Lecture 2: Recognition and Intangibles

1. in general acct std only allow assets to be recognised if it is probable that any future economic
benefits will flow to the entity
2. the current conceptual framework suggests that assets with a low probability of future inflow of
benefits should not be recognised.

aasb 15 revenue from contracts with customers

revenue recognition: GAAP specifies two recognition criteria :
- eared(delivered a GOS)
- realized or realizabe (probable the entity will collect)

assb 138 intangible assets

probable that the expected future economic benefits that are atributale to the assets will flo to the entity
and the cost of the asset can be measured reliably

aasb 137 provisions

- an entity has a prsent obligation as a result of a apst event
- it is probable that an otflow of resources embodying economic benefits will be required to settle
the obligation and
- a reliable estimate can be made of the amount of the obligation
if not met, no provisions shall be recognized

aasb 137 contingent assets /liabilities

an entity shall not reconise a contingent L
//_______________________________A

definition of probable = more likely than not

Implication for bias in Financial reports

Value of asset = probability of cash flow * expected amount of cash flow
Therefore probability criterion of probable in the acct std creates a bias downward for both assets and
liabilities

Understanding probabilities
1. the level of probability does not always imply the value of an sset is low:asset value =
probability * payoff
Thus the acct recognition criteria of Pr>0.5. could give rise to significant bias due to nature of distribution
of assets payoffs
- share/asset returns have systematic skewness implying a small number of extreme low
probability events have very high payoffs
- this is consistent with corporate managers having an investment strategy/portfolios with high
positive skewness
- this implies high expected value projected (ow prob x high payoff) may not be recognised and
thus not valued or monitors under acct std.
2. a low probability event does not always imply that the value of an asset is unreliable
- current acct std do not allow recognition of low probability events possibly based on the invalid
premise that the value is unreliable
- expected value of an asset = payoff x probability (if the probability of the payoff is objective or
known then a reliable measure of an asset values can be obtained
objective probabilities are those where the probability distribution of future outcomes is known with
close to perfect certainty
subjective probabilities are those that have to be estimated and are subject to error (with sufficient
historical evidence these can be estimated with a high degree of reliability)
if probabilities are known (such as dice) then assuming the payoff is also known the value of an asset
can be measured with perfect reliability

therefore the premise underlying the std that cash flows have to “probable” for either an asset to be
measured reliably (or have value) is not correct
low probability events are being confused by standard-setters with reliability

The economics of intangibles (a case of recognition)

intangibles: as a non-monetary asset without physical substance

deposit, bonds, licences, software, brands,…

unique economic characteristics which have implications for both preparers and users
- preparers. the unique attributes of intangible assets lead to significant measurement problems
due uncertainty and thus lack of reliability in measurement of value
- users. the unique attributes of intangible assets have implications for assessing both the level
and uncertainty of firm performance
difficult to claim and enforce property rights (limited excludability)
- lack of full control over the benefits as firm can only be partially excluded from using the
intangibles (a firm may invest in training -> not rise benefit, not control employees, if the
employees shift to other firm, taking the investment in human capital)
lack of separability of many intangibles from each other and the firm
- many intangibles assets involve suing assets jointly (firm may invest in positive workplace culture,
this culture can not be solved because intangibles cannot be separated from the firm, difficult to
determine a separate individual value)
high risk and thus uncertainty of future benefits
absence of markets for many intangibles
- the results of R&D cannot be sold directly
Sunk cost (intangibles expenditure that may give rise to sunk costs include mrk to create brand name
and research expenditure), cannot be recovered
- increase cost of finance
- create barriers to entry
scalability (and non-rivalry in use) and marginal costs of production of zero

Accounting Rules of recognition of intangibles assets

AASB 138 summarise:

- no internally generated intangible assets are allowed to be recognised as an asset except for
certain types of development expenditure
- externally acquired intangible assets are required to be recognised as an asset at the cost of
acquisition ( this inc those assets acquired directly and those acquired as part of business
combination)
thus big difference between the acct for internal versus external intangible assets.

