Intangibles - The Main Influences

1. Intangibles - The Main Influences • Goodwill • IFRS 3 (business combinations) • IAS 36 (impairment) • IAS 38 (intangibles) • Other intangibles • IAS 38 (intangibles) • IAS 36 (impairment) • IFRS 13 (fair value)

2. Goodwill • The difference between the value of a business and the fair value of its separable assets and liabilities • Separable asses are those which can be sold separately and thus include intangibles such as patents • Goodwill may be positive or negative

3. Why does goodwill exist? • There are many items of benefit to a business which are not included in assets • Well-known brand name • A good reputation • Strong customer base • The business may have a highly skilled workforce

4. How is goodwill valued? • Master valuation method • Value the business as a whole using earnings or dividend model • Goodwill is the difference between the total value and the fair value of the separable net assets

5. How is goodwill valued? • Super profits method • Identify profits which can be regarded as over and above a normal return • Capitalise at an appropriate rate that will reflect the level of risk

6. The nature of goodwill • Inherent goodwill • will not be brought into the accounts • Purchased goodwill • must be accounted for

7. Accounting for goodwill • Fixed asset • Deduction from shareholders’ funds (the dangling debit) • Immediate write-off

8. Goodwill as a fixed asset • Retained indefinitely unless a permanent reduction in value becomes apparent • Amortised to income statement over its expected economic life • Amortised to reserves over its expected economic life

9. Goodwill deducted from shareholders’ funds • Known as “the dangling debit” • Retained indefinitely unless a permanent reduction in value becomes apparent • Amortised to income statement over its expected economic life • Amortised to reserves over its expected economic life

10. Goodwill immediate write-off ? • Write-off to income statement • Write-off to reserves

11. Goodwill and intangible assets • Positive goodwill To be classified under intangible assets ie. should be ‘capitalised’ To undergo annual impairment test IAS 36 • Negative goodwill To be taken in full to the profit or loss as income of the reporting period during which the transaction occurred

12. Goodwill acquired in abusiness combination IFRS 3 • Classify (capitalise) under non-amortisable intangible assets • The goodwill must undergo an impairment test at the end of each year IAS 36

13. Goodwill and intangible assets • Purchased goodwill is part of a larger asset for which management remains accountable • Intangible assets • those that can be readily identified and separately measured (e.g. trade marks and patents) • those that are essentially similar to goodwill (e.g. brands)

14. Internally generated (inherent) goodwill Should never be capitalised

15. Positive purchased goodwill • Capitalise as an intangible fixed asset • Amortise to income statement over its economic life, normally not more than 20 years • impairment test after one year • further impairment tests if loss in value is suspected • immediate write-off of value losses • If goodwill has an indefinite life it should not be amortised • impairment test at the end of each year • immediate write-off of value losses

16. Negative purchased goodwill • The gain (bargain purchase) should be recognized in the profit or loss of the acquirer • Credit the bargain purchase in full in the profit or loss of the current reporting period during which the transaction occurred

17. Intangible fixed assets • Capitalise at cost if purchased separately from the purchase of a business • Capitalise at fair value if purchased as part of the purchase of a business and it can be separately valued • Include as part of goodwill if purchased as part of the purchase of a business and it cannot be separately valued • Amortise to income statement over its economic life • Internally developed intangible fixed asset may be capitalised only if it has a readily ascertainable market value

18. IAS 36 Impairment and IAS 38 • Assets will need to be grouped as income-generating units and fair value determined by discounting expected (future) cash flows • If there is a decline in value of an income-generating unit then the assets within that unit should be written down starting with goodwill and intangibles

19. IAS 36 and IAS 38 Research and Development • Covers expenditure ranging from the broad concept of “general research” to the specific application of “development” of a product that can be produced and marketed • Important accounting concepts • accruals • prudence • prudence will prevail if there is a conflict

20. Definitions • Pure research • original investigation to gain new scientific or technical knowledge • not primarily directed towards any specific application • Applied research • original investigation to gain new scientific or technical knowledge • directed towards a specific application • Development • the use of new scientific or technical knowledge to produce a new or improved product

21. IAS 36 and IAS 38 do not apply to: • Expenditure relating to locating or exploiting mineral deposits • Expenditure relating to locating or exploiting oil deposits • Expenditure reimbursable by third parties

22. Costs to be includedin research and developmentexpenditure • Payroll costs • Material costs • Equipment depreciation • Overhead expenses • Amortisation of patents • Other related costs

23. Accounting treatment • Pure research • write-off to income statement in the year in which the expenditure is incurred • Applied research • write-off to income statement in the year in which the expenditure is incurred • Development • may be capitalised (IAS 38 should be capitalised) • may be written-off to income statement in the year in which the expenditure is incurred (but no for IAS 38)

24. Capitalisation of development expenditure • Must be a clearly defined project • Expenditure must be separately identifiable • Project must be technically feasible • Must be commercially viable • Costs must be more than covered by related revenues • Adequate resources must be available to complete the project

25. Amortisation of development expenditure • Commence in the period in which commercial production begins • Amortise on the basis of • revenues earned • use of the product • time • Review deferred expenditure at each balance sheet date • write-off irrecoverable expenditure • do not write-back expenditure that has previously been written-off

26. The choice of policy regarding development expenditure • Experience in forecasting techniques • Does the expenditure fluctuate each year? • Standard policy in the industry • Amount of expenditure relative to the company’s total expenditure • Importance of commercial secrecy • Does the company want to boost its balance sheet?

