Capitalisation of expenditure – 1 Complete answer

Capitalisation of expenditure

Capitalisation of expenditure is only possible when one of the following situations occur:

  • Capital expenditure (including equipment repairs and maintenance)
  • Recording lease contracts – Right-of-Use Assets
  • Capitalisation of borrowing costs
  • Capitalisation of cloud computing costs
  • Capitalisation of intangible assets
  • Capitalisation of internally capitalized intangible assets
  • Research & development costs
  • Prepaid expenses

Capital expenditure (including equipment repairs and maintenance)

The cost of an item of property, plant and equipment under IAS 16 Property, plant and equipment shall be recognised as an asset if, and only if:

  • it is probable that future economic benefits associated with the item will flow to the entity; and
  • the cost of the item can be measured reliably. (IAS 16.7)

Investment property

Certain properties which are used on rental are classified as an investment property in which case IAS 40 Investment property will apply. Only tangible items which have a useful life of more than one period are classified as property, plant and equipment as per IAS 16. But refer to the words “more than one period” as more than one accounting period of 12 months.

Also, an entity shall determine a threshold limit commensurate to its size for recognizing a tangible item as property, plant and equipment. For example, a tangible item of insignificant amount although satisfying the definition of property, plant and equipment may be expensed.

Initial recognition of indirect costs

Items of property, plant and equipment may be acquired for safety or environmental reasons. The acquisition of such property plant and equipment, although not directly increasing the future economic benefits of any particular existing item of property, plant and equipment, may be necessary for an entity to obtain the future economic benefits from its other assets.

Such items of property plant and equipment qualify for recognition as assets because they enable an entity to derive future economic benefits from related assets in excess of what could be derived had those items not been acquired.

Subsequent recognition of indirect costs

Day to day servicing:

An entity does not recognise in the carrying amount of an item of property plant and equipment the costs of the day-to-day servicing of the item. The purpose of these expenditures is often described as for the ‘repairs and maintenance’ are primarily the costs of labour and consumables, and may include the cost of small parts. These costs are expensed through profit and loss.

Replacement parts:

Parts of some items of property plant and equipment may require replacement at regular intervals or acquired to make a less frequently recurring replacement, an entity recognises in the carrying amount of an item of property plant and equipment the cost of replacing part of such an item when that cost is incurred provided that the recognition criteria are met.

Major inspections:

Costs incurred for major inspections for faults regardless of whether parts of the item are replaced are recognised to the carrying amount of the item of property, plant and equipment. Any remaining carrying amount of the cost of the previous inspection (as distinct from physical parts) is derecognised. This occurs regardless of whether the cost of the previous inspection was identified in the transaction in which the item was acquired or constructed.

Recording lease contracts – Right-of-Use Assets

On the commencement date, the lessee recognizes and measures the right-of-use asset at cost. Cost is comprised of the following:

Capitalisation of expenditure

Notes
*The definition of initial direct costs is consistent with the definition of incremental costs of obtaining a contract contained in IFRS 15. These are costs incurred to obtain a lease that would not have been incurred otherwise. These costs typically consist of commissions, legal fees (e.g. costs of originating the lease contract), administrative fees with negotiating the terms and conditions of the lease contract. General overhead or costs associated with obtaining offers for leases are typically not direct costs.
**The asset retirement obligation includes an estimate of costs to the lessee for:

  • Dismantling and removing the underlying asset;
  • Restoring the site where the underlying asset is located; or
  • Restoring the underlying asset to a condition specified by the terms and conditions of the lease (unless those costs are incurred to produce inventories).

Subsequent Measurement of the Right-of-Use Asset

At the commencement date, a lessee shall measure the lessee’s right-of-use asset at cost.

Depending on the type of the right-of-use asset, it is subsequently either measured at cost or a revalued/fair value amount as illustrated in the following table:

Type of Right-of-use Asset

Subsequent Measurement

Class of property, plant and equipment to which the entity applies the revaluation model in IAS 16 Property, Plant and Equipment.

May elect to apply the revaluation model to all of the right-of-use assets in that class of assets. Otherwise, use cost.

