
160 (20) 140

Example:
A Cash Generating Unit holds the following assets:
Rs. in million
Goodwill 4
Patent 8
Property, plant and equipment 12
Total 24
An annual impairment review is required as the CGU contains goodwill. The most recent review
assesses its recoverable amount to be Rs.18,000,000. An impairment loss of Rs.6,000,000 has
been incurred and is recognised in the statement of comprehensive income. First, the entity
reduces the carrying amount of goodwill. As the impairment loss exceeds the value of goodwill
within the CGU, all the goodwill is written off. The entity then reduces the amount of other assets
on a pro rata basis. Hence the remaining loss of Rs.2,000,000 should be allocated pro rata
between the property, plant and equipment and the patent. Revised balances should be as
follows:
Rs. in m
Goodwill (4 -4) –
Patent 8 - (8/20 x 2) 7.2
Property, plant and equipment [12 – (12/20 x 2)] 10.8
Total 18.0

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 Chapter 8: IAS 36: Impairment of assets

SOLUTIONS TO PRACTICE QUESTIONS

Solution 1
On 31 December Year 3 the machine was stated at the following amount:

a) Carrying amount of the machine on 31 December Year 3 Rs

Cost 240,000
Accumulated depreciation (3 × (240,000 ÷ 20 years)) (36,000)
Carrying amount 204,000
b) Impairment loss at the beginning of Year 4 of Rs.104,000 (Rs.204,000 – Rs.100,000).
This is charged to profit or loss.

c) Depreciation charge in Year 4 of Rs.10,000 (= Rs.100,000 ÷ 10). The depreciation

charge is based on the recoverable amount of the asset.

Solution 2
a) Carrying amount on Rs.
Cost 240,000
Accumulated depreciation at 1 January Year 3
(2 years × (240,000 ÷ 20)) (24,000)
Carrying amount 216,000
Valuation at 1 January Year 3 250,000
Revaluation surplus 34,000
b) When the asset is revalued on 1 January Year 3, depreciation is charged on the
revalued amount over its remaining expected useful life.
On 31 December Year 3 the machine was therefore stated at:
Rs.
Valuation at 1 January (re-valued amount) 250,000
Accumulated depreciation in Year 3 (= Rs.250,000 ÷ 18)) (13,889)
Carrying amount 236,111
Note: The depreciation charge of Rs.13,889 is made up of Rs.12,000 (being that part
of the charge that relates to the original historical cost) and Rs.1,889 being the
incremental depreciation.
Rs.1,889 would be transferred from the revaluation surplus into retained earnings.
c) On 1 January Year 4 the impairment review shows an impairment loss of Rs.136,111
(Rs.236,111 – Rs.100,000).
An impairment loss of Rs.32,111 (Rs.34,000  Rs.1,889) will be taken to other
comprehensive income (reducing the revaluation surplus for the asset to zero).
The remaining impairment loss of Rs.104,000 (Rs.136,111  Rs.34,000) is
recognised in the statement of profit or loss for Year 4.
d) Year 4 depreciation charge is Rs.10,000 (Rs.100,000 ÷ 10 years).

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Financial accounting and reporting II

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 Certificate in Accounting and Finance

CHAPTER
Financial accounting and reporting II

9
IAS 38: Intangible assets

Contents
1 IAS 38: Intangible assets – Introduction
2 Internally-generated intangible assets
3 Intangible assets acquired in a business combination
4 Measurement after initial recognition
5 Disclosure requirements

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Financial accounting and reporting II

INTRODUCTION

Learning outcomes
The overall objective of the syllabus is to broaden the knowledge base of basic accounting acquired in earlier
modules with emphasis on International Financial Reporting Standards.

