Introduction
The global economic system has undergone a gradual but radical transformation since 1978, growing inexorably from being industrial to one that openly favours knowledge and services. A vital offshoot was that intangible assets grew in gross disproportion to tangible assets. Still, despite growing ‘suspect’ irregularities in the accounting of intangible assets that emerged from time to time, the world did not place proper regulations in place; one of these missing regulations included presenting clear and proper information of all intangible assets in the balance sheet.
There is no doubt that the Enron disaster of 2001 sparked off rapid reforms aimed at better quality accounting standards, improved auditing practices and stronger enforcement mechanisms . While the UK reforms came in 2004 in the form of the impressive IAS38 , it has since done a lot to improve the pre-2004 accounting standards vis-à-vis intangible assets. However, many limitations still exist, thereby letting some intangible assets continue to evade mention in balance sheets.
Definition, Features and Classification of Intangible Assets
There can be little argument that the concept of intangible assets has an unreal, otherworldly quality to it. An intangible asset has been defined by the IASB as a recognizable nonmonetary property that is not physically real. It has certain upside, value-increasing features, namely, it is not scarce , it possesses the quality of scalability , it has strong network effects , and it precipitates future economic benefits.
It has a distinctive downside, value-decreasing characteristics as well, such as it is problematic to manage, control, trade, measure or value, it represents a riskier investment, and unlike its tangible counterpart, it is not a financially proven asset. Intangible assets can be classified into 5 groups: marketing-relevant , customer-relevant , technology-relevant , contract-related and artistic-relevant .
Growth of Intangible Assets in 2 Decades from 1978
As the world economic system changed during the last 2 decades, it also resulted in a principal change in the fundamental principles of accounting. The intangible capital of organisations began to constitute their principal resource and base of their strategy besides influencing the performance of management. As a result of this fundamental change, the accounting of intangible assets also dramatically changed. While such assets globally accounted for just 5% of all accounting assets in 1978, they grew to 75% of total assets in 1998.
Accounting Treatment of Intangible Assets before 2001
There used to be no distinction between the 3 components of intangible assets: human capital, structural capital and market capital. even though for many years appraisers analysed, identified, and valued many distinct intangible assets, these assets remained officially ‘undefined intangibles.’ Arguably the main culprit, the US, had for long recognised the existence and importance of intangible assets and intellectual property, yet did nothing to regulate their accounting properly. The high-profile collapse of Enron in 2001 suddenly brought into international focus seemingly innocuous accounting headlines in the US and Europe that appeared much before Enron, involving restatement of earnings, increasing employment of ‘proforma’ earnings, and quick, unexpected write-downs of intangible assets involving massive values.
It was increasingly realised that organisations need to place values on intangible assets in their balance sheets to help investors. One of the problems hindering this was that intangible assets were being valued by using different sets of valuation standards such as fair market value versus investment value versus acquisition value. Another problem was that intangible assets did not have a specific legal (i.e., determined by statute) life because their owners may have more external commercialisation of opportunities compared to owners of other intangible assets. Added to them all was the problem of corporate raiders frequently focusing on intangible assets, thereby precipitating acquisitions that were driven primarily by the desire to capture ownership of those intangible assets.
Global Reaction to Enron Disaster
One of Enron’s most unpleasant details was the way company auditors Arthur Andersen connived with Enron to unnaturally minimise accounting costs and unnaturally enhance asset value. Intangible assets are widely featured in dishonest manipulation. Corporate heads, government dignitaries and public opinion all over the world were badly shaken and there were widespread calls for strong statutory regulations. The International IASB, US GAAP and UK ASB who were complacently certain that their standards were the best in the world, were shocked out of their lethargy by the Enron debacle. The US swiftly responded by passing the Sarbanes-Oxley Act in 2002. In the UK, deliberations were underway to adopt an Amended Version of IAS38.
The UK adopts IAS38 (Amended)
The UK implemented the IAS38 (Amended Version) on 31 March 2004.
Clauses 8 and 12 of the Amended IAS38 define an intangible asset as one that possesses certain specific characteristics. Firstly, it is identifiable as it has originated from rights emanating from contracts or the law. Secondly, it is subject to the control of the enterprise that has the authority to derive benefits from it. Thirdly, it has the potential to bring economic advantages to the enterprise in future. Lastly, it can be separated and subjected to sale, transfer, licence, rent or exchange either by itself or as part of a package deal.
Clause 21 of Amended IAS38 designates ‘Recognition’ as the test for intangible status. An enterprise must prove that the cost was determined reliably and that it is expected to bring economic advantages to it in future; if it cannot, then it is not permitted to capitalise the cost as an intangible asset in its Balance Sheet and is obliged to expense it in its Profit and Loss Account. Furthermore, the enterprise cannot, at any later date, reinstate such an expense in the form of an intangible asset.
This relates to intangible assets purchased externally. It also pertains to internally generated intangibles but these are subject to 3 additional ‘Initial Recognition’ stipulations. Firstly, costs related to Research should be treated as expenses , but costs related to the Developmental phase can be treated as an intangible asset but only after conclusive technical and commercial proof that they can generate future benefit if sold or used ; if an enterprise is unable to separate Research costs from those involving Development, then it should treat the whole cost as if Research-oriented and is obliged to treat it as a total expense.
