START-UP Costs, how to record them ?

HOW to record Start-Up Costs arising from a new operation activities ? Should this type of cost be treated as Intangible Assets based on IAS 38 ?

Referring to IAS 38, the standard requires an entity to recognize an Intangible Asset, whether purchased or self-created (at cost), if, and only if :

1. it is probable that the expected future economic benefits that are attributable to the asset will flow to the entity; and
2. the cost of the asset can be measured reliably

An entity shall assess the probability of expected future economic benefits using reasonable and supportable assumptions that represent management’s best estimate of the set of economic conditions that will exist over the useful life of the asset.

Read also my previous post : Recognition Criteria of Intangible Asset

Paragraph 68 of IAS 38 states that expenditure on an intangible item shall be recognized as an EXPENSE when it is incurred unless :

1. it forms part of the cost of an intangible asset that meets the recognition criteria (as stated above)
2. the item is acquired in a business combination and cannot be recognized as an intangible asset. If this is the case, it forms part of the amount recognized as goodwill at the acquisition date.

Further, paragraph 69 gives examples of the types of cost that are indistinguishable from the costs of developing the business as a whole and that should, therefore, be EXPENSED when it is incurred. The kind of such costs are include :

1. expenditure on START-UP activities (ie START-UP COSTS), unless this expenditure is included in the cost of an item of property, plant and equipment in accordance with IAS 16. Start-up costs may consist of establishment costs such as legal and secretarial costs incurred in establishing a legal entity, expenditure to open a new facility or business (ie Pre-Opening Costs) or expenditures for starting new operations or launching new products or processes (ie Pre-Operating Costs);
2. expenditure on training activities;
3. expenditure on advertising and promotional activities (including mail order catalogues);
4. expenditure on relocating or reorganizing part or all of an entity.

From the above explanations, it is clear that START-UP Cost has to be EXPENSED as incurred.

Following is the illustrated example of Start-Up Cost excerpted from Intermediate Accounting - Kieso, Weygandt, Warfield :

U.S-based Hilo Beverage Company decides to construct a new plant in Brazil. This represents Hilo’s first entry into the Brazilian market. Hilo plans to introduce the company’s major U.S brands into Brazil, on a locally produced basis. The following costs might be involved :

1. Travel-related costs; costs related to employee salaries; and costs related to feasibility studies, accounting, tax, and government affairs
2. Training of local employees related to product, maintenance, computer systems, finance, and operations
3. Recruiting, organizing, and training related to establishing a distribution network

Hilo Beverage Company should EXPENSE all these start-up costs  as incurred.

The same accounting treatment as Start-Up Cost, the Initial Operating Losses incurred in the start-up of a business also may not be capitalized (HRD).

Determine the USEFUL LIVES of Intangible Assets

IAS 38 regarding Intangible Assets defines USEFUL LIFE as :

1. the period over which an asset is expected to be available for use by an entity; or
2. the number of production or similar units expected to be obtained from the asset by an entity

Further, IAS 38 requires an entity to assess whether the useful life of an intangible asset is FINITE or INDEFINITE and, if finite, the length of, or number of production or similar units constituting, that useful life. An intangible asset shall be regarded by the entity as having an indefinite useful life when, based on an analysis of all of the relevant factors, there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows for the entity.

IAS 38 contains guidance on factors to be taken into account when estimating useful life of an intangible asset, which includes :

1. Expected usage by the entity of the asset and whether it could be managed efficiently by another management team;
2. The typical product life cycle for the asset and published information about useful lives of similar assets that are used in a similar way. This might include comparison with useful lives disclosed in the financial statements of companies that have a similar business using similar assets;
3. Technical, technological, commercial or other types of obsolescence;
4. The stability of the industry in which the asset operates and changes in market demand for the products or services from or related to the asset;
5. Expected actions by actual or potential competitors;
6. The level of maintenance required to maintain the asset’s operating capability and whether management intends to perform that level of maintenance;
7. The period for which the entity has control of the asset and any legal or similar limits on the asset’s use, including for example, expiry dates of leases or licences or geographical restrictions;
8. Whether the asset’s useful life is dependent on the useful life of other assets of the entity. For example, use of a trademark or brand may cease if production of the goods represented by the trademark or brand is discontinued.

