International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards

by International GAAP 2019 (pdf)

  from TC. TC has a contract with Customer to be its exclusive provider of sporting goods but has no contract

  for the supply of electronics to Customer. Both TC and AC believe that only one overall customer relationship

  exists between TC and Customer.

  The contract to be Customer’s exclusive supplier of sporting goods, whether cancellable or not, meets the

  contractual-legal criterion. In addition, as TC establishes its relationship with Customer through a contract, the

  customer relationship with Customer meets the contractual-legal criterion. Because TC has only one customer

  relationship with Customer, the fair value of that relationship incorporates assumptions about TC’s relationship

  with Customer related to both sporting goods and electronics. However, if AC determines that it has two separate

  customer relationships with Customer, for sporting goods and for electronics, AC would need to assess whether

  the customer relationship for electronics is separable before it could be recognised as an intangible asset.

  (iii)

  Order backlog and recurring customers

  AC acquires TC in a business combination on 31 December 2019. TC does business with its customers solely

  through purchase and sales orders. At 31 December 2019, TC has a backlog of customer purchase orders

  from 60 per cent of its customers, all of whom are recurring customers. The other 40 per cent of TC’s

  customers are also recurring customers. However, as at 31 December 2019, TC has no open purchase orders

  or other contracts with those customers.

  Regardless of whether they are cancellable or not, the purchase orders from 60 per cent of TC’s customers meet

  the contractual-legal criterion. Additionally, because TC has established its relationship with 60 per cent of its

  customers through contracts, not only the purchase orders but also TC’s customer relationships meet the

  contractual-legal criterion. Because TC has a practice of establishing contracts with the remaining 40 per cent of

  its customers, its relationship with those customers also arises through contractual rights and therefore meets the

  contractual-legal criterion even though TC does not have contracts with those customers at 31 December 2019.

  (iv)

  Motor insurance contracts

  AC acquires TC, an insurer, in a business combination on 31 December 2019. TC has a portfolio of one-year

  motor insurance contracts that are cancellable by policyholders.

  Because TC establishes its relationships with policyholders through insurance contracts, the customer

  relationship with policyholders meets the contractual-legal criterion.

  One of the most difficult areas of interpretation is whether an arrangement is

  contractual or not. Contractual customer relationships are always recognised separately

  from goodwill but non-contractual customer relationships are recognised only if they

  are separable. Consequently, determining whether a relationship is contractual is

  critical to identifying and measuring customer relationship intangible assets and

  different conclusions could result in substantially different accounting outcomes.

  Paragraph IE28 in the Illustrative Examples explains that a customer relationship is

  deemed to exist if the entity has information about the customer and regular contact with

  it and the customer can make direct contact with the entity. A customer relationship ‘may

  also arise through means other than contracts, such as through regular contact by sales or

  service representatives’. However, the argument is taken a stage further. Regardless of

  whether any contracts are in place at the acquisition date, ‘customer relationships meet

  the contractual-legal criterion for recognition if an entity has a practice of establishing

  contracts with its customers’. [IFRS 3.IE28]. An example of what is meant by this is given in

  Example 9.9 above. In the third illustration, ‘Order backlog and recurring customers’, it

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  combinations

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  states ‘Because TC has a practice of establishing contracts with the remaining 40 per cent

  of its customers, its relationship with those customers also arises through contractual

  rights and therefore meets the contractual-legal criterion even though TC does not have

  contracts with those customers at 31 December 2019’.

  In 2008 the Interpretations Committee considered the circumstances in which non-

  contractual customer relationships arise. The staff’s survey of Interpretations

  Committee members indicated that there were diverse practices regarding which

  customer relationships have a contractual basis and which do not. In addition, valuation

  experts seemed to be taking different views.35

  The Interpretations Committee noted that the IFRS Glossary of Terms defined the term

  ‘contract’. Whilst the manner in which a relationship is established is relevant to

  confirming the existence of a customer relationship, it should not be the primary basis for

  determining whether an intangible asset is recognised by the acquirer. What might be

  more relevant is whether the entity has a practice of establishing contracts with its

  customers or whether relationships arise through other means, such as through regular

  contact by sales and service representatives (i.e. the matters identified in paragraph IE28).

  The existence of contractual relationships and information about a customer’s prior

  purchases would be important inputs in valuing a customer relationship intangible asset,

  but should not determine whether it is recognised.36 Therefore, a customer base (e.g.

  customers of a fast food franchise or movie theatres) is an example of a non-contractual

  customer relationship that would not be recognised in a business combination.

