from TC. TC has a contract with Customer to be its exclusive provider of sporting goods but has no contract
for the supply of electronics to Customer. Both TC and AC believe that only one overall customer relationship
exists between TC and Customer.
The contract to be Customer’s exclusive supplier of sporting goods, whether cancellable or not, meets the
contractual-legal criterion. In addition, as TC establishes its relationship with Customer through a contract, the
customer relationship with Customer meets the contractual-legal criterion. Because TC has only one customer
relationship with Customer, the fair value of that relationship incorporates assumptions about TC’s relationship
with Customer related to both sporting goods and electronics. However, if AC determines that it has two separate
customer relationships with Customer, for sporting goods and for electronics, AC would need to assess whether
the customer relationship for electronics is separable before it could be recognised as an intangible asset.
(iii)
Order backlog and recurring customers
AC acquires TC in a business combination on 31 December 2019. TC does business with its customers solely
through purchase and sales orders. At 31 December 2019, TC has a backlog of customer purchase orders
from 60 per cent of its customers, all of whom are recurring customers. The other 40 per cent of TC’s
customers are also recurring customers. However, as at 31 December 2019, TC has no open purchase orders
or other contracts with those customers.
Regardless of whether they are cancellable or not, the purchase orders from 60 per cent of TC’s customers meet
the contractual-legal criterion. Additionally, because TC has established its relationship with 60 per cent of its
customers through contracts, not only the purchase orders but also TC’s customer relationships meet the
contractual-legal criterion. Because TC has a practice of establishing contracts with the remaining 40 per cent of
its customers, its relationship with those customers also arises through contractual rights and therefore meets the
contractual-legal criterion even though TC does not have contracts with those customers at 31 December 2019.
(iv)
Motor insurance contracts
AC acquires TC, an insurer, in a business combination on 31 December 2019. TC has a portfolio of one-year
motor insurance contracts that are cancellable by policyholders.
Because TC establishes its relationships with policyholders through insurance contracts, the customer
relationship with policyholders meets the contractual-legal criterion.
One of the most difficult areas of interpretation is whether an arrangement is
contractual or not. Contractual customer relationships are always recognised separately
from goodwill but non-contractual customer relationships are recognised only if they
are separable. Consequently, determining whether a relationship is contractual is
critical to identifying and measuring customer relationship intangible assets and
different conclusions could result in substantially different accounting outcomes.
Paragraph IE28 in the Illustrative Examples explains that a customer relationship is
deemed to exist if the entity has information about the customer and regular contact with
it and the customer can make direct contact with the entity. A customer relationship ‘may
also arise through means other than contracts, such as through regular contact by sales or
service representatives’. However, the argument is taken a stage further. Regardless of
whether any contracts are in place at the acquisition date, ‘customer relationships meet
the contractual-legal criterion for recognition if an entity has a practice of establishing
contracts with its customers’. [IFRS 3.IE28]. An example of what is meant by this is given in
Example 9.9 above. In the third illustration, ‘Order backlog and recurring customers’, it
Business
combinations
625
states ‘Because TC has a practice of establishing contracts with the remaining 40 per cent
of its customers, its relationship with those customers also arises through contractual
rights and therefore meets the contractual-legal criterion even though TC does not have
contracts with those customers at 31 December 2019’.
In 2008 the Interpretations Committee considered the circumstances in which non-
contractual customer relationships arise. The staff’s survey of Interpretations
Committee members indicated that there were diverse practices regarding which
customer relationships have a contractual basis and which do not. In addition, valuation
experts seemed to be taking different views.35
The Interpretations Committee noted that the IFRS Glossary of Terms defined the term
‘contract’. Whilst the manner in which a relationship is established is relevant to
confirming the existence of a customer relationship, it should not be the primary basis for
determining whether an intangible asset is recognised by the acquirer. What might be
more relevant is whether the entity has a practice of establishing contracts with its
customers or whether relationships arise through other means, such as through regular
contact by sales and service representatives (i.e. the matters identified in paragraph IE28).
The existence of contractual relationships and information about a customer’s prior
purchases would be important inputs in valuing a customer relationship intangible asset,
but should not determine whether it is recognised.36 Therefore, a customer base (e.g.
customers of a fast food franchise or movie theatres) is an example of a non-contractual
customer relationship that would not be recognised in a business combination.
