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IAS 38 Intangible assets

Cases

Instituut van de Bedrijfsrevisoren 1

December 12, 2008


Cases

Véronique Weets


Cases


December 12, 2008

TABLE OF CONTENT

Table of content ............................................................................................................................................. 2

IAS 38 Intangible assets .................................................................................................................................. 3

Purchased intangible assets ....................................................................................................................... 3

Research and development ........................................................................................................................ 4

Cost of an internally generated intangible asset ........................................................................................ 7

Intangible assets acquired in a business combination ............................................................................... 9

Assessing the useful lives of intangible assets .......................................................................................... 12

Amortization of Intangible assets ............................................................................................................. 14

Impairment of intangible assets ............................................................................................................... 16

Subsequent costs ...................................................................................................................................... 17

Comprehensive case ................................................................................................................................. 19

Annual improvements 2007 ......................................................................................................................... 20

IFRIC 12 – Service concession arrangements ............................................................................................... 21

Scope ........................................................................................................................................................ 21

Financial asset/Intangible asset ................................................................................................................ 22

AccountIng for service concession arrangements .................................................................................... 23


Purchased intangible assets


December 12, 2008

IAS 38 INTANGIBLE ASSETS

PURCHASED INTANGIBLE ASSETS

1. Operator F pays commissions of 175 to a third party dealer for the acquisition of a subscriber

that has passed the usual credit check. The subscriber signs a 12‐month contract with a minimum revenue

guarantee. Operator F has estimated that the expected margin from the minimum contracted revenues

will be 250. The subscriber acquisition costs are expected to be recovered in full within the initial contract

term. Operator F tracks subscriber acquisition costs by subscriber (PWC, Telecom, 122.39).

Should subscriber acquisition costs be capitalised as an intangible asset ?

2. When a customer connects to its network on tariff AAA, Operator B agrees to make payments to

dealers of 12% of the gross billings to the customer over the life of the contract. Typically, the revenue

share payments are calculated monthly and paid quarterly in arrears. The subscriber signs a 12‐month

contract. Operator B expects that each AAA customer will generate gross billings of 1 000 over the

contract period. The dealer has no further service to render to the operator (such as billings, customer

care etc). Therefore, the contract between the dealer and operator B is not an executory contract (PWC,

Telecom 122.41).

How should an operator account for commitments to share customer revenues with dealers ?

.


Research and development


December 12, 2008

RESEARCH AND DEVELOPMENT

1. Consider the development of new technology to be used in a manufacturing plant. The process could

be split into the following stages (PWC, pg 15027‐15028):

Stage 1: Identify a need for/benefit of new technology

Stage 2: Board commissions a project to investigate the new technology

Stage 3: Investigate other technologies available in the market

Stage 4: Investigate competitors’ use of other technology

Stage 5: Commission the design of alternative types of new technology and get input from the

manufacturing floor for feasibility

Stage 6: Prepare a shortlist of five alternatives from stage 5 and prepare costing

Stage 7: Board prepares a budget for the new technology and agrees to the shortlist and the

replacement of technology

Stage 8: Send the shortlist to line managers for input and list three based on feedback

Stage 9: Present the final three to the board for final selection

Stage 10: Finalize a development plan for the final selection

Stage 11: Develop new technology

Stage 12: Test new technology

Stage 13: Train staff on new technology

Stage 14: Roll out new technology to the production line

Determine at what stage the entity should start to capitalize the costs of the project.

2. Stellenbosch Laboratories Ltd manufactures and distributes a wide range of general pharmaceutical

products. Selected audited data for the financial year ended 31 December 20X5 are as follows (Alfredson et

al.(2007), pg. 476, problem 11.2):

CU

Gross Profit 17 600 000

Profit before income tax 1 700 000

Income tax expense 500 000

Profit for the period 1 200 000

Total assets:

Current 7 300 000

Non‐current 11 500 000

The company uses a standard mark‐up on cost. From your audit files, you ascertain that total research and

development expenditure for the year amounted to 4 700 000 CU. This amount is substantially higher than in

previous years and has eroded the profitability of the company. M. Bosch, the company's finance director, has

asked for your firm's advice on whether it is acceptable accounting practice for the company to carry forward

any of its expenditure to a future accounting period.

Your audit files disclose that the main reason for the significant increase in research and development costs

was the introduction of a planned five‐year laboratory program to attempt to find an antidote for the common

cold. Salaries and identifiable equipment costs associated with this program amounted to 2 350 000 for the

current year.

The following additional items were included in research and development costs for the year:




December 12, 2008

• Costs to test a new tamper‐proof dispenser pack for the company's major selling line (20% of sales) of

antibiotic capsules ‐ 760 000 CU. The new packs are to be introduced in the 20X6 financial year.

• Experimental costs to convert a line of headache powders to liquid form ‐ 590 000 CU. The company

hopes to phase out the powder form if the tests to convert to the stronger and better handling liquid form

prove successful.

• Quality control required by stringent company policy and by law on all items of production for the

year ‐ 750 000 CU.

