As an aid to your revision, list the examples given in IAS 38 of activities that might be included in either research or development.
Answer
IAS 38 gives these examples. Research
Activities aimed at obtaining new knowledge
The search for applications of research findings or other knowledge
The search for product or process alternatives
The formulation and design of possible new or improved product or process alternatives
Development
The evaluation of product or process alternatives
The design, construction and testing of pre-production prototypes and models
The design of tools, jigs, moulds and dies involving new technology
The design, construction and operation of a pilot plant that is not of a scale economically feasible for commercial production
Question
Project
Forkbender Co develops and manufactures exotic cutlery and has the following projects in hand. Project 1 2 3 4 $'000 $'000 $'000 $'000 Deferred development Expenditure b/f 1.1.X2 280 450 – – Development expenditure Incurred during the year
Salaries, wages and so on 35 – 60 20
Overhead costs 2 – – 3
Materials and services 3 – 11 4
Patents and licences 1 – – –
Market research – – 2 –
Project 1: was originally expected to be highly profitable but this is now in doubt, since the scientist in charge of the project is now behind schedule, with the result that competitors are gaining ground. Project 2: commercial production started during the year. Sales were 20,000 units in 20X1 and future sales are expected to be: 20X2 30,000 units; 20X3 60,000 units; 20X4 40,000 units; 20X5 30,000 units. There are no sales expected after 20X5.
Project 3: these costs relate to a new project, which meets the criteria for deferral of expenditure and which is expected to last for three years.
Project 4: is another new project, involving the development of a 'loss leader', expected to raise the level of future sales.
The company's policy is to defer development costs, where permitted by IAS 38. Expenditure carried forward is written off evenly over the expected sales life of projects, starting in the first year of sale.
Required
Show how the above projects should be treated in the accounting statements of Forkbender Co for the year ended 31 December 20X2 in accordance with best accounting practice. Justify your treatment of each project.
Answer
Project 1 expenditure, including that relating to previous years, should all be written off in 20X2, as there is now considerable doubt as to the profitability of the project.
Since commercial production has started under project 2 the expenditure previously deferred should now be amortised. This will be done over the estimated life of the product, as stated in the question.
Project 3: the development costs may be deferred.
Since project 4 is not expected to be profitable its development costs should not be deferred. STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X2 (extract)
$'000 NON-CURRENT ASSETS
Intangible assets
Development costs (Note 2) 431
NOTES TO THE ACCOUNTS 1 Accounting policies
Research and development
Research and development expenditure is written off as incurred, except that development costs incurred on an individual project are carried forward when their future recoverability can be foreseen with reasonable assurance. Any expenditure carried forward is amortised over the period of sales from the related project.
2 Development costs
$'000 $'000
Balance brought forward 1 January 20X2 730
Development expenditure incurred
during 20X2 139
Development expenditure amortised
during 20X2 (321 + 90 + 27) 438
(299)
Balance carried forward 31 December 20X2 431
Note. IAS 38 would not permit the inclusion of market research in deferred development costs. Market research costs might, however, be carried forward separately under the accruals principle. Workings 1 2 3 4 Total $'000 $'000 $'000 $'000 $'000 B/F 280 450 – – 730 Salaries etc 35 – 60 20 115 Overheads 2 – – 3 5 Materials etc 3 – 11 4 18 Patents etc 1 – – – 1 C/F – (360) (71) – (431) Written off 321 90 –-- – 27 438
*Note. An alternative basis for amortisation would be: 180
20
450 = 50
The above basis is more prudent, however, in this case.
6 Goodwill
Impairment rules follow IAS 36. There are substantial disclosure requirements. Goodwill is created by good relationships between a business and its customers.
(a) By building up a reputation (by word of mouth perhaps) for high quality products or high standards of service
(b) By responding promptly and helpfully to queries and complaints from customers
(c) Through the personality of the staff and their attitudes to customers
The value of goodwill to a business might be extremely significant. However, goodwill is not usually valued in the accounts of a business at all, and we should not normally expect to find an amount for goodwill in its statement of financial position. For example, the welcoming smile of the bar staff may contribute more to a bar's profits than the fact that a new electronic cash register has recently been acquired. Even so, whereas the cash register will be recorded in the accounts as a non-current asset, the value of staff would be ignored for accounting purposes.
On reflection, we might agree with this omission of goodwill from the accounts of a business. (a) The goodwill is inherent in the business but it has not been paid for, and it does not have an
'objective' value. We can guess at what such goodwill is worth, but such guesswork would be a matter of individual opinion, and not based on hard facts.
(b) Goodwill changes from day to day. One act of bad customer relations might damage goodwill and
one act of good relations might improve it. Staff with a favourable personality might retire or leave to find another job, to be replaced by staff who need time to find their feet in the job. Since goodwill is continually changing in value, it cannot realistically be recorded in the accounts of the business.
