AASB 138 states that “An intangible asset is an identifiable non-monetary asset without physical substance.” The asset must be controlled by the entity as a result of events in the past and something from which the entity expects future economic benefits to flow. Whereas AASB Framework for the Preparation and Presentation of Financial Statements defines an asset as “a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.” “An asset is recognized in the balance sheet when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably.” (Framework AASB)
In order to assess that whether an internally generated intangible asset can be recognized or not, the entity classifies the generation of the asset into a research phase and a development phase. Intangible asset resulting from the research stage will not be recognized and expenses on research (or in the research stage of an internal project) will be recognized as an expense when it is incurred. The reason for this kind of accounting treatment is that, in the research phase of an internal project, an entity cannot demonstrate that an intangible asset will generate probable future economic benefits. If an entity is unable to distinguish the research phase from the development stage of an internal project to create an intangible asset, the entity treats the expenditure on that project as if it was incurred in the research stage only. Standard has specifies certain examples of research activities that are as follows:
(a) activities aimed at obtaining new knowledge;
(b) the search for, evaluation and final selection of, applications of
research findings or other knowledge;
(c) the search for alternatives for materials, devices, products,
processes, systems or services; and
(d) the formulation, design, evaluation and final selection of
possible alternatives for new or improved materials, devices,
products, processes, systems or services. (AASB 138)
According to AASB 138 “an intangible asset arising from development (or from the development phase of an internal project) shall be recognized if, and only if, an entity can demonstrate all of the following:
a) the technical feasibility of completing the intangible asset so
that it will be available for use or sale;
b) its intention to complete the intangible asset and use or sell
c) its ability to use or sell the intangible asset;
d) how 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;
e) the availability of adequate technical, financial and other
resources to complete the development and to use or sell the intangible asset; and
f) its ability to measure reliably the expenditure attributable to
the intangible asset during its development. (AASB 138)
Following are the examples of development activities that are specified in the standard :
(a) the design, construction and testing of pre-production or pre-use
prototypes and models;
(b) the design of tools, jigs, moulds and dies involving new
(c) the design, construction and operation of a pilot plant that is not
of a scale economically feasible for commercial production; and
(d) the design, construction and testing of a chosen alternative for
new or improved materials, devices, products, processes,
systems or services. (AASB 138)
As a whole rules pertaining to research and development costs are consistent with the asset definition and recognition criteria specified in the Framework but contains some minor differences.
According to the framework, the asset has three important characteristics: future economic benefit, control, the transaction to acquire control has already taken place.
Control over intangible asset can be assessed if the entity is able to prevent the access of others to the benefits derived from the asset e.g. if the intangible asset is protected by a legal right. While control over assets can be gained by purchasing or producing them, but other transactions or events may generate assets. Secondly, research activities by definition do not meet the criteria for recognition under AASB 138. Development cost qualify for recognition as intangible asset by not only showing that future benefits will flow to the entity but also the entity should demonstrate the existence of a market for the output of the intangible asset or the usefulness of the intangible asset, if it is to be used internally. Thirdly, the cost allocated to an internally generated intangible asset should be only costs that can be directly attributed or allocated on a reasonable and consistent basis to creating, producing or preparing the asset for its intended use. The principles underlying the costs which may or may not be included are similar to those for other than non-current assets and inventory. The cost of an internally generated intangible asset is the sum of the expenditure incurred from the date when the intangible asset first meets the recognition criteria. If, as often happens, considerable costs have already been recognized as expenses before management could demonstrate that the criteria have been met, this earlier expenditure should not be retrospectively recognized at a later date as part of the cost of an intangible asset. Examples of directly attributable costs that are specified in the standard are as follows:
(a) costs of materials and services used or consumed in generating
the intangible asset;
(b) costs of employee benefits (as defined in AASB 119) arising
from the generation of the intangible asset;
(c) fees to register a legal right; and
(d) amortisation of patents and licences that are used to generate the
intangible asset. (AASB 138)
In case of assets, “cost is the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction.” (Framework)
These inconsistencies arise because framework discusses the objective and scope of the whole group of assets while AASB 138 discusses only the intangible asset. Moreover, there is an additional requirement in AASB 138 that intangible asset must be identifiable that results in inconsistencies.
Efficient market hypothesis is the idea that information is quickly and efficiently incorporated into asset prices at any point in time, so that old information cannot be used to predict future price movements. Three forms of EMH are being distinguished on the basis of level of available information. The weak form EMH specifies that asset prices already reflect past price and volume information. The information contained in the past trend of prices of a security is fully reflected in the current market price of that security. It is known as weak form because the security prices are easily accessible by public. It implies that no one can beat the market. The semi strong form EMH states that all publicly available information is similarly already incorporated into asset prices. In simple words, all publicly available information is fully reflected in a security’s current market price. The information stated to public not only includes past prices but also data reported in a company’s financial statements, company’s decisions, economic factors and others. The strong form EMH includes that insider information is quickly incorporated by market prices and therefore cannot be used to reap abnormal trading profits. Thus, all information, whether public or private, is fully incorporated in a security’s current market price. This means, even the insider dealing is not able to make gains from inside information they hold. The main reason to support is that the market anticipates in an unbiased manner, future development and therefore information has been incorporated and evaluated into market price in much more objective and informative way than insiders.