• Costs of a time and motion study aimed at improving production efficiency by redesigning plan layout

of existing equipment ‐ 50 000 CU

• Construction and testing of a new prototype machine for producing hypodermic needles ‐ 200 000

CU. Testing has been successful to date and is nearing completion. Hypodermic needles accounted for 1% of

the company's sales in the current year, but it is expected that the company's market share will increase

following introduction of this new machine.

Respond to M. Bosch's question for each item above.

3. a. A pharmaceutical entity has obtained scientific regulatory approval for a new respiratory drug in

Country Agara. It is now progressing through the additional development procedures necessary to gain

approval in Country Belan. Management believes that achieving regulatory approval in this secondary market

is a formality. Mutual recognition treaties and past experience show that Belan's authorities rarely refuse

approval for a new drug that has been approved in Agara.

b. A pharmaceutical entity has obtained scientific regulatory approval for a new AIDS drug in Country

Spartek and is progressing through the additional development procedures necessary to gain approval in

Country Oceana. Experience shows that significant additional clinical trials will be necessary to meet the

Oceanese scientific regulatory approval requirements. Some drugs accepted in Spartek have not been

accepted for sale in Oceana, even after additional clinical trials (PWC, Pharma, 2).

Should the development costs in each scenario be capitalized ?

4. A Pharmaceutical entity is developing a generic version of a painkiller that has been sold in the market

by another company for many years. The technical feasibility of the asset has already been established

because it is a generic version of a product that has already been approved, and its chemical equivalence has

been demonstrated. The lawyers advising the entity do not anticipate that any significant difficulties will delay

the process of obtaining commercial regulatory approval (PWC, Pharma, 3).

Should management capitalize the development costs at this point ?

5. Pharmaceutical entity MagicCure has obtained scientific regulatory approval for a new respiratory

drug and is now incurring expenditure to educate its sales force and perform market research (PWC, Pharma,

4).

Should it capitalize these costs ?




December 12, 2008

6. Pharmaceutical entity Astro engages a contract research organisation (CRO) to perform research

activities for a period of 2 years in order to obtain know‐how and try to discover a cure for AIDS. The CRO is

well known in the industry for having modern facilities and good practitioners dedicated to investigation. The

CRO receives a non‐refundable, upfront payment of CU 3 million in order to carry out the research under the

agreement. It will have to present a quarterly report to Astro with the results of its research. Astro has full

rights of access to all the research performed, including control of the research undertaken on the potential

cure for AIDS. The CRO has no rights to use the results of the research for its own purposes (PWC, Pharma, 16).

How should Astro account for upfront payments made to third parties to conduct research ?

7. Van Gogh Ltd. Has obtained regulatory approval for its new antidepressant drug and has started

commercialization. Van Gogh is now undertaking studies to verify the advantages of its drug over competing

drugs already on the market. These studies will support Van Gogh's sales efforts (PWC, Pharma, 38).

Should costs incurred to compare various drugs with the intent of determining relative performance for

certain indications, be capitalized as development costs ?

8. Da Vinci Pharma is currently developing a drug that will be used in the treatment of a very specific

ailment affecting a small group of patients. Generally, Da Vinci pursues development of a drug if the market

potential is sufficient to obtain future economic benefits. However, Da Vinci has decided to pursue with this

drug for reputation reasons. Da Vinci has filed for initial regulatory approval, and believes that all other

capitalization criteria have been met except for concerns about its market potential (PWC, Pharma, 39).

Do limits to potential sales markets prevent management from capitalizing development costs related to

this drug ?

9. Sisley Pharma contracts with Wright Pharma to research possible candidates for further development

in its anti‐hypertension program. Sisley pays Wright on a cost‐plus basis for the research, plus CU 100 000 per

development candidate which Sisley elects to pursue further. Sisley will own the rights to any such

development candidates. After two years, Wright succeeds in confirming 10 candidates that will be used by

Sisley (PWC, Pharma, 43).

How should payments for pharmaceutical research that subsequently becomes development be accounted

for ?

.


Cost of an internally generated intangible asset


December 12, 2008

COST OF AN INTERNALLY GENERATED INTANGIBLE ASSET

1. Operator A is considering upgrading its billing system. A completed a feasibility study that

considered several software systems before deciding whether to go ahead with the upgrade. A

subsequently decided to upgrade its billing system. The development will take six months to complete. A

will use internal resources to customize the software. The total cost is expected to be 250 000, including

10 000 for the feasibility study, 25 000 to train the personnel who will be using the billing system and 215

000 of labour time for those personnel who were dedicated to the customization and upgrade of the

billing system (PWC, Telecom, 122.1).

When should an operator capitalize internally‐developed software ?

2. Pharmaceutical entity Pilax has obtained a loan from Qula, another pharmaceutical company, to

finance the late‐stage development of a drug to treat cancer. Qula will have co‐marketing rights over any

product that is developed. Pilax's management has decided to capitalize all the development costs

incurred after filing for scientific regulatory approval (PWC, Pharma, 23).

Should Pilax capitalize the interest incurred for borrowings obtained to finance R&D activities ?

