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with those customers.
The purchase orders from 60 per cent of T’s customers (whether cancellable or not) meet the contractual-legal
criterion, so the order backlog is recognised as an intangible asset separate from goodwill. Additionally, because
T has a practice of establishing contracts (purchase and sales orders) with all of its customers, its relationship
with all of its customers (not just the 60 per cent in respect of which there is a backlog of purchase orders) also
arises through contractual rights, and therefore meets the contractual-legal criterion for identification as an
intangible asset, even though T does not have contracts with 40% of those customers at 31 December 2018.
Motor insurance contracts
A acquires T, an Insurer, in a business combination. T has a portfolio of one-year motor insurance contracts
that are cancellable by policyholders.
Because T establishes its relationships with policyholders through insurance contracts, the customer
relationship with policyholders meets the contractual-legal criterion for identification as an intangible asset.
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
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critical to identifying and measuring customer relationship intangible assets and
different conclusions could result in substantially different accounting outcomes. This
is discussed in more detail in Chapter 9 at 5.5.2.B.
Given the widespread confusion the matter was referred to the IASB and the FASB with
a recommendation to review and amend IFRS 3 by:
• 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.
When it considered the issue in March 2009, the Interpretations Committee was
unable to develop an Interpretation clarifying the distinction between contractual
and non-contractual.
The IASB deferred both recommendations of the Interpretations Committee to the
post-implementation review (PIR) of IFRS 3, which was completed in June 2015. As a
result of the PIR of IFRS 3 the issue of the 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. In April 2018,
the IASB decided not to consider allowing any identifiable intangible assets acquired in
a business combination to be included within goodwill. 3 The research project is
covered in further detail in Chapter 9 at 1.1.1 and 5.5.2.B.
Despite the IASB’s decision there will be divergent treatments in practice, depending
on how entities interpret ‘contractual’ and ‘non-contractual’ customer-related
intangible assets in a particular business combination.
5.5
In-process research and development
The term ‘in-process research and development’ (IPR&D) refers to those identifiable
intangible assets resulting from research and development activities that are acquired in
a business combination. An acquirer should recognise IPR&D separately from goodwill
if the project meets the definition of an intangible asset. This is the case when the
IPR&D project meets the definition of an asset and is identifiable, i.e. it is separable or
arises from contractual or other legal rights. [IAS 38.34].
IPR&D projects, whether or not recognised by the acquiree, are protected by legal rights
and are clearly separable, as they can be bought and sold by entities in the normal course
of business.
Any subsequent expenditure incurred on the project after its acquisition should be
accounted for in accordance with the general rules in IAS 38 on internally generated
intangible assets which are discussed at 6.2 below. [IAS 38.42]. In summary, this means
that the subsequent expenditure is accounted for as follows: [IAS 38.43]
• research expenditure is recognised as an expense when incurred;
• development expenditure that does not satisfy the criteria for recognition as an
intangible asset is recognised as an expense when incurred; and
• development expenditure that satisfies the recognition criteria is added to the
carrying value of the acquired in-process research or development project.
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This approach results in some IPR&D projects acquired in business combinations
being treated differently from similar projects started internally because there are
different criteria for recognition. The IASB acknowledged this point but decided
that it could not support a treatment that allowed acquired IPR&D to be subsumed
within goodwill. [IAS 38.BC82]. Until the Board finds time to address this issue, users
of financial statements will have to live with the problem that an asset can be
recognised for acquired research and development projects despite the fact that the
entity might recognise as an expense the costs of internal projects at a similar stage
of development.
The implication is that if an acquired project is ultimately successful, the asset
recognised will have a higher carrying amount and related amortisation charged to profit
and loss over its useful life than an equivalent internal project.
If the carrying value cannot be justified, the acquired asset will be impaired. An
impairment test will be performed before the end of the period of acquisition and
annually thereafter in accordance with the requirements of IAS 36 for intangible assets
not yet available for use (see Chapter 20). [IAS 36.10]. Any impairment loss will be
reflected in the entity’s statement of profit or loss as a post-acquisition event.