6.1 Purchased goodwill
If a business has goodwill, it means that the value of the business as a going concern is greater than the value of its separate tangible assets. The valuation of goodwill is extremely subjective and fluctuates constantly. For this reason, non-purchased goodwill is not shown as an asset in the statement of financial position.
There is one exception to the general rule that goodwill has no objective valuation. This is when a business is sold. People wishing to set up in business have a choice of how to do it – they can either buy their own non-current assets and inventory and set up their business from scratch, or they can buy up an existing business from a proprietor willing to sell it. When a buyer purchases an existing business, he will have to purchase not only its long-term assets and inventory (and perhaps take over its accounts payable and receivable too) but also the goodwill of the business.
Purchased goodwill is shown in the statement of financial position because it has been paid for. It has no tangible substance, and so it is an intangible non-currentasset.
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6.2 How is the value of purchased goodwill decided?
When someone purchases a business as a going concern the purchaser and vendor will fix an agreed price which includes an element in respect of goodwill. The way in which goodwill is then valued is not an accounting problem, but a matter of agreement between the two parties.
When a business is sold, there is likely to be some purchased goodwill in the selling price. But how is the amount of this purchased goodwill decided?
This is not really a problem for accountants, who must simply record the goodwill in the accounts of the new business. The value of the goodwill is a matter for the purchaser and seller to agree upon in fixing the purchase/sale price. However, two methods of valuation are worth mentioning here.
(a) The seller and buyer agree on a price without specifically quantifying the Goodwill.The purchased goodwill will then be the difference between the price agreed and the value of the tangible assets in the books of the new business.
(b) However, the calculation of goodwill often precedes the fixing of the purchase price and becomes a
central element of negotiation. There are many ways of arriving at a value for goodwill and most of them are related to the profit record of the business in question.
No matter how goodwill is calculated within the total agreed purchase price, the goodwill shown by the purchaser in his accounts will be the difference between the purchase consideration and his own valuation of the tangible net assets acquired. If A values his tangible net assets at $40,000, goodwill is agreed at $21,000 and B agrees to pay $61,000 for the business but values the tangible net assets at only $38,000, then the goodwill in B's books will be $61,000 – $38,000 = $23,000.
6.3 IFRS 3 (Revised) Business combinations
Purchased goodwill is retained in the statement of financial position as an intangible asset under the requirements of IFRS 3. It must then be reviewed for impairment annually.
IFRS 3 covers the accounting treatment of goodwill acquired in a business combination.
It is possible to define goodwill in different ways. The IFRS 3 definition of goodwill is different from the more traditional definition and emphasises benefits, rather than the method of calculation.
Goodwill. An asset representing the future economic benefits arising from other assets acquired in a
business combination that are not individually identified and separately recognised. (IFRS 3) Goodwill recognised in a business combination is an asset and is initially measured at cost. Cost is the excess of the cost of the combination over the acquirer's interest in the net fair value of the acquiree's identifiable assets, liabilities and contingent liabilities.
After initial recognition goodwill acquired in a business combination is measured at cost less any
accumulated impairment losses. It is not amortised. Instead, it is tested for impairment at least annually, in accordance with IAS 36 Impairment of assets.
6.3.1 Goodwill and non-controlling interests
The old IFRS 3 looked at goodwill from the point of view of the parent company, ie comparing, consideration transferred with the parent's share of net assets acquired.
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Key terms
IMPORTANT!
The revised IFRS 3 views the group as an economic entity. This means that it treats all provides of equity including non-controlling interests as shareholders in the group, even if they are not shareholders in the parent.
Therefore, goodwill attributed to the non-controlling interest needs to be recognised.
We will come back to this point in Chapter 12.
6.3.2 Bargain purchase
A bargain purchase arises when the net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed exceeds the consideration transferred (see Chapter 12).
A bargain purchase might happen, for example, in a business combination that is a forced sale in which the seller is acting under compulsion. However, the recognition or measurement exceptions for particular items may also result in recognising a gain (or change the amount of a recognised gain) on a bargain purchase.
Before recognising a gain on a bargain purchase, the acquirer must reassess whether it has correctly identified all of the assets acquired and all of the liabilities assumed and must recognise any additional assets or liabilities that are identified in that review. The acquirer must then review the procedures used to measure the amounts this IFRS requires to be recognised at the acquisition date for all of the following: (a) The identifiable assets acquired and liabilities assumed
(b) The non-controlling (formerly minority) interest in the acquiree, if any
(c) For a business combination achieved in stages, the acquirer's previously held interest in the acquiree
(d) The consideration transferred
The purpose of this review is to ensure that the measurements appropriately reflect all the available information as at the acquisition date.