Investment property in accordance with IAS 40 Investment Property if the lessee applies the fair value model to its investment property.

Apply the IAS 40 fair value model

Other

Cost (i.e., the right-of-use asset is measured at cost less any less any accumulated depreciation and any accumulated impairment losses).

If the lease liability is revised for a reassessment or lease modification, the cost of the right-of-use asset is adjusted accordingly.

Capitalisation of borrowing costs

Borrowing costs refer to the interest and other costs that an entity incurs in connection with the borrowing of funds as ascertained at the effective rate of interest. An entity should capitalize borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of that asset. An entity should recognise other borrowing costs as expenses in the period in which the entity incurs these costs. A qualifying asset is an asset that necessarily takes a substantial period of time before it is ready for its intended use or sale.

Certain bearer or consumable biological assets may take a considerable period of time before they are ready for sale. However, in terms of IAS 41 Agriculture, an entity does not include any cash flows for the financing of the biological assets, taxation, or the re-establishing of biological assets after harvest for example, the cost of replanting trees in a plantation forest after harvest.

Although some biological assets require a considerable period of time to mature, the effect of biological transformation is recognised as income as it happens and likewise the borrowing cost relating to these biological assets should be expensed when incurred and not capitalized.

Capitalisation of cloud computing costs

As the use of technology, data and connectivity expands, cloud computing arrangements are becoming more common. Cloud computing arrangements are arrangements in which the customer does not currently have possession of the underlying software used in the arrangement. Rather, the customer accesses and uses the software on an as-needed basis (e.g., through the internet, or via a dedicated line).

Examples of cloud computing arrangements include software as a service, platform as a service, infrastructure as a service and other hosting arrangements. IFRS standards do not contain explicit guidance on a customer’s accounting for cloud computing arrangements or the costs to implement them.

Therefore, an entity will need to apply judgement to account for these arrangements and may need to apply various IFRS standards, including IFRS 16 Leases, IAS 38 Intangible Assets, and IAS 16 Property, Plant and Equipment. The following diagram summarises the accounting for cloud computing arrangements.

Capitalisation of expenditure

Accounting for a cloud computing arrangement that does not include an intangible asset

– Fees in the arrangement

If a cloud computing arrangement does not contain a lease in the scope of IFRS 16 and does not contain an intangible asset in the scope of IAS 38, then the right to access the underlying software in the cloud computing arrangement is generally a service contract. Therefore, an entity should expense the fees paid for the cloud computing arrangement as the service is provided.

Entities generally recognise an asset for costs they prepay that relate to a service they will receive over time, which may be the case for cloud computing arrangements. For example, a customer that makes payments to a supplier of cloud computing services in advance of the related service period may determine that it is appropriate to recognise a prepaid asset (e.g., prepaid service contract) for those costs. Importantly, these costs are considered a prepaid asset that should be subsequently recognised as operating expense (and not presented as amortisation that is used to calculate EBITDA) as the services are provided.

Up-front payments the customer makes to the cloud computing supplier that relate to enhancing the functionality of the cloud computing service to be received over time should also generally be treated as a prepaid asset that is expensed over the term of the arrangement.

– Internal and third-party implementation costs

In a cloud computing service arrangement (i.e., an arrangement without a software license), a customer may incur implementation and other up-front costs to get the cloud computing arrangement ready for use and directly or indirectly relate to the software service received over time. These costs may relate to activities performed by the customer’s internal personnel or third parties.

Implementation costs can include the following:

  • Research costs (e.g., needs assessment and software evaluation)
  • Hardware costs
  • Costs to configure the underlying software
  • Customisation of software
  • Changes to other entity systems
  • Training costs
  • Data conversion
  • Testing

The guidance in IAS 38 addresses how customers that obtain software licenses evaluate whether to capitalize or expense certain costs, but it does not apply when software is accounted for as a service (i.e., service arrangements that do not include a software license). Entities incur implementation and other upfront costs for a variety of service arrangements. As a result, entities will need to carefully review both the services they will receive and the implementation costs they will incur.