3. Coupono plc has incurred 1200000 CU in capital expenditure for the development of new

software during the year, for its time recording and link with invoicing. At year‐end, 120 000 CU related to

the construction of the software is included in creditors. The software is considered to be a qualifying

asset under IAS 23 ‐ Borrowing Costs.

Coupono plc has the following borrowings outstanding:

• Bank overdraft: 120 000 CU at 16% • Long‐term loan: 300 000 CU at 5,1% (nominal interest rate) • Debentures: 1 100 000 CU at 6,8%

Ancillary costs of 5000 CU have been incurred in connection with the arrangement of the long‐term loan,

which has the following characteristics:

• Issuing date: 1 January of year 1 • Maturity date: 3 years • Repayment schedule: 300000 CU at maturity date

a. Determine the interest rate on the long‐term loan using the effective interest rate method.

b. Account for the long‐term loan.

c. Calculate the amount of borrowing costs to be capitalized, assuming that Coupono plc has a 31

December year‐end and that the expenditures took place on the following dates:

• 1 February 600000 CU • 1 July 400000 CU • 1 November 200000 CU

d. Calculate the amount of borrowing costs to be capitalized, assuming that the debentures were

not in existence. The entity applies the same method as in d)


Cost of an internally generated intangible asset


December 12, 2008

4. Tiepolo Pharma has appointed Tintoretto Laboratories, a third party, to develop an existing

compound owned by Tiepolo on its behalf. Tintoretto will act purely as a service provider without taking

any risks during the development phase and will have no further involvement after regulatory approval.

Tiepolo will retain full ownership of the compound. Tintoretto will not participate in any marketing and

production arrangements. A milestone plan is included in the contract. Tiepolo agrees to make the

following non‐refundable payments to Tintoretto (PWC, Pharma, 44):

CU 2 million on signing the agreement

CU 3 million on successful completion of phase 2

How should pharmaceutical entities account for upfront payments and subsequent milestone payments

in a long‐term research and development arrangement in which a third party develops their intellectual

property ?

5. Tiepolo Pharma has appointed Tintoretto Laboratories, a third party, to develop an existing

compound owned by Tiepolo on its behalf. The agreement effectively out‐licenses Tiepolo's compound to

Tintoretto. Tiepolo and Tintoretto will set up a development steering committee to jointly perform the

development and will participate in the funding of the development costs according to specific terms.

Tiepolo agrees to make the following payments to Tintoretto:

CU 5 million on signing the agreement as an advance payment. Tintoretto has to refund the entire payment in the event of failure in development

50% of total development costs on successful completion of phase 2 (after deducting the advance payment)

In the case of successful completion of development and commercialization, Tintoretto will receive milestone payments and royalty streams (PWC, Pharma, 45).

How should pharmaceutical entities account for upfront payments and subsequent milestone payments

in a long‐term research and development arrangement in which a third party develops their intellectual

property ?

6. Sargent and Chagall enter into a collaboration deal in which Sargent will pay Chagall for

developing and manufacturing a new antibiotic originally discovered by Chagall. Sargent will have

exclusive marketing rights of the antibiotic if it is approved. The contract terms require the following

payments:

Upfront payment of CU 5 million on signing of the contract

Milestone payment of CU 5 million on filing for stage 3 clinical trial approval

Milestone payment of CU 7 million on securing final regulatory approval, and

CU 11.5 per unit, which equals the estimated cost plus 15% once commercial production begins

The cost‐plus 15% is consistent with Sargent's other recently negotiated supply arrangements for drugs

with comparable manufacturing complexity (PWC, Pharma, 47).

How should pharmaceutical entities account for collaboration agreements to develop a new drug

compound ?


Intangible assets acquired in a business combination


December 12, 2008

INTANGIBLE ASSETS ACQUIRED IN A BUSINESS COMBINATION

1. The following are examples of identifiable intangible assets acquired in a business combination. Some

of the examples may have characteristics of assets other than intangible assets.

Intangible assets are identifiable if they have a contractual basis or if they are separable. Intangible assets

identified as having a contractual basis might also be separable but separability is not a necessary condition for

an asset to meet the contractual‐legal criterion.

Explain for the following intangible assets why they meet the definition of an identifiable asset.

Marketing‐related intangible assets

Trademarks, trade names, service

marks, collective marks and

certification marks

Internet domain names

Customer‐related intangible assets

Customer lists

Order or production backlog

Customer contracts and the related

customer relationships

Non‐contractual customer

relationships

Artistic‐related intangible assets

Plays, operas and ballets

Books, magazines, newspapers and

other literary works




December 12, 2008

Musical works such as compositions,

song lyrics and advertising jingles

Pictures and photographs

Video and audiovisual material,

including motion pictures or films,

music videos and television

programmes

Contract based intangible assets

Servicing contracts, such as

mortgage servicing contracts

Employment contracts

Use rights, such as drilling, water,

air, timber cutting and route

authorities

Computer software and mask works

Databases, including title plants

Trade secrets such as secret

formulas, processes and recipes




December 12, 2008

2. Determine for the following situations whether an intangible assets should be recognised

2.1 Acquirer Company (AC) acquires Target Company (TC) in a business combination on 31 December 20X5. TC

has a five‐year agreement to supply goods to Customer. Both TC and AC believe that Customer will renew the

agreement at the end of the current contract. The agreement is not separable.

