Intangible assets are an increasingly significant metric in the books of many listed companies and their accounting treatment has always been, and remains, a contentious area for preparers and users of financial statements.
This in-depth guide explores how to appropriately account for intangible assets under IFRS, including its scope and measurement, impacts and information your auditors will need from you.
Definition and scope
IAS 38 defines an intangible asset as an identifiable non-monetary asset without physical substance. Such an asset is identifiable when it is separable, or when it arises from contractual or other legal rights. Separable assets can be sold, transferred or licensed. Examples of intangible assets include computer software, research and development costs, licences, trademarks, patents, films, copyrights and import quotas. Goodwill acquired in a business combination is accounted for in accordance with IFRS 3 and is outside the scope of IAS 38. Internally generated goodwill is within the scope of IAS 38 but is not recognised as an asset because it is not an identifiable resource.
Separate standards prescribe the accounting treatment for specific types of intangible assets and an entity is required to apply that standard instead of applying IAS 38. These are:
- Intangible assets held by an entity for sale in the ordinary course of business; IAS 2 – Inventories
- Deferred tax assets; IAS 12 – Income Taxes
- Leases of intangible assets accounted for in accordance with IFRS 16 Leases
- Assets arising from employee benefits; IAS 19 – Employee Benefits
- Exploration for and Evaluation of Mineral Resources; IFRS 6
- Financial assets as defined in IAS 32. The recognition and measurement of some financial assets are covered by IFRS 10 Consolidated Financial Statements, IAS 27 Separate Financial Statements, and IAS 28 Investments in Associates and Joint Ventures
- Contracts within the scope of IFRS 17 Insurance Contracts and any assets for insurance acquisition cash flows as defined in IFRS 17
- Non-current intangible assets classified as held for sale (or included in a disposal group that is classified as held for sale) in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
- Assets arising from contracts with customers that are recognised in accordance with IFRS 15 Revenue from Contracts with Customers.
There are instances where some intangible assets are contained in or on a physical substance, such as legal documentation in the case of a patent or licence, and therefore have both tangible and intangible elements. An entity is required to exercise judgement to determine which element is more significant and whether it should be treated under IAS 38 or IAS 16 Property, Plant and Equipment. In the patent example above, the physical documentation is only a form of information storage and does not form an integral part of the patent. The patent can be stored in any other form such as electronic copies. It would therefore be appropriate to account for it as an intangible asset under IAS 38.
Most entities often expend resources or incur liabilities on the acquisition, development, maintenance or enhancement of intangible resources. Examples of such resources are scientific or technical knowledge, design and implementation of new processes or systems, licences, intellectual property, market knowledge and trademarks. If an item within the scope of IAS 38 does not meet the definition of an intangible asset – ie, identifiability, control over a resource, and existence of future economic benefits – expenditure to acquire it or generate it internally is recognised as an expense when it is incurred.
Relevance of IAS 38 in capital markets
In the capital markets, where investors need transparent, comparable, and reliable financial information, the application of IAS 38 plays a crucial role in several ways:
1. Recognition of intangible assets
IAS 38 specifies the criteria for recognising an intangible asset. For an asset to be recognised, it must:
- Be identifiable (ie, separable or arising from contractual/legal rights)
- Provide future economic benefits
- Its cost must be reliably measurable.
Where investors evaluate companies based on future growth potential, especially in industries driven by innovation (eg, technology and pharmaceuticals), recognising intangible assets correctly is vital. A failure to properly recognise intangible assets can lead to undervaluation, while over-recognition could lead to inflated asset values, misleading investors.
2. Capitalisation vs expensing of R&D costs
One of the most debated areas in IAS 38 is how to treat research and development (R&D) costs. IAS 38 distinguishes between:
- Research costs, which are expensed immediately
- Development costs, which may be capitalised if certain criteria are met, such as technical feasibility, intention to complete and ability to use or sell.
This has a direct impact on a company’s financial statements. Technology companies or pharmaceutical firms involved in extensive R&D can boost their asset base and profitability by capitalising qualifying development costs. However, improper application can lead to manipulation, where companies capitalise costs that should be expensed to inflate profits, which could misinform investors.
