Costs Incurred Internally To Create Intangibles Are

Creating intangible assets within a company can be a strategic move, providing a competitive edge and long-term value. However, it also involves a complex accounting treatment, especially when considering the costs incurred internally. Understanding which costs can be capitalized (recorded as an asset) and which must be expensed (recorded as an expense in the income statement) is crucial for accurate financial reporting. This article delves into the intricacies of identifying and accounting for internal costs related to creating intangible assets, aligning with established accounting standards and practical examples.

Understanding Intangible Assets

Intangible assets are non-physical assets that provide economic benefits to a company over a period longer than one year. They lack physical substance but represent valuable rights and privileges. Examples include:

• Patents: Exclusive rights granted for an invention.
• Trademarks: Symbols, names, or logos that distinguish goods and services.
• Copyrights: Legal rights protecting original works of authorship.
• Trade Secrets: Confidential information that gives a business a competitive edge.
• Goodwill: Arises from the acquisition of another company and represents the excess of the purchase price over the fair value of identifiable net assets acquired.
• Software: Computer programs and related documentation.
• Customer Lists: Information about customers, including contact details and purchase history.
• Franchises: Rights granted by a franchisor to operate a business under a specific brand.

Intangible assets can be acquired externally (e.g., purchasing a patent from another company) or created internally (e.g., developing a new software program). The accounting treatment differs significantly depending on how the asset is obtained.

The Challenge of Accounting for Internally Generated Intangibles

The primary challenge in accounting for internally generated intangible assets lies in determining which costs directly contribute to creating the asset and provide future economic benefits. This determination is subject to interpretation and requires careful judgment. Accounting standards, such as those issued by the Financial Accounting Standards Board (FASB) in the United States and the International Accounting Standards Board (IASB) internationally, provide guidance, but the application can still be complex.

The core principle is that costs that can be reliably attributed to the creation of an identifiable intangible asset and that will provide probable future economic benefits should be capitalized. Costs that do not meet these criteria must be expensed as incurred.

Research and Development (R&D) Costs: The Key Distinction

A critical distinction in accounting for internally generated intangibles lies in the categorization of costs as either research or development.

• Research: Research activities are aimed at discovering new scientific or technical knowledge. They are exploratory and investigative, with the hope of finding something new.
• Development: Development activities involve applying research findings or other knowledge to plan or design the production of new or substantially improved materials, devices, products, processes, systems, or services before the start of commercial production or use.

This distinction is crucial because accounting standards generally require research costs to be expensed as incurred, while development costs may be capitalized under certain conditions.

Expensing Research Costs

The rationale behind expensing research costs is that the future economic benefits from research activities are uncertain and difficult to predict. It's often challenging to directly link research activities to a specific intangible asset that will generate future revenues. Common examples of research costs that must be expensed include:

• Laboratory research aimed at discovering new knowledge.
• Searching for applications of new research findings.
• Conceptual formulation and design of possible product or process alternatives.

Capitalizing Development Costs

Development costs, on the other hand, can be capitalized if certain criteria are met, indicating a higher probability of future economic benefits. These criteria are designed to ensure that only costs related to projects that are technically and commercially feasible are capitalized. The IASB, under IAS 38 Intangible Assets, outlines the following criteria for capitalizing development costs:

1. Technical Feasibility: Completing the intangible asset so that it will be available for use or sale is technically feasible.
2. Intention to Complete: The entity intends to complete the intangible asset and use or sell it.
3. Ability to Use or Sell: The entity has the ability to use or sell the intangible asset.
4. Generation of Future Economic Benefits: The intangible asset will generate probable future economic benefits. Among 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 to be used internally, the usefulness of the intangible asset.
5. Availability of Resources: Adequate technical, financial, and other resources to complete the development and to use or sell the intangible asset are available.
6. Reliable Measurement of Costs: The entity can measure reliably the expenditure attributable to the intangible asset during its development.

If all of these criteria are met, the development costs can be capitalized as an intangible asset. This typically involves recording the costs as an asset on the balance sheet and amortizing them over the asset's useful life.

Specific Costs to Consider

Determining which specific costs qualify for capitalization requires careful consideration of the nature of the costs and their direct relationship to the creation of the intangible asset. Here's a breakdown of common cost categories:

Direct Labor

• Capitalizable: Salaries, wages, and benefits of employees directly involved in the development of the intangible asset, such as software developers, engineers, and designers, are generally capitalizable, provided the capitalization criteria are met.
• Expense: Salaries and benefits of employees involved in research activities or general overhead are expensed.

Materials and Supplies

• Capitalizable: The cost of materials and supplies directly used in the development of the intangible asset can be capitalized. For example, the cost of software licenses, equipment used solely for development, and raw materials used in prototyping.
• Expense: Materials and supplies used in research activities or for general administrative purposes are expensed.

Software and Technology

• Capitalizable: Costs associated with acquiring software or technology specifically used in the development of the intangible asset can be capitalized. This might include licenses, subscription fees, and implementation costs.
• Expense: General-purpose software or technology used for research or administrative purposes is expensed.

Legal Fees

• Capitalizable: Legal fees directly related to securing legal protection for the intangible asset, such as patent application fees or trademark registration fees, can be capitalized.
• Expense: Legal fees related to defending existing intellectual property rights against infringement are typically expensed.