2.2. AC acquires TC in a business combination on 31 December 20X5. TC manufactures goods in two

distinct lines of business: sporting goods and electronics. Customer purchases both sporting goods and

electronics from TC. TC has a contract with Customer to be its exclusive provider of sporting goods but has no

contract for the supply of electronics to Customer. Both TC and AC believe that only one overall customer

relationship exists between TC and Customer.

2.3. AC acquires TC in a business combination on 31 December 20X5. TC does business with its customers

solely through purchase and sales orders. At 31 December 20X5, TC has a backlog of customer purchase orders

from 60 % of its customers, all of whom are recurring customers. The other 40 % of TC's customers are also

recurring customers. However, as of 31 December 20X5, TC has no open purchase orders or other contracts

with those customers.

2.4. AC acquires TC, an insurer, in a business combination on 31 December 20X5. TC has a portfolio of one‐

year motor insurance contracts that are cancellable by policyholders.

3. Olegna acquires Enile on 30 December 20X8. In the balance sheet of Enile there is amount recognized

for goodwill in relation to an acquisition on 1 February 2008 of Siabot.

Is this goodwill part of the identifiable assets acquired an liabilities assumed in the business combination on

30 December 20X8 ?


Assessing the useful lives of intangible assets


December 12, 2008

ASSESSING THE USEFUL LIVES OF INTANGIBLE ASSETS

Determine the useful life and the subsequent accounting for each of the following examples of acquired

intangible assets.

1. A direct‐mail marketing company acquires a customer list and expects that it will be able to derive

benefit from the information on the list for at least one year, but no more than three years.

2. An entity acquires a patent that expires in 15 years. The product protected by the patented

technology is expected to be a source of net cash inflows for at least 15 years. The entity has a commitment

from a third party to purchase that patent in five years for 60 % of the fair value of the patent at the date it

was acquired, and the entity intends to sell the patent in five years.

3. An acquired copyright has a remaining legal life of 50 years. An analysis of consumer habits and

market trends provides evidence that the copyrighted material will generate net cash inflows for only 30 more

years.

4. A broadcasting company acquires a broadcasting license that expires in five years. The broadcasting

license is renewable every 10 years if the entity provides at least an average level of service to its customers

and complies with the relevant legislative requirements. The license may be renewed indefinitely at little cost

and has been renewed twice before the most recent acquisition. The acquiring entity intends to renew the

license indefinitely and evidence supports its ability to do so. Historically, there has been no compelling

challenge to the license renewal. The technology used in broadcasting is not expected to be replaced by

another technology at any time in the foreseeable future. Therefore, the license is expected to contribute to

the entity's net cash inflows indefinitely.

5. The licensing authority for the broadcasting license in the previous example subsequently decides

that it will no longer renew broadcasting licenses, but rather will auction the licenses. At the time the licensing

authority's decision is made, the entity's broadcasting license has three years until it expires. The entity

expects that the license will continue to contribute to net cash inflows until the license expires.

6. An acquired airline route authority between two European cities that expires in three years. The route

authority may be renewed every five years, and the acquiring entity intends to comply with the applicable

rules and regulations surrounding renewal. Route authority renewals are routinely granted at a minimal cost

and historically have been renewed when the airline has complied with the applicable rules and regulations.

The acquiring entity expects to provide service indefinitely between the two cities from its hub airports and

expects that the related supporting infrastructure (airport gates, slots, and terminal facility leases) will remain

in place at those airports for as long as it has the route authority. An analysis of demand and cash flows

supports those assumptions.

7. An entity acquired a trademark used to identify and distinguish a leading consumer product that has

been a market‐share leader for the past eight years. The trademark has a remaining legal life of five years but

is renewable every 10 years at little cost. The acquiring entity intends to renew the trademark continuously

and evidence supports its ability to do so. An analysis of (1) product life cycle studies, (2) market, competitive

and environmental trends, and (3) brand extension opportunities provides evidence that the trademarked

product will generate net cash inflows for the acquiring entity for an indefinite period.

8. An entity acquired a trademark acquired 10 years ago that distinguishes a leading consumer product.

The trademark was regarded as having an indefinite useful life when it was acquired because the trademarked

product was expected to generate net cash inflows indefinitely. However, unexpected competition has

recently entered the market and will reduce future sales of the product. Management estimates that net cash

inflows generated by the product will be 20 % less for the foreseeable future. However, management expects

that the product will continue to generate net cash inflows indefinitely at those reduced amounts.


Assessing the useful lives of intangible assets


December 12, 2008

9. An entity acquired a trademark for a line of products that was acquired several years ago in a business

combination. At the time of the business combination the acquiree had been producing the line of products

for 35 years with many new models developed under the trademark. At the acquisition date the acquirer

expected to continue producing the line, and an analysis of various economic factors indicated there was no

limit to the period the trademark would contribute to net cash inflows. Consequently, the trademark was not

amortized by the acquirer. However, management has recently decided that production of the product line

will be discontinued over the next four years.