6
INTERNALLY GENERATED INTANGIBLE ASSETS
6.1
Internally generated goodwill
IAS 38 explicitly prohibits the recognition of internally generated goodwill as an asset
because internally generated goodwill is neither separable nor does it arise from
contractual or legal rights. [IAS 38.48]. As such, it is not an identifiable resource controlled
by the entity that can be measured reliably at cost. [IAS 38.49]. It therefore does not meet
the definition of an intangible asset under the standard or that of an asset under the
IASB’s Conceptual Framework. The standard maintains that the difference between the
fair value of an entity and the carrying amount of its identifiable net assets at any time
may capture a range of factors that affect the fair value of the entity, but that such
differences do not represent the cost of intangible assets controlled by the entity.
[IAS 38.50].
6.2
Internally generated intangible assets
The IASB recognises that it may be difficult to decide whether an internally generated
intangible asset qualifies for recognition because of problems in:
(a) confirming whether and when there is an identifiable asset th
at will generate
expected future economic benefits; and
(b) determining the cost of the asset reliably, especially in cases where the cost of
generating an intangible asset internally cannot be distinguished from the cost of
maintaining or enhancing the entity’s internally generated goodwill or of running
day-to-day operations. [IAS 38.51].
To avoid the inappropriate recognition of an asset, IAS 38 requires that internally
generated intangible assets are not only tested against the general requirements for
recognition and initial measurement (discussed at 3 above), but also meet criteria
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which confirm that the related activity is at a sufficiently advanced stage of
development, is both technically and commercially viable and includes only directly
attributable costs. [IAS 38.51]. Those criteria comprise detailed guidance on
accounting for intangible assets in the research phase (see 6.2.1 below), the
development phase (see 6.2.2 below) and on components of cost of an internally
generated intangible asset (see 6.3 below).
If the general recognition and initial measurement requirements are met, the entity
classifies the generation of the internally developed asset into a research phase and a
development phase. [IAS 38.52]. Only expenditure arising from the development phase
can be considered for capitalisation, with all expenditure on research being recognised
as an expense when it is incurred. [IAS 38.54]. If it is too difficult to distinguish an activity
between a research phase and a development phase, all expenditure is treated as
research. [IAS 38.53].
The standard distinguishes between research and development activities as follows:
Research is original and planned investigation undertaken with the prospect of gaining
new scientific or technical knowledge and understanding. [IAS 38.8].
The standard gives the following examples of research activities: [IAS 38.56]
(a) activities aimed at obtaining new knowledge;
(b) the search for, evaluation and final selection of, applications of research findings
or other knowledge;
(c) the search for alternatives for materials, devices, products, processes, systems or
services; and
(d) the formulation, design, evaluation and final selection of possible alternatives for
new or improved materials, devices, products, processes, systems or services.
Development 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 before the start of commercial production or use.
[IAS 38.8].
The standard gives the following examples of development activities:
(a) the design, construction and testing of pre-production or pre-use prototypes and
models;
(b) the design of tools, jigs, moulds and dies involving new technology;
(c) the design, construction and operation of a pilot plant that is not of a scale
economically feasible for commercial production; and
(d) the design, construction and testing of a chosen alternative for new or improved
materials, devices, products, processes, systems or services. [IAS 38.59].
6.2.1 Research
phase
An entity cannot recognise an intangible asset arising from research or from the
research phase of an internal project. Instead, any expenditure on research or the
research phase of an internal project should be expensed as incurred because the
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entity cannot demonstrate that there is an intangible asset that will generate probable
future economic benefits. [IAS 38.54-55].
If an entity cannot distinguish the research phase from the development phase, it should
treat the expenditure on that project as if it were incurred in the research phase only
and recognise an expense accordingly. [IAS 38.53].
6.2.2 Development
phase
The standard requires recognition of an intangible asset arising from development (or
the development phase of an internal project) while it imposes stringent conditions that
restrict recognition. These tests create a balance, ensuring that the entity does not
recognise unrecoverable costs as an asset.