Secondly, internally generated computer software should be treated as an expense until the enterprise can successfully prove, on technical and commercial grounds, that the software can be used or sold in future at an economic benefit. Thirdly, certain specific costs that must be treated purely as expenses only; these are in-process Research and Development Acquired in a Business Combination , internally generated goodwill , brands, publishing titles, mastheads, customer lists and costs relating to pre-opening, pre-operating, start-up, training, advertising and relocation .
Amended IAS38 next clarifies the measurement of intangible assets. Initially, intangible assets are calculated at cost . After the acquisition, measurement can be done using the Cost model , or the Revaluation model .
If the Revaluation model measurement is used, then the asset should be further examined based on its useful life. An intangible asset having finite life is expected to generate limited economic advantage, therefore the cost of such an asset with less residual value should be amortised over that finite life . An intangible asset with an indefinite life does not have a predictable limit to the time over which it can generate cash flows. Clause 107 precludes it from amortisation. Clause 109 requires the use of life to be reviewed periodically to conclude if it is worthy of retaining its indefinite life status or if it should be shifted to the finite life category.
Clause 60 of Amended IAS38 clarifies Subsequent Expenditure, stating that all costs incurred on an intangible asset following its purchase or completion should be expensed. However, such costs are permitted to be added to the value of the related intangible asset if they can be reliably measured and can prove to bring future benefit.
Clauses 118, 122 and 124 of Amended IAS38 lay down in detail the various areas of Disclosure required for all classes of intangible assets ranging from useful life, gross carrying amount and commitments of acquisition to detailed reconciliation of the carrying amount from start to end of the accounting period.
Advantages of IAS 38 (Amended)
There are many advantages associated with the Amended IAS38 approach. Firstly, before Amended IAS38, enterprises had to provide irrefutable proof that intangible assets acquired in a business combination were measured correctly and reliably. There were many difficulties associated with such measurement. Amended IAS38 replaced it with a refutable assumption that value is ‘normally’ measurable with enough reliability to make it an intangible asset. Secondly, Amended IAS38 assures a smoother passage of deals involving intangible assets acquired in a business combination from EU based enterprises.
This is because the improvement brought about in UK standards by Amended IAS38, which made it satisfy all requirements of financial connection, easy assimilation, dependability and comparability, prompted acceptance by the EU. Thirdly, by prohibiting brands, goodwill, research and other costs from being classified as intangible assets, Amended IAS38 safeguards the interest of stakeholders and the general public. The former is saved from being deceived by irrationally high asset values in balance sheets, and the latter is saved from price increases that can follow such erroneously high asset evaluation.
Limitations of IAS38 (Amended)
Firstly, it does not indicate how to value intangibles like design, service and customising, to distinguish winners from losers. Secondly, intangible assets acquired in business combinations before 31 March 2004 cannot be subjected to Amended IAS38, and therefore cannot partake of its better accounting standards. Thirdly, due to its intricate nature, it is often very difficult to segregate R&D expenditures convincingly, thus unfairly forcing the enterprise to show the entire cost as Research and expense it.
Recommendations
With the Enron Disaster having thrust the issue of full disclosure of all intangible assets of organisations into the global limelight and given the undeniable and increasing complexity of intangible assets and the mindset of a large sector of corporate leaders, international account standard setters need to review and revise their standards in cooperation with each other regularly. The primary intangible asset – intellectual capital – has become so vital that it is fair to say an organisation that is not managing knowledge is not paying attention to business.
Due to the intricate nature of intangible assets and constant new developments in the modern world, it is important to keep in touch with reality. A good example of reality is the finding of PwC in a survey that as many as 62% of executives overall thought that their financial statements do not communicate effectively. While the US is taking steps in the right direction ever since the Norwalk Agreement was signed between the IASB and FASB, it should initiate similar bilateral cooperation with the UK.
While it is pleasing to note in the UK that 9 proposed amendments sought as a result of discussions in meetings in July 2006, October 2007, December 2007, January 2008, April 2008, May 2008 and June 2008, February 2009, March 2009 may be approved and come into effect after 1 January 2010 the country should do more by initiating tripartite cooperation between itself, the IASB and FASB. Most importantly, the UK should explore ways and means of circumventing the limitations that encumber fully effective action of the IAS38 (Amended).
Conclusion
Three inescapable facts have emerged prominently in the corporate world of today. We are embroiled in the throes of a dramatic change of economic ideas and practices that has contributed to the Information Age. Human capital, a fashionable concoction for employees, is the foundation of all other intangible assets. As knowledge forms a crucial portion of organisations’ far-sightedness, it is only right that it exists as a crucial portion of the organisations’ value.
These facts are the reasons why intangible assets have grown astronomically in significance and value during the last 3 decades, while completely outpacing tangible assets. Intangibles have increasingly asserted their importance on the global scenario as well, arguably the most impressively during international transfer pricing between nations. Following the example of other countries, organisations in the UK too should realise that intangible assets are vital to their prospects, and respond by rigorously managing, monitoring, monetising, and growing the value of such assets. As a result, in the UK as well as elsewhere in the world, given their immense importance, there is no deviating from the exercise of providing users of financial statements with full and comparable data about all intangible assets in the Balance Sheets of organisations.
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