Careful consideration will be required if a customer contracts with a third-party supplier (unrelated to the software service supplier), or incurs internal costs to perform certain activities that are directly or indirectly related to a software service arrangement. Customers should carefully evaluate these types of costs to determine whether the costs should be expensed, recognised as a prepaid asset, or capitalized, depending on the specific services that are provided.

The following sections provide considerations for applying this guidance to various implementation costs of a cloud computing arrangement.

Research costs

Costs to perform research (e.g., conceptual formulation of alternatives, evaluation of alternatives, determination of the existence of needed technology, final selection of alternatives) are generally considered research activities. Therefore, the costs for these activities are expensed as incurred, regardless of whether a cloud computing arrangement includes a software license. Examples of research activities that should be expensed include:

  • Making strategic decisions to allocate resources between various projects. For example, should resources be focused on a new inventory management system or a new customer service and information system?
  • Determining the performance requirements of the cloud computing system. For example, should the cloud computing system be limited to performing a certain number of functions and uses, or should the cloud computing system have broader functionality and be available to more users throughout the entity?
  • Exploring alternative means of achieving the performance requirements. For example, should the information system be owned by the entity or obtained through a cloud computing arrangement?
  • Determining the technology requirements necessary to achieve the performance requirements of the entity. Is existing hardware capable of achieving the performance requirements or is new hardware required?
  • Inviting vendors to demonstrate their cloud computing system to management
  • Selecting vendor(s) of the cloud computing system
  • Selecting consultants to assist in the implementation of the cloud computing system
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Hardware costs

Costs to obtain hardware as part of a cloud computing arrangement are generally capitalized and should be accounted for under IAS 16.

Costs to configure the underlying cloud computing service arrangement

Costs incurred to configure the underlying cloud computing service arrangement generally should be expensed as incurred. That is because configuration activities affect a resource that is controlled by the cloud computing arrangement supplier and would not qualify as a separate intangible asset. These costs would not qualify as directly attributable costs of preparing the asset for its intended use under IAS 38 because the cloud computing arrangement does not include a software license.

Customisation of software

An entity should evaluate whether customization of the underlying hosted software creates an intangible asset that the customer controls. This evaluation will require significant judgement. For example, if a third party changes the cloud computing supplier’s underlying software code for the customer, the software code likely would be controlled by the cloud computing supplier and not the customer.

However, if a third party is writing the code and it could be used by the customer in another cloud computing arrangement, then the code would be considered an asset to the customer and an entity would conclude that a payment to the third party should be capitalized. In other situations, an entity may conclude that all payments made to a third party, in the context of an overall arrangement that is a service contract, should be expensed as incurred because the third party is preparing a service rather than an asset for its intended use.

Changes to other entity systems

Customers may incur costs to modify or enhance their existing software (e.g., ERP system) that will continue to be used in conjunction with software services they will receive under a cloud computing arrangement. Customers should follow the guidance in IAS 38 to determine whether to capitalize or expense costs related to internal-use software (i.e., software owned or licensed by the user).

Upgrades and enhancements are modifications to existing software that result in additional functionality (i.e., modifications to enable the software to perform tasks that it previously was not capable of performing). Upgrades and enhancements normally require new software specifications or changes that augment all, or part, of existing software specifications. From the perspective of the user of the software, a modification that only extends the useful life without adding additional functionality is a maintenance activity, the costs of which should be expensed as incurred.

Therefore, qualifying costs of specified upgrades and enhancements should only be capitalized if it is probable that the upgrade or enhancement will result in additional functionality. Entities that cannot separate internal costs on a reasonably cost-effective basis between maintenance and relatively minor upgrades and enhancements should expense such costs as incurred. Entities that can distinguish between maintenance and relatively minor upgrades and enhancements should expense these costs (e.g., maintenance) or capitalize them (e.g., upgrades) depending on their nature.

Entities generally should capitalize the portion of implementation costs associated with cloud computing arrangements (that are considered service contracts) that are incurred to integrate (bridge) the cloud computing arrangement with their existing internal-use software or make improvements to their current on-premise software for the cloud computing arrangement to work seamlessly because those costs generally enhance the functionality of the existing software.

