Intangible assets such as software, data, customer franchises now make up a bulk of enterprise value of most new economy companies. But accounting standards have not changed which has made accounting statements less relevant.
Initial recognition: research and development costs
Charge all research cost to expense. [IAS 38.54] Development costs are capitalised only after technical and commercial feasibility of the asset for sale or use have been established. This means that the entity must intend and be able to complete the intangible asset and either use it or sell it and be able to demonstrate how the asset will generate future economic benefits. [IAS 38.57]
As shown above, R&D costs could be capitalized as long as they are feasible for use or sale. The company just needs to demonstrate this.
For goodwill, sometimes it’s quite difficult to reliably measure the value of internally generated goodwill. A different matter for goodwill acquired in a business combination as we could use the transaction price.
As for customer acquisition costs, costs incurred related to contracts to those customers could be capitalized based on IFRS 15.
I like to see goodwill as the opposite of a gain on acquisition of a business. That would be a loss. However, acquired assets are recorded at cost, it won't be fair to recognize a loss immediately. With that said, the goodwill also provide companies with the opportunity to buy another company over fair market price without suffering the consequences, and even benefiting from it by capitalizing it. The rationale given by the rule is that the company is paying the extra money for other soft assets such as management expertise and technical know how that are not traditionally represented on the balance sheet. Which makes sense. But I don't think internally developing a goodwill even makes sense. Who is to judge if a goodwill has been created?
I was really hoping to read something insightful but instead, all I got from the first 3 pages or so were basically baby arguments. Not to mention the errors abound within the literature. One needs to understand the standard setting processes and also financial history and the impact of frauds on the global economy before delving into such issues as the relevancy of standards and financial statements. For correction on one or perhaps two things you spoke of, 1) software costs are capitalized once technological feasibility is achieved., 2) SFAS 2 was replaced and incorporated into another SFAS, I believe it was either SFAS 5 or 8.
Also, FASB adopts a conservative approach in reporting financial transactions as a fundamental concept. This concept helps both the SEC and FASB to keep control on scrupulous entities and prevent them from misleading and defrauding investors.
The purpose of this post is to address the realities of what happens. Can you show me where Google, Microsoft and Amazon or any SaaS company is capitalizing this R&D spend?
And if they aren't, do you believe the $100B+ they have spent on R&D have no value beyond the year they expensed it?
Please refer to below information extracted from Google’s (Alphabet Inc.) 2019 Financial Statements:
Software Development Costs
We expense software development costs, including costs to develop software products or the software component of products to be sold, leased, or marketed to external users, before technological feasibility is reached. Technological feasibility is typically reached shortly before the release of such products and as a result, development costs that meet the criteria for capitalization were not material for the periods presented.
Software development costs also include costs to develop software to be used solely to meet internal needs and cloud based applications used to deliver our services. We capitalize development costs related to these software applications once the preliminary project stage is complete and it is probable that the project will be completed and the software will be used to perform the function intended. Costs capitalized for developing such software applications were not material for the periods presented.
Sukri had provided Google's disclosure and policy on treatment of R&D costs in his comment. That's exactly what what a company should be doing. Giving the conservative approach and the matching principles, unscrupulous companies that might want to follow in the footsteps of Enron are prevented from spending their investor's monies with the sole purpose of making their balance sheets look good without any proof of probable future profitability. This is the same reason why contingent gains are not recorded until realized. Misleading investors by the use of their own money could have detrimental consequences to the American public.
It would also be worth mentioning that, the standards are updated whenever the need to arises. The update of GAAP is a process that involves seeking and gathering opinions of the public, including accountants and investors and all interested parties. These opinions are reviewed and analyzed, incorporated into the draft, and voted on by the 7 member FASB board befor issuing as an update. So you see, this rules are not pulled from thin air. They come as a result of public consensus and considerable deliberations among the professional community.
Alex, the point is that as an investor, you need to understand what's going on with the companies you're investing in and potentially make adjustments in earning to determine real earnings power.
I agree with you that accounting standards have to tread the line between conservatism, usefulness, and a number of other trade-offs and didn't really suggest accounting needs an overhaul.
I'll like to state and admit an error I made in my response. I mistook SFAS for SFAC. But I still stand by the other arguments I made concerning the processes, principles and concepts on the basis of which standards are drafted and implemented and updated.
How about just not using two statements for your financial analysis and getting behind the idea of non-GAAP measures in the financials. If they don’t currently disclose, there’s probably a reason.
