Intangibles

Typical coverage of US GAAP Characteristics Acquisition of intangibles: Purchased intangibles Internally created intangibles Types of intangibles Periodic valuation Carrying value Impairment Definition of impairment indicators Recognition Frequency of testing Determination Calculation Cost allocation Goodwill Research and development costs Other costs

Executive summary IFRS permits periodic revaluation of intangible assets (except for goodwill) to fair value. US GAAP does not allow revaluation. IFRS has a one-step approach for determining the impairment of intangible assets while US GAAP has a two-step approach. In addition, the calculations to compute the amount of loss are different. IFRS allows for the reversal of impairment losses on intangible assets (except for goodwill) while this is prohibited under US GAAP. IFRS requires that development costs are capitalized when technical and economic feasibility of a project can be demonstrated in accordance with specific criteria. Under US GAAP, most types of development costs are expensed as incurred.

Progress on convergence In 2006, the FASB and the IASB agreed to converge their standards on intangible assets. However, in 2007 both Boards agreed not to add a project to their joint agenda. In 2008, the FASB indicated that it will consider in the future whether to undertake a project to eliminate the differences in the accounting for research and development costs by fully adopting IAS 38 at some point in the future. Impairment is one of the short-term convergence projects agreed to by the FASB and the IASB in their 2006 Memorandum of Understanding. At their joint meeting in April 2008, the Boards chose to defer work on this project.

Acquisition of intangibles Purchased intangibles US GAAP Permits certain costs incurred subsequent to its initial recognition (e.g., legal costs to defend a patent infringement) to be capitalized. IFRS These costs would be expensed, except in the rare circumstance that they improve future economic benefit.

Types of intangibles US GAAP IFRS Market-related intangible assets. Similar Customer-related intangible assets. Similar Artistic-related intangible assets — these ownership rights are protected by copyrights. Similar Contract-related intangible assets — a common form is a franchise. Similar Technology-related intangible assets. Similar

Periodic revaluation Carrying value US GAAP IFRS Assuming no impairment, intangible assets are valued at cost less any accumulated amortization. Similar

Periodic valuation Carrying value US GAAP Revaluation is not permitted. IFRS Revaluation to the fair value of intangible assets other than goodwill is an allowable alternative treatment: Because this requires reference to an active market for the specific type of intangible, it is relatively uncommon in practice. Increases in value should be credited to the account “revaluation surplus.” Revaluation surplus is an account that is included in accumulated OCI. Increases in value are not recorded in the revaluation surplus account if the increase reverses a loss that was previously expensed; that portion may be credited to an unrealized gain account which will flow through net income. Any decrease in value should be included as an unrealized loss in income unless it reverses the revaluation surplus relating to the same asset; that portion can be debited to revaluation surplus (OCI).

Periodic valuation Carrying value US GAAP Revaluation is not permitted. IFRS Revaluation (continued): If the revalued basis of an asset exceeds the cost basis, there will be an increase in the annual amortization. To the extent there is an increase in amortization expense, per IAS 38, paragraph 87, an entity may reverse the portion of reserve surplus related to this increase by debiting revaluation surplus and crediting retained earnings. Alternatively, this transfer may be completed upon disposal of the asset. When an asset is disposed of, any remaining revaluation surplus related to that asset can be transferred to retained earnings.

Periodic valuation Carrying value US GAAP Revaluation is not permitted. IFRS Revaluation (continued): If an intangible asset is revalued, an entity can account for the accumulated amortization at the date of revaluation by: Amortization elimination method: the accumulated amortization can be eliminated against the intangible asset itself. Proportionate restatement method: the accumulated amortization can be restated proportionately with the change in the gross carrying amount of the asset so that the carrying amount of the asset after revaluation equals its revalued amount. The proportionate restatement method is rarely used in practice, thus no example is provided.

Carrying value example Revaluation Intangibles Inc. owns a freely transferable bus operator’s license, which it acquired on January 1, 2010 at an initial cost of $100,000. The useful life of the license is five years (based on the date until which it is valid). The entity uses the straight-line method to amortize the intangible. Such licenses are frequently traded between existing operators. At the balance sheet date, December 31, 2011, due to a government-permitted increase in fixed bus fares, the traded value of such a license was $130,000. The accumulated amortization on December 31, 2011, amounted to $40,000. What journal entries are required on December 31, 2011, to reflect the change in carrying value (cost or revalued amount less accumulated amortization) on the revaluation of the operating license using US GAAP and IFRS? What journal entries are required on December 31, 2012, using US GAAP and IFRS?