Training costs

Training costs (including costs to train employees to develop, configure, or implement the cloud computing arrangement) are not related to cloud computing development. Therefore, customers should expense training costs generally when the related training service is rendered, regardless of whether a cloud computing arrangement includes a software license. Training costs are listed in IAS 38.69 as an example of expenditure that should be expensed as incurred.

Data conversion

Data conversion is the process of transferring data from the existing computer system to the new cloud computing system. Entities should capitalize costs incurred to develop or obtain software that allows for access or conversion of existing data by the new cloud computing system. Costs to obtain or develop data conversion software is not treated as part of the cost of the cloud computing arrangement, but is a separate software component.

All other costs (outside costs to obtain or develop data conversion software) incurred during the data conversion process should be expensed as incurred.

Typical activities involved during the data conversion process that should be expensed as incurred include:

  • Reconciling or balancing the new data with the data extracted from the old system
  • Purging existing data
  • Creating or inputting new data required by the new cloud computing system

Testing

Costs of testing whether an asset is functioning properly is an example listed in IAS 38 of a directly attributable cost of preparing the asset for its intended use. However, in a cloud computing service arrangement, there is no underlying intangible asset that the customer controls. Therefore, costs to test the cloud computing arrangement as a whole should be expensed as incurred.

Accounting for a cloud computing arrangement that includes an intangible asset

– Fees in the arrangement

Under IAS 38, an item that meets the definition of an intangible asset should only be recognised if, at the time of initial recognition of the expenditure:

  • It is probable that the expected 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 test (that the item meets both the definition of an intangible asset and the criteria for recognition) is performed when an entity incurs potentially eligible expenditures, whether to acquire or internally generate an intangible asset or to add to, replace part of, or service it subsequent to initial recognition.

Separately acquired intangible rights (i.e., software licenses in cloud computing arrangements) will normally be recognised as assets. IAS 38 assumes that the price paid to acquire an intangible asset usually reflects expectations about the probability that the future economic benefits embodied in it will flow to the entity.

That is, the entity always expects there to be a flow of economic benefits, even if it is uncertain about the timing or amount. Therefore, the standard assumes that the cost of a separately acquired intangible asset can usually be measured reliably, especially where the purchase consideration is in the form of cash or other monetary assets.

In some cases, entities enter into a cloud computing arrangement that requires them to pay the cloud computing supplier or other third party to provide implementation activities and other services such as training employees to use the software, maintenance work to be performed by the third party, rights to future upgrades and enhancements, data conversion, and hardware.

An entity should allocate the fee in a cloud computing arrangement to these implementation activities and other services. One way an entity could allocate the fees in a cloud computing arrangement to each element in the contract (e.g., software license, hosting, implementation activities) is based on the relative standalone price or relative fair value of each element in the contract.

The statement of work for the implementation activities can often be complicated, so an entity will need to apply judgement to determine the components of implementation costs to which the purchase consideration should be allocated, which will determine the amounts that should be capitalized and the amounts that should be expensed as incurred.

Elements that meet both the definition of an intangible asset and the criteria for recognition should be accounted for in accordance with IAS 38. Elements outside the scope of IAS 38 (e.g., hosting) should be accounted for based on other IFRS standards. In addition, IAS 38 specifically states that certain expenditures should be expensed as incurred (i.e., training costs, start-up costs).

The asset recognised for the software license should be the present value of the license obligation if the cloud computing arrangement is to be paid for over time. An entity should record a liability to the extent that all or a portion of the amount allocated to the software license is not paid on or before the recognition of the license.

– Implementation costs

Customers often incur implementation costs to get a cloud computing arrangement ready for use. Implementation costs can include the following:

  • Research costs (e.g., needs assessment and software evaluation)
  • Hardware costs
  • Costs to configure or customize the underlying software
  • Changes to other entity systems
  • Training costs
  • Data conversion
  • Testing

Costs incurred by customers to implement a cloud computing arrangement that includes a software license are accounted for based on the nature of the costs. The guidance in IAS 38 should be applied by customers that obtain software licenses to evaluate whether to capitalize or expense certain costs.

