Recognizing intangible assets, or: comparability is not uniformity!

As part of its activities, the European Securities and Markets Authority (ESMA) organizes a forum of enforcers from 38 different European jurisdictions, all of whom carry out monitoring and review programs similar to those carried out here by the Canadian Securities Administrators. ESMA recently published some extracts from its confidential database of enforcement decisions on financial statements, covering twelve cases arising in the period from December 2020 to January 2023, with the aim of “strengthening supervisory convergence and providing issuers and users of financial statements with relevant information on the appropriate application of IFRS.” There’s no way of knowing whether these are purely one-off issues or more widespread, but some of them certainly have some relevance to matters discussed within Canadian entities once in a while. Here’s one:

  • The issuer is a pharmaceutical company that develops drugs for the treatment of rare diseases, with no operational revenues from sales. In 2019 and 2020, the issuer announced a strategic concentration of its financial and personnel resources into two drug candidates: A and B, both for the treatment of rare diseases..
  • Furthermore, the issuer also had a development project for another drug, candidate C, which was classified as a “non-core asset”. Candidate C had orphan drug designation in Europe and the USA, as well as an Investigational New Drug approval and fast track designation for clinical development in the USA. The issuer classified this project as a clinical Phase I project transitioning to enter clinical Phase II. According to the issuer, the remaining development period (Phase II) was expected to start in 2022, clinical Phase III was intended to start in 2024, and regulatory approval was expected for 2028. The issuer was in discussions with partners for collaboration to ensure financial support for the project to carry out clinical Phase II, but no firm commitment had been reached. Around 90% of the total cost to complete the project to obtain regulatory approval was expected to be incurred in clinical Phase III.
  • The issuer had expensed all costs related to candidates A and B. For candidate C, development costs incurred within the period 2013-2017 were recognised as an intangible asset in the issuer’s financial statements throughout that period, while the costs related to candidate C incurred from April 2017 onwards were expensed.
  • The issuer recognized an intangible asset for candidate C based on expenditures at a development stage prior to market (regulatory) approval. The issuer argued that IAS 38 does not explicitly require regulatory approval to recognize an asset and referred to management’s judgement. In explaining why candidate C’s accounting treatment differed from candidates A and B, it also referred to paragraph 2.27 of the Conceptual Framework, which states that “comparability is not uniformity (..) Comparability of financial statements is not enhanced by making unlike things look alike (..)”.
  • According to the issuer, an external valuation of the risk-adjusted net present value of the future economic benefits of the project for IAS 36 purposes supported the carrying value. Furthermore, the issuer assumed that the project had reached a stage where a disposal of the whole project was an option to gain future economic benefits and referred to ongoing discussions with potential partners and acquirees.

The enforcer (as ESMA likes to term it) disagreed, considering that there were significant uncertainties regarding completion of the candidate C project, both in terms of technical feasibility and financial resources, concluding that the recognition criteria set out in paragraph 57 of IAS 38 were not met, and requiring the issuer to derecognize the intangible asset related to that item.

Well, as written above, the issuer’s explanation does sound a little threadbare (reaching for “comparability is not uniformity” to justify a particular accounting treatment seems particularly desperate, although one imagines that the person who came up with it might have felt quite proud). On the probability of generating future economic benefits, ESMA notes that “the valuation involved significant uncertainties in relation to the timetable, estimated costs, future regulatory approvals and market conditions,” making it “highly questionable, whether future economic benefits could have been considered probable at the time the costs were incurred and capitalized.” In terms of other criteria supporting asset recognition under IAS 38, the enforcer concluded that the technical feasibility of completing the intangible asset wasn’t ensured, given that the final regulatory approval depended on external parties in the USA and in the EU who were not controlled by the issuer, and that remaining development activities were subject to a complex verification and registration process requiring a significant amount of work and time. On the availability of adequate technical, financial, and other resources to complete the project, the issuer had among other things negative operational cash flow, practically no revenue, and was seeking external financing through partners or a potential (partial) sale of the project. So ESMA reasonably felt it was on pretty safe ground…

The opinions expressed are solely those of the author.

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