An Intangible Asset that is determined to have an INDEFINITE USEFUL LIFE is not amortized. While, assets having a FINITE USEFUL LIFE must be amortized over the useful life, and this may be done in any of the usual ways (pro rata over time, over units of production, etc.). If control over the future economic benefits from an intangible asset is achieved through legal rights for a finite period, then the useful life of the intangible asset should not exceed the period of legal rights, unless the legal rights are renewable and the renewal is a virtual certainty. Thus, as a practical matter, the shorter legal life will set the upper limit for an amortization period in most cases.

There are illustrative examples in IAS 38 that cover assessing of the useful life of intangible assets, which include the Customer Lists, Patents, Copyrights, and also Renewable License Rights. Please refer to IAS 38 for further explanation.

The Useful Life of a finite life intangible asset should be reviewed at least at each financial year end. Changes in useful lives should be accounted for as changes in estimates in accordance with IAS 8.

Where an intangible asset is not being amortized because its useful life is considered to be indefinite, an entity should carry out a review in each accounting period to confirm whether or not events and circumstances still support the assumption of an indefinite life. If they don’t, the change from the indefinite to finite useful life should be accounted for as a change in estimate under IAS 8 (HRD).

Sources :

1. Manual of Accounting, IFRS 2014 – Vol.2 (PwC)
2. Wiley, 2013 Interpretation and Application of IFRS
3. www.ifrs.org

Computer Software Cost, Capitalized or Expensed ?

Based on IAS 38 Intangible Assets, paragraph 4 which explains that some intangible assets may be contained in or on a physical substance such as a compact disc (in the case of computer software), legal documentation (in the case of license or patent) or film. In determining whether an asset that incorporates both intangible and tangible elements should be treated under IAS 16 Property, Plant and Equipment or as an intangible asset under IAS 38, an entity uses judgment to assess which element is more significant.

For example, computer software for a computer-controlled machine tool that cannot operate without that specific software is an integral part of the related hardware and it is treated as property, plant and equipment. The same applies to the operating system of a computer. When the software is not an integral part of the related hardware, computer software is treated as an intangible asset.

In connection with the accounting approach for the recognition of computer software costs, several questions may come up :

1. In the case of a company developing software programs for sale, should the costs incurred in developing the software be expensed, or should the costs be capitalized and amortized ?
2. If the developing software programs to be used for in-house applications only, how is the treatment ?
3. In the case of purchased software, should the cost of the software be capitalized as a tangible asset or as an intangible asset, or should it be expensed fully and immediately ?

Referring to the provision of IAS 38, the above questions can be clarified as follows :

(1) In the case of a software-developing company, the costs incurred in the development of software programs are research and development costs. Accordingly, as regulates in para. 54 of IAS 38, all expenses incurred in the research phase would be expensed. That is, all expenses incurred before technological feasibility for the product has been established should be expensed. The reporting entity would have to demonstrate both technological feasibility and a probability of its commercial success.

Technological feasibility would be established if the entity has completed a detailed program design or working model. The entity should have completed the planning, designing, coding, and testing activities and established that the product can be successfully produced.

Apart from being capable of production, the entity should demonstrate that it has the intention and ability to use or sell the program. Action taken to obtain control over the program in the form of copyrights or patents would support capitalization of these costs. At this stage the software program would be able to meet the criteria of identifiability, control, and future economic benefits, and can thus be capitalized and amortized as an intangible asset.

(2) In the case of software internally developed for in-house use – for example, a computerized payroll program developed by the reporting entity itself – the accounting approach would be different. While the program developed may have some utility to the entity itself, it would be difficult to demonstrate how the program would generate future economic benefits to the entity. Also, in the absence of any legal rights to control the program or to prevent others from using it, the recognition criteria would not be met. Further, the cost proposed to be capitalized should be recoverable. In view of the impairment test prescribed by the standard, the carrying amount of the asset may not be recoverable and would accordingly have to be adjusted. Considering the above facts, such costs may need to be expensed.

(3) In the case of purchased software, the treatment could differ and would need to be evaluated on a case-by-case basis. Software purchased for sale would be treated as inventory. However, software held for licensing or rental to others should be recognized as an intangible asset. On the other hand, cost of software purchased by an entity for its own use and which is integral to the hardware (because without that software the equipment cannot operate), would be treated as part of cost of the hardware and capitalized as property, plant, or equipment. Thus, the cost of an operating system purchased for an in-house computer, or cost of software purchased for computer-controlled machine tool, are treated as part of the related hardware.