Carrying value example Revaluation Example 1 solution: 2011 US GAAP: Revaluation is not permitted. IFRS: Accumulated amortization $ 40,000 Intangible asset $ 40,000 Intangible asset $ 70,000 Revaluation surplus – intangibles (OCI) $ 70,000 The net result is that the asset has a revised carrying amount of $130,000 ($100,000 – $40,000 + $70,000). The accumulated amortization may alternatively be restated proportionately. 2012 US GAAP: Amortization expense $ 20,000 Accumulated amortization $ 20,000 Amortization expense $ 43,333 Accumulated amortization $ 43,333 Revaluation surplus – intangibles (OCI) $ 23,333 Retained earnings $ 23,333 Note that this journal entry is optional.

Carrying value example Restatement of accumulated amortization at revaluation The Boston Commons Company (BCC) reports using IFRS and owns a franchise of tea shops in the Boston area named Tea Party. BCC currently carries the franchise rights for Tea Party at $120,000. In this last year, Tea Party’s business has been quite successful due to the demand for its English tea products. This success resulted in an increase in the market value of the franchise rights to $150,000. Accordingly, BCC has revalued these rights. The original cost basis of the rights is $300,000, and the current accumulated amortization is $180,000. Please provide the journal entries to record the revaluation of these franchise rights.

Carrying value example Restatement of accumulated amortization at revaluation Example 3 solution: Amortization elimination: Accumulated amortization $180,000 Franchise rights $180,000 Franchise rights $30,000 Revaluation surplus – franchise (OCI) $30,000

Periodic valuation Impairment – definition of impairment indicators US GAAP IFRS Impairment indicators for an asset include such items as significant change in its use, projected losses related to its use and a significant decline in its market value. Similar

Periodic valuation Impairment – recognition US GAAP IFRS Similar, although an exception exists where an intangible asset has been revalued and the impairment loss is reversing an accumulated revaluation surplus balance for that asset. In that case, the portion of impairment that is reversing a prior increase in valuation may be debited to revaluation surplus (thus decreasing accumulated OCI). An impaired asset must be written down and the write-down should be recorded in net income.

Periodic valuation Impairment – frequency of testing for indefinite-lived intangible assets including goodwill US GAAP IFRS Indefinite-lived intangible assets including goodwill must be reviewed at least annually for impairment, regardless of the existence of impairment indicators. Similar

Periodic valuation Impairment – frequency of impairment testing for finite-lived assets US GAAP Finite-lived intangibles are tested whenever impairment indicators exist. A review for impairment indicators for finite-lived intangible assets is performed whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. IFRS The existence of impairment indicators must be assessed annually for finite-lived assets.

Periodic valuation Impairment – determination for indefinite-lived intangible assets other than goodwill US GAAP IFRS A one-step process is used to determine whether to impair indefinite-lived assets other than goodwill. Similar

Periodic valuation Impairment – determination for finite-lived intangible assets US GAAP A two-step approach is used for determining impairment of finite-lived assets: 1. A recoverability test is performed first. The carrying amount of the asset is compared to the sum of the future undiscounted cash flows generated through use and eventual disposition. 2. If it is determined the asset is not recoverable, an impairment loss is calculated. IFRS A one-step approach is used if impairment indicators exist. The one-step determination is that same calculation used to determine the amount of the loss.

Periodic valuation Impairment – determination for goodwill US GAAP A two-step approach is also used for determining impairment of goodwill similar to finite-lived assets; however, the recoverability test (step 1) is done at the reporting unit (RU) level, which is typically thought of as an operating segment or one step below an operating segment. The test compares the carrying amount of the RU (including goodwill) to the fair value of the RU. IFRS A one-step approach is used that requires an impairment loss to be calculated for goodwill at the CGU level (as defined following) if impairment indicators exist.