LO 2 Account for transactions relating to tangible and intangible assetsincluding

transactions relating to their common financing matters.
LO2.1.1 Explain and apply the accounting treatment of property, plant and equipment and intangible
assets.
LO2.1.2 Formulate accounting policies in respect of property, plant and equipment and intangible
assets

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 Chapter 9: IAS 38: Intangible assets

1 IAS 38: INTANGIBLE ASSETS - INTRODUCTION

Section overview

„ Introduction
„ Definition of an intangible asset
„ Recognition criteria for intangible assets
„ Separate acquisition
„ Exchange transactions
„ Granted by government
„ Subsequent expenditure on intangible assets

1.1 Introduction
An intangible asset is non-physical asset that has a useful life of greater than one year or
has an indefinite useful life. IAS 38: Intangible assets sets out rules on the recognition,
measurement and disclosure of intangible assets. It was developed from the viewpoint that there
should be no real difference in how tangible and intangible assets are accounted for. However,
there is an acknowledgement that it can be more difficult to identify the existence of an intangible
asset so IAS 38 gives broader guidance on how to do this when an intangible asset is acquired
through a variety of means.
IAS 38:
‰ requires intangible assets to be recognised in the financial statements if, and only if,
specified criteria are met and explains how these are applied however an intangible asset
is acquired.
x A key issue with expenditure on ‘intangible items’ is whether it should be treated as
an expense and included in full in profit or loss for the period in which incurred, or
whether it should be capitalised and treated as a long-term asset.
x IAS 38 sets out criteria to determine which of these treatments is appropriate in
given circumstances.
‰ explains how to measure the carrying amount of intangibles assets when they are first
recognised and how to measure them at subsequent reporting dates;
x Most types of long-term intangible asset are ‘amortised’ over their expected useful
life. (Amortisation of intangible assets is the equivalent of depreciation of tangible
non-current assets.)
‰ sets out disclosure requirements for intangible assets in the financial statements.

1.2 Definition of an intangible asset

Definitions
An asset: A resource controlled by the company as a result of past events and from which future
economic benefits are expected to flow.
Intangible asset: An identifiable, non-monetary asset without physical substance’

Expenditure on an intangible item must satisfy both definitions before it can be considered to be
an asset.

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Financial accounting and reporting II

Commentary on the definitions

Control
The existence of control is useful in deciding whether an intangible item meets the criteria for
treatment as an asset.
Control means that a company has the power to obtain the future economic benefits flowing from
the underlying resource and also can restrict the access of others to those benefits.
Control would usually arise where there are legal rights, for example legal rights over the use of
patents or copyrights. Ownership of legal rights would indicate control over them. However, legal
enforceability is not a necessary condition for control.
For tangible assets such as property, plant and equipment, the asset physically exists and the
company controls it. However, in the case of an intangible asset, control may be harder to
achieve or prove.
In the absence of legal rights to protect, an entity usually has insufficient control over the
expected future economic benefits, for example, a team of skilled staff, or customer relationships
and loyalty.
Some companies have tried to capitalise intangibles such as the costs of staff training or
customer lists on the basis that they provide access to future economic benefits. However, these
would not be assets as they are not controlled.
‰ Staff training: Staff training creates skills that could be seen as an asset for the employer.
However, staff could leave their employment at any time, taking with them the skills they
have acquired through training.
‰ Customer lists: Similarly, control is not achieved by the acquisition of a customer list, since
most customers have no obligation to make future purchases. They could take their
business elsewhere.

Illustration: Team of skilled staff

A company might have a team of skilled staff and may be able to identify incremental staff
skills leading to future economic benefits from training and expect that the staff will
continue to make their skills available to the company.
However, staff could leave their employment at any time, taking with them the skills they
have acquired through training. Therefore, a company usually has insufficient control over
the expected future economic benefits for these items to meet the definition of an
intangible asset.