Just my two-cents. If we refer to the IFRS:
Initial recognition: research and development costs
Charge all research cost to expense. [IAS 38.54] Development costs are capitalised only after technical and commercial feasibility of the asset for sale or use have been established. This means that the entity must intend and be able to complete the intangible asset and either use it or sell it and be able to demonstrate how the asset will generate future economic benefits. [IAS 38.57]
As shown above, R&D costs could be capitalized as long as they are feasible for use or sale. The company just needs to demonstrate this.
For goodwill, sometimes it’s quite difficult to reliably measure the value of internally generated goodwill. A different matter for goodwill acquired in a business combination as we could use the transaction price.
As for customer acquisition costs, costs incurred related to contracts to those customers could be capitalized based on IFRS 15.
I like to see goodwill as the opposite of a gain on acquisition of a business. That would be a loss. However, acquired assets are recorded at cost, it won't be fair to recognize a loss immediately. With that said, the goodwill also provide companies with the opportunity to buy another company over fair market price without suffering the consequences, and even benefiting from it by capitalizing it. The rationale given by the rule is that the company is paying the extra money for other soft assets such as management expertise and technical know how that are not traditionally represented on the balance sheet. Which makes sense. But I don't think internally developing a goodwill even makes sense. Who is to judge if a goodwill has been created?
I was really hoping to read something insightful but instead, all I got from the first 3 pages or so were basically baby arguments. Not to mention the errors abound within the literature. One needs to understand the standard setting processes and also financial history and the impact of frauds on the global economy before delving into such issues as the relevancy of standards and financial statements. For correction on one or perhaps two things you spoke of, 1) software costs are capitalized once technological feasibility is achieved., 2) SFAS 2 was replaced and incorporated into another SFAS, I believe it was either SFAS 5 or 8.
Also, FASB adopts a conservative approach in reporting financial transactions as a fundamental concept. This concept helps both the SEC and FASB to keep control on scrupulous entities and prevent them from misleading and defrauding investors.
The purpose of this post is to address the realities of what happens. Can you show me where Google, Microsoft and Amazon or any SaaS company is capitalizing this R&D spend?
And if they aren't, do you believe the $100B+ they have spent on R&D have no value beyond the year they expensed it?
Please refer to below information extracted from Google’s (Alphabet Inc.) 2019 Financial Statements:
Software Development Costs
We expense software development costs, including costs to develop software products or the software component of products to be sold, leased, or marketed to external users, before technological feasibility is reached. Technological feasibility is typically reached shortly before the release of such products and as a result, development costs that meet the criteria for capitalization were not material for the periods presented.
Software development costs also include costs to develop software to be used solely to meet internal needs and cloud based applications used to deliver our services. We capitalize development costs related to these software applications once the preliminary project stage is complete and it is probable that the project will be completed and the software will be used to perform the function intended. Costs capitalized for developing such software applications were not material for the periods presented.
I understand where you are coming from Tanay.
Sukri had provided Google's disclosure and policy on treatment of R&D costs in his comment. That's exactly what what a company should be doing. Giving the conservative approach and the matching principles, unscrupulous companies that might want to follow in the footsteps of Enron are prevented from spending their investor's monies with the sole purpose of making their balance sheets look good without any proof of probable future profitability. This is the same reason why contingent gains are not recorded until realized. Misleading investors by the use of their own money could have detrimental consequences to the American public.
It would also be worth mentioning that, the standards are updated whenever the need to arises. The update of GAAP is a process that involves seeking and gathering opinions of the public, including accountants and investors and all interested parties. These opinions are reviewed and analyzed, incorporated into the draft, and voted on by the 7 member FASB board befor issuing as an update. So you see, this rules are not pulled from thin air. They come as a result of public consensus and considerable deliberations among the professional community.
Alex, the point is that as an investor, you need to understand what's going on with the companies you're investing in and potentially make adjustments in earning to determine real earnings power.
I agree with you that accounting standards have to tread the line between conservatism, usefulness, and a number of other trade-offs and didn't really suggest accounting needs an overhaul.
I'll like to state and admit an error I made in my response. I mistook SFAS for SFAC. But I still stand by the other arguments I made concerning the processes, principles and concepts on the basis of which standards are drafted and implemented and updated.
Don't all these issues disappear if you look at cash flow instead of income? Then you can compare like for like, no?
How about just not using two statements for your financial analysis and getting behind the idea of non-GAAP measures in the financials. If they don’t currently disclose, there’s probably a reason.
Another good resource on this topic is the book "Capitalism Without Capital"