A European example of challenges in applying the concepts of IAS 38
Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 19th edition:
- The issuer, a producer of transport equipment, acquired Entity A in 2008. Its intention was to enter a new geographical market by acquiring a widespread dealer network. The dealers sell the goods to retail customers and provide them with maintenance. The relationships between the acquired entity and the dealers were not based on contracts establishing exclusive relationships between Entity A and the dealers but on ongoing business. In the course of the purchase price allocation, the issuer identified the dealer network as a separate intangible asset. It considered that the period over which the dealer network would generate net cash inflows would have no foreseeable limit. The issuer recognized an intangible asset with an indefinite useful life, which according to paragraph 107 of IAS 38 shall not be amortized. In the issuer’s view the dealer network was one self-renewing asset rather than separate relationships with the individual dealers.
The enforcer (as ESMA likes to term it) disagreed with this assessment, taking the view that the dealer network doesn’t have an indefinite useful life and the intangible asset should have been amortized since its acquisition. Here’s how it sets that out:
- According to paragraph B31 of IFRS 3, an acquirer in a business combination shall recognize intangible assets if they are identifiable. According to paragraph 12 of IAS 38 (which is consistent with paragraphs B32 and B33 of IFRS 3) an intangible asset is identifiable if it is either:
- separable, i.e. capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or liability, regardless of whether the entity intends to do so; or
- arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.
- The dealer network was not separable from Entity A but according to paragraph IE28 of IFRS 3 customer relationships meet the contractual-legal criterion if an entity has a practice of establishing contracts with its customers, regardless of whether a contract exists at the acquisition date. Like the example in IFRS 3, the relationships between the dealers and Entity A were based on ongoing business which in turn is established through contracts. Therefore, the contractual-legal criterion was fulfilled.
- However, the contractual-legal criterion was met for the individual relationships with the single dealers within the dealer network, not the network itself. Even if the issuer intended to acquire a dealer network in its entirety, the identifiable intangible asset only refers to the relationships with the individual dealers.
- The useful life of the relationships with the individual dealers is finite because they continuously cease. Therefore, the intangible asset has to be amortized over its useful life in accordance with paragraph 97 of IAS 38. The fact that dealers with whom the relationship ends could be replaced does not alter this assessment. The acquired asset relates only to those dealers with which Entity A had established relationships at the acquisition date.
At this point we might recall that as part of the project on goodwill and impairment set out in its 2015 feedback statement, the IASB intends to re-examine which intangible assets should be separated from goodwill. When you get into the kind of intangible assets addressed in this example, it’s hard not to think such a re-examination might be timely. For example, I expect we can all follow the reasoning why a workforce isn’t recognized as an intangible asset, on the basis that an entity “usually has insufficient control over the expected future economic benefits” arising from it. But on the other hand, the entity likely has information about and regular contact with its employees, and may have a practice of establishing contracts with them, of the same kind that the standard deems sufficient to recognize customer relationships as an intangible asset. The demarcation seems like fuzzy science at best.
So I think one can certainly question the virtue of recognizing this kind of intangible asset, and can question what value it provides for a user. But that aside, taking IAS 38 as it stands, the notion that the dealer network as described above constitutes “one self-renewing asset” doesn’t seem to make much sense: if the “network,” such as it is, consists of a collection of separately-established relationships with individual customers, all of whom by their nature have finite lifespans, there’s no basis for assuming that these individual customers as they fade away will automatically spawn replacements. Unfortunately, the sometimes rather fanciful concepts of IAS 38 seem to encourage some preparers to a similar degree of fancifulness in applying them…
The opinions expressed are solely those of the author