Illustration: Customer lists

A company may have a portfolio of customers which it expects to continue to trade with the
company. In the absence of legal rights to protect the relationship, the company usually has
insufficient control over the expected economic benefits to meet the definition of an
intangible asset.
However, exchange transactions for the same or similar non-contractual customer
relationships provide evidence that the company is able to control those benefits in the
absence of such legal rights.
Such exchange transactions also provide evidence that the customer relationship is
separable so, thus meeting the intangible asset definition.
This means that a purchased customer list would usually be capitalised.

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 Chapter 9: IAS 38: Intangible assets

Future economic benefits

These may include revenues and/or cost savings.
Evidence of the probability that economic benefits will flow to the company may come from:
‰ market research;
‰ feasibility studies; and,
‰ a business plan showing the technical, financial and other resources needed and how the
company will obtain them.

Need to be identifiable
An intangible asset must also be ‘identifiable’. Intangibles, by their very nature, do not physically
exist. It is therefore important that this ‘identifiability test’ is satisfied.
IAS 38 states that to be identifiable an intangible asset:
‰ must be separable; or
‰ must arise from contractual or other legal rights.
To be separable, the intangible must be capable of being separated or divided from the
company, and sold, transferred, licensed, rented or exchanged.
Many typical intangibles such as patent rights, copyrights and purchased brands would meet this
test, (although they might fail other recognition criteria for an intangible asset).

Without physical substance

Non-physical form increases the difficulty of identifying the asset.
Certain intangible assets may be contained in or upon an article which has physical substance
(e.g. floppy disc). Whether such assets are treated as tangible or intangible requires. This
judgement is based on which element is the most significant.
‰ Computer software for a computer controlled machine tool that cannot operate without that
specific software is an integral part of the related hardware and it is treated as property,
plant and equipment. The same applies to the operating system of a computer.
‰ Computer software, other than the operating system, is an intangible asset. The same
applies to licences, patents or motion picture films acquired or internally generated by the
reporting company.
Identifiable assets that result from research and development activities are intangible assets
because any physical element of those assets (for example, a prototype) is secondary to the
knowledge that is the primary outcome of those activities.

Example:
Ateeq Ltd acquires new technology that will significantly reduce its energy costs for
manufacturing. Costs incurred include:
Amount in Rs.
Cost of new technology 1,500,000
Trade discount provided 200,000
Training course for staff in new technology 70,000
Initial testing of new technology 20,000
Losses incurred while other parts of plant shutdown
during testing and training. 30,000

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Financial accounting and reporting II

Example: (continued)

The cost that can be capitalised is:

Cost of a new technology 1,500,000
Less discount (200,000)
Plus initial testing 20,000
1,320,000

The prominent types of intangibles are described below:

Patent
Patent rights entitle their owners, for limited period of time, the monopoly to manufacture or use a
certain product or process.
Trademark
Trademarks are the exclusive rights to proprietary symbols, names, and other unique properties
of a product, such as packaging, style, and even color in some instances.
Copyright
Copyrights represent the legal right on both published and unpublished work of an author to sell,
copy, or perform a piece of literary, musical, or art work. Copyrights protect the works
from reproduction or derivative use without the consent from the copyright owner (usually the
author or publisher).
License
Licenses are the contractual rights to use another's property, whether it be a patent, trademark,
copyright, lease or exploration for natural resources.
Franchise
Franchises provide their holders with the right to practice a certain kind of business in a certain
geographical location as sanctioned by the franchiser. Fast-food restaurants, for example, often
expand by selling franchise rights.
Goodwill
Goodwill refers to the price or value above the market value of the tangible assets of a company.
When a company is bought, the price paid will often be higher than the market value of its
facilities, equipment, inventory etc. A company develops this intangible asset by establishing a
strong business track record, credit rating, reputation and name.

1.3 Recognition criteria for intangible assets

Introduction

If an intangible item satisfies the definitions it is not necessarily recognised in the financial
statements. In order to be recognised it must satisfy the recognition criteria for intangible assets.
If an item meets the definitions of being an asset, and being intangible, certain recognition criteria
must be applied to decide whether the item should be recognised as an intangible asset.