  The Interpretations Committee was unable to develop an Interpretation clarifying the

  distinction between contractual and non-contractual. Given the widespread confusion

  the matter was referred to the IASB and the FASB with a recommendation to review

  and amend IFRS 3 by:37

  • removing the distinction between ‘contractual’ and ‘non-contractual’ customer-

  related intangible assets recognised in a business combination; and

  • reviewing the indicators that identify the existence of a customer relationship in

  paragraph IE28 of IFRS 3 and including them in the standard.

  However, the IASB deferred both recommendations of the Interpretations Committee to

  the PIR of IFRS 3, which was completed in June 2015. As a result of the PIR of IFRS 3 the

  issue of identification and fair value measurement of intangible assets such as customer

  relationships and brand names was added to the IASB’s active agenda within its Goodwill

  and Impairment research project (see 1.1.1 above). In May 2018, the IASB tentatively

  decided not to consider allowing some identifiable intangible assets acquired in a business

  combination to be included within goodwill. Therefore, divergent treatments will remain

  in practice, depending on how entities interpret ‘contractual’ and ‘non-contractual’

  customer-related intangible assets in a particular business combination.

  5.5.2.C

  Combining an intangible asset with a related contract, identifiable asset

  or liability

  IAS 38 states that an intangible asset acquired in a business combination might be

  separable, but only together with a related contract, identifiable asset, or lia
bility. In such

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  cases, the acquirer recognises the intangible assets separately from goodwill, but together

  with the related item. [IAS 38.36].

  Similarly, the acquirer may recognise a group of complementary intangible assets as a

  single asset provided the individual assets have similar useful lives. For example, ‘the

  terms “brand” and “brand name” are often used as synonyms for trademarks and other

  marks. However, the former are general marketing terms that are typically used to refer

  to a group of complementary assets such as a trademark (or service mark) and its related

  trade name, formulas, recipes and technological expertise.’ [IAS 38.37].

  It is not clear whether an intangible asset that is only separable in combination with a

  tangible asset should be recognised together as a single asset for financial reporting

  purposes in all circumstances. IFRS 3 gives an example of a licence to operate a nuclear

  power plant, and says that the fair value of the operating licence and the fair value of the

  power plant may be recognised as a single asset for financial reporting purposes, if the

  useful lives of those assets are similar (see 5.5.2 above), yet the requirements in IAS 38 only

  refer to similar useful lives in the context of a group of complementary intangible assets.

  In practice entities account for intangible assets separately from the related tangible

  asset if the useful lives are different. The Rank Group Plc considers that its casino and

  gaming licences have indefinite useful lives and accounts for them separately from the

  buildings with which they are acquired, as disclosed in its accounting policy.

  Extract 9.1: The Rank Group Plc (2017)

  Notes to the financial statements [extract]

  1

  General information and accounting policies [extract]

  Summary of significant accounting policies [extract]

  1.12 Intangible

  assets

  [extract]

  (b)

  Casino and other gaming licences and concessions

  The Group capitalises acquired casino and other gaming licences and concessions. Management believes that

  licences, except for the casino concessions in Belgium, have indefinite lives as there is no foreseeable limit to the

  period over which the licences are expected to generate net cash inflows, and each licence holds a value outside the

  property in which it resides. Each licence is reviewed annually for impairment.

  In respect of the concessions in Belgium, the carrying value is amortised over the expected useful life of the concession.

  As at 30 June 2017 the licences have a remaining useful life of 3.5 years and 0.2 years respectively.

  Any costs in renewing licences or concessions are expensed as incurred.

  Guidance on determining useful lives of intangible assets is discussed in Chapter 17 at 9.1.

  5.5.2.D

  In-process research or development project expenditure

  IFRS 3 itself only refers to in-process research and development in its Basis for

  Conclusions, where it is made clear that the acquirer recognises all tangible and intangible

  research and development assets acquired in a business combination. [IFRS 3.BC149-BC156].

  IAS 38’s general recognition conditions require it to be probable that expected future

  economic benefits will flow to the entity and that the costs can be measured reliably

  before an intangible asset can be recognised. [IAS 38.21].

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  combinations

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  IAS 38 states that ‘an acquiree’s in-process research and development project meets the

  definition of an intangible asset when it meets the definition of an asset, and is

  identifiable, i.e. is separable or arises from contractual or other legal rights.’ [IAS 38.34].