The Interpretations Committee was unable to develop an Interpretation clarifying the
distinction between contractual and non-contractual. Given the widespread confusion
the matter was referred to the IASB and the FASB with a recommendation to review
and amend IFRS 3 by:37
• removing the distinction between ‘contractual’ and ‘non-contractual’ customer-
related intangible assets recognised in a business combination; and
• reviewing the indicators that identify the existence of a customer relationship in
paragraph IE28 of IFRS 3 and including them in the standard.
However, the IASB deferred both recommendations of the Interpretations Committee to
the PIR of IFRS 3, which was completed in June 2015. As a result of the PIR of IFRS 3 the
issue of identification and fair value measurement of intangible assets such as customer
relationships and brand names was added to the IASB’s active agenda within its Goodwill
and Impairment research project (see 1.1.1 above). In May 2018, the IASB tentatively
decided not to consider allowing some identifiable intangible assets acquired in a business
combination to be included within goodwill. Therefore, divergent treatments will remain
in practice, depending on how entities interpret ‘contractual’ and ‘non-contractual’
customer-related intangible assets in a particular business combination.
5.5.2.C
Combining an intangible asset with a related contract, identifiable asset
or liability
IAS 38 states that an intangible asset acquired in a business combination might be
separable, but only together with a related contract, identifiable asset, or lia
bility. In such
626 Chapter
9
cases, the acquirer recognises the intangible assets separately from goodwill, but together
with the related item. [IAS 38.36].
Similarly, the acquirer may recognise a group of complementary intangible assets as a
single asset provided the individual assets have similar useful lives. For example, ‘the
terms “brand” and “brand name” are often used as synonyms for trademarks and other
marks. However, the former are general marketing terms that are typically used to refer
to a group of complementary assets such as a trademark (or service mark) and its related
trade name, formulas, recipes and technological expertise.’ [IAS 38.37].
It is not clear whether an intangible asset that is only separable in combination with a
tangible asset should be recognised together as a single asset for financial reporting
purposes in all circumstances. IFRS 3 gives an example of a licence to operate a nuclear
power plant, and says that the fair value of the operating licence and the fair value of the
power plant may be recognised as a single asset for financial reporting purposes, if the
useful lives of those assets are similar (see 5.5.2 above), yet the requirements in IAS 38 only
refer to similar useful lives in the context of a group of complementary intangible assets.
In practice entities account for intangible assets separately from the related tangible
asset if the useful lives are different. The Rank Group Plc considers that its casino and
gaming licences have indefinite useful lives and accounts for them separately from the
buildings with which they are acquired, as disclosed in its accounting policy.
Extract 9.1: The Rank Group Plc (2017)
Notes to the financial statements [extract]
1
General information and accounting policies [extract]
Summary of significant accounting policies [extract]
1.12 Intangible
assets
[extract]
(b)
Casino and other gaming licences and concessions
The Group capitalises acquired casino and other gaming licences and concessions. Management believes that
licences, except for the casino concessions in Belgium, have indefinite lives as there is no foreseeable limit to the
period over which the licences are expected to generate net cash inflows, and each licence holds a value outside the
property in which it resides. Each licence is reviewed annually for impairment.
In respect of the concessions in Belgium, the carrying value is amortised over the expected useful life of the concession.
As at 30 June 2017 the licences have a remaining useful life of 3.5 years and 0.2 years respectively.
Any costs in renewing licences or concessions are expensed as incurred.
Guidance on determining useful lives of intangible assets is discussed in Chapter 17 at 9.1.
5.5.2.D
In-process research or development project expenditure
IFRS 3 itself only refers to in-process research and development in its Basis for
Conclusions, where it is made clear that the acquirer recognises all tangible and intangible
research and development assets acquired in a business combination. [IFRS 3.BC149-BC156].
IAS 38’s general recognition conditions require it to be probable that expected future
economic benefits will flow to the entity and that the costs can be measured reliably
before an intangible asset can be recognised. [IAS 38.21].
Business
combinations
627
IAS 38 states that ‘an acquiree’s in-process research and development project meets the
definition of an intangible asset when it meets the definition of an asset, and is
identifiable, i.e. is separable or arises from contractual or other legal rights.’ [IAS 38.34].
