Friday, September 7, 2012

Accounting for intangible assets - Self-generated intangible assets

Recently, while browing through the financial article, we noticed one interesting article from relating to intangible assets. We have extracted some paragraphs as below:

"Any business professor will tell you that the value of companies has been shifting markedly from tangible assets, "bricks and mortar", to intangible assets like intellectual capital. These invisible assets are the key drivers of shareholder value in the knowledge economy, but accounting rules do not acknowledge this shift in the valuation of companies. Statements prepared under generally accepted accounting principles do not record these assets. Left in the dark, investors must rely largely on guesswork to judge the accuracy of a company's value.
But although companies' percentage of intangible assets has increased, accounting rules have not kept pace. For instance, if the R&D efforts of a pharmaceuticals company create a new drug that passes clinical trials, the value of that development is not found in the financial statements. It doesn't show up until sales are actually made, which could be several years down the road. Or consider the value of an e-commerce retailer. Arguably, almost all of its value comes from software development, copyrights and its user base. While the market reacts immediately to clinical trial results or online retailers' customer churn, these assets slip through financial statements.

As a result, there is a serious disconnect between what happens in capital markets and what accounting systems reflect. Accounting value is based on the historical costs of equipment and inventory, whereas market value comes from expectations about a company's future cash flow, which comes in large part from intangibles such as R&D efforts, patents and good ol' workforce "know-how". "

Our audit client may have invested research & development costs, payroll costs in developing intangible assets, e.g. new drugs, software, new machines. The invention may subsequently lead the Company to apply for patents, which is essentially the intangible assets of the Company. According to IFRS, internally generated goodwill should not be recognised on the balance sheet of the Company. Some of the readers may wonder why this asset should not be recognised on the balance sheet of the Company.

Let us answer this question by giving you a scenario by assuming intangible assets can be recognised. The Company would capitalise the costs incurred as an intangible assets, i.e.

Dr. Intangible Assets
Cr. Costs (i.e. R&D costs, payroll costs)

By capitalising the intangible assets, the Company will be able to reduce the costs and increase the profitability. There's a incentive for certain Company to capitalise intangible assets as much as possible, in order to reduce the costs incurred, even for certain costs that may not yiled economic benefits to the Company.

Sometimes, it is hard to measure the real economic benefit of an intangible assets. A Company should not recognise intangible assets if it is not econmical benificial to the Company. This is the issue with the recognition. Also, for the measurement, how should intangible assets be measured. Some might argue that, it should be the full amount of costs incurred. However, what if the full amonut of costs is not 100% beneficial to the Company? Do we still recognise the full amount?

It will be a challenge for the accountant, auditor, and even general invenstor to understand the nature or amount of the intangible assets being recognised on the balance sheet. Hence, in order to protect financial statement user, self generated intangible assets should not be recognised. However, this amount can be disclosed in the financial statement for financial statement user to understand the Company better.

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