Financial and Intangible Assets

Two asset types whose accounting is dominated by judgement. Financial assets are classified by management's business model, and that classification dictates whether fair-value swings hit income, OCI, or nothing. Intangible assets are mostly off the balance sheet when grown internally and on it when bought — distorting comparisons — and the on-balance-sheet ones (especially goodwill) are governed by impairment tests riddled with discretion.

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Financial assets Classification & measurement Income & equity impact Intangible assets R&D & internal intangibles Expensers vs purchasers Goodwill Goodwill impairment

Financial assets are investments in another entity's shares, notes or bonds, held to earn interest, dividends and disposal gains — not strategic stakes in subsidiaries, associates or joint ventures (those come later in the course). Even non-financial companies hold large financial-asset piles, so their measurement can swing reported profit.

Financial assets — fair value vs amortised cost

The two measurement bases are fair value (the price to sell in an orderly transaction — most often market price) and amortised cost (initial recognition, minus principal repayments, plus/minus amortisation of any discount or premium, minus impairment). Which one applies is decided by classification — and classification reflects management's business model for the asset.

Classification determines measurement

Implications for income and equity

Take a debt security paying interest income of 2,500,000 with an unrealised fair-value gain of 2,000,000. The interest income flows to retained earnings (via income) and cash in every case; the unrealised gain is treated very differently:

Intangible assets (IAS 38)

An intangible asset is an identifiable non-monetary asset without physical substance, meeting three tests: identifiability (separable, or arising from contractual/legal rights), control (power to obtain its benefits), and future economic benefits. Examples: patents, copyrights, trademarks, franchises, brands, technology, know-how, goodwill. They sit on the balance sheet when purchased or acquired (allocating the price involves discretion) and largely off it when internally developed. IAS 38 capitalises an intangible only if future benefits are probable and cost is reliably measurable — otherwise the spend is expensed as incurred.

R&D and internally generated intangibles

For internally generated intangibles, IFRS splits R&D: research-phase costs are expensed; development-phase costs are capitalised once specific criteria are met. Other internal intangibles (start-up costs, brands, customer lists) are expensed (usually SG&A). US GAAP is similar but prohibits capitalising development costs (except certain software).

Distortion: expensers vs purchasers

Omitting internally generated intangibles distorts ROA, asset turnover, ROE and margins, and investors fixating on net income tend to underestimate R&D's future payoff — undervaluing high-R&D-growth (early-stage) firms and overvaluing low-R&D-growth (mature) firms (Lev et al., 2005), and ignoring how well past R&D converted into sales (Cohen et al., 2013).

Goodwill

On-balance-sheet intangibles must be identifiable. In an acquisition (the acquisition method), the acquirer allocates the purchase price to each identifiable asset and liability at fair value; any excess is goodwill:

Goodwill captures the target's unidentifiable intangibles (reputation, trained staff, in-process research), the strategic positioning of the combined entity, and synergies. After acquisition, finite-life intangibles are amortised; indefinite-life intangibles and goodwill are not amortised but carried at cost and tested for impairment.

Goodwill impairment — discretion and research

Goodwill is allocated to a cash-generating unit (CGU) at inception. Impairment compares the CGU's carrying value with the present value of its future cash flows — requiring estimates of a growth rate, a discount rate and the choice of CGU. That is a great deal of discretion. The research is unflattering:

• Ramanna & Watts (2012): since goodwill is not amortised, impairment is the only way managers are held accountable for acquisition premiums — yet reluctance to impair often reflects CEO reputational concerns, not private good news.
• Gu & Lev (2011): overpriced acquirer shares tempt managers to overpay for synergies, setting up later write-offs; the worse the overpayment, the worse subsequent returns.
• Hayn & Hughes (2006): write-offs lag the economic impairment by 3–4 years on average — up to ten for a third of firms.
• Riedl (2004): write-offs are associated with "big bath" behaviour — opportunistic, not informative.