IAS 38: Goodwill, Research and Development

1 Introduction

In this chapter we will consider two types of intangible assets that you are required to know about for the examination. Intangible assets are assets which have a value to the business, but cannot be touched (i.e. have no physical substance).

The two that you must have knowledge of are goodwill, and research and development, and we will consider the accounting treatment of both.

IAS 38 Intangible Assets defines an intangible asset as an identifiable non-monetary asset without physical substance. Other examples you will meet are patents, trademarks, licences and purchased computer software. When one of these is bought separately it is recorded at its cost and amortised over its useful life, in the same way as development costs (section 4).

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2 Goodwill

Goodwill is the excess of the value of a business over the fair value of the net assets.

Purchased goodwill

This is goodwill that arises when a company purchases another company. It is commonly the case that the consideration paid is greater than the fair value of the net assets, and this excess is the goodwill. This goodwill is capitalised as a non-current asset (an intangible asset). It is not amortised: instead it is reviewed for impairment every year and written down if its value has fallen. The detail of that review goes beyond what BA3 asks you to calculate.

Non-purchased goodwill

An existing company is likely to be worth more, were it to be sold, than the worth of the net tangible assets. A company could therefore claim that there was an extra asset of goodwill.

However, non-purchased (internally generated) goodwill should not be recognised in the financial statements. This is because no event has occurred to identify the value of the business: it is not an identifiable resource and its cost cannot be measured reliably. You will only know what the business is worth when you try to sell it.

3 Research and Development

IAS 38 Intangible assets governs the accounting treatment of these costs.

Research

This is ‘original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding’.

Development

This 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 prior to the commencement of commercial production or use’.

In plain words: during research you are looking for something new but do not yet know what you will end up with, or whether you will find anything at all. During development you know what the product will be, and the spending is getting it ready to make and sell.

4 Accounting treatment

4.1 Research expenditure

Research expenditure should all be charged to the Statement of Profit or Loss as an expense in the period in which it is incurred.

4.2 Development expenditure

Development expenditure should be capitalised and shown as an intangible asset on the Statement of Financial Position if (and only if) the entity can show all six of the following conditions:

If any one of the conditions is not met, the expenditure should be written off in the Statement of Profit or Loss in the period incurred. Development costs spent before the conditions were all met stay as an expense: they are not added back to the asset later, even when the project succeeds.

4.3 Amortisation

If the costs are capitalised, then they must be amortised in line with the pattern of income resulting. Amortisation is simply the word used for depreciation when the asset is intangible.

• Amortisation begins when the asset is ready for use — that is, when the product is ready and commercial production or sale begins — not when the project started.

• If the pattern of income cannot be estimated reliably, the straight-line method is used: cost ÷ useful life.

• The double entry is: Dr Amortisation expense (statement of profit or loss), Cr Accumulated amortisation (deducted from the asset in the statement of financial position).

• Carrying amount = cost − accumulated amortisation.

The same rules apply to an intangible asset that is bought, such as a patent or a licence: it is recorded at cost and amortised over its useful life. An intangible asset with no foreseeable limit to its life, such as purchased goodwill, is not amortised but reviewed for impairment each year.

4.4 Tangible assets used in research and development

(Note that all the above only applies to intangible assets. If any tangible assets are purchased then they must be capitalised and depreciated as normal.)

Watch for this in questions. A laboratory building or equipment bought for a research project is a tangible non-current asset: it is capitalised and depreciated as normal, whether the project is research or development. Only the intangible spending — such as the salaries of the scientists and the materials they use — follows the research and development rules. The depreciation of the laboratory for the year is itself a cost of the project.

5 Disclosure requirements

The following should be disclosed in the financial statements:

1. the amortisation method used for development expenditure

2. the amount of amortisation during the period

3. a reconciliation between the carrying amount brought forward and the carrying amount carried forward

4. the amount of research expenditure charged in the Statement of Profit or Loss for the period.

The position of each development project should be reviewed each year. If any project no longer meets the IAS 38 criteria then it should be written off.

6 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.