Overhead Costs

• Capitalizable: A portion of overhead costs that can be directly attributed to the development of the intangible asset may be capitalized. This requires a reasonable and consistent allocation method. Examples include rent, utilities, and depreciation of equipment used in the development process.
• Expense: General overhead costs that cannot be directly linked to the development of the intangible asset are expensed.

Interest Costs

• Capitalizable: In some cases, interest costs incurred during the development phase may be capitalized, particularly if the intangible asset is a qualifying asset, meaning it takes a substantial period to get ready for its intended use or sale. This is governed by specific accounting standards related to interest capitalization.
• Expense: Interest costs not meeting the criteria for capitalization are expensed.

Example: Software Development Costs

Consider a company developing a new software application for internal use. The company incurs the following costs:

• Research Phase:
  • Salaries of research scientists exploring different programming languages: $50,000
  • Materials and supplies used in initial testing: $10,000
• Development Phase:
  • Salaries of software developers writing the code: $150,000
  • Cost of software licenses used for development: $20,000
  • Legal fees for drafting user agreements: $5,000
  • Overhead costs allocated to the development project: $15,000

In this scenario:

• The $50,000 in research salaries and $10,000 in materials and supplies would be expensed as incurred.
• Assuming the company meets all the capitalization criteria for development costs, the following costs could be capitalized:
  • $150,000 in software developer salaries
  • $20,000 in software licenses
  • $5,000 in legal fees
  • $15,000 in allocated overhead costs

The capitalized costs would be recorded as an intangible asset on the balance sheet and amortized over the software's estimated useful life.

Amortization of Intangible Assets

Once an intangible asset is capitalized, it must be amortized over its useful life. Amortization is the systematic allocation of the cost of an intangible asset over the period it is expected to generate economic benefits. The amortization method should reflect the pattern in which the asset's economic benefits are consumed. If the pattern cannot be reliably determined, the straight-line method is typically used.

The useful life of an intangible asset is the period over which the asset is expected to be available for use. This may be a finite period, such as the legal life of a patent, or an indefinite period, such as the life of a well-known trademark. Intangible assets with finite lives are amortized, while those with indefinite lives are not. Instead, intangible assets with indefinite lives are tested for impairment at least annually.

Impairment of Intangible Assets

An impairment loss occurs when the carrying amount of an asset (its recorded value on the balance sheet) exceeds its recoverable amount (the higher of its fair value less costs to sell and its value in use). If an intangible asset is impaired, the carrying amount must be reduced to its recoverable amount, and an impairment loss must be recognized in the income statement.

Intangible assets with finite lives are tested for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Intangible assets with indefinite lives are tested for impairment at least annually, regardless of whether there are any indicators of impairment.

Disclosure Requirements

Accounting standards require companies to disclose significant information about their intangible assets in their financial statements. This includes:

• The carrying amount of each class of intangible asset.
• The amortization method and useful lives or amortization rates.
• The amount of amortization expense recognized during the period.
• A reconciliation of the carrying amount at the beginning and end of the period, showing additions, disposals, amortization, impairment losses, and other changes.

These disclosures provide users of financial statements with valuable information about a company's investment in intangible assets and their impact on financial performance.

Practical Considerations

• Documentation: Maintaining thorough documentation is crucial for supporting the capitalization of development costs. This documentation should include detailed project plans, time sheets, expense reports, and other evidence demonstrating that the capitalization criteria have been met.
• Consistency: Applying accounting policies consistently over time is essential for ensuring the comparability of financial statements. Once a company has adopted a policy for capitalizing development costs, it should continue to apply that policy consistently unless there is a valid reason to change it.
• Professional Judgment: Determining whether development costs meet the capitalization criteria often requires significant professional judgment. Companies should consult with qualified accountants and auditors to ensure that they are applying the accounting standards appropriately.
• Tax Implications: The accounting treatment of internally generated intangible assets can have significant tax implications. Companies should consult with tax advisors to understand the tax consequences of capitalizing or expensing these costs.

The Impact of Different Accounting Standards

While the general principles for accounting for internally generated intangible assets are similar under U.S. GAAP and IFRS, there are some key differences:

• Research and Development Costs: Both U.S. GAAP and IFRS require research costs to be expensed as incurred. However, IFRS allows for the capitalization of development costs if specific criteria are met, while U.S. GAAP has more restrictive rules for certain industries, such as software development.
• Impairment Testing: Both U.S. GAAP and IFRS require impairment testing of intangible assets. However, the specific methods and requirements for impairment testing may differ.
• Goodwill: Goodwill is an intangible asset that arises from the acquisition of another company. The accounting for goodwill is similar under U.S. GAAP and IFRS, but there are some differences in the impairment testing requirements.

Understanding these differences is essential for companies that prepare financial statements under both U.S. GAAP and IFRS.

Conclusion

Accounting for the costs incurred internally to create intangible assets is a complex process that requires careful consideration of accounting standards and professional judgment. By understanding the distinction between research and development costs, the capitalization criteria, and the amortization and impairment rules, companies can ensure that they are accurately reporting their investment in intangible assets. Maintaining thorough documentation, applying accounting policies consistently, and consulting with qualified professionals are essential for navigating this complex area of accounting. Accurately accounting for these costs not only provides a clearer picture of a company's financial health but also supports strategic decision-making and long-term value creation.