The cost of a separately acquired intangible asset includes its purchase price, as well as import duties and non-refundable purchase taxes after deducting trade discounts and rebates, and any directly attributable cost of preparing the asset for its intended use. Therefore, implementation costs may be part of the cost of a separately acquired intangible asset or they may qualify as a separate internally generated intangible asset.

Examples of directly attributable costs of preparing a separately acquired intangible asset for its intended use include the following:

  • Costs of employee benefits arising directly from bringing the asset to its working condition
  • Professional fees arising directly from bringing the asset to its working condition
  • Costs of testing whether the asset is functioning properly

The following types of expenditures are not considered to be part of the cost of a separately acquired intangible asset:

  • Costs of introducing a new product or service, including costs of advertising and promotional activities
  • Costs of conducting business in a new location or with a new class of customer, including costs of staff training
  • Administration and other general overhead costs
  • Costs incurred in using or redeploying an intangible asset, such as:
  • Costs incurred while an asset capable of operating in the manner intended by management has yet to be brought into use
  • Initial operating losses, such as those incurred while demand for the asset’s output builds up

The cost of an internally generated intangible asset comprises all directly attributable costs necessary to create, produce and prepare the asset to be capable of operating in the manner intended by management. Examples of directly attributable costs are:

  • Costs of materials and services used or consumed in generating the intangible asset
  • Costs of employee benefits arising from the generation of the intangible asset
  • Fees to register a legal right
  • Amortisation of patents and licenses that are used to generate the intangible asset
  • Borrowing costs that meet the criteria under IAS 23 (which requires that the asset takes a substantial period of time to get ready for its intended use) for recognition as an element of cost
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For example, costs that are capitalized for developing software or obtaining a software license included in a cloud computing arrangement include external direct costs of materials and services incurred in developing or obtaining the software and payroll and payroll related costs (benefits) for employees who are directly involved with and who devote time to developing the cloud computing system, to the extent the time is spent directly on the project’s development activities.

External direct costs include, among others, fees paid to develop the software or supplemental software (e.g., to write program code), cost to purchase the cloud computing software license from third parties and travel expenses incurred by employees in their duties directly associated with developing the cloud computing system. Examples of employee activities include program coding and testing during development.

Indirect costs and general overheads, even if they can be allocated on a reasonable and consistent basis to the development project, cannot be recognised as part of the cost of any intangible asset. IAS 38 also specifically prohibits recognition of the following items as a component of cost:

  • Selling, administrative and other general overhead expenditure unless this expenditure can be directly attributed to preparing the asset for use
  • Identified inefficiencies and initial operating losses incurred before the asset achieves planned performance
  • Expenditure on training staff to operate the asset

For these purposes it does not make any difference whether the costs are incurred directly by the entity or relate to services provided by third parties.

Capitalisation of costs to develop an intangible asset should cease no later than the point at which the project is substantially complete and ready for its intended use.

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, but also meet criteria 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.

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. 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. If the research phase cannot be distinguished from the development phase, all expenditure is treated as research.

IAS 38 gives the following examples of research activities:

  • Activities aimed at obtaining new knowledge
  • The search for, evaluation and final selection of, applications of research findings or other knowledge
  • The search for alternatives for materials, devices, products, processes, systems or services
  • 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 states the design, construction and testing of a chosen alternative for new or improved materials, devices, products, processes, systems or services is an example of a development activity.

The following sections provide considerations for applying the guidance in IAS 38 to various implementation costs of a cloud computing arrangement.

Research costs

Costs to perform research (e.g., conceptual formulation of alternatives, evaluation of alternatives, determination of existence of needed technology, final selection of alternatives) are generally considered research activities and, therefore, the costs for these activities are expensed as incurred. Examples of research activities that should be expensed include:

  • Making strategic decisions to allocate resources between various projects. For example, should resources be focused on developing a new inventory management system or developing a new customer service and information system?
  • Determining the performance requirements of the cloud computing system. For example, should the cloud computing system be limited to performing a certain number of functions or should the cloud computing system have broader functionality and be available to more users throughout the entity?
  • Exploring alternative means of achieving the performance requirements. For example, should the information system be owned by the entity or obtained through a cloud computing arrangement?
  • Determining the technology requirements necessary to achieve the performance requirements of the entity. Is existing hardware capable of achieving the performance requirements or is new hardware required?
  • Inviting vendors to demonstrate their cloud computing system to management
  • Selecting vendor(s) of the cloud computing system
  • Selecting consultants to assist in the implementation of the cloud computing system

Hardware costs

Costs to obtain hardware as part of a cloud computing arrangement are generally capitalizede and should be accounted for under IAS 16.