Amortization of intangible assets


December 12, 2008

AMORTIZATION OF INTANGIBLE ASSETS

1. Operator D pays commissions of 175 to a third party dealer for the acquisition of a subscriber

that has passed the usual credit check. The subscriber signs a 12‐month contract. The average life of D's

subscribers is 24 months. Operator D can reliably establish the recoverability of the 175 and has the

systems to track the payment for each subscriber acquired separately (PWC, Telecom, 122.40).

Over what period should an operator amortize subscriber acquisition costs ?

2. Operator B purchases a telecom license in 1999 for 1 million. The license has a term of 12 years.

B then constructs its telecom network. The telecom network is capable of delivering service in 20X1, two

years after the license was initially purchased. The license has a remaining term of 10 years. C expects its

subscriber base to grow over the next few years and reach a critical mass in four years' time ‐ that is, 20X5

(PWC , Telecom, 122.2 and 122.3).

When should an operator commence the amortization of its telecom license ?

Which basis of amortization should an operator adopt in respect of its telecom licenses ?

3. Operator D purchased a telecom license in 20C for 1 billion. The license has an initial term of 10

years. The license agreement is silent about D's right to renew the license. While D expects to be able to

renew its license at the end of its initial term, it is not known what charge, if any, the government would

make for such a renewal (PWC, Telecom, 122.4).

Over what period should an operator amortize its telecom license ?

4. Operator E purchased a telecom license in 20X0 for 1 billion. The license has an initial term of 10

years. Te license agreement is silent about E's right to renew the license. There is an established practice

of the regulator granting a single renewal of telecom licenses at no additional cost provided operators

adhere to the requirements of the license. The license requires E to meet certain network build

milestones, to provide service to a fixed percentage of the population and to adhere to any new

regulations issued. E has already met the first two criteria and management intends to comply with new

regulations as and when they are issued (PWC, Telecom, 122.5).

Over what period should an operator amortize its telecom license ?

5. A pharmaceutical entity acquired a compound in development for CU5 million on 1 January

20X3. The entity amortizes its intangible assets on a straight‐line basis over the estimated useful life of the

asset. The entity receives regulatory and marketing approval on 1 March 20 and starts using the

compound in its production process on 1 June 20X4 (PWC, Pharma, 7).

When should it begin amortizing its intangible assets ?


Amortization of intangible assets


December 12, 2008

6. Picasso Pharma has acquired a new drug compound, which is currently in phase I clinical

development. Picasso has capitalized the costs for acquiring the new drug compound as an intangible

asset. Subsequently, Picasso's scientists detect that the new drug substance is much more effective when

used in a combination therapy with another drug. Management stops the current development activities

for the new drug. New phase I clinical trials are started for the combination therapy (PWC, Pharma, 49).

How should a pharmaceutical entity amortize an intangible asset related to an acquired early‐stage

project when utilizing the results for development of a drug other than the drug for which the project

was originally acquired ?

7. Raphael & Co has begun commercial production and marketing of an approved product.

Development costs for this product were capitalized in accordance with the criteria specified in IAS 38.

The patent underlying the new product will expire in 10 years (PWC, Pharma, 66).

Once a drug is being used as intended, what is the appropriate method of amortizing the capitalized

development costs ?

8. Raphael & Co has begun commercial production and marketing of an approved product.

Development costs for this product were capitalized in accordance with the criteria specified in IAS 38.

The patent underlying the new product will expire in 10 years; however, Raphael's business plan is to use

the compound in an over‐the‐counter drug after nine years to establish market presence. The business

plan indicates a future economic useful life for the compound of 10 years after patent expiry and supports

separate attribution of the intangible cost to the patent and the compound (PWC, Pharma 67).

Once a drug is being used as intended, what is the appropriate method of amortizing the capitalized

development costs ?


Impairment of intangible assets


December 12, 2008

IMPAIRMENT OF INTANGIBLE ASSETS

1. Dali Pharmaceuticals has capitalized external development costs as an intangible asset relating to

a compound that has not been approved. Subsequently, Dali identified side effects associated with the

compound that indicate its value is severely diminished and an impairment charge must be recognized

(PWC, Pharma, 60).

Where should pharmaceutical entities classify impairment charges on development intangible assets

before such assets are available for use ?

2. Dali Pharmaceuticals has capitalized development costs as an intangible asset relating to a drug

that has been approved and is being marketed. Competitive pricing pressure from the early introduction

of generic drugs causes Dali to recognize an impairment of the intangible asset (PWC, Pharma 61).

Where should pharmaceutical entities classify impairment charges on development intangible assets

which are currently marketed ?

3. By way of a collaboration agreement, Veronese SpA acquired the rights to market a topical

fungicide cream in the Eastern Hemisphere. The acquired rights apply broadly to the entire territory. For

unknown reasons, patients in Greece prove far more likely to develop blisters from use of the cream,

causing Veronese to withdraw the product from that country. As fungicide sales in Greece were not

expected to be significant, loss of the territory, taken in isolation, does not cause the overall net present

value from sales of the drug to be less than its carrying value (PWC, Pharma, 62).