Intangibles: identifiability, non-monetary nature, lack of physical substance.

application of recognition criteria for intangible assets varies across means of acquisition:
 - internally generated intangible assets: not recognised except for development expenditure
- research expenditure:not-recognised
- development expenditure: recognised subject to specific criteria
- by external separate acquisition: recognised
- as part of a business combination: recognised

Recognition internally generated:

The flw are specially excluded from recognition per AASB 138/IAS 38:
Internally generated:
- good will - research - Brands
- Mastheads - publishing titles - customer lists

Recognition: separate acquisition

separate acquired intangibles are recognise
aasb 138 considers that the probability recognition criteria is always considered to be satisfied for
separately acquired intangibles
cost can usually be measured reliably, although there may be issued where the acquirer is giving up
non-monetary assets rather than cash

recognition: acquisition as part of business combination

the acquirer of a business combination may acquire intangibles that were not able to be recognised by
the seller (internally generated assets such as brands, mastheads, and publishing titles)
these are allowed to be recognise on acquisition of a subsidiary in the group accounts

Research: original and planned investigation undertaken with the prospect of gaining new scientific or
technical knowledge and understanding
Development: the application of research findings or other knowledge to a plan or design for the
production of new or substantially improved materials, deices, product, processes, systems or service
before the start of commercial production or use

consequences of non-recognition of intangibles:

- measurement error of performance in financial reports
- non-comparability of performance across companies with different assets
- lack of accountability of managers for investment in intangible assets
- influence on managerial incentives
-> the above consequences have significant negative effects on the allocation of real resource in the
economy

Biased error in measurement of performance

- net assets are biased.downward
- up or downward bias in net income(depends on rate of prowth of invesment, timing of future
benefits
- //__________________ROE(depened on both direction and relative magnitude of the biases in
both ent inome and net assets)

Bias in ROE
ROE = net income / shareholder equit
non-recognition of assets gives rise to bias in measurement of both net income(numerator0 and equity
(denominator)
the sign and nmagitude of bias could result in ROE being either > or < than true economic rate of ROE
Bias in net income
reported earnings are biased due to mismatching of revenue from investment in intangibles with costs
from invaest ment in intangibles
direction and magnitude depends on the rate of growth of investment in intangibles and timing of
realization of benefits.

constant investment increase investment decreasing investment

net income correct understated overstated

example
a. assume a compnay with a once-off investment in an intangible project of 100$ that generates a
return in the following periods of 10%.
the true income: 10$

year 1 year 2

Rev

sales 0 110

Exp

Expenditure 100 0

profit/loss (100) 110

was an internally generated intangible investment in year 1 => expense incurred, no revenue, report a
loss of 10 => net income is significantly understated. in year1
year2, total rev is 110, not record any expenditure already recorded in y1. record an income of 110$, the
income no. should be 10$, but we not matching against this total revenue, the associated cost of100
were significantly overstating income.
=> due to mismatching is the heart of the issue, we have not match the reveue against the associated
costs inthe correct period => accoutning no. are incorrect in both periods

b. assume a cpmpany with an increasing (decreasein) investment in intangibles at the rate of 5%

that generates a return on investment of 10%
growing investment

year

1 2 3 4 5

Rev

sales 0 110 115.50 121.28 127.34

Expenses

expenditure 100 105 110.25 115.76 121.55

acct profit (100) 5 5.25 5.51 5.79

 true economic 10 10.50 11.03 11.58
income

y1, we incur expense on intangible -> we mst expenses given rise to an accounting reportinglos of 100$
y2, sales revenue wil be100, we assume the investment will geneate a return of 10% => total revenue is
110. we assume th firm will grow its investment in intangibles at 5%. last year we invest 100$, this year
we invest 105$(5%. increase)

year

1 2 3 4 5

Rev

sales 0 110 110 110 110

Expenses

expenditure 100 100 100 100 100

acct profit (100) 10 10 10 10

true economic 0 10 10 10 10
income

investment strategy

perfomance metric constant inv increasing inv decreasing inv

net income correct under over

net assets(equity) under under under

ROE ROEoverstated effect ambiguous overstated

Bias in ROE
- non-recognition of assets inderstates equity
- the efect on net income and ROE depend on the rate of growth of investment