Costs to configure or customize the underlying software

Costs incurred to code, configure or customize the underlying software of the cloud computing arrangement are generally directly attributable costs of preparing the asset for its intended use and should be capitalized. However, minor changes to a cloud computing arrangement’s interface or similar types of changes (e.g., cosmetic changes) may be considered to be costs incurred while an asset capable of operating in the manner intended by management has yet to be brought into use, in which case, they should be expensed as incurred.

Changes to other entity systems

Customers also may incur costs to modify or enhance their existing software (e.g., enterprise resource planning (ERP) system) that will continue to be used in conjunction with software services they will receive under a cloud computing arrangement. Customers should follow the guidance in IAS 38 to determine whether to capitalize or expense costs related to internal-use software (i.e., software owned or licensed by the user).

Upgrades and enhancements are modifications to existing software that result in additional functionality (i.e., modifications to enable the software to perform tasks that it previously was not capable of performing). Upgrades and enhancements normally require new software specifications or changes that augment all, or part, of existing software specifications. From the perspective of the user of the software, a modification that only extends the useful life without adding additional functionality is a maintenance activity, the costs of which should be expensed as incurred.

Therefore, qualifying costs of specified upgrades and enhancements should only be capitalized if the upgrade or enhancement will result in additional functionality. Entities generally should capitalize the portion of implementation costs associated with cloud computing arrangements that are incurred to integrate (bridge) the cloud computing arrangement with their existing internal use software or make improvements to their current on-premise software for the cloud computing arrangements to work seamlessly because those costs generally enhance the functionality of the existing software.

Entities that cannot separate internal costs on a reasonably cost-effective basis between maintenance and relatively minor upgrades and enhancements should expense such costs as incurred. Entities that can distinguish between maintenance and relatively minor upgrades and enhancements should expense these costs (e.g., maintenance) or capitalize them (e.g., upgrades) depending on their nature.

Training costs

Training costs (including costs to train employees to develop, configure, or implement software) are not related to software or cloud computing system development. Therefore, customers should expense training costs generally when the related training service is rendered, regardless of whether a cloud computing arrangement includes a software license. Training costs are listed in IAS 38.69 as an example of expenditure that should be expensed as incurred.

Data conversion

Data conversion is the process of transferring data from the existing computer system to the new system. Entities should capitalize costs incurred to develop or obtain software that allows for access or conversion of existing data by a new system. Costs to obtain or develop data conversion software are not treated as part of the cost of the software license included in the cloud computing arrangement but are a separate software component. All other costs (outside of costs to obtain or develop data conversion software) incurred during the data conversion process should be expensed as incurred.

Typical activities involved during the data conversion process that should be expensed as incurred include:

  • Reconciling or balancing the new data with the data extracted from the old system
  • Purging existing data
  • Creating or inputting new data required by the new cloud computing system

Testing

Costs of testing whether an asset is functioning properly is an example listed in IAS 38 of a directly attributable cost of preparing the asset for its intended use. Therefore, costs to test the cloud computing arrangement should be capitalized.

Capitalisation of intangible assets

Intangible assets are assets, excluding financial assets that lack physical substance. In determining whether an identifiable intangible asset should be recognized separately from goodwill, as part of accounting for a Business combination (IFRS 3), the acquirer should evaluate whether the asset meets either of the following criteria:

  • Contractual-legal criterion: The intangible asset arises from contractual or other legal rights (regardless of whether those rights are transferable or separable from the acquired business or from other rights and obligations) in accordance with IFRS 3.B32.
  • Separability criterion: The intangible asset is capable of being separated or divided from the acquired business and sold, transferred, licensed, rented, or exchanged. An intangible asset that the acquirer would be able to sell, license, or otherwise exchange for something of value meets the separability criterion, even if the acquirer does not intend to sell, license, or otherwise exchange it. If an intangible asset cannot be sold, transferred, licensed, rented, or exchanged individually, it is still considered separable if it can be sold, transferred, licensed, rented, or exchanged in combination with a related contract, asset, or liability. However, there cannot be restrictions on the transfer, sale, or exchange of the asset in accordance with IFRS 3.B33.