How should pharmaceutical companies account for the rescission of a drug's marketing approval in a

specific territory ?

4. Seurat Pharmaceutical acquired a new drug compound, which is currently in phase I clinical

development. Seurat capitalized the costs for acquiring the drug as an intangible asset. Soon after

acquisition of the drug, the results of the clinical trials show that the drug is not likely to be effective for

the intended therapy. Management terminates development of the drug. Seurat's scientists will use

technology directly related to the acquired intangible in developing one of Seurat's other drugs (PWC,

Pharma, 63).

How should a pharmaceutical entity amortise an intangible asset related to an acquired early‐stage

project when utilising the results for development of a drug other than the drug for which the project

was originally acquired ?

5. Rubens Corp. markets a weight‐loss drug for which development costs have been capitalized. A

competing drug was launched on the market with much lower pricing. Rubens recorded an impairment of

the capitalized development intangible asset due to a reduction in the amounts it estimated that it could

recover as a result of this rival drug. Subsequently, the competing drug was removed from the market

because of safety concerns. The market share and forecast cash flows generated by Ruben's drug

significantly increased (PWC, Pharma, 64).

How should pharmaceutical entities account for reversals of impairment losses for intangible assets

accounted for under the cost model ?


Subsequent costs


December 12, 2008

SUBSEQUENT COSTS

1. Velazquez Pharma has a registered patent on a currently marketed drug. Uccello Medicines Ltd.

copies the drug's active ingredient and sells the drug during the patent protection period. Velazquez goes

to trial and is likely to win the case, but has to pay costs for its lawyers and other legal charges (PWC,

Pharma, 42).

Should legal costs relating to the defense of pharmaceutical patents be capitalized ?

2. The Hy‐Tech Services Corporation employs researchers based in countries around the world.

Employee time is the basis upon which charges to many customers are made. The geographically

dispersed nature of its operations makes it extremely difficult for the payroll staff to collect time records,

so the management team authorized the design of an in‐house, Web‐based timekeeping system (Epstein,

pg 303).

a. Determine for the following costs incurred by the project team whether they should be

expensed or capitalized

Cost type Amount Expensed Capitalized

Concept design 2500

Evaluation of design alternatives 3 700

Determination of required technology 8 100

Final selection of alternatives 1 400

Software design 28 000

Software coding 42 000

Quality assurance testing 30 000

Data conversion costs 3900

Training 14 000

Overhead allocation 6 900

General and administrative costs 11 200

Ongoing maintenance costs 6 000

b. Determine the amortization charge to be recognized as soon as all testing is completed. The

estimated useful life of the timekeeping system is five years.

100 000/60 months = 1 666.67


Subsequent costs


December 12, 2008

c. Once operational, management elects to construct another module for the system that issues an

e‐mail reminder for employees to complete their timesheets. This represents significant added

functionality. The following costs are incurred:

Labor type Labor cost Payroll taxes Benefits Total cost

Software developers 11 000 842 1 870 13 712

Quality assurance testers 7 000 536 1 190 8 726

Total 18 000 1 378 3 060 22 438

By the time this additional work is completed, the original system has been in operation for one year.

Should the company capitalize these costs ? If yes, what would be amortization charge ?

d. After the system has been operating for two years, a Hy‐tech customer sees the timekeeping

system in action and begs management to sell it as a stand‐alone product. The customer becomes a

distributor, and lands three sales in the first year. From these sales Hy‐Tech receives revenues of 57 000

and incurs the following related expenses:

Distributor commission (25%) 14 250

Service costs 1 900

Installation costs 4 300

Total 20 450

Give the appropriate journal entries

e. Immediately thereafter, Hy‐Tech’s management receives a sales call from an application service

provider who manages an Internet‐based timekeeping system. The terms offered are so attractive that

Hy‐Tech abandons its in‐house system at once and switches to the server system.

What should the entity do ?

3. An entity is developing a new production process. During 20X5, expenditure incurred was CU1

000, of which CU900 was incurred before 1 December 20X5 and CU100 was incurred between 1

December 20X5 and 31 December 20X5. The entity is able to demonstrate that, at 1 December 20X5, the

production process met the criteria for recognition as an intangible asset. The recoverable amount of the

know‐how embodied in the process (including future cash outflows to complete the process before it is

available for use) is estimated to be CU500.

When should the entity recognize an intangible asset and for what amount ?

During 20X6, expenditure incurred is CU2 000. At the end of 20X6, the recoverable amount of the know‐

how embodied in the process (including future cash outflows to complete the process before it is

available for use) is estimated to be CU1 900.

How should the entity account for the subsequent cost and the recoverable amount ?


Comprehensive case


December 12, 2008

COMPREHENSIVE CASE

1. Bitterfontein plc is a South African mail‐order film developer. Although the photo‐developing business

in South Africa is growing slowly, Bitterfontein plc has reported significant increases in sales and net income in

recent years. While sales increased from 50 mCU in 20X1 to 120 mCU in 20X4, profit increased from 3 mCU to

12 mCU over the same period. The stock market and analysts believe that the company’s future is very

promising. In early 20X5, the company was valued at 350 mCU, which is three times its 20X4 sales and 26 times

its estimated 20X5 profit.

