MGT401 spring 2011 Assignment No. 01

“Financial Accounting II (MGT-401)”

Assignment No. 01 Total Marks: 15

LG is one of the most promising and growing company in electronic sector. Now-a-days, it is spending extensively on research and development to improve its products quality and customer satisfaction. LG has a policy of capitalizing development expenditures, but writes off pure and applied kind of research expenditures immediately in accordance with the requirements of IAS-38 (Intangible Assets).

In latest annual report of the company, it includes a page of voluntarily disclosure about the efficiency of the company’s research programs. Results indicate that the company’s prosperity depends on the development of new products and this can be a long term ongoing process.

The company often funded academic research studies into theoretical areas in order to maintain its technical lead. Some of the studies led to breakthroughs which enabled LG to patent and develop into new product ideas. The company argues that the money consumed in this way as a good investment because for every ten unsuccessful projects there is usually at least one valuable finding which generates enough profit to cover the whole cost of the research activities.

Unfortunately, it is impossible to tell in advance which project would succeed in this way.

A major shareholder of the company expressed dissatisfaction at LG’s policy of writing off research cost in this manner. He felt that it would be disproportionately pessimistic if company earned a good return from its research activities. He felt that the company should depart from the requirements of IAS-38 in order to achieve a fair presentation.

Requirements:

Marks (9)

a. You are required to mention three reasons which argue why it might be justifiable for LG to capitalize its research cost?

Solution:-

· Charge all research cost to expense. [IAS 38.54]

· Development costs are capitalized only after technical and commercial feasibility of the asset for sale [IAS 38.57]

· Or uses have been established. This means that the entity must intend and be able to complete the intangible asset and either uses it or sells it and be able to demonstrate how the asset will generate future economic benefits. [IAS 38.57]

· Purchased: capitalize

Initial Recognition: In-process Research and Development Acquired in a Business

Combination

A research and development project acquired in a business combination is recognized as an asset at cost, even if a component is research. Subsequent expenditure on that project is accounted for as any other research and development cost (expensed except to the extent that the expenditure satisfies the criteria in IAS 38 for recognizing such expenditure as an intangible asset).

[IAS 38.34]

b. Explain briefly why IAS-38 compels a rigid set of structure which prevents the capitalization of all research expenditures and make it difficult to capitalize development expenditures?

Solution:-

SUMMARY OF IAS 38

Source = http://www.iasplus.com/standard/ias38.htm

Objective

The objective of IAS 38 is to prescribe the accounting treatment for intangible assets that are not dealt with specifically in another IFRS. The Standard requires an entity to recognize an intangible asset if, and only if, certain criteria are met. The Standard also specifies how to measure the carrying amount of intangible assets and requires certain disclosures regarding intangible assets. [IAS 38.1]

Scope

IAS 38 applies to all intangible assets other than: [IAS 38.2-3]

· Financial assets

· Exploration and evaluation assets (extractive industries)

· Expenditure on the development and extraction of minerals, oil, natural gas, and similar resources

· Intangible assets arising from insurance contracts issued by insurance companies

· intangible assets covered by another IFRS, such as intangibles held for sale, deferred tax assets, lease assets, assets arising from employee benefits, and goodwill. Goodwill is covered by IFRS3.

Key Definitions

Intangible asset: an identifiable nonmonetary asset without physical substance.

An asset is a resource that is controlled by the entity as a result of past events (for example, purchase or self-creation) and from which future economic benefits (inflows of cash or other assets) are expected. [IAS 38.8] Thus, the three critical attributes of an intangible asset are:

· Identifiably

· control (power to obtain benefits from the asset)

· Future economic benefits (such as revenues or reduced future costs)

· Identifiably: an intangible asset is identifiable when it: [IAS 38.12]

· is separable (capable of being separated and sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract) or

· 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.

Examples of possible intangible assets include:

· computer software

· patents

· copyrights

· motion picture films

· customer lists

· mortgage servicing rights

· licenses

· import quotas

· franchises

· customer and supplier relationships

· marketing rights

Intangibles can be acquired:

· by separate purchase

· as part of a business combination

· by a government grant

· by exchange of assets

· by self-creation (internal generation)

Recognition

Recognition criteria. IAS 38 requires an entity to recognize an intangible asset, whether purchased or self-created (at cost) if, and only if: [IAS 38.21]

· It is probable that the future economic benefits that are attributable to the asset will flow to the entity; and

· The cost of the asset can be measured reliably.

