FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland deals with the issue of intangible assets (but not goodwill) at Section 18 Intangible Assets other than Goodwill.
Unlike previous UK GAAP, goodwill is not dealt with in the intangible assets section, instead it is dealt with in Section 19 Business Combinations and Goodwill.
Intangible assets tend to cause some complexities because sometimes they can be extremely subjective items to account for and over recent months some questions have begun to emerge concerning the accounting treatment of certain items under FRS 102, which this article aims to clear up. In addition, we will also consider some of the changes that have been made to the accounting for intangible assets other than goodwill as part of the Financial Reporting Council’s triennial review of UK GAAP which completed in December 2017.
Definition of an intangible asset
Paragraph 18.2 of FRS 102 (September 2015) defines an intangible asset as ‘… an identifiable non-monetary asset without physical substance.’ The definition refers to the term ‘identifiable’ and the Glossary to FRS 102 says that an intangible asset is identifiable when:
- it is separable, i.e. capable of being separated or divided from the entity and sold, transferred, licensed, rented, exchanged, either individually or together with a related contract, asset or liability; or
- it 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.
It follows, therefore, that all assets which are separable are identifiable. Separability is not, however, the only indication of identifiability. An asset which arises from contractual or legal rights can also be identifiable.
Recognition and measurement
Care needs to be taken not to inappropriately recognise intangible assets on a company’s balance sheet. For example, internally generated goodwill is strictly prohibited under paragraph 18.8C (as was the case in FRS 10 Goodwill and intangible assets and the FRSSE). Over the years some entities have recognised internally generated goodwill on the balance sheet in contravention of accounting standards. The reason internally generated goodwill is prohibited is because it fails the recognition criteria. If a company purchases goodwill, then that purchased goodwill can be recognised on the balance sheet.
Paragraph 18.4 of FRS 102 says that an entity shall recognise an intangible asset if, and only if:
- it is probable that the expected future economic benefits will flow to the entity; and
- the cost or value of the asset can be measured reliably.
(Note, the word ‘asset’ in b) above is shown in bold type to denote that the term is a defined term in the Glossary to FRS 102. The September 2015 edition of FRS 102 does not show the term in bold, but it does in the revised FRS 102 following the triennial review).
Internally generated goodwill fails test b) because there is no reliable measure of cost, generally because there is no ‘active market’ from which to derive a reliable measure of cost. The term ‘active market’ is defined in the Glossary to FRS 102 as:
‘A market in which all the following conditions exist:
(a) the items traded in the market are homogeneous;
(b) willing buyers and sellers can normally be found at any time; and
(c) prices are available to the public.’
Simply obtaining a valuation of goodwill does not mean it can be recognised on the balance sheet as there is still no active market.
Ordinarily, goodwill will only arise in a business combination under FRS 102, hence it being placed in Section 19 Business Combinations and Goodwill.
Software and website development costs
An issue which is generating debate is the accounting treatment for software and website development costs. FRS 102 does not address the classification of software and website development costs and therefore in the absence of specific guidance, reporting entities are required to develop and apply a suitable accounting policy to classify such costs as either tangible or intangible fixed assets.
Software and website costs which are being developed internally are dealt with under Section 18 of FRS 102 as research and development costs. All research expenditure (pure and applied) must be written off to profit or loss as expenditure; there is no option at all to capitalise research expenditure. This is because in the research phase of a project, an entity will be unable to demonstrate than an intangible asset exists which will generate probable future economic benefits.
Once the research phase has completed and the project has been moved into the development phase, the entity may recognise software and website development costs if, and only if, an entity can demonstrate all of the following:
- The technical feasibility of completing the intangible asset so that it will be available for use or sale.
- Its intention to complete the intangible asset and use or sell it.
- Its ability to use or sell the intangible asset.
- 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.
- The availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset.
- Its ability to measure reliably the expenditure attributable to the intangible asset during its development.
Micro-entities reporting under FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime cannot capitalise any development costs; all such costs are written off to the profit and loss account as incurred.
Accounting treatment: website development costs
Website development costs should only be capitalised if they meet the recognition criteria of an asset; one of those criteria being that ‘it is probable that the expected future economic that are attributable to the asset will flow to the entity’.
To assess whether costs qualify for recognition on the balance sheet, the entity must look at the overall functionality of the website. If the website will allow third parties to place orders for goods or services, then this creates a revenue stream for the business (i.e. economic benefit). Provided the cost can be measured reliably and none of the expenditure relates to research costs, then the website may be capitalised on the balance sheet as an intangible asset and amortised over its useful economic life. Please note that under FRS 102, intangible assets cannot have indefinite useful lives (see ‘Amortisation of intangible assets’ below).
If the website does not generate income for the business, then it will fail to meet the asset recognition criteria and the costs must be written off to profit or loss.
Care must be taken with the accounting treatment for website development costs because mistakes can be costly (especially if the incorrect tax treatment is applied).