Non-comparability
- Inconsistency in the accounting for intangibles with internally generated not
- bein g recognised and externally acquired being recognised
- non-comparability of reported P&L and BS between two entities which. have the same
fundamental investment in intangibles but have acquired the differently
Lack of Accountability.
- not all the intanbigle assets a business may have are recorded in the BS
- mitigates stewardship function of reporting as immediate expensing upon investment provides no
information about project development and obscures most failures
managerial incentives
 - create incentives to use r&d expenditure as an earnings managment tool resulting in a lower level
of r&d investment and innovation in the economy
- if firms need to manage eanings to meet an earnings target they may choose to cut r&d
expenditure to raise their net income
Negative effects on real resource allocation in the economy
- increase adverse selection. as stock difficult to value gives to underpriced securities and thus
underinvestment
- misallocation of resources: investors systematically misprice the shares of intangibles-intensive
enterprise giving rise to a mis allocation of resources
Potential alleged benefits from non-recog of Int.
- efficient contracting as no. that are reported are more reliable
- conservative financial reports may guard against managerial optimism and opportunistic
behaviour
BUT Non-reg of intangibles will not result in conservatism over the life of firm
benefits and reasons for non-recog of intangibles:
1. minimization of proprietary costs

HOW SHOULD WE REPORT ON INTANGIBLES?

Current accounting:
TUTORIAL
TUTORIAL TWO
Q1 Refer to Case Study in Appendix. Explain how Mags Ltd’s costs should be accounted for under
AASB 138/IAS 38 Intangible Assets, giving reasons for your answer.
Q2 The market-to-book (MB) ratio is the ratio of the market capitalization of the firm
(measured as share price * shares outstanding) divided by the net assets of the firm as reported in
the balance sheet. The market-to-book (MB) ratio is a heuristic widely used by investors to assess
the value of a company.
The graph shows that market-to-book ratios have been increasing across time. Some commentors
allege that this is due to the non-recognition of intangibles.

Below are the descriptive statistics and a histogram for the market-to-book ratio for Australian
companies grouped by size over the period from 2010-2020. Discuss what the descriptive statistics
imply about the frequency and magnitude of the non-recognition of assets. Does a market-to-book
ratio greater than 1 imply that assets have not been recognized?

The data and R-Code to compute the histogram and descriptive statistics are attached. Restrict the
sample to the sample of firms with MB lie between 0 and 10 and produce for all firms. Include
vertical lines on the histogram at MB = 1 and at MB = 2.27.

The descriptive statistics and histogram are tabulated below. The mean and median market-to-book
(MB) values for large Australian company are 1.79 and 3.23. These imply the market capitalization of a
firm (share price*shares outstanding) is substantially greater than the net assets or the common
shareholders equity reported in the balance sheet. The median of 1.79 implies the balance sheet has
reported a value of $1 and the share-market has a value of $1.79. Does this imply that assets have not
been recorded?
The non-recognition of assets could be a possible explanation for MB > 1. Consider a firm that invests in
internally generated intangible assets and this is not recognized and is expensed as incurred (Dr Expense
Cr Bank). Therefore, the net assets of the firm recorded by the accountant in the balance sheet is lower
than the true net assets and the market capitalization will be greater than the book value.
However non-recognition of a past acquired asset is not the only explanation for a MB > 1. Market value
(and thus market capitalization) is function of all expected future cashflows and the discount rate. The
bulk of future expected cashflows is a function of the market’s expectation of future growth. Therefore, if
the share market expects a firm to grow significantly, due for example because of an anticipated increase
in demand for a firm’s product, then these expected future sales will be impounded into share price. The
accountant does not record these expected future sales in the balance sheet as an asset (as the revenue has
not yet been earned from a transaction with an external party). Therefore, the non-recognition of future
growth by the accounting system can also explain why MB is greater than 1.
Finally, market values substantially greater than equity book values could reflect high market values
associated with low cost of capital (e.g. the discount rate) due for example low interest rates. Across the
past 20 to 30 years interest rates (and thus cost of capital) have decreased. Therefore a partial explanation
for an increase in market-to-book across time is declining interest rates.
It is also worth noting that a significant percentage of firms have a market-to-book less than one. For
example, in the smallest size group, the 25thPercentile is 0.40 implying 25% of firms have a
market-to-book less than 1. Market values less than equity book values could reflect either low market
values associated with risk of these firms or high book values associated with overstated assets or
understated liabilities.