This requirement applies whether an intangible asset is acquired externally or generated internally. IAS 38 includes additional recognition criteria for internally generated intangible assets (see below).

The probability of future economic benefits must be based on reasonable and supportable assumptions about conditions that will exist over the life of the asset. [IAS 38.22] The probability recognition criterion is always considered to be satisfied for intangible assets that are acquired separately or in a business combination. [IAS 38.33]

If recognition criteria not met. If an intangible item does not meet both the definition of and the criteria for recognition as an intangible asset, IAS 38 requires the expenditure on this item to be recognized as an expense when it is incurred. [IAS 38.68]

Business combinations. There is a presumption that the fair value (and therefore the cost) of an intangible asset acquired in a business combination can be measured reliably. [IAS 38.35] An expenditure (included in the cost of acquisition) on an intangible item that does not meet both the definition of and recognition criteria for an intangible asset should form part of the amount attributed to the goodwill recognized at the acquisition date.

Reinstatement. The Standard also prohibits an entity from subsequently reinstating as an intangible asset, at a later date, an expenditure that was originally charged to expense. [IAS 38.71]

Initial Recognition: Research and Development Costs

· Charge all research cost to expense. [IAS 38.54]

· Development costs are capitalized only after technical and commercial feasibility of the asset for sale or use have been established. This means that the entity must intend and be able to complete the intangible asset and either use it or sell it and be able to demonstrate how the asset will generate future economic benefits. [IAS 38.57]

If an entity cannot distinguish the research phase of an internal project to create an intangible asset from the development phase, the entity treats the expenditure for that project as if it were incurred in the research phase only.

Initial Recognition: In-process Research and Development Acquired in a Business

Combination

A research and development project acquired in a business combination is recognized as an asset at cost, even if a component is research. Subsequent expenditure on that project is accounted for as any other research and development cost (expensed except to the extent that the expenditure satisfies the criteria in IAS 38 for recognizing such expenditure as an intangible asset).

[IAS 38.34]

Initial Recognition: Internally Generated Brands, Mastheads, Titles, Lists

Brands, mastheads, publishing titles, customer lists and items similar in substance that are internally generated should not be recognized as assets. [IAS 38.63]

Initial Recognition: Computer Software

· Purchased: capitalize

· Operating system for hardware: include in hardware cost

· Internally developed (whether for use or sale): charge to expense until technological feasibility, probable future benefits, intent and ability to use or sell the software, resources to complete the software, and ability to measure cost.

· Amortization: over useful life, based on pattern of benefits (straight-line is the default).

Initial Recognition: Certain Other Defined Types of Costs

The following items must be charged to expense when incurred:

o Internally generated goodwill [IAS 38.48]

o Start-up, pre-opening, and pre-operating costs [IAS 38.69]

o Training cost [IAS 38.69]

o Advertising and promotional cost, including mail order catalogues [IAS 38.69]

o Relocation costs [IAS 38.69]

For this purpose, 'when incurred' means when the entity receives the related goods or services. If the entity has made a prepayment for the above items, that prepayment is recognized as an asset until the entity receives the related goods or services. [IAS 38.70]

Initial Measurement

Intangible assets are initially measured at cost. [IAS 38.24]

Measurement Subsequent to Acquisition: Cost Model and Revaluation Models Allowed

An entity must choose either the cost model or the revaluation model for each class of intangible asset. [IAS 38.72]

Cost model. After initial recognition the benchmark treatment is that intangible assets should be carried at cost less any amortization and impairment losses. [IAS 38.74]

Revaluation model: Intangible assets may be carried at a revalued amount (based on fair value) less any subsequent amortization and impairment losses only if fair value can be determined by reference to an active market. [IAS 38.75] Such active markets are expected to be uncommon for intangible assets. [IAS 38.78]

Examples where they might exist:

· Production quotas

· fishing licenses

· taxi licenses

Under the revaluation model, revaluation increases are credited directly to "revaluation surplus" within equity except to the extent that it reverses a revaluation decrease previously recognized in profit and loss. If the revalued intangible has a finite life and is, therefore, being amortized (see below) the revalued amount is amortized. [IAS 38.85]