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 Chapter 9: IAS 38: Intangible assets

Recognition
An intangible asset is recognised when it:
‰ complies with the definition of an intangible asset; and,
‰ meets the recognition criteria set out below.

Recognition criteria
An intangible asset must be recognised if (and only if):
‰ it is probable that future economic benefits specifically attributable to the asset will flow to
the company; and,
‰ the cost of the asset can be measured reliably.
The probability of future economic benefits must be assessed using reasonable and supportable
assumptions that represent management’s best estimate of the set of economic conditions that
will exist over the useful life of the asset.
These recognition criteria are broadly the same as those specified in IAS 16 for tangible non-
current assets.

Measurement
An intangible asset must be measure at cost when first recognised.

Means of acquiring intangible assets

A company might obtain control over an intangible resource in a number of ways. Intangible
assets might be:
‰ purchased separately;
‰ acquired in exchange for another asset;
‰ given to a company by way of a government grant.
‰ internally generated; or
‰ acquired in a business combination;
IAS 38 provides extra guidance on how the recognition criteria are to be applied and/or how the
asset is to be measured in each circumstance.

1.4 Separate acquisition

Recognition guidance
The probability recognition criterion is always satisfied for separately acquired intangible assets.
The price paid to acquire separately an intangible asset normally reflects expectations about the
probability that the future economic benefits embodied in the asset will flow to the company. The
effect of the probability is reflected in the cost of the asset.
Also the cost of a separately acquired intangible asset can usually be measured reliably
especially when the purchase consideration is in the form of cash or other monetary assets.

Cost guidance
Cost is determined according to the same principles applied in accounting for other assets.
The cost of a separately acquired intangible asset comprises:
‰ its purchase price, including any import duties and non-refundable purchase taxes, after
deducting any trade discounts and rebates; and
‰ any directly attributable expenditure on preparing the asset for its intended use. For
example:

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Financial accounting and reporting II

x costs of employee benefits (as defined in IAS 19, Employee Benefits) arising directly
from bringing the asset to its working condition;
x professional fees for legal services; and
x costs of testing whether the asset is functioning properly.
The recognition of costs ceases when the intangible asset is in the condition necessary for it to
be capable of operating in the manner intended by management.
Deferred payments are included at the cash price equivalent and the difference between this
amount and the payments made are treated as interest.

1.5 Exchange transactions

An intangible asset may be acquired in exchange or part exchange for another intangible asset
or another asset.
The cost of such items is measured at fair value unless:
‰ the exchange transaction lacks commercial substance; or,
‰ the fair value of neither the asset received nor the asset given up is reliably measurable.
If the acquired item is not measured at fair value it is measured at the carrying amount of the
asset given up.
Note, that these rules are the same as those described for tangible assets in an earlier chapter.

1.6 Granted by government

A government transfers or allocates intangible assets such as airport landing rights, licences to
operate radio or television stations, import licences or quotas or rights to access other restricted
resources.
An intangible asset may be acquired free of charge, or for nominal consideration, by way of a
government grant.
IAS 20: Accounting for Government Grants and Disclosure of Government Assistance, allows the
intangible asset and the grant to be recorded at fair value initially or at a nominal amount plus
any expenditure that is directly attributable to preparing the asset for its intended use.

1.7 Subsequent expenditure on intangible assets

Subsequent expenditure is only capitalised if it can be measured and attributed to an asset and
enhances the value of the asset. This would rarely be the case:
‰ The nature of intangible assets is such that, in many cases, there are no additions to such
an asset or replacements of part of it.
‰ Most subsequent expenditure is likely to maintain the expected future economic benefits
embodied in an existing intangible asset rather than meet the definition of an intangible
asset and the recognition criteria.
‰ Also it is often difficult to attribute subsequent expenditure directly to a particular intangible
asset rather than to the business as a whole.
Maintenance expenditure is expensed out in profit or loss account.