The Xth percentile of a variable’s distribution is the value for which X% of the observations are less. So as an example in the
25th percentile for Large stocks is 1.11 which implies 25% of companies have a MB lower than 1.11

Histogram of Market-to-Book. All Australian Firms

Interest Rates across Past 30 Years

Q3 Refer to the attached article in Australian Financial Review “Large dollar profit doesn’t mean
high returns: Westpac” (1st March 2018). Westpac argues that their economic return is lower than
other industries. Explain how the variation in the industry reported accounting returns in the AFR
article could be due to accounting measurement biases rather than variation in underlying
economic return.
The reported accounting ROE for the banking sector of 13.8 percent is approximately what would be
expected (the long-run share returns is 10 to 12%). This can be explained by there being a lower amount
of recognition and measurement accounting biases for the primary assets of banks being financial assets
than other industries where the primary assets are physical and intangible. The primary asset of a bank is
a loan. All of these loans are recognized and recorded. In contrast in other industries such as
pharmaceutics and biotechs significant investment in intangible assets such as research are not
recognized. Furthermore, the measured value of the loans in the balance sheet being the financial amount
owing more closely approximates the current value than the reported historical cost of physical and
intangible assets in other industries.
The extremely large ROE in the healthcare sector of 35.9 percent is more likely due to accounting
measurement biases. Assume this sector includes biotech companies that invest in research into medical
devices etc and the investment pattern is lumpy. There is large single upfront investment in R&D and
then no investment (so essentially a declining investment pattern). Then research expenditure is expensed
and assets are understated. Net income will also be biased. In the year in which the research expenditure
is incurred income will be biased downward and in subsequent years it will be biased upward (as revenue
from the research is not being matched against the research expenditure incurred). Thus ROE will be
overstated.
An ROE of more than 20 percent in the IT, telecommunications and consumer discretionary sector could
be due to accounting measurement biases but possibly also abnormal profits from lack of competition. A
principal resource of the consumer discretionary sector is the value of the firm’s brand name. Yet GAAP
requires these firms to immediately expense advertising and other costs incurred to develop their brand
names. Thus their assets bases are understated.
Assuming there are some companies who adopt a strategy of having large-up investment in advertising to
capture the market and create barriers to entry. Therefore across time the level of investment by the sector
in intangibles is declining. Therefore, across time the expenditure that is directly expensed in each period
will be lower than the benefits (sales) in that period from the prior advertising expenditure. Therefore,
net income is biased upward and thus overall ROE is biased upward.

Q4 Case study of the Accounting and Reporting of Intangibles by Woolworths

Back Ground
Woolworths is a traditional “brick and mortar” store whose primary assets could be expected to be
tangible and physical (e.g. the store and the food). However according to the consulting firm
BrandFinance (one of the world's leading brand valuation consultancy firms) Woolworths Ltd has the
most valuable brand in Australia:
“Woolworths (brand value up 18% to $16.2 billion) remains the most valuable brand in Australia for the 4th consecutive year.
Woolworths has continued its focus on customer experience, including the roll out of curated ranges tailored to local
communities, and offering more inclusive experiences to a wider range of consumers.

Woolworths also continued to manage the impacts of climate change, working to reduce emissions from its own operations
through green electricity and electric vehicle trials, as well as the phasing out of some plastic use. These factors continued to
maintain the brand’s strong reputation and loyalty amongst Australian consumers and its position as the nation’s most valuable
brand” ( BrandFinance, Annual Report on Australian Brand Values, January 2023, page 10).

Obtain the 30 June 2022 Annual Financial Report for Woolworths. Read the relevant sections (in
particular page 4 to 6 and the relevant sections of the financial statements ) to address the following
questions
How does Woolworths report on intangibles and why? Is Woolworths (a traditional “brick and mortar
store”) investing in potential intangible assets? What are the categories and types of intangible assets?
What is the magnitude of the investment? How have Woolworth accounted for and reported on
intangibles and why is the disclosure so poor? What are the most significant limitations of the reporting
on intangibles for assessing the performance of Woolworths? What is your overall assessment of the
quality of reporting by Woolworths on its intangible investments?
Does this reporting give rise to a bias in reported performance as measured by ROE? Compute the
ROE for Woolworths for FY 2022. Estimate the direction and magnitude of bias in ROE due to
unreported intangible assets ?
How should Woolworths and all other firms report on intangibles?
Based on you analyses of Woolworths discuss how you think firms should report on intangibles? What
principles and concepts in the current accounting reporting framework need to be changed to give rise to
more informative reporting of intangibles?

How does Woolworths report on intangibles and why?

Is Woolworths (a traditional “brick and mortar store”) making investing that have the potential to be
intangible assets? How should firms categorize and label these potential intangible assets?
According to Woolworths Annual Report (see page 4 ) the primary value drivers of Woolworths are
consistent with significant investments in intangible assets. Specifically, the primary value drivers are:
The investment in these primary value drivers is consistent with the definition of an intangible asset “an
identifiable non-monetary asset without physical substance”.