27. IAS 38 Intangible Assets • Choice should be removed • if expenditure meets development criteria then it should be capitalised • if expenditure does not meet development criteria then it should not be capitalised

28. IAS 36 Impairment of Assets and Goodwill and IFRS 3 and 13 • Fixed assets and goodwill should be reviewed for impairment if there is some indication that impairment has occurred • If possible individual assets should be tested for impairment • Impairment testing is based upon expected cash flows therefore it may not be possible to test an individual asset

29. Impairment of Fixed Assets and Goodwill • Groups of assets may need to be identified • Asset groups are known as income-generating units (IGU) or cash generating units (CGU) • Impairment is measured by comparing the carrying value of the asset or IGU with its recoverable amount

30. Impairment of Fixed Assets and Goodwill • Impairment losses are normally recognised in the income statement • Impairment losses arising on a previously revalued fixed asset are included in the Statement of Total Recognised Gains and Losses (STRGL) until the carrying value falls below depreciated historical cost

31. Impairment of Fixed Assets and Goodwill • Recoverable amount is the higher of net realisable value (NRV) and value in use (VIU) • VIU depends upon the recognition of future cash flows which should be discounted to a present value using the rate of return which the market would expect from an equally risky investment

32. What Might Cause Impairment ? • A current period operating loss (relating to the IGU) combined with past period operating losses or expected future operating losses or cash outflows • A significant decline in a fixed asset's market value in the period • Evidence of obsolescence or physical damage to a fixed asset

33. What Might Cause Impairment ? • A significant adverse change in the business or market in which the IGU is operating • A significant adverse change in statutory or other regulatory environment • A significant adverse change in any indicator of value used to measure the fair value of a fixed asset on acquisition

34. What Might Cause Impairment ? • A commitment by management to undertake a significant reorganisation • A major loss of key employees • A significant increase in market interest rates or other market rates of return that are likely to materially affect the IGU's recoverable amount

35. Impairment of Fixed Assetsand Goodwill Events which might cause impairment could also have an effect on the economic life of the IGU and this should also be reviewed

36. Impairment of Fixed Assetsand Goodwill • Where impairment is apparent the losses should be applied first to any goodwill in the IGU, then to any capitalised intangible assets and finally to the tangible assets • Where appropriate past impairments may be reversed (except goodwill)

37. Impairment and Risk • May be taken into account through the discount rate used • May be taken into account through an adjustment to the cash flows which may involve some element of probability analysis • Tax will also affect the discount rate or cash flows

38. Goodwill valuation methods • Master valuation methods • Value the business as a whole using earnings or dividend model • Super profits method • Identify profits which can be regarded as over and above a normal return

39. Master valuation method Based on dividend model Dt  - G = NAV (1+i)t G = Goodwill Dt = Expected future dividends i = Investors’ required rate of return NAV = Value of the net assets

40. Master valuation method Based on dividend model D0(1+g) G = - NAV (i-g) G = Goodwill D0 = Current dividend i = Investors’ required rate of return g = Expected dividend growth rate NAV = Value of the net assets

41. Master valuation method Based on dividend model ra (E-D0) D0 + rc G - NAV = rc G = Goodwill D0 = Current dividend ra = Expected rate of return on marginal investments rc = Market capitalisation rate E = Current earnings NAV = Value of the net assets

42. Master valuation method Based on earnings model Em - G = NAV k G = Goodwill Em = Maintainable earnings k = Market capitalisation rate NAV = Value of the net assets

43. Master valuation method Based on earnings models G = Em  P/E - NAV G = Goodwill Em = Maintainable earnings P/E = An appropriate P/E ratio NAV = Value of the net assets

44. Super profits method Et-rA G = j G = Goodwill Et = Expected earnings rA = Normal return on the investment in net tangible assets j = Capitalisation rate for super profits

45. Super profits method (Et-En)  G = (1+j)t G = Goodwill Et = Expected earnings En = Normal earnings j = Capitalisation rate for super profits

46. Super profits method (1+rg)(Et-En)  G = (1+j)t G = Goodwill rg = Earnings growth rate Et = Expected earnings En = Normal earnings j = Capitalisation rate for super profits