The cost of other software programs should be treated as intangible assets (as opposed to being capitalized along with the related hardware), as they are not an integral part of the hardware. For example, the cost of payroll or inventory software (purchased) may be treated as an intangible asset provided it meets the capitalization criteria under IAS 38.

Source : IAS 38 Intangible Assets and Wiley – Interpretation and Application of IFRS, Barry J. Epstein and Eva K. Jermakowicz

Guidance on Amortization of Intangible Assets

The accounting for an intangible asset is based on its useful life. An intangible asset with a finite useful life is amortised, and an intangible asset with an indefinite useful life is not.

What is the definition of Amortization ?

Amortization is the systematic allocation of the depreciable amount of an intangible asset over its useful life.

IAS 38 para. 97-106 rules the amortization of finite useful lives of intangible assets.

Paragraph 97 of IAS 38 states that the depreciable amount of an intangible asset with a finite useful life shall be allocated on a systematic basis over its useful life. Amortization shall begin when the asset is available for use, ie when it is in the location and condition necessary for it to be capable of operating in the manner intended by management.

Amortization shall cease at the earlier of the date that the asset is classified as held for sale (or included in a disposal group that is classified as held for sale) in accordance with IFRS 5 and the date that the asset is derecognized.

The amortization method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. If that pattern cannot be determined reliably, the straight-line method shall be used.

The amortization charge for each period shall be recognized in profit or loss unless this or another Standard permits or requires it to be included in the carrying amount of another asset.

According to Para. 98, a variety of amortization methods can be used to allocate the depreciable amount of an asset on a systematic basis over its useful life. These methods include the straight-line method, the diminishing balance method and the unit of production method. The method used is selected on the basis of the expected pattern of consumption of the expected future economic benefits embodied in the asset and is applied consistently from period to period, unless there is a change in the expected pattern of consumption of those future economic benefits.

Further, para. 99 of IAS 38 states that amortization is usually recognized in profit or loss. However, sometimes the future economic benefits embodied in an asset are absorbed in producing other assets. In this case, the amortization charge constitutes part of the cost of the other asset and is included in its carrying amount. For example, the amortization of intangible assets used in a production process is included in the carrying amount of inventories.

While para. 104 requires an entity to review the amortization period and method at least at each financial year-end.

If the expected useful life of the asset is different from previous estimates, the amortization period shall be changed accordingly. If there has been a change in the expected pattern of consumption of the future economic benefits embodied in the asset, the amortization method shall be changed to reflect the changed pattern. Such changes shall be accounted for as changes in accounting estimates in accordance with IAS 8.

During the life of an intangible asset, it may become apparent that the estimate of its useful life is inappropriate. For example, the recognition of an impairment loss may indicate that the amortization period needs to be changed.

Over time, the pattern of future economic benefits expected to flow to an entity from an intangible asset may change. For example, it may become apparent that a diminishing balance method or amortization is appropriate rather than a straight-line method. Another example is if use of the rights represented by a license is deferred pending action on other components of the business plan. In this case, economic benefits that flow from the asset may not be received until later periods (Hrd).

Source : IFRS as issued at 1 January 2010

Identifying the Internally Generated Intangible Assets

With internally generated intangible assets, problems arise in identifying whether there is an identifiable asset that will generate future economic benefit and in reliably determining its cost.

Goodwill

IAS 38 proscribes the recognition of internally generated goodwill as an asset. The rationale behind this is that any expenditure incurred does not result in an asset that is an identifiable resource – it is not separable, nor does it arise from a contractual or other legal rights – or that is controlled  by the entity. In addition, any costs incurred are unlikely to be specifically identifiable as generating the goodwill. The position that the difference between a valuation of a business and the carrying amount of its individual assets and liabilities may be capitalized as goodwill falls down insofar as that difference cannot be categorized as the cost and therefore cannot be recognized as an asset.

Other Internally Generated Intangible Assets

IAS 38 sets out rules for the recognition of other internally generated intangible assets and broadly defines such expenditures as research and development. It proscribes the recognition of internally generated brands, mastheads, publishing titles, customer lists, and similar items, because expenditure thereon, like expenditure on internally generated goodwill, cannot be distinguished from the cost of developing the business as a whole and is therefore not separately identifiable.