Periodic valuation Impairment calculation – finite and indefinite-lived intangible assets other than goodwill US GAAP The impairment loss for finite and indefinite-lived intangible assets (other than goodwill) is the amount by which the carrying amount of the asset exceeds its fair value, as calculated in accordance with ASC 820, Fair Value Measurements and Disclosure. Note that per ASC 820-10-35-7, transaction costs (selling costs) are not included in the determination of fair value; however, these costs would be used to help determine the most advantageous market per ASC 820-10-55-45 to then determine the appropriate fair value for that market. IFRS The impairment loss is the amount by which the carrying amount of the asset exceeds its recoverable amount: The recoverable amount is the higher of: The fair value less costs to sell. The value in use (the present value of future cash flows in use, including disposal value). Note the definition of fair value in IFRS has certain differences from the definition in US GAAP.

Periodic valuation Impairment calculation – goodwill US GAAP The impairment is the amount by which the carrying amount of the goodwill exceeds the implied fair value of the goodwill within its RU. The implied fair value is the fair value of the RU less the fair value of the net assets (excluding goodwill) of the RU. IFRS Using IFRS, the impairment is the amount by which the cash generating unit (CGU) carrying amount exceeds its recoverable amount (as defined above). A CGU is defined in IAS 36.6 as, “... the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or group of assets.” The impairment amount is first allocated to reduce goodwill to zero, then to the other assets in the CGU pro rata on the basis of the carrying value of each asset.

Summary of impairment of intangibles Frequency of test Number of steps in the impairment determination calculation process Impairment determination Impairment calculation IFRS allows reversal of impairment? Type of intangible asset US GAAP IFRS US GAAP US GAAP only Finite lived When indicators exist Annually 2 1 Recoverability test (1) Carrying value less fair value Carrying value less recoverable amount (4) Yes Indefinite lived, other than goodwill None Goodwill Fair value test on RU (2) Carrying value less implied fair value (3) Carrying value of CGU less recoverable amount of CGU (4) No Compare the carrying value to the sum of undiscounted cash flows. Compare the carrying value of the reporting unit to the fair value of the RU(including goodwill). The implied fair value of goodwill equals the fair value of the RU less the fair value of the net assets (excluding goodwill) of the RU. Recoverable amount is the higher of: (1) the fair value less selling costs and (2) the present value of future discounted cash flows.

Impairment determination and calculation example Finite-lived intangible asset The Corporate Protection Company (CPC) has a patent on new fingerprint security technology. The fair value of the patent is $18 million, excluding selling costs of $3 million. The present value of future cash flows is $16 million. The sum of the undiscounted future cash flows is $19 million. CPC currently carries the patent at a value of $20 million. What journal entries would CPC prepare to record an impairment of the patent using both US GAAP and IFRS?

Impairment determination and calculation example Finite-lived intangible asset Example 4 solution: US GAAP Recoverability test: is the carrying value greater than the sum of the future undiscounted cash flows? Yes, since $20 million is greater than $19 million. Calculation of the impairment: Carrying value - fair value = $20 million - $18 million Journal entry to record the impairment: Impairment loss $2 million Patent $2 million

Impairment determination and calculation example Finite-lived intangible asset Example 4 solution (continued): IFRS Test for impairment: does the carrying amount exceed the recoverable amount? Yes, the carrying amount of $20 million is higher than the recoverable amount of $16 million. The recoverable amount is calculated as the higher of the fair value less the selling costs ($18 million - $3 million = $15 million), and the value in use (present value of future cash flows = $16 million) Calculation of the impairment (note that the determination and calculation of impairment are the same step): Carrying value - recoverable amount = $20 million - $16 million = $4 million Journal entry to record the impairment: Impairment loss $4 million Patent* $4 million *Note that the credit could be recorded to an accumulated impairment loss account instead of being recorded directly to the asset account. This would allow management to easily track accumulated impairment losses for potential reversal as discussed in example 8.

Impairment determination and calculation example Finite-lived intangible asset Fountain of Youth Incorporated (FYI) has a patent for some revolutionary new skin care products. The fair value of the patent is $16 million with selling costs of $2 million. The present value of the future cash flows is $14 million. The sum of the undiscounted future cash flows is $15 million. FYI currently carries the patent at a value of $10 million. What journal entries would FYI prepare to record an impairment of the patent using both US GAAP and IFRS?