An intangible asset arising from development or from the development phase of an
internal project should be recognised if, and only if, an entity can demonstrate all of
the following:
(a) the technical feasibility of completing the intangible asset so that it will be available
for use or sale;
(b) its intention to complete the intangible asset and use or sell it;
(c) its ability to use or sell the intangible asset;
(d) how the intangible asset will generate probable future economic benefits. Among
other things, the entity can demonstrate the existence of a market for the output
of the intangible asset or the intangible asset itself or, if it is to be used internally,
the usefulness of the intangible asset;
(e) the availability of adequate technical, financial and other resources to complete
the development and to use or sell the intangible asset; and
(f) its ability to measure reliably the expenditure attributable to the intangible asset
during its development. [IAS 38.57].
The fact that an entity can demonstrate that the asset will generate probable future
economic benefits distinguishes development activity from the research phase, where
it is unlikely that such a demonstration would be possible. [IAS 38.58].
It may be challenging to obtain objective evidence on each of the above conditions because:
• condition (b) relies on management intent;
• conditions (c), (e) and (f) are entity-specific (i.e. whether development expenditure
meets any of these conditions depends both on the nature of the development
activity itself and the financial position of the entity); and
• condition (d) above is more restrictive than is immediately apparent because the
entity needs to assess the probable future economic benefits using the principles
in IAS 36, i.e. using discounted cash flows. If the asset will generate economic
benefits only in conjunction with other assets, the entity should apply the concept
of cash-generating units. [IAS 38.60]. The application of IAS 36 is discussed in
Chapter 20.
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IAS 38 indicates that evidence may be available in the form of:
• a business plan showing the technical, financial and other resources needed and
the entity’s ability to secure those resources;
• a lender’s indication of its willingness to fund the plan confirming the availability
of external finance; [IAS 38.61] and
• detailed project information demonstrating that an entity’s costing systems can
measure reliably the cost of generating an intangible asset internally, such as salary
and other expenditure incurred in securing copyrights or licences or developing
computer software. [IAS 38.62].
In any case, an entity should maintain books and records in sufficient detail that allow
it to prove whether it meets the conditions set out by IAS 38.
Certain types of prod
uct (e.g. pharmaceuticals, aircraft and electrical equipment)
require regulatory approval before they can be sold. Regulatory approval is not
one of the criteria for recognition under IAS 38 and the standard does not prohibit
an entity from capitalising its development costs in advance of approval. However,
in some industries regulatory approval is vital to commercial success and its
absence indicates significant uncertainty around the possible future economic
benefits. This is the case in the pharmaceuticals industry, where it is rarely
possible to determine whether a new drug will secure regulatory approval until it
is actually granted. Accordingly, it is common practice in this industry for costs to
be expensed until such approval is obtained. See Extract 17.6 and the discussion
at 6.2.3 below.
The standard does not define the terms ‘research phase’ and ‘development phase’
but explains that they should be interpreted more broadly than ‘research’ and
‘development’ which it does define. [IAS 38.52]. The features characterising the
research phase have less to do with what activities are performed, but relate more
to an inability to demonstrate at that time that there is an intangible asset that will
generate probable future benefits. [IAS 38.55]. This means that the research phase may
include activities that do not necessarily meet the definition of ‘research’. For
example, the research phase for IAS 38 purposes may extend to the whole period
preceding a product launch, regardless of the fact that activities that would
otherwise characterise development are taking place at the same time, because
certain features that would mean the project has entered its development phase are
still absent (such as confirming an ability to use or sell the asset; demonstrating
sufficient market demand for a product; or uncertainty regarding the source of funds
to complete the project). As a result, an entity might not be able to distinguish the
research phase from the development phase of an internal project to create an
intangible asset, in which case it should treat the expenditure on that project as if it
were incurred in the research phase only and recognise an expense accordingly.
[IAS 38.53]. It also means that the development phase may include activities that do
not necessarily meet the definition of ‘development’. The example below illustrates