Common identifiable intangible assets

These steps describe general approaches for detecting identifiable intangible assets in a business combination. Practitioners also often ask for a ‘checklist’ of the intangible asset types most commonly identified in business combinations. Any such checklist should be treated with a degree of caution.

Best practice is to maintain a wide focus in the detection phase so that relevant identifiable intangible assets are not overlooked. The intangibles to be identified vary in each case and depend greatly on the industry of the acquired business and the circumstances of the business combination.

Despite the limitations of any checklist, a list of common examples can help to focus the analysis and provide an indication of possible end results. Accordingly, ‘Case value intangibles in a business combination’ discusses a number of intangible asset types that are commonly detected in business combinations, including customer relationships, trademarks or non-compete agreements (and common measurement methods used to estimate their fair values).

Illustrative examples within IFRS 3 IE 18 – 44

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Capitalisation of expenditure

Capitalisation of internally generated intangible assets

Under IFRS (IAS 38) companies are not required to capitalize internally generated intangible assets on the balance sheet. The main reason is that the information would probably not be useful for investors and would be very costly for companies to prepare. If social media companies were required to recognize data or workforce as an intangible asset on the balance sheet, would investors find that information useful in valuing a company? In general this is considered doubtful, because the information would be highly subjective, require forward looking estimates, and would probably not be comparable across companies.

Research & development costs

It may be challenging to assess whether an internally generated intangible asset qualifies for recognition, due to issues in:

  • Identifying whether and when the identifiable asset will generate expected future economic benefits; and
  • Determining the costs of the asset reliably. In some cases, 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 from the running of the day to day operations.

In this respect, in addition to complying with the criteria to qualify as an intangible asset and the recognition criteria mentioned above, to assess whether internally generated intangible assets meet the recognition criteria, an entity is required to classify the generation of the assets into 2 phases:

Research phase

Development phase

Research’ is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. Research costs are expensed as they are incurred.

Examples of research activities include:

  1. Activities aimed at obtaining new knowledge;
  2. The search for, evaluation and final selection of, applications of research findings or other knowledge;
  3. The search for alternatives for materials, devices, products, processes, systems or services; and
  4. 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. Development does not include the maintenance or enhancement of ongoing operations.

Examples of development activities are:

  1. The design, construction and testing of pre-production or pre-use prototypes and models; and
  2. The application and infrastructure development, graphical design and content development (content falls under development, to the extent that it is developed for purposes other than to advertise and promote an entity’s own products and services).

In view of the above, a company needs to be able to make a distinction between the 2 phases of its projects. The costs attributable to activities that fall under the research phase (as defined above), need to be accounted for as an expense. On the other hand, anything that qualifies as development could be capitalized, if they satisfy the recognition criteria that will be discussed in more detail below.

Should the company not be in a position to distinguish between the 2 phases of its internal project to create the intangible asset, all the expenditure incurred on the project needs to be treated as if it was incurred in the research phase and hence expensed when incurred.

It is also important to note that when the standard refers to development, it does not necessarily need to be in relation to an entirely new innovation; but rather it needs to be new to the specific entity.