3. Amortisation and impairment
Intangible assets with a finite useful life must be amortised over their useful life, while those with indefinite useful lives (eg, goodwill) are subject to annual impairment testing. The impairment of intangible assets can significantly impact a company’s earnings and market valuation. For example, a large impairment charge could signal to investors that a company’s previously anticipated growth or success (based on the ability to generate value from its intangible assets) may not materialise. An entity must apply IAS 36 to determine whether an intangible asset is impaired by comparing its recoverable amount with its carrying amount annually and whenever there are impairment indicators present.
The subjective nature of impairment testing, which requires companies to exercise judgement and utilise estimates in their valuation models, such as growth rates, inflation and discount rate, adds another layer of complexity. Misjudging or manipulating impairment can lead to mispricing of a company’s shares in the market.
4. Impact on earnings and share price
The capital markets are highly sensitive to earnings reports, and the treatment of intangible assets under IAS 38 can have a material impact on earnings. For instance:
- If a company capitalises its development costs, its expenses will decrease, leading to higher reported earnings
- Conversely, if intangible assets are amortised or impaired, the company’s earnings will be reduced.
Since investors often rely on earnings to value companies, these accounting treatments can influence stock prices. A significant write-down of intangible assets would also be likely to decrease investor confidence, leading to a drop in share prices, particularly if the intangible assets were central to the company’s valuation.
5. Valuation and M&A activity
In the capital markets, especially during mergers and acquisitions (M&A), the fair valuation of intangible assets such as goodwill, customer lists, patents and trademarks becomes crucial. IAS 38 helps ensure that acquirers and investors can evaluate the intangible assets of target companies consistently.
Post-acquisition, the handling of intangible assets, including goodwill, is governed by IAS 38 and IFRS 3 (Business Combinations). Companies involved in M&A must carefully assess the fair value of the acquired intangibles including separately identifiable intangibles on acquisition. Improper valuation can lead to financial misstatements, which could potentially impact on both the acquirer’s and the target company’s stock prices.
6. Disclosure requirements
IAS 38 also mandates detailed disclosures in the financial statements, which are critical for transparency in the capital markets given the wide range of intangible asset types and companies which will have different policies with regard to expensing or capitalising development costs. These disclosures include:
- The carrying amounts of intangible assets
- Amortisation policies
- Impairment losses
- Capitalised development costs
- Reconciliations of opening and closing balances of intangible assets.
Investors, analysts and regulators rely on these disclosures to assess the quality of earnings, the sustainability of intangible assets and the company’s potential for growth. Transparency in these disclosures helps mitigate information asymmetry.
7. Sector specific relevance
The relevance of IAS 38 varies across sectors, for instance:
- Technology companies: These often hold a significant portion of their value in intellectual property, software or brand value. Correct application of IAS 38 is crucial for investors to understand the company’s innovation pipeline and long-term growth potential.
- Pharmaceutical companies: The valuation of patents, trademarks and drug development costs is critical, particularly in light of the lengthy R&D processes.
- Media and entertainment companies: Intangible assets such as copyrights, licensing agreements and brand names are core to these businesses.
Failure to properly apply IAS 38 in these sectors could distort the company’s value and risk misinforming investors.
8. Market comparability
IAS 38 is an internationally recognised accounting standard under IFRS, meaning that companies applying IFRS in different capital markets must follow the same rules when accounting for intangible assets. This uniformity enhances comparability across companies in different jurisdictions, which is essential for investors who diversify their portfolios globally.
For example, if two competing tech companies are listed in different countries but both apply IAS 38, investors can more easily compare their respective R&D capitalisation and amortisation policies and the value of their intangible assets.
Measurement of intangible assets
Initial measurement (IAS 38.24-28)
Intangible assets are initially measured at cost. The cost of an intangible asset comprises:
- Acquisition cost: If the asset is purchased separately, its cost includes the purchase price, import duties and non-refundable taxes after deducting trade discounts.
- Internally developed assets: For internally developed assets, the cost includes all directly attributable costs necessary to create, produce and prepare the asset for its intended use, such as materials, labour and overhead. The key issue in measuring internally developed assets is how to identify which costs should be capitalised and how these can be supported by sufficient, appropriate audit evidence. Development costs tend to be mostly staff time which is supported by contracts and timesheets. Management must apply judgement in considering whose time and the quantum of costs to capitalise. Management must consider whether staff activity and the relevant costs are directly attributable to the intangible asset.
