Accounting for Purchased Intangibles: A Comprehensive Guide
Explore the intricacies of accounting for purchased intangibles, including initial measurement, recognition, and recording in Canadian accounting practices.
7.2 Accounting for Purchased Intangibles
In the realm of accounting, intangible assets represent non-physical assets that can provide significant value to a business. These assets, such as patents, trademarks, and copyrights, are crucial for companies in various industries, particularly those focused on technology, pharmaceuticals, and media. Understanding how to account for purchased intangibles is essential for accurate financial reporting and compliance with Canadian accounting standards.
Understanding Intangible Assets
Intangible assets are identifiable non-monetary assets without physical substance. They are distinguishable from goodwill, which is an unidentifiable intangible asset arising from business combinations. Intangible assets can be purchased or internally generated, but this section focuses on those acquired through purchase.
Characteristics of Intangible Assets
- Identifiability: An intangible asset must be identifiable, meaning it can be separated from the entity and sold, transferred, licensed, rented, or exchanged.
- Control: The entity must have control over the asset, meaning it can obtain future economic benefits and restrict others from accessing those benefits.
- Future Economic Benefits: The asset should be expected to provide future economic benefits, such as revenue generation, cost savings, or other advantages.
Initial Measurement of Purchased Intangibles
Purchased intangible assets are initially measured at cost. The cost of a purchased intangible asset includes its purchase price and any directly attributable costs necessary to prepare the asset for its intended use. This includes legal fees, registration costs, and any other expenses directly related to acquiring the asset.
Components of Cost
- Purchase Price: The amount paid to acquire the intangible asset.
- Directly Attributable Costs: Costs directly associated with bringing the asset to its intended use, such as legal fees, registration fees, and professional fees.
Example: Acquiring a Patent
Consider a company that acquires a patent for $100,000. The company incurs $5,000 in legal fees and $2,000 in registration fees. The total cost of the patent would be $107,000, which includes the purchase price and directly attributable costs.
Recognition and Recording of Purchased Intangibles
The recognition of purchased intangibles requires that the asset meets the definition and recognition criteria of an intangible asset. This involves ensuring that the asset is identifiable, the entity has control over it, and it is expected to provide future economic benefits.
Recognition Criteria
- Probable Future Economic Benefits: It is probable that the expected future economic benefits attributable to the asset will flow to the entity.
- Reliable Measurement: The cost of the asset can be measured reliably.
Recording in Financial Statements
Purchased intangible assets are recorded on the balance sheet at their initial cost. Subsequent to initial recognition, entities must choose between the cost model and the revaluation model for measuring intangible assets.
- Cost Model: The asset is carried at cost less any accumulated amortization and impairment losses.
- Revaluation Model: The asset is carried at a revalued amount, being its fair value at the date of revaluation less any subsequent accumulated amortization and impairment losses. This model is less common due to the difficulty in reliably measuring the fair value of intangibles.
Amortization of Purchased Intangibles
Amortization is the systematic allocation of the depreciable amount of an intangible asset over its useful life. The depreciable amount is the cost of the asset, or other amount substituted for cost, less its residual value.
Determining Useful Life
The useful life of an intangible asset is the period over which the asset is expected to contribute to the cash flows of the entity. It can be finite or indefinite.
- Finite Useful Life: The asset is amortized over its useful life. The amortization method should reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity.
- Indefinite Useful Life: The asset is not amortized but is tested for impairment annually.
Example: Amortizing a Trademark
A company acquires a trademark with a finite useful life of 10 years for $50,000. The company decides to use the straight-line method for amortization. The annual amortization expense would be $5,000 ($50,000 / 10 years).
Impairment of Purchased Intangibles
Intangible assets with finite useful lives are reviewed for impairment whenever there is an indication that the asset may be impaired. Intangible assets with indefinite useful lives are tested for impairment annually.
Impairment Testing Process
- Identify Indicators of Impairment: Look for signs such as significant changes in market conditions, legal or regulatory changes, or a decline in the asset’s market value.
- Calculate Recoverable Amount: The recoverable amount is the higher of an asset’s fair value less costs to sell and its value in use.
- Compare Carrying Amount and Recoverable Amount: If the carrying amount exceeds the recoverable amount, an impairment loss is recognized.
Example: Impairment of a License
A company holds a license with a carrying amount of $30,000. Due to regulatory changes, the recoverable amount is determined to be $20,000. The company recognizes an impairment loss of $10,000.
Accounting for Purchased Intangibles in Business Combinations
When intangible assets are acquired as part of a business combination, they are recognized separately from goodwill if they meet the definition of an intangible asset and their fair value can be measured reliably.
Fair Value Measurement
The fair value of an intangible asset acquired in a business combination is its market value at the acquisition date. If the market value is not available, other valuation techniques such as the income approach or cost approach may be used.
Example: Business Combination
Company A acquires Company B, which holds a customer list valued at $200,000. The customer list is recognized as a separate intangible asset on Company A’s balance sheet, distinct from goodwill.
Regulatory Framework and Standards
In Canada, accounting for purchased intangibles is governed by International Financial Reporting Standards (IFRS) as adopted by the Canadian Accounting Standards Board (AcSB). For private enterprises, the Accounting Standards for Private Enterprises (ASPE) provide guidance.
IFRS vs. ASPE
- IFRS: Provides detailed guidance on the recognition, measurement, and disclosure of intangible assets. IFRS 3, IFRS 13, and IAS 38 are particularly relevant.
- ASPE: Offers simplified guidance for private enterprises, focusing on cost measurement and amortization.
Practical Considerations and Challenges
Accounting for purchased intangibles involves several challenges, including determining the useful life, estimating the fair value, and assessing impairment. Companies must also navigate the complexities of business combinations and the allocation of purchase price to intangible assets.
Common Pitfalls
- Overestimating Useful Life: Leads to under-amortization and overstated asset values.
- Inaccurate Fair Value Measurement: Can result in incorrect recognition and measurement of intangible assets.
- Failure to Recognize Impairment: Results in overstated assets and understated expenses.
Best Practices
- Regular Review of Useful Life: Periodically reassess the useful life of intangible assets to ensure accurate amortization.
- Robust Valuation Techniques: Use reliable and consistent valuation methods for fair value measurement.
- Comprehensive Impairment Testing: Conduct thorough impairment testing to identify and recognize impairment losses promptly.
Conclusion
Accounting for purchased intangibles is a critical aspect of financial reporting, requiring a deep understanding of recognition, measurement, and disclosure principles. By adhering to Canadian accounting standards and best practices, companies can ensure accurate and transparent financial statements.
References and Further Reading
- International Financial Reporting Standards (IFRS): IFRS 3, IFRS 13, IAS 38
- Accounting Standards for Private Enterprises (ASPE)
- CPA Canada: Guidance on intangible assets and business combinations