Recognition criteria for internally generated intangible assets arising from the development phase

If an internally generated intangible asset arises from the development phase of a project, then directly attributable expenditure is capitalized from the date on which the entity can demonstrate:

  1. How the intangible asset will generate probable future economic benefits. Amongst 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 used internally, the usefulness of the intangible asset;
  2. Its intention to complete the intangible asset so that it will be available for use or sale. It may be challenging to obtain this evidence since it relies on management’s intent;
  3. The availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset. Financial and other resources needed to complete the development are not required to be secured at the start of the project. An entity may be able to demonstrate its ability to secure these resources through business plans and external financing plans in which potential customers, investors or lenders have expressed interest;
  4. Its ability to use or sell the intangible asset;
  5. The technical feasibility of completing the intangible asset so that it will be available for use or sale. The recognition criterion of technical feasibility is very subjective and relies also on management’s intent;
  6. Its ability to reliably measure the expenditure attributable to the intangible asset during its development. The Company would require an appropriately equipped costing system (including for example a time keeping system if the entity’s human resources are being used in the asset’s development) to reliably determine the cost of production.

Cost of internally generated intangible assets

On initial recognition, an intangible asset should be measured at cost if it is probable that future economic benefits that are attributable to the asset will flow to the entity and the cost of the asset can be measured reliably.

The cost of an internally generated intangible asset includes the directly attributable expenditure of preparing the asset for its intended use. Expenditure on training activities, identified inefficiencies and initial operating losses is expensed as it is incurred.

The cost to be recognised is the sum of expenditure incurred from the date when the intangible asset first meets the recognition criteria and prohibits reinstatement of expenditure previously recognised as an expense.

Directly attributable costs comprise all costs necessary to create, produce, and prepare the asset to be capable of operating in the manner intended by management. Examples of directly attributable costs are:

Capitalisation of expenditure

The below are not components of the cost of an internally generated intangible asset:

  • Selling, administrative and other general overhead expenditure unless this expenditure can be directly attributable to preparing the asset for use;
  • Identified inefficiencies and initial operating losses incurred before the asset achieves planned performance; and
  • Expenditure on training staff to operate the asset.

The capitalisation cut off is determined by when the testing stage of the software has been completed and the software is ready to go live. Costs incurred after the final acceptance testing and launch have been successfully completed, should be expensed.

Subsequent capitalisation

There may be a period after the launch of the asset that would still be accounted for as part of the development phase, for example in the case of platform development, activities to improve its functionality to deal with higher volumes of players, could constitute development.

However, this does not necessarily mean that the Company would be able to capitalize all the related expenditure. It needs to:

  • Enhance the asset’s economic benefits potential. In view of the nature of the intangible assets, in many cases there are no additions to such an asset or replacement of part of it. Most of subsequent expenditures are likely to maintain the expected future economic benefits embodied in the existing intangible asset, rather than meet the definition of an intangible asset and the recognition criteria in the standard.
  • Meet the 6 criteria listed above for the recognition of development costs as an asset.

Prepaid expenses

Prepaid expenses are future expenses that are paid in advance. On the balance sheet, prepaid expenses are first recorded as an asset. After the benefits of the assets are realized over time, the amount is then recorded as an expense.

Insurance is an excellent example of a prepaid expense, as it is customarily paid for in advance. If a company pays $12,000 for an insurance policy that covers the next 12 months, then it would record a current asset of $12,000 at the time of payment to represent this prepaid amount. In each month of the 12-month policy, the company would recognize an expense of $1,000 and draw down the prepaid asset by this same amount.

Prepaid expense – Insurance costs

P&L – Insurance costs

DT 12,000

1

CR -1,000 = DT 11,000

DT 1,000

2

CR -1,000 = DT 10,000

DT 1,000

3

CR -1,000 = DT 9,000

DT 1,000

4

CR -1,000 = DT 8,000

DT 1,000

5

CR -1,000 = DT 7,000

DT 1,000

6

CR -1,000 = DT 6,000

DT 1,000

7

CR -1,000 = DT 5,000

DT 1,000

8

CR -1,000 = DT 4,000

DT 1,000

9

CR -1,000 = DT 3,000

DT 1,000

10

CR -1,000 = DT 2,000

DT 1,000

11

CR -1,000 = DT 1,000

DT 1,000

12

CR -1,000 = 0

DT 1,000

Annualreporting provides financial reporting narratives using IFRS keywords and terminology for free to students and others interested in financial reporting. The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Annualreporting is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org or the local representative in your jurisdiction.

Something else -   Common cash flow classification errors in practice in 1 way

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Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure

Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure

Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure Capitalisation of expenditure

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