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 Chapter 9: IAS 38: Intangible assets

2 INTERNALLY GENERATED INTANGIBLE ASSETS

Section overview

„ Internally-generated intangible items

„ Research and development
„ Accounting treatment of development costs

2.1 Internally-generated intangible items

An internally-generated intangible asset is created by a company through its own efforts. (An
internally-generated asset differs from an acquired asset that has been purchased from an
external seller.) For example, a publishing company may build up legal copyrights by publishing
books.
It can sometimes be difficult for a company to assess whether an internally-generated asset
qualifies for recognition as an asset in the financial statements because:
‰ it is not identifiable: or
‰ its cost cannot be determined reliably.

Recognition prohibited
IAS 38 prohibits the recognition of the following internally-generated intangible items:
‰ goodwill
‰ brands
‰ mastheads (Note: a masthead is a recognisable title, usually in a distinctive typographical
form, appearing at the top of an item. An example is a newspaper masthead on the front
page of a daily newspaper)
‰ publishing titles
‰ customer lists.
Recognition of these items as intangible assets when they are generated internally is prohibited
because the internal costs of producing these items cannot be distinguished separately from the
costs of developing and operating the business as a whole.
Note that any of these items would be recognised if they were purchased separately.

Other internally generated intangibles

IAS 38 provides further guidance on how to assess whether other internally generated
intangibles assets meet the criteria for recognition.

2.2 Research and development

The term ‘research and development’ is commonly used to describe work on the innovation,
design, development and testing of new products, processes and systems.
Assessment of whether an internally generated intangible asset meets the criteria for recognition
requires a company to classify the generation of the asset into:
‰ a research phase; and
‰ a development phase.
If the research phase cannot be distinguished from the development phase the expenditure on
the project is all treated as that incurred on the research phase.

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Financial accounting and reporting II

Research phase

Definition: Research
Research is original and planned investigation undertaken with the prospect of gaining new
scientific or technical knowledge and understanding.

Examples of research activities include:

‰ Activities aimed at obtaining new knowledge.
‰ The search for and evaluation of applications of knowledge obtained from research.
‰ The search for alternative materials, products or processes.
‰ The formulation and testing of possible alternatives for new materials, products or
processes.
Research costs cannot be an intangible asset. Expenditure on research should be recognised as
an expense as it is incurred and included in profit or loss for the period.

Development phase

Definition: Development
Development is the application of research findings or other knowledge to a plan or design for the
production of new or substantially improved materials, devices, products, processes, systems or
services before the start of commercial production or use.

Examples of development activities include:

‰ The design, construction and testing of pre-production prototypes and models.
‰ The design of tolls involving new technology.
‰ The construction and operation of a pilot plant that is not large enough for economic
commercial production.
‰ The design, construction and testing of new materials, products or processes.

2.3 Accounting treatment of development costs

Development costs are capitalised when they meet certain further criteria. (These comprise more
detailed guidance on whether it is probable that future economic benefits from the asset will flow
to the entity and whether the cost can be measured reliably).
Development costs must be recognised as an intangible asset, but only if all the following
conditions can be demonstrated.
‰ It is technically feasible to complete the development project.
‰ The company intends to complete the development of the asset and then use or sell it.
‰ The asset that is being developed is capable of being used or sold.
‰ Future economic benefits can be generated. This might be proved by the existence of a
market for the asset’s output or the usefulness of the asset within the company itself.
‰ Resources are available to complete the development project.
‰ The development expenditure can be measured reliably (for example, via costing records).
If any one of these conditions is not met, the development expenditure must be treated in the
same way as research costs and recognised in full as an expense when it is incurred.
Only expenditure incurred after all the conditions have been met can be capitalised.
Once such expenditure has been written off as an expense, it cannot subsequently be reinstated
as an intangible asset.

© Emile Woolf International 224 The Institute of Chartered Accountants of Pakistan