Cooking the Financials: 7 areas to watch out when analyzing the Intangible Assets

The history of accounting dates back thousands of years to ancient civilizations such as the Babylonians, Egyptians, and Greeks. These civilizations developed various forms of accounting to keep track of their financial transactions.? Double-entry bookkeeping, which is the foundation of modern accounting, was developed in Italy in the 13th century by a Franciscan friar named Luca Pacioli. In the early 20th century, the field of accounting began to professionalize, with the establishment of the first accounting organizations and the introduction of certification programs.?

So that by now, we have only two major sets of accounting standards available: IFRS, used by companies in over 100 countries, including many European countries, Australia, and Canada, and US GAAP, used in the USA.

The need for systematization and unification of accounting has always been mostly by availability of inherent fraud in preparation of accounts, or so-called cooking the financials. One early example of financial manipulation was the stock market crash of 1929, which was fueled in part by companies engaging in fraudulent accounting practices to inflate stock prices. In response, the U.S. government passed the Securities Act of 1933 and the Securities Exchange Act of 1934, which created the Securities and Exchange Commission (SEC) and established regulations to prevent financial fraud.

The later obvious cases of fraud and further changes in the accounting profession were caused by Enron and business combination reporting and accounting for financial assets and liabilities correspondingly. The standard-setters always lag behind.

Cooking the financials is centered upon the two potential ideas:? overstate assets/understate liabilities and overstate earnings/understates expenses. Cooking the financials is basically a result of accrual method of accounting, a key concept in modern reporting. It is very difficult to cook a lot with the cash flows, though such are also available

The more complex the accounting area is the more room there is for judgements by management and as a result in potentially unfair financial reporting.

Since modern economics creates predominantly intangible value, the most obvious area where to detect potential areas of manipulation is accounting for intangible assets.

The largest accounting scandal with accounting for intangible assets was that of Worldcom, an American telecommunications company. In 2002 it was discovered that WorldCom had inflated its assets by almost $11 billion by underreporting line costs by capitalizing instead of expensing them and had inflated its revenues by making false entries. The scandal first came to light when the company’s internal audit department found almost $3.8 billion in fraudulent accounts. The company’s CEO, Bernie Ebbers, was sentenced to 25 years in prison for fraud, conspiracy and filing false documents. The scandal resulted in over 30,000 job losses and over $180 billion in losses by investors.

In IFRS this area of accounting is guided by almost 20-year old IAS 38 Intangible assets (though upgraded a little since the issue date). This is a very high-level standard, which allows a lot of judgment and huge work to implement in real life. To seek additional guidance we usually refer to a number of guides issued by large accounting firms and respective US GAAP standards. For example, in accounting for software in the US GAAP ASC 985-20 Software – Costs of Software to Be Sold, Leased or Marketed and ASC 350-40, Intangibles—Goodwill and Other—Internal-Use Software are applied).

Real-life experience shows a number of areas where the management should exercise its judgment when preparing the financial reporting and therefore should be extremely cautious.

Area #1. Determination of the product’s life cycle: proof of concept. IAS 38 sets three stages of intangible lifecycle: Stage 1 - research, Stage 2 - development, Stage 3- sales of products to market/internal usage (if the product is for company’s internal use).?

IAS 38 requires expensing all the costs on stages 1 and 3 allows to capitalize costs related to the intangible asset only on the development stage.?

The research stage is a general search for potential alternatives without choosing a single concept, while a development stage marks active development of the product for further sales to market or company’s internal use.

The point between stages 1 and 2, let’s call it point of proof of concept (PoC point), is very vague and requires a lot of judgment. To pass this point the company should confirm technical and economic feasibility of the further developments, which is very subtle at such early stages.

Area #2. Determination of the product’s life cycle: development stage and ready-for-sale point (RFSP-point).? Once the point proof-of-concept is passed the company can capitalize the costs up to the ready-for-sale point, which marks the end of the development stage and first sales.?

The determination of RFSP-point can also be very tricky, since first sales does not prove that the development stage is over. The first user experience can and usually does bring need for further development of the product.

When faced with the dilemma of clear criteria for separation of minimal viable product (MVP) (still development and capitalization of costs, though first sales are already made) and RFSP product (end of development and capitalization of costs), one can establish some quantitative criteria in terms of revenue earned from sales up to RFSP point and over the estimated useful life of the product. Let’s say 5-10%. As you can see, once again a lot of assumptions.

This moves us to the next areas of judgment: what do we sell, what is the product?

Area #3. Determination of the product.? It can be very tricky to determine what the product is when we talk about intangibles. Let’s imagine we are developing a complex software which involves thousands of hours of work evolving in multiple releases.

IAS 38 prohibits capitalization subsequent to the product being read for sale, or after passing the RFSP point. However, it allows subsequent expenditure to be capitalized if it meets the definition of assets, or brings additional future economic benefits to the IT product.

A way to tackle this situation can be dividing the product development into a matrix of functional areas (MVP, base and advanced stage) and releases. The releases can further be analyzed into capitalized (let’ call them major releases) or expensed (let’ call them minor releases) depending if the company can prove additional future economic benefits.?

Area #4. Determination of the costs to be capitalized (personnel costs).? The standard allows capitalization of all direct costs related with the development. Obviously, the key elements to be capitalized are mostly personnel costs of the company’s employees and contractors. However, the tricky question is how to allocate the incurred costs to the asset.?

This requires sophisticated time-tracking tools able to get the right information (like, timesheets) and rigorous business processes to get the employees to register their time spent by detailed tasks available. If the company does not have it (believe me, most companies do not), then this are should be further scrutinized for potential cooking.

Area #5. Determination of the costs to be capitalized (overheads). IAS 38 also allows some overheads to be capitalized. The question is usually how to allocate the overheads between capitalized and expensed and further capitalized costs between the projects. This usually requires a system of allocation drivers, which sometimes are very judgmental, to be in place.

There are multiple further questions related to capitalization, for example on capitalization of borrowing costs under IAS 23, which allows a very broad space for evaluation of the carrying values of the intangible assets.

Area #6. How to prove the inflow of economic benefits. An IT-product evolves through a number of stages some of them capitalized, some of them expensed. The basic requirement for the capitalization is availability of financial forecasts showing that the IT-product is capable of creating value.?

Various assumptions in the financial forecast, like volumes, prices, costs and discount rates should all be analyzed and can be full of invalid assumptions.

Moreover, those financial forecasts should be regularly updated and validated.

Area #7. How long do we plan to sell the product? ?The final point is the timeline when we plan to sell the product, so called useful life. It determines the amount of cost reported in profit and loss or amortization. The management often strives to maximize this period, thus showing higher profits. However, assuming ever changing modern economics and regular changes of technology, one should be very cautious in setting too long useful lives.

In addition, those useful lives should be regularly reviewed and updated.

I hope this brief analysis will help the users to better understand the areas to look at when dealing with intangible assets.