Impairment determination and calculation example Finite-lived intangible asset Example 5 solution: US GAAP: Recoverability test: is the carrying value greater than the sum of the future undiscounted cash flows? No, since $10 million is less than $15 million; therefore, no impairment loss needs to be calculated. IFRS: Test for impairment: does the carrying amount exceed the recoverable amount? No, the carrying amount of $10 million is less than the recoverable amount of $14 million. The recoverable amount is calculated as the higher of fair value less selling costs ($16 million - $2 million = $14 million), and the value in use (present value of future cash flows = $14 million). As there is no impairment, no journal entry is required.

Impairment determination and calculation example Indefinite-lived intangible asset other than goodwill Example 6 The KCH&H Company (KCH&H) has a trademark that it expects to have an indefinite life. The carrying value of the trademark is $750,000. As of December 31, 2010, the fair value of the trademark was $600,000. The present value of the future cash flows is $630,000 and the undiscounted summation of the future cash flows is $700,000. The costs to sell the trademark would be insignificant. What journal entries would KCH&H prepare to record an impairment of the trademark using both US GAAP and IFRS? KCH&H ®

Impairment determination and calculation example Indefinite-lived intangible asset other than goodwill Example 6 solution: US GAAP: There is not a separate recoverability test for indefinite-lived intangible assets. The fair value test is used. Since the carrying value of the trademark ($750,000) is greater than the fair value ($600,000), KCH&H would writedown the trademark by $150,000. Journal entry to record the impairment: Impairment loss $150,000 Trademark $150,000 IFRS: The impairment loss is calculated as the carrying value ($750,000) less the recoverable amount. The recoverable amount is the greater of the fair value less selling costs ($600,000) and the value in use ($630,000). Therefore, KCH&H would writedown the trademark by $120,000. Impairment loss $120,000 Trademark* $120,000 *Note that the credit could be recorded to an accumulated impairment loss account instead of being recorded directly to the asset account. This would allow management to easily track accumulated impairment losses for potential reversal as discussed in example 8.

Impairment determination and calculation example Goodwill The Caring Card Company (CCC) has goodwill recorded in two CGUs, as defined under IFRS. These two CGUs make up one reporting unit (RU), as defined under US GAAP. CCC carries the first CGU at a value of $2 million, which includes $500,000 of goodwill. The fair value is $4 million and the recoverable amount of the unit is $4 million. CCC carries the second CGU at a value of $3.5 million, which includes $750,000 attributable to goodwill. The fair value of the CGU is $3 million and the recoverable amount of the unit is $3 million. The fair value of the net assets of the RU excluding goodwill is $6,000,000. Compute the amount of impairment CCC should record using US GAAP and provide any necessary journal entries. Compute the amount of impairment CCC should record using IFRS and provide any necessary journal entries.

Impairment determination and calculation example Goodwill Example 7 solution: Carrying value of unit (including goodwill) Carrying value of goodwill Fair value of unit Recoverable amount of unit Fair value of net assets of unit excluding goodwill CGU 1 $2,000,000 $ 500,000 $4,000,000 CGU 2 3,500,000 750,000 3,000,000 RU $5,500,000 $1,250,000 $7,000,000 $6,000,000

Impairment determination and calculation example Goodwill Example 7 solution (continued): US GAAP: Recoverability test: does the carrying value of the RU exceed the fair value of the RU? No, since $5.5 million is less than $7 million. Note that if CCC did need to compute an impairment amount, the amount would be determined as the carrying amount of goodwill of $1,250,000 less the implied fair value of goodwill of $1,000,000, which is the fair value of the RU ($7,000,000) less the fair value of the net assets of the RU excluding goodwill ($6,000,000). IFRS: Test of impairment: does the carrying value of the CGU exceed the recoverable amount of the CGU? CGU 1 – No, since $2 million is less than $4 million. CGU 2 – Yes, since $3.5 million is greater than $3 million by $500,000. Journal entry to record the impairment: Impairment loss $500,000 Goodwill $500,000

Periodic valuation Impairment – reversal US GAAP IFRS A reversal of an impairment loss for goodwill is prohibited. Similar

Periodic valuation Impairment – reversal US GAAP Reversal of impairment losses is prohibited for all intangible assets. IFRS Finite and indefinite-lived intangible assets (other than goodwill) must be reviewed annually for reversal indicators. If appropriate, a loss may be reversed up to the newly estimated recoverable amount, not to exceed the initial carrying amount adjusted for amortization.