In order to determine whether an internally generated intangible asset qualifies for recognition, its generation is divided into a research phase and a development phase. If the two phases cannot be distinguished, then the entire expenditure is classified as research.

Expenditure on research (or the research phase of an internal project) is to be written off as an expense as and when incurred, as it is not possible to demonstrate that an asset exists that will generate future economic benefit. Examples include :

• Activities aimed at obtaining new knowledge
• The search for, evaluation, and selection of applications of research findings or knowledge
• The search for alternatives for materials, devices, products, systems, or processes
• The formulation, design, evaluation, and selection of possible alternatives for new or improved materials, devices, products, systems, or processes

Development expenditure may be recognized as an intangible asset when, and only when, all of the following can be demonstrated :

• The technical feasibility of completing the asset so that it will be available for use or sale
• The intention to complete the asset and use or sell it
• The ability to use or sell the asset
• How the asset will generate probable future economic benefit, including demonstrating a market for the asset’s output, or for the asset itself, or the asset’s usefulness
• The availability of sufficient technical, financial, and other resources to complete the development and to use or sell the asset
• The ability to reliably measure the expenditure attributable to the asset during its development

Examples of activities that may fail to be recognized as intangible assets include :

• The design, construction, and testing of pre-use prototypes or models
• The design of tools and jigs involving new technology
• The design, construction, and operation of a pilot plan that is not capable of commercial production
• The design, construction, and testing of a chosen alternative for new or improved materials, devices, products, systems, or processes

Source : IFRS Practical Implementation Guide and Workbook (2nd Edition) – Abbas Ali Mirza, Magnus Orrell and Graham J. Holt

RECOGNITION Criteria of Intangible Asset

An intangible asset is an identifiable non-monetary asset without physical substance.

The recognition of an item as an intangible asset requires an entity to demonstrate that the item meets :

1. the definition of an intangible assets (par. 8-17 of IAS 38); and
2. the recognition criteria (par. 21-23 of IAS 38)

Entities frequently expend resources, or incur liabilities, on the acquisition, development, maintenance or enhancement of intangible resources such as scientific or technical knowledge, design and implementation of new processes or system, licenses, intellectual property, market knowledge and trademarks (including brand names and publishing titles). Common examples of items encompassed by these broad headings are computer software, patents, copyrights, motion picture films, customer lists, mortgage servicing rights, fishing licenses, import quotas, franchises, customer or supplier relationship, customer loyalty, market share and market rights (IAS 38 par. 9).

Not all the items described above meet the definition of an intangible asset, ie identifiability, control over a resource and existence of future economic benefits. If an item within the scope of this Standard (IAS 38) does not meet the definition of an intangible asset, expenditure to acquire it or generate it internally is recognised as an expense when it is incurred. However, if the item is acquired in a business combination, it forms part of the goodwill recognised at the acquisition date (IAS 38 par. 10).

IDENTIFIABILITY. The definition of an intangible asset requires an intangible asset to be identifiable to distinguish it from goodwill.

IAS 38 states that an asset is identifiable if it either :

1. is separable, ie is capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability); or
2. arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations

CONTROL. An entity controls an asset if the entity has the power to obtain the future economic benefits flowing from the underlying resource and to restrict the access of others to those benefits. Normally, enterprises register patents, copyrights, etc to ensure control over these intangible assets, although entities often have to engage in litigation to preserve that control.

FUTURE ECONOMIC BENEFITS. Generally an asset is recognised only if it is probable that future economic benefits specifically associated therewith will flow to the reporting entity, and the cost of the asset can be measured reliably.

Par. 21 of IAS 38 states that an intangible asset shall be recognised if, and only if :

1. it is probable that the expected future economic benefits that are attributable to the asset will flow to the entity; and
2. the cost of the asset can be measured reliably.

An entity shall assess the probability of expected future economic benefits using reasonable and supportable assumptions that represent management’s best estimate of the set of economic conditions that will exist over the useful life of the asset (IAS 38 par. 22).

An entity uses judgment to assess the degree of certainty attached to the flow of future economic benefits that are attributable to the use of the asset on the basis of the evidence available at the time of initial recognition, giving greater weight to external evidence (IAS 38 par. 23) (HRD).