What is the secret of Bitterfontein plc’s success? Company management and many investors attribute the

company’s success to its marketing flair and expertise. Instead of competing on price, Bitterfontein plc prefers

to focus on service and innovation, including

• offering customers a CD of their photos and a set of prints from the same roll of film for a set price • giving customers (at no extra charge) a “picture index” showing mini photos of every photo on the roll • giving every customer a replacement roll (at no extra charge) with every development order.

As a result of such innovations, customers accept prices that are 60% above those of competing discount‐film

developers, and Bitterfontein plc maintains a gross profit margin of around 40%.

Nevertheless, some investors have doubts about the company because they are uneasy about certain

accounting policies it has adopted. For example, Bitterfontein plc capitalizes the costs of its direct mailings to

prospective customers (4,2 mCU at 30 June 20X4) and amortizes them on a straight‐line basis over three years.

This practice is considered to be questionable as there is no guarantee that customers will be obtained and

retained from direct mailings.

In addition to the mailing lists developed by in‐house marketing staff, Bitterfontein plc purchased a customer

list from a competitor for 800 000 CU on 4 July 20X5. This list is also recognized as a non‐current asset.

Bitterfontein plc estimates that this list will generate sales for at least another two years, more likely another

three years. The company also plans to add names, obtained from a telephone survey conducted in August

20X5, to the list. These extra names are expected to extend the list’s useful life by another year.

Bitterfontein plc’s 20X4 statement of financial position also reported 7,5 mCU of marketing costs as non‐

current assets. If the company had expensed marketing costs as incurred, 20X4 net income would have been

10 mCU instead of the reported 12 mCU. The concerned investors are uneasy about this capitalization of

marketing costs, as they believe that Bitterfontein plc’s marketing practices are relatively easy to replicate.

However, Bitterfontein plc argues that its accounting is appropriate. Marketing costs are amortized at an

accelerated rate (55% in the first year, 29% in the second year, and 16% in the third year), based on 15 years

knowledge and experience of customer purchasing behaviour.

Explain how Bitterfontein plc’s costs should be accounted for under IAS 38, giving reasons for your answers

(Alfredson et al.(2007), pg. 478, problem 11.6)


Annual improvements 2007


December 12, 2008

ANNUAL IMPROVEMENTS 2007

1. Kandinsky Medical recently completed a major study comparing its Alzheimer's drug to

competing drugs. The results of the study were highly favourable and Kandinsky has invested in a

significant new marketing campaign. The campaign will be launched at the January 20X5 International

Alzheimer's Conference. Kandinsky has also paid for direct‐to‐customer (DTC) television advertising which

will appear in February 20X. Related DTC internet advertising will likewise begin in February, and will be

paid based on 'click‐through' to its Alzheimer's site (PWC, Pharma, 78).

How should the marketing campaign costs incurred be treated in its December 20X4 financial

statements ?

2. Goya Laboratories is eager to increase knowledge of its new generic pain medication within

hospitals. Accordingly, Goya's sales force distributes free samples of the pain medication during sales calls

and at certain hospital conventions. Additionally, Goya runs a special promotion where hospitals get 13

tablets for the price of 12 (PWC, Pharma, 80).

How should management classify, and account for, the costs of free samples distributed in order to

promote a product ?

IFRIC 12 – Service concession arrangements

Scope


December 12, 2008

IFRIC 12 – SERVICE CONCESSION ARRANGEMENTS

SCOPE

Decide for the following scenarios whether IFRIC 12 should be applied or not

1. A construction company has an agreement with the French government to construct a tunnel

through a mountain. The tunnel is constructed on land of the French government, which means that the

French government is the legal owner of the tunnel. During a period of 15 years the company will collect

toll from drivers using the tunnel. The fare is limited to €5 by the French government. During the 15

year‐period the tunnel must be maintained by the construction company. After this period the

government will take over the maintenance.

2. A power company builds a power plant. It contracts a power purchase agreement with the local

government. Through the agreement it is obliged to generate energy for the adjacent city. The

government will pay a fixed capacity payment to the company, if the plant is available, regardless of it

being dispatched. At the end of the 15‐year agreement, the power company can manage its plant at its

sole discretion. The power plant has a useful life of 30 years.


government. Through the agreement it is obliged to generate energy for the adjacent city. The

government will pay a fixed capacity payment to the company, if the plant is available, regardless of it

being dispatched. At the end of the 25‐year agreement, the power company can manage its plant at its

sole discretion. The power plant has a useful life of 30 years.


government. Through the agreement it is obliged to generate energy for the adjacent city. The users will

pay a fixed price per MW acquired to the company. At the end of the 25‐year agreement, the power

company can manage its plant at its sole discretion. The power plant has a useful life of 30 years.


government. Through the agreement it is obliged to generate energy for the adjacent city. The users will

pay a fixed price per MW acquired to the company. At the end of the 15‐year agreement, the power

company can manage its plant at its sole discretion. The power plant has a useful life of 30 years.