Reversal of impairment loss example Indefinite-lived intangible asset In addition to the information from example 6, in 2011, KCH&H reviewed its trademark for impairment reversal indicators. Upon review of these indicators, KCH&H determined that reversal of the impairment was appropriate. The fair value of the trademark and the present value of future cash flows is both $800,000. The costs to sell the trademark continue to be insignificant. What journal entries would KCH&H prepare to record the reversal of the impairment loss for the trademark using both US GAAP and IFRS? KCH&H ®

Reversal of impairment loss example Indefinite-lived intangible asset Example 8 solution: US GAAP: No reversal of impairment losses is permitted. IFRS: An impairment loss may be reversed up to the newly estimated recoverable amount ($800,000), not to exceed the initial carrying amount adjusted for amortization ($750,000). As this asset has an indefinite life, amortization is not a factor. As the initial carrying amount is less than the newly estimated recovery amount, the reversal is limited to the initial loss that was recorded. The reversal is recorded into income. Journal entry to reverse the impairment losses: Trademark* $120,000 Impairment loss $120,000 *Note that if the impairment was initially credited to an accumulated impairment loss account instead of being recorded directly to the asset account , the accumulated impairment loss account would be debited instead of the asset account.

Cost allocation Finite-lived intangible assets US GAAP IFRS Amortization of intangible assets over their estimated useful lives is generally required. Similar

Cost allocation Finite-lived intangible assets US GAAP Under ASC 985-20-35, capitalized software costs are amortized on a product-by-product basis: The annual amortization is the greater of the amount computed using: (a) the ratio that current gross revenues for a product bear to the total of the current and anticipated future gross revenues for that product; or (b) the straight-line method over the remaining estimated economic life of the product, including the period being reported. IFRS This method is not prohibited, but it is not required.

Cost allocation Indefinite-lived intangible assets US GAAP IFRS If there is no foreseeable limit to the period during which an intangible asset is expected to generate net cash inflows to the entity, the useful life is considered to be indefinite and is not amortized. Similar

Goodwill US GAAP IFRS Goodwill is recognized only as a result of a business combination. For a 100% acquisition, the acquirer recognizes the acquiree’s net identifiable assets (including any intangible assets) at fair value at the acquisition date and recognizes goodwill, which represents the excess of the purchase price over the acquirer’s interest in the fair value of the identifiable net assets of the acquiree. Similar Goodwill is subject to an annual impairment test. Similar Negative goodwill is recognized immediately as income (after reassessing the purchase price allocation). Similar

Research and development US GAAP IFRS Internal costs related to the research phase of research and development are expensed as incurred under both accounting models. Similar Under converged standards, in-process research and development is to be recognized as an indefinite-lived intangible asset separately from goodwill at its acquisition-date fair value. Similar

Research and development US GAAP Development costs are expensed as incurred, unless addressed by a separate standard. IFRS Development costs are capitalized when technical and economic feasibility of a project can be demonstrated in accordance with specific criteria. Some of the criteria include: demonstrating technical feasibility, intent to complete the asset and ability to sell the asset in the future, as well as others.

Research and development example Example 9 – Internet Imaging Inc. (Triple I), is working on a project to create a database of picture images which it intends to sell over the internet. Triple I has identified the following stages and costs incurred in its project: Research stage This stage included identifying the system requirements, searching for an appropriate database and other system materials and images to purchase, gaining the technical knowledge necessary to collect and transfer the images and overall project feasibility. Costs incurred were $50,000 during the period of January 1, 2010 through March 31, 2010. On April 1, 2010, Triple I determined that it would complete the intended project. Additional research costs of $75,000 were incurred during the period of April 1, 2010 through June 30, 2010. Development stage This stage included performing market analysis to identify potential demand, acquiring system materials and images to populate the database; designing the website; and testing a system prototype. During the period of May 1, 2010 through August 31, 2010, Triple I incurred development costs of $100,000. On August 31, 2010, Triple I determined that its project was technically feasible. During the period of September 1, 2010 through October 31, 2010, Triple I incurred development costs of $50,000. On October 31, 2010, Triple I received its results from its market study and determined that the project was economically feasible. Additional development costs of $200,000 were incurred during the period of November 1, 2010 through December 31, 2010. Production stage Triple I will launch its imaging database on the internet on January 1, 2011.