- Acquisition as part of business combination: If an intangible asset is acquired in a business combination, its cost is recognised at fair value at the acquisition date.
Subsequent measurement (IAS 38.72-87)
After initial recognition, an entity must choose between two models for subsequent measurement:
1. Cost model (IAS 38.74)
- The asset is carried at cost less any accumulated amortisation and impairment losses
- Amortisation is based on the useful life of the asset (finite or indefinite) and impairment testing must be conducted if there are indicators of impairment.
2. Revaluation model (IAS 38.75-87)
- Intangible assets can be carried at revalued amounts (fair value) less any subsequent amortisation and impairment losses
- The fair value must be based on an active market, which is rarely available for most intangible assets, so the revaluation model is less commonly used
- Revaluation gains are credited to other comprehensive income (OCI) unless they reverse a previously recognised loss.
Amortisation of intangible assets
1. Finite useful life (IAS 38.97-106) – If the asset has a finite useful life, it should be amortised on a systematic basis over that useful life. Key aspects of amortisation include:
- Useful life: The useful life of an intangible asset may depend on factors such as the expected usage, legal rights and technical obsolescence
- Amortisation method: The amortisation method should reflect the pattern in which the asset’s future economic benefits are expected to be consumed (straight-line, diminishing balance, or other method)
- Residual value: The residual value of an intangible asset is assumed to be zero unless certain conditions are met (such as an active market).
2. Indefinite useful life (IAS 38.107-110) – If the asset has an indefinite useful life, it is not amortised. Instead, the entity must:
- Test for impairment at least annually and whenever there is an indication of impairment
- Review the useful life each period to determine if there are any changes in the indefinite classification. If the asset is no longer expected to have an indefinite life, it should be amortised prospectively.
Impairment of intangible assets (IAS 38.111-123)
Impairment of intangible assets is governed by IAS 36: Impairment of Assets. Intangible assets must be tested for impairment if there is an indication that the asset might be impaired. For assets with an indefinite useful life or not yet ready for use, impairment testing must be performed annually.
The impairment test involves comparing the carrying amount of the intangible asset to its recoverable amount, which is the higher of its fair value less costs to sell and value in use. If the carrying amount exceeds the recoverable amount, an impairment loss is recognised in the statement of profit and loss.
Derecognition (IAS 38.112-117)
An intangible asset is derecognised:
- On disposal (sale or abandonment)
- When no future economic benefits are expected from its use or disposal.
The gain or loss on derecognition is calculated as the difference between the net disposal proceeds and the carrying amount of the asset. The gain or loss is recognised in the income statement in the period in which the derecognition occurs.
Key information that auditors will require in auditing intangible asset balances
- Ownership agreements and other legal documents to support underlying rights and obligations to the asset
- Management paper outlining the phase at which the asset is, that is, research/development phase and demonstrating the technical feasibility of completing the asset so it will be available for use or sale, management’s intention to complete and ability to use or sell the asset, how the asset will generate probable future economic benefits, the availability of resources to complete the asset and the ability to measure reliably the expenditure attributable to the asset during its development
- Detailed cashflow forecasts to determine the future economic benefits of the asset
- Details of management’s key assumptions and estimates such as useful life, future sales and discount factor
- The nature and amount of any significant intangible assets acquired during the period
- The nature and amount of significant intangible asset additions during the period and underlying support such as employment contracts and timesheets
- Board meeting minutes related to the asset.
Conclusion
IAS 38 plays a significant role in ensuring the accurate and consistent reporting of intangible assets. Its application affects a company’s earnings, asset values and stock price, directly influencing investor perception and market valuations. Transparent and consistent treatment of intangible assets is critical for investor confidence, as intangible assets often represent a significant portion of a company’s value in knowledge-driven industries. Capital market participants, including analysts, investors and regulators, heavily rely on the proper application of IAS 38 to assess the long-term growth potential and financial health of companies.
For more information on IAS 38 and intangible assets, please contact Elorm Numadzi or Imogen Massey.