Accounting treatment: software costs
When software costs meet the recognition criteria for an asset, again consideration must be given as to the type of software being capitalised. If the software is not critical for the hardware to operate then the software should be capitalised as an intangible fixed asset. However, if the software is a critical aspect of enabling the hardware to work (for example, an operating system), then the software costs are capitalised as part of the hardware, i.e. as a tangible fixed asset.
Regardless of whether the software is capitalised as an intangible asset or a tangible asset, the software must be amortised or depreciated over its useful economic life.
On transition, reclassification may not be necessary because it is unlikely that the amounts will be material and hence this accounting treatment may only apply to additions under FRS 102.
Amortisation of intangible assets
As mentioned above, all intangible assets have finite useful lives under current UK GAAP. It is no longer permissible to carry intangible assets with indefinite useful lives as it was under previous FRS 10 and the FRSSE.
The useful life of an intangible asset which has arisen from contractual or other legal rights must not exceed the period of the contractual or other legal rights. However, it may be shorter depending on how long the entity expects to use the intangible asset.
FRS 102 places a cap of 10 years on amortisation in exceptional cases only. This 10-year rule has caused an element of confusion because some accountants believe this to be a maximum period for all intangible assets, which is not the case.
Paragraph 18.21 of FRS 102 says that intangible assets are amortised on a systematic basis over their useful lives. It would not be unreasonable for certain intangible assets to have a longer life than 10 years and as long as management can provide evidence to support their assessment of that useful life, it would be acceptable to amortise the intangible assets over that said period. The 10-year rule in FRS 102 is triggered when management are unable to make a reliable estimate of the useful life of an intangible asset. Therefore, if management cannot arrive at a reliable estimate of the intangible asset’s useful life, then they must amortise it up to a maximum of 10 years.
Many practitioners expressed concern about this cap and assumed that, on transition to FRS 102, any client with intangible assets having a remaining life of, say, 15 years would be required to accelerate five years’ worth of amortisation on transition. This is categorically not the case; and the Financial Reporting Council are keen to emphasise that this would only be the case in exceptional circumstances.
Impairment of intangible assets
Under FRS 102, assets cannot be carried in the balance sheet in excess of recoverable amount and this principle applies to fixed assets (i.e. tangible and intangible) also. This does not mean, in practice, that an impairment calculation has to be carried out at each balance sheet date; FRS 102 only requires an assessment of whether there are any indicators of impairment. If there are indicators of impairment, then recoverable amount of the asset must be calculated and compared to carrying values. Where the carrying amount of a fixed asset exceeds recoverable amount, the fixed asset is impaired and is written down to recoverable amount.
Under FRS 102, management should then undertake assessments of the amortisation period and amortisation method for its intangible assets. Paragraph 18.24 refers to factors such as a change in how an intangible asset is used, technological advancement and changes in market prices which may indicate that residual values attached to intangible assets, or the useful life of an intangible asset has changed since the last reporting date. Where such indicators are present, management must review previous estimates and, where current expectations differ, amend the residual value, amortisation method or useful life accordingly. This amendment will be accounted for as a change in accounting estimate under Section 10 Accounting Policies, Estimates and Errors and hence will be applied prospectively (i.e. no retrospective restatement is needed).
Disclosure of amortisation rates
FRS 102 requires an entity to disclose the useful lives OR the amortisation rates used for each class of intangible asset together with the reasons for choosing those periods.
Recent changes to Section 18
The definition of an intangible asset in FRS 102 is different than under previous UK GAAP and gave rise to the need to recognise additional intangible assets that were acquired in a business combination (i.e. where a parent acquires a subsidiary). This has increased costs of compliance in some instances, which the FRC have recognised goes against the principles of standard-setting.
The FRC decided to amend Section 18 Intangible Assets other than Goodwill as part of the triennial review so as to provide entities with an accounting policy choice of either separately recognising intangible assets acquired in a business combination or including them within goodwill. If the entity chooses to separately recognise intangible assets, they must apply this policy to all intangible assets in the same class and on a consistent basis.
Paragraph 18.8 has been heavily amended and the amended paragraph 18.8 states:
‘Intangible assets acquired in a business combination shall be recognised separately from goodwill when all the following three conditions are satisfied:
(a) the recognition criteria set out in paragraph 18.4 are met;
(b) the intangible asset arises from contractual or other legal rights; and
(c) the intangible asset is separable (ie 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).
An entity may additionally choose to recognise intangible assets separately from goodwill for which condition (a) and only one of (b) or (c) above is met. When an entity chooses to recognise such additional intangible assets, this policy shall be applied to all intangible assets in the same class (ie having a similar nature, function or use in the business), and must be applied consistently to all business combinations. Licences are an example of a category of intangible asset that may be treated as a separate class, however, further subdivision may be appropriate, for example, where different types of licences have different functions within the business.’
The effect of the above change is to reduce the costs of compliance of having to separately recognise intangible assets acquired as part of a business combination. Reporting entities can continue to separately recognise such intangible assets if they wish, provided this accounting policy is applied consistently to all intangible assets in the same asset class.
Steve Collings is the audit and technical partner at Leavitt Walmsley Associates Ltd.