Research and development example Example 9 continued: Complete the diagram below by inputting the research and development costs for 2010 in the appropriate periods based on the information above. Based on the diagram, determine which research and development costs Triple I can capitalize related to this project during 2010 using US GAAP and IFRS? Research phase Development phase $ January 1, 2010 March 31, 2010 April 1, 2010 May 1, 2010 June 30, 2010 August 31, 2010 September 1, 2010 October 31, 2010 November 1, 2010 December 31, 2010 Research Initiated Decision to complete the project Development initiated Research completed Technical feasibility reached Economic feasibility reached Development completed

Research and development example Example 9 solution: Using US GAAP, Triple I cannot capitalize any research and development costs. Using IFRS, Triple I cannot capitalize any research costs, similar to US GAAP; however, Triple I may capitalize development costs when technical and economic feasibility of a project can be demonstrated in accordance with specific criteria. Some of the stated criteria include: demonstrating technical feasibility, intent to complete the asset and ability to sell the asset in the future, as well as others. As shown in the diagram below, Triple I met these criteria on October 31, 2010; therefore, the $200,000 incurred from November 1, 2010 through December 31, 2010, prior to the product launch on January 1, 2011, may be capitalized. Research phase Development phase $50,000 $75,000 $100,000 $200,000 January 1, 2010 March 31, 2010 April 1, 2010 May 1, 2010 June 30, 2010 August 31, 2010 September 1, 2010 October 31, 2010 November 1, 2010 December 31, 2010 Research Initiated Decision to complete the project Development initiated Research completed Technical feasibility reached Economic feasibility reached Development completed

Other costs US GAAP IFRS Start-up costs, including initial operating losses, cannot be capitalized. Similar

Other costs US GAAP Advertising and promotional costs are either expensed as incurred or expensed when the advertising takes place for the first time under US GAAP. Direct-response advertising may be capitalized if the specific criteria in ASC 340-20-25-4, Other Assets and Deferred Costs-Capitalized Advertising Costs-Recognition, are met. IFRS Advertising and promotional costs are expensed as incurred. A prepayment may be recognized as an asset only when payment for the goods or services is made in advance of the entity having access to the goods or receiving the services.

Disclosures US GAAP IFRS The disclosure requirements under US GAAP and IFRS for intangible assets are, in most respects, similar. Similar

Disclosures US GAAP IFRS GAAP does not, within a single standard, address comprehensive disclosure requirements for intangible assets: Under SEC rules, SEC registrants are required to disclose identifiable intangible assets separately from unidentifiable intangible assets and goodwill, along with the method of determining their respective amounts. Despite the additional disclosures required by SEC rules, it is likely that there will be more disclosures for intangible assets under IAS 38 than under US GAAP IFRS IAS 38 includes a long list of general disclosures for each class of intangible asset: Internally generated intangible assets must be distinguished from other intangible assets. Separate disclosure is required for intangible assets being amortized over more than 20 years, for intangible assets being carried under the allowed alternative treatment at revalued amounts, and for research and development expenditures. IAS 38 encourages disclosure of a description of any fully amortized intangible asset that is still in use and disclosure of a description of any intangible asset that did not meet the recognition criteria.

Disclosures US GAAP Requires disclosures about impairment losses and the circumstances giving rise to those losses. However, detailed disclosures by individual asset or CGU are not required. Because ASC 360 does not permit the revaluation of assets, it does not provide guidance on revaluation. IFRS Requires disclosures about impairment losses in the aggregate and by class of asset and reportable segment and, if material, by individual asset or CGU. IAS 36 specifies additional reporting requirements for impairment losses and the reversal of those impairment losses for revalued assets.

Disclosures US GAAP If a surrogate for fair value is developed by discounting an enterprise’s estimates of an asset’s future cash flows, ASC 360 requires disclosure of that fact, but not of the discount rate or the key assumptions used. IFRS If an asset’s recoverable amount is measured as its value in use, IAS 36 requires disclosure of the discount rate used in calculating that measure and encourages, but does not require, disclosure of the key assumptions used.