This concept of efficient market is applicable to AASB 138 because development costs are recognized when the entity demonstrates the existence of a market for the output of the intangible asset or the intangible asset itself (AASB 138). Existence of active market is necessary in order to assess the future economic benefits of from the intangible asset. Quoted market prices in an active market provide the most reliable estimate of the fair value of an intangible asset.
In efficient market, the prices of securities traded reflect all the relevant information which is available to the buyers and sellers. In other words, share prices change quickly to reflect all new information about future prospects. Moreover, in efficient market no individual dominates the market and transaction costs are not so high as to discourage trading significantly.
In an efficient market, equity research and valuation would be a costly task that provided no benefits. The technique of finding an undervalued stock should be random i.e. no parties should have asymmetric information. Ideally, the benefits from information collection and research would cover the costs of doing the research.
In an efficient market, a strategy of randomly diversifying across stocks or indexing to the market, carrying little or no information cost and minimal execution costs, would be superior to any other strategy that created larger information and execution costs. Value added by portfolio planners and investment managers would be little.
In an efficient market, a strategy of minimized trading, i.e., creating a portfolio and not trading unless cash was needed would be take lead over a strategy that required frequent trading.
Agency theory explains how to best arrange and organize relationships, procedures and rules in which one party (the principal) determines the work, which another party (the agent) undertakes. Although the ideas of agency and contract are closely linked, some academics suggest that they are essentially the same. The theory states that under conditions of partial information and uncertainty, which characterize most business firms, two problems relating to agency arise, adverse selection and moral hazard. Adverse selection is the condition under which the principal cannot determine if the agent accurately represents his ability to do the work for which he is being hired and paid. Moral hazard is the condition under which the principal is not sure if the agent has put forth maximal effort. The primary agency relationship in business is that between shareholders and directors. A company’s director may have personal goals that compete with the shareholder’s goal of maximization of their wealth.
Since the shareholders authorize directors to administer the company’s assets, a potential conflict of interest exists between the two groups. The optimal solution is can be applied where directors’ compensation is tied to performance. Most publicly traded companies are now using performance shares, which are shares given to directors on the basis of performances as defined by financial measures such as, return on total assets, earnings per share, return on equity, and stock price changes. If company’s performance is above the financial targets, the firm’s directors earn more shares. Directors may want to increase profits and earn good bonuses while shareholders would like to receive more dividends from the profits. In order to show good profits to the shareholders, managers use those accounting policies that help them attain their objective of increased profits.
In case of research and development costs, most managers would like to recognize the intangible asset and would strive hard to meet the conditions specified in the standard regarding the recognition. Expensing out the cost of development would lower the profits and eventually the bonuses of the directors would be lost. On the other hand, if intangible asset is recognized, it will not only improve the asset position in the balance sheet but it will also improve the profitability ratios. Though recognition of intangible asset would result in amortization cost added in the income statement but it would not affect the cash flow of the firm.
IMPLICATION OF SUCH VIEW:
According to agency theory the directors should act in the best interest of the shareholders. The accounting policy for research and development costs should not be used in such a way that it distorts the true financial position of the company. The contracting theory implies that shareholders must be educated about the research and development activities going in the company so that the shareholders could forecast the financial prospects of the firm. Incentives are given to the directors on the basis of their work in the area of research and development. In order to keep check and balance on the directors, shareholders carry out auditing activities so that they cannot manipulate the figures in pursuit of rewards. This standard AASB 138 describes all the ways in which the development and research cost can be incorporated and shareholders are given true and fair view of the financial statements’
Lambert RA, (2001), ‘Contracting Theory and Accounting,’ the Wharton School,
University of Pennsylvania,
Staff of the Australian Accounting Standards Board (AASB), (2001), ‘Intangible Assets,’ Australian Accounting Standards Board
Staff of the Australian Accounting Standards Board (AASB), (2004), ‘Framework for the
Preparation and Presentation of Financial Statements,’ Australian Accounting Standards Board
AGENCY THEORY FRAMEWORK, http://www.babson.edu/entrep/fer/papers96/shane/shane3.htm
MARKET EFFICIENCY – DEFINITION AND TESTS, http://pages.stern.nyu.edu/~adamodar/New_Home_Page/invemgmt/effdefn.htm, accessed on 2008-12-25
Kleiman RT, Agency Theory, http://www.enotes.com/biz-encyclopedia/agency-theory, accessed on 2008-12-25