Purchased, internally developed and acquired intangibles

Does it matter whether a company buys, builds or acquires an intangible?

Yes. Identical economics produce different statements depending on the route. A intangible purchased separately is an asset at cost. An internally developed intangible is mostly an expense. An intangible acquired in a business combination is an asset at fair value, including items the target itself never recorded.

How the company got the intangible

• Purchased separately Memorize asset at cost; investing outflow
  • Group purchase cost split by relative fair value
• Developed internally Memorize mostly expensed; operating outflow
  • IFRS exception development phase, once all criteria are met
  • US GAAP exception qualifying software costs only
• Acquired in a business combination Memorize each identifiable intangible at fair value
  • Not identifiable falls into goodwill

Before any of that, an item has to qualify. An identifiable intangible asset under IFRS is separable or arises from legal or contractual rights, is controlled by the company, and is expected to produce future benefits. The recognition criteria then add two tests: the benefits are probable, and the cost can be measured reliably.

Exam tip When a question splits spending into pieces, capitalize only what comes after the point where every condition is met. Earlier development spending stays expensed.

How is a purchased intangible reported?

At cost, which is treated as its fair value at the purchase date. If several intangibles come in one purchase, the price is split between them by relative fair value. The payment is an investing outflow, and the asset is then amortized if its life is finite.

An analyst cares more about what was bought (franchise rights, a customer base, a license) than the exact split of the price, because the split rests on heavy judgment. What a company buys tells you where it is heading.

How are internally developed intangibles reported?

Mostly as an expense in the period they are incurred. The spending never appears as an asset and sits in operating cash flow. Two exceptions let some of it onto the balance sheet.

Under IFRS the line falls between two phases. The research phase is original investigation to gain new knowledge, before anyone can show an asset is being created. It is always expensed. The development phase applies findings to a plan or design before commercial production. Once the company can show every condition (technical feasibility, intention to complete, ability to use or sell, probable benefits, adequate resources and reliable cost measurement), development spending from that day on is capitalized.

US GAAP generally expenses both research and development. The exception is software development costs :

• Software to be sold: expensed until technological feasibility is established, capitalized afterwards.
• Software for internal use: expensed until it is probable the project will be completed and used as intended, capitalized afterwards.

Completion is easier to show than technological feasibility, so internal-use software starts to be capitalized earlier.

Spending on an internal project

• Research phase Memorize expensed under IFRS and US GAAP
• Development phase Memorize IFRS and US GAAP differ
  • IFRS capitalize from the day all criteria are met
  • US GAAP, general expense
  • US GAAP, software for sale capitalize after technological feasibility
  • US GAAP, internal-use software capitalize once completion is probable

$$C = M\,(13 - k), \qquad X = M\,(k - 1)$$

Here M is the spending per month, spread evenly over a 12-month year, and k is the month in which all the criteria are first met. Everything before that month is expensed and cannot be added back later.

What does buying versus building do to the statements?

Building hides the asset and moves the cash outflow into operations; buying shows the asset and puts the outflow in investing. The result is lower assets and lower CFO for the builder in the year of spending, and a different ROA.

$$ROA = \frac{\text{Net income}}{\text{Total assets}}$$

In later years the Builder has no amortization, so its profit catches up. Its asset base stays smaller, so its later ROA can look better than the Buyer’s. The comparison depends on the year you look at, which is why analysts compare trends, not one year.

How are intangibles acquired in a business combination reported?

The acquirer allocates the purchase price to every asset acquired and liability assumed at fair value. This is purchase price allocation . Every identifiable intangible is recognized, whether or not the target ever recorded it: customer relationships, a brand the target built itself, and in-process R&D. What cannot be identified is goodwill.

$$Goodwill = \text{Price paid} - \text{Fair value of net identifiable assets}$$

Under US GAAP the rule for separate recognition is two-part: the item arises from legal or contractual rights, or it is separable from the company. Anything that meets neither test is goodwill.

Go deeper Why acquisitive companies look asset-heavy

A company that grows by buying others carries purchased intangibles at fair value plus goodwill. A competitor that grows organically has spent similar sums on research, marketing and training, but expensed them. Compared directly, the acquirer shows more assets, lower ROA and a larger investing outflow, while the organic grower shows lower assets, higher ROA and a larger operating outflow. When you compare the two, adjust for the difference (for example by capitalizing the organic company’s R&D) before drawing a conclusion.

Go deeper In-process R&D in an acquisition

Under both frameworks, research and development in progress that the acquirer buys as part of a business combination is recognized at fair value as an asset. That is the opposite of the target’s own treatment, where the same spending would normally have been expensed as incurred.