  In-process research and development projects, whether or not recognised by the

  acquiree, are protected by legal rights and are clearly separable as on occasion they are

  bought and sold by entities without there being a business acquisition. Both of the

  standard’s general recognition criteria, probability of benefits and reliable

  measurement, are always considered to be satisfied for in-process research and

  development projects acquired in a business combination. The fair value of an

  intangible asset reflects expectations about the probability of these benefits, despite

  uncertainty about the timing or the amount of the inflow. There will be sufficient

  information to measure the fair value of the asset reliably if it is separable or arises from

  contractual or other legal rights. If there is a range of possible outcomes with different

  probabilities, this uncertainty is taken into account in the measurement of the asset’s

  fair value. [IAS 38.33-35].

  Therefore, recognising in-process research and development as an asset on acquisition

  applies different criteria to those that are required for internal projects. The research

  costs of internal projects may under no circumstances be capitalised. [IAS 38.54]. Before

  capitalising development expenditure, entities must meet a series of exacting

  requirements. They must demonstrate the technical feasibility of the intangible assets,

  their intention and ability to complete the assets and use them or sell them and must be

  able to measure reliably the attributable expenditure. [IAS 38.57]. The probable future

  economic benefits must be assessed using the principles in IAS 36 – Impairment of

  Assets – which means that they have to be calculated as the net present value of the

  cash flows generated by the asset or, if it can only generate cash flows in conjunction

  with other assets, of the cash-generating unit of which it is a part. [IAS 38.60]. This process

  is described further in Chapter 17 at 6.

  What this means is that entities will be required to recognise on acquisition some

  research and development expenditure that they would not have been able to recognise

  if it had been an internal project. The IASB is aware of this inconsistency, but concluded

  that this did not provide a basis for subsuming in-process research and development

  within goodwill. [IAS 38.BC82].

  Although the amount attributed to the project is accounted for as an asset, IAS 38 goes

  on to require that any subsequent expenditure incurred after the acquisition of the

  project is to be accounted for in accordance with paragraphs 54 to 62 of IAS 38.

  [IAS 38.42]. These requirements are discussed in Chapter 17 at 6.2.

  In summary, this means that the subsequent expenditure is:

  (a) recognised as an expense when incurred if it is research expenditure;

  (b) recognised as an expense when incurred if it is development expenditure that does

  not satisfy the criteria for recognition as an intangible asset in paragraph 57; and

  (c) added to the carrying amount of the acquired in-process research or development

  project if it is development expenditure that satisfies the recognition criteria in

  paragraph 57. [IAS 38.43].

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  9

  The inference is that the in-process research and development expenditure recognised

  as an asset on acquisition that never progresses to the stage of satisfying the recognition

  criteria for an internal project will ultimately be impaired, although it may be that this

  impairment will not arise until the entity is satisfied that the p
roject will not continue.

  However, since it is an intangible asset not yet available for use, such an evaluation

  cannot be significantly delayed as it will need to be tested for impairment annually by

  comparing its carrying amount with its recoverable amount, as discussed in Chapter 20

  at 10. [IAS 36.10].

  5.5.2.E Emission

  rights

  Emission rights or allowances under a cap and trade emission rights scheme (see

  Chapter 17 at 11.2) meet the definition of an intangible asset and should therefore be

  recognised at the acquisition date at their fair value. Likewise, the acquirer is

  required to recognise a liability at fair value for the actual emissions made at the

  acquisition date.

  One approach that is adopted in accounting for such rights is the ‘net liability

  approach’ whereby the emission rights are recorded at a nominal amount and the

  entity will only record a liability once the actual emissions exceed the emission

  rights granted and still held. As discussed in Chapter 17 at 11.2.5, the net liability

  approach is not permitted for purchased emission rights and therefore is also not

  permitted to be applied to emission rights of the acquiree in a business combination.

  Although the acquiree may not have recognised an asset or liability at the date of

  acquisition, the acquirer should recognise the emission rights as intangible assets at

  their fair value and a liability at fair value for the actual emissions made at the

  acquisition date.

  One impact of this is that subsequent to the acquisition, the consolidated income

  statement will show an expense for the actual emissions made thereafter, as a provision

  will have to be recognised on an ongoing basis. As discussed in Chapter 17 at 11.2.2,

  there are different views of the impact that such ‘purchased’ emission rights have on

  the measurement of the provision and on accounting for the emissions.

  The emission rights held by the acquiree will relate to specific items of property, plant

  and equipment. Therefore when determining the fair value of these assets, care needs

  to be taken to ensure that there is no double counting of the rights held.

  5.5.2.F

  Determining the fair values of intangible assets

  Little guidance relating to fair value remains in IFRS 3 as it is now included in IFRS 13