Financial asset/intangible asset


December 12, 2008

FINANCIAL ASSET/INTANGIBLE ASSET

Decide for the following scenarios whether a financial asset or an intangible asset should be recognized

1. A waste incineration company has an agreement with the Belgian government to construct and

operate a waste incineration oven. The company can use this oven to treat any waste collected by the

Belgian municipalities for a period of 20 years. The price paid by the municipalities for waste incineration

is fixed by the government and is reviewed every year. After 20 years, the oven will become the property

of the Belgian government.

2. A privately owned hospital that has an arrangement with the Swiss government to construct,

maintain, and operate a division for AIDS patients for 20 years. Under the arrangement, the hospital is

paid by the patients for care but if patients cannot afford to pay for the care the Swiss government

reimburses the hospital. The payments should at least cover the cost of the infrastructure, the

maintenance of the infrastructure and the variable costs of the care. In addition, if there are not

sufficient payments by the patients to cover the fixed cost of the hospital, the government will

compensate for those costs. At the end of the concession period the infrastructure either reverts to the

government or the concession is renewed.

3. A construction company has an agreement with grantor Spain to construct a road and maintain

and operate the road for twelve years. Under the contract, the company will be paid an annual amount,

with the total to be paid over the arrangement being equal to 70% of the total costs to be incurred. The

company will be able to charge users a toll, which is capped by the grantor.


Accounting for service concession arrangements


December 12, 2008

ACCOUNTING FOR SERVICE CONCESSION ARRANGEMENTS

Arrangement terms:

Cost of construction: 100

Profit on construction: 10

Cash flows over life: 200

A. Financial Asset Model

Assume that the interest revenue to be recognized over the life of the contract (based on the effective interest

rate method in accordance with IAS 39 – Financial Instruments: Recognition and Measurement) is 10.

During construction:

Dr Financial asset 110

Cr Revenue 110

Dr Cost of construction 100

Cr Cash 100

In accordance with IAS 39, the entity recognizes a financial asset at the fair value of the construction and

recognizes the cost of the construction. Revenue of 110, costs of 100 and a profit of 10 is thus recognized

during the construction.

During operational phase:


Cr Finance revenue 10


Cr Revenue 80

Dr Cash 200

Cr Financial asset 200

Total revenue over the life of the contract: 200

Total cash flows over the life of the contract: 200

Over the life of the construction period the financial asset is measured using the effective interest method. In

this example, the finance revenue recognized under this method is 10. The excess of the total cash flows over

the life of the contract (200) over the carrying amount of the financial asset (110+10=120), is recognized as

revenue (80). When cash is received the financial asset is credited. Total Revenue of 90 is therefore

recognized during the operational phase. (NB: This is a simplified example. Concession arrangements will

normally also incorporate significant running costs during the life of the concession).

B. Intangible Asset Model


Dr Construction costs 100




December 12, 2008

Cr Cash 100

Dr Intangible asset 110

Cr Revenue 110

During the construction, the cost of the construction services provided is recognized as work in process and

then a subsequent exchange transaction of construction WIP for an intangible asset is recognized at the fair

value of the constructions services provided. This gives revenue of 110, costs of 100 and a profit of 10 during

the construction.


Dr Amortization expense 110

Cr Intangible asset 110

Dr Cash 200

Cr Revenue 200



During the life of the concession the intangible asset is amortized and the cash flows are recognized as

revenue. This means that during the operational phase of the service concession arrangement 110 of

concession costs are recognized and 200 of revenue is recognized. This leads to a profit of 90 during the

operational phase of the contract.

C. Bifurcated Model

Additional information: Cash flows guaranteed by the government are 60, which is 54% of the fair value of the

construction. Assume that the interest revenue that should be recognized over the life of the contract (based

on the effective interest rate in accordance with IAS 39 – Financial Instruments: Recognition and

Measurement) is 6.


Dr Receivable 60

Cr Revenue 60

A financial asset of 60, equal to the cash flows guaranteed by the government, is recognized as construction

services are provided.

Dr Cost (exp) 54

Dr Construction WIP 46

Cr Cash 100

Since the government guarantees 54% of the fair value of the construction, a cost of 54 related to the financial

asset is recognized during the course of construction in the income statement. The remaining part of the

construction costs (100‐54=46) are considered to be costs that are related to acquisition of the intangible

asset.

Dr Intangible asset 50

Cr Revenue 50




December 12, 2008

An intangible asset is recognized for the difference between the fair value of the construction (110) and the

value of the financial asset (60).

Dr Cost of sales 46

Cr WIP 46

The construction cost related to the construction of the intangible asset is recognized as cost of sales. During

the construction the entity recognizes revenue of 110, costs of 100 and profit of 10.



Cr Finance revenue 6

The financial asset is measured in accordance with the effective interest method.

Dr Amortization expense 50

Cr Intangible asset 50

The intangible asset is amortized.

Dr Cash 200

Cr Revenue 134

Cr Financial asset 66

The cash received is split between revenue and the reduction of the receivable (60+6).

During the operational phase of the contract the entity recognizes revenue of 140, costs of 50 and profit of 90.



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