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IFT Notes for Level I CFA® Program

R22 Long Lived Assets

Part 2


2. Acquisition of Intangible Assets

Intangible assets lack physical substance. Classic examples include software, customer lists, patents, copyrights, and trademarks. Accounting for an intangible asset depends on how it is acquired.

Acquired in a Business Combination

This refers to a situation where one company buys another company and in the process, acquires intangible assets.

  • Both IFRS and US GAAP require the use of acquisition method in accounting for business combinations. (This method will be studied in detail at Level II.)
  • Under the acquisition method, identifiable intangible assets such as patents, copyrights, and trademarks are recorded at their fair value.
  • Goodwill is an intangible asset that cannot be identified separately. It is recorded when one business acquires another business. If the purchase price exceeds the fair value of the net identifiable assets (both the tangible assets and the identifiable intangible assets, minus liabilities) acquired. For example, Tan Hospitals Inc. acquires Man Equipments Inc. for $100 million. The fair value of Man Equipments’ net assets equal $95 million. In this case, the excess of $5 million will be recorded as goodwill.

Purchased in Situations Other than Business Combinations

This refers to a situation where an identifiable intangible asset is purchased. The identifiable intangible asset is recorded at fair value.

Developed Internally

Costs to internally develop intangible assets are generally expensed when incurred, although there are exceptions. The differences in whether the costs are capitalized or expensed affect financial statement ratios as outlined below:

  • Balance sheet: A company that develops intangible assets internally will expense costs and record lower assets compared to a company that acquires such assets through purchase.
  • Statement of cash flows: The costs of internally developing intangible assets are classified as operating cash flows, while the cost of acquiring intangible assets is classified as investing cash flows.

For internally developed intangible assets, there are two phases: the research phase and the development phase.

Research phase refers to the period during which commercial feasibility of an intangible asset is yet to be established. It is defined as “original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.”

Development phase refers to the period during which the technical feasibility of completing an intangible asset has been established with the intent of either using or selling the asset.

The treatment for the two phases varies slightly under IFRS and US GAAP as outlined below:

Under IFRS:

  • Research costs are expensed.
  • Development costs can be capitalized if technical feasibility and the intent to sell the asset are established.

Under US GAAP:

  • Both research and development costs are expensed, but there are exceptions for software development.
  • Software for sale: Costs incurred to develop a software product for sale are expensed until the product’s feasibility is established, and capitalized after the product’s feasibility has been established. Determining feasibility involves judgment.
  • Software for internal use: All development costs should be capitalized.


Acme Inc. starts an internal software development project on January 1, 2012. It incurs expenditures of $10,000 per month during the fiscal year ended December 31, 2012. By March 31, it is clear that the product will be developed successfully and will be used as intended. How are the software development costs recorded before and after March 31 according to IFRS and US GAAP?


IFRS: Under IFRS all costs are expensed until feasibility is established if the software is developed for internal use. So, $30,000 (period from January 1 to March 31, 2012) is expensed and $90,000 is capitalized (from April 1 to December 31, 2012).

U.S GAAP: The entire cost of $120,000 should be capitalized.

3. Capitalization versus Expensing: Impact on Financial Statements and Ratios

Capitalizing:  In general, when a company acquires a long-lived tangible or intangible asset, its cost is capitalized if the asset is expected to provide economic benefits beyond a year. The company records an asset in an amount equal to the acquisition cost plus any other cost to get the asset ready for its intended use.

Capitalizing results in spreading the cost of acquiring an asset over a specified period of time instead of immediately expensing it. All other costs to make the asset ready for intended use are also capitalized. Capitalizing leads to higher profitability in the period when the asset is purchased. The effect of capitalizing an expenditure on the financial statements is summarized below:

Effect of capitalization on financial statements
Initially when an expenditure is capitalized. Balance sheet: non-current assets increase by the capitalized amount.
Statement of cash flows: investing cash flow decreases.
Subsequent periods over the asset’s useful life. Income statement: depreciation or amortization expense.

Net income decreases.

Balance sheet: non-current assets (carrying value of the asset) decreases.

Retained earnings decreases.

Equity decreases.

Expensing: The cost of an asset is expensed if it has uncertain or no impact on future earnings and provides economic benefit only in the current period. Immediate recognition of an asset’s cost as an expense on the income statement results in lower profitability in the current period and higher profits in the future.

Effect of expensing on financial statements
When an expenditure is expensed. Income statement: Net income decreases by the after-tax amount of the expenditure.

No depreciation/amortization expense.

Balance sheet: No asset is recorded.

Lower retained earnings due to lower net income.

Statement of cash flow: Operating cash flow decreases.

The table below summarizes the effects of capitalizing versus expensing on various financial statement items.

  Capitalizing Expensing
Total assets Higher Lower
Equity Higher Lower
Income variability Lower Higher
Net income (1st year) Higher Lower
Net income (later) Lower Higher
CFO Higher Lower
CFI Lower Higher
D/E Lower Higher
Interest coverage (initially) Higher Lower
Interest coverage (later) Lower Higher
ROA and ROE (initially) Higher Lower
ROA and ROE (later) Lower Higher

4. Capitalization of Interest Costs

When an asset requires a long period of time to get ready for its intended use, the interest costs associated with constructing or acquiring the asset are capitalized. Capitalized interest is reported as part of the asset’s cost on the balance sheet; in the future, it is reported as part of the asset’s depreciation expense in the income statement.

For constructed assets, interest costs during construction are capitalized as part of the asset cost

  • Use rate on borrowing related to construction; if no construction debt is outstanding, interest rate is based on existing unrelated debt.
  • Capitalized interest is not reported as interest expense on I/S.
  • IFRS: Interest on short-term lending offsets capitalized costs (not allowed in U.S. GAAP).

Effect of Capitalized Interest on Financial Statements:

  • Higher net income and greater interest coverage ratios during the period of capitalization.
  • Higher asset values and depreciation lead to lower net income, EBIT and interest coverage ratio in the subsequent periods.

Instructor’s Note: Section 5 ‘Capitalization of Interest and Internal Development Costs’ is not testable and hence not covered.