In-process research and development projects, whether or not recognised by the
acquiree, are protected by legal rights and are clearly separable as on occasion they are
bought and sold by entities without there being a business acquisition. Both of the
standard’s general recognition criteria, probability of benefits and reliable
measurement, are always considered to be satisfied for in-process research and
development projects acquired in a business combination. The fair value of an
intangible asset reflects expectations about the probability of these benefits, despite
uncertainty about the timing or the amount of the inflow. There will be sufficient
information to measure the fair value of the asset reliably if it is separable or arises from
contractual or other legal rights. If there is a range of possible outcomes with different
probabilities, this uncertainty is taken into account in the measurement of the asset’s
fair value. [IAS 38.33-35].
Therefore, recognising in-process research and development as an asset on acquisition
applies different criteria to those that are required for internal projects. The research
costs of internal projects may under no circumstances be capitalised. [IAS 38.54]. Before
capitalising development expenditure, entities must meet a series of exacting
requirements. They must demonstrate the technical feasibility of the intangible assets,
their intention and ability to complete the assets and use them or sell them and must be
able to measure reliably the attributable expenditure. [IAS 38.57]. The probable future
economic benefits must be assessed using the principles in IAS 36 – Impairment of
Assets – which means that they have to be calculated as the net present value of the
cash flows generated by the asset or, if it can only generate cash flows in conjunction
with other assets, of the cash-generating unit of which it is a part. [IAS 38.60]. This process
is described further in Chapter 17 at 6.
What this means is that entities will be required to recognise on acquisition some
research and development expenditure that they would not have been able to recognise
if it had been an internal project. The IASB is aware of this inconsistency, but concluded
that this did not provide a basis for subsuming in-process research and development
within goodwill. [IAS 38.BC82].
Although the amount attributed to the project is accounted for as an asset, IAS 38 goes
on to require that any subsequent expenditure incurred after the acquisition of the
project is to be accounted for in accordance with paragraphs 54 to 62 of IAS 38.
[IAS 38.42]. These requirements are discussed in Chapter 17 at 6.2.
In summary, this means that the subsequent expenditure is:
(a) recognised as an expense when incurred if it is research expenditure;
(b) recognised as an expense when incurred if it is development expenditure that does
not satisfy the criteria for recognition as an intangible asset in paragraph 57; and
(c) added to the carrying amount of the acquired in-process research or development
project if it is development expenditure that satisfies the recognition criteria in
paragraph 57. [IAS 38.43].
628 Chapter
9
The inference is that the in-process research and development expenditure recognised
as an asset on acquisition that never progresses to the stage of satisfying the recognition
criteria for an internal project will ultimately be impaired, although it may be that this
impairment will not arise until the entity is satisfied that the p
roject will not continue.
However, since it is an intangible asset not yet available for use, such an evaluation
cannot be significantly delayed as it will need to be tested for impairment annually by
comparing its carrying amount with its recoverable amount, as discussed in Chapter 20
at 10. [IAS 36.10].
5.5.2.E Emission
rights
Emission rights or allowances under a cap and trade emission rights scheme (see
Chapter 17 at 11.2) meet the definition of an intangible asset and should therefore be
recognised at the acquisition date at their fair value. Likewise, the acquirer is
required to recognise a liability at fair value for the actual emissions made at the
acquisition date.
One approach that is adopted in accounting for such rights is the ‘net liability
approach’ whereby the emission rights are recorded at a nominal amount and the
entity will only record a liability once the actual emissions exceed the emission
rights granted and still held. As discussed in Chapter 17 at 11.2.5, the net liability
approach is not permitted for purchased emission rights and therefore is also not
permitted to be applied to emission rights of the acquiree in a business combination.
Although the acquiree may not have recognised an asset or liability at the date of
acquisition, the acquirer should recognise the emission rights as intangible assets at
their fair value and a liability at fair value for the actual emissions made at the
acquisition date.
One impact of this is that subsequent to the acquisition, the consolidated income
statement will show an expense for the actual emissions made thereafter, as a provision
will have to be recognised on an ongoing basis. As discussed in Chapter 17 at 11.2.2,
there are different views of the impact that such ‘purchased’ emission rights have on
the measurement of the provision and on accounting for the emissions.
The emission rights held by the acquiree will relate to specific items of property, plant
and equipment. Therefore when determining the fair value of these assets, care needs
to be taken to ensure that there is no double counting of the rights held.
5.5.2.F
Determining the fair values of intangible assets
Little guidance relating to fair value remains in IFRS 3 as it is now included in IFRS 13
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 124