These investments could be categorized into the following types of intangibles assets:
· Customer services (e.g. customer experience)
· Team work (e.g. human capital)
· Trusted Brands (e.g. brand capital)
· Digitalized Retail Platforms (e.g. software)

Woolworths also invests in sustainability which is arguably an potential intangible assets as it may
enhance Woolworths brand image and appeal to sustainability conscious consumers. Thus Woolworths
has a “does well be doing good” strategy.

Does this expenditure/investment give rise to an intangible asset for Woolworths?

Under the condition that the expenditure gives rise to future economic benefits to Woolworths with a
probability > 0 then an asset exists.
It is probable that the investment in customer services, team work, brands and sustainability gives rise to
some future sales and thus an intangible asset exists. However it is very difficult to determine the
magnitude of these future sales and thus the value of the intangible asset.
A fundamental measurement issue associated with intangible assets is that the property rights over
intangibles are not as tightly defined and secured as those over physical and financial assets, challenging
owners to capture large and sustained share of the benefits. For example. employees often shift
employers taking with them the investment in team human capital. Can Woolworths exclude Coles from
accessing the benefits of the human capital training? However, in this case of Woolworths as they are
investing in team and culture and it is arguable they should be able to capture and retain some benefits
from this strategy and thus there is a probability >0 of a future increase in sales and thus an intangible
asset exists.
How have these assets been accounted for and reported on by Woolworths?
Under AASB 138 all internally generated assets with the exception of development expenditure are not
allowed to be recognized.
Thus, any expenditure incurred by Woolworths on the development of brands via advertising, team works
via expenditure on human resource training and team events and customer experience would not be
allowed to be capitalized.
Under AASB 138 software development costs are an element of R&D costs. AASB 138 requires that all
research costs are expensed. AASB 138 states that development costs must be capitalised on meeting the
six conditions specified in paragraph 57 of the standard; all other development costs are expensed. See
Note 3.6 (p121 of Woolworths financial report) Therefore assuming Woolworths expenditure on
digitalized retail platforms (such as software for the on-line sales platform, software to generate
personalised customer offers), meets the six conditions then this software expenditure would be
capitalized as an asset. Consistent with this Woolworths does capitalize some of its development
expenditure on software Following is an extract from Woolworth 2022 Financial report Note 3.6

Many firms have software expenditure (such as website development) as an capitalized asset. See Table 1
at the end of these solutions that documents the frequency of different types of recognized intangible
assets for Australian companies.

What is the magnitude of the investment in these non-recognized intangible assets that are Woolworths
value drivers?
There is no disclosure of the expenditure on investment in internally generated assets from customer
service, teams and brands. See Woolworths annual P&L statement.
Woolworths only discloses highly aggregated line-items for its expenditure categorized into Branch
expenses and Administration expenses. This is notwithstanding that according to Woolworths strategy
(page 4 annual report) their primary value drivers are customer service, teams and brands. However,
there is no disclosure of the magnitude of investment in internally generated assets associated with these
value drivers.

Magnitude of Investment in Recognized Externally Acquired Intangible Asset

As a starting point to understand the magnitude of the potential unreported internally generated assets,
examine the magnitude of intangible assets that are recognized presumably from external acquisitions
(see balance sheet and Note 3.6 page 120 ).
In 2022 PPE and Intangibles assets are respectively $M8,231 and $M5,278 implying the level of
investment in intangibles relative to physical assets is very substantial. This in turn implies intangibles are
a very important part of the business model of Woolworths and the unrecognized intangibles due to
internally generated could be substantial.

Why is the disclosure of investment in internally generated assets so poor?

There could be a number of reasons why the disclosure is poor.
· Proprietary costs. Proprietary Costs of disclosure arise if a firm discloses information that
gives their competitors an advantage or puts the firm at competitive disadvantage. Thus
Woolworths may not want to reveal their investments (in for example customer service and
advertising) as they want to maintain a competitive advantage over Coles and Aldi by not
revealing their specific strategy.
· Moral Hazard. Management do not want to be held accountable for their strategy. As the level
of investment in the strategy is not reported it is very difficult to assess if the strategy is a
success or failure and thus the performance management cannot be determined.
· The Non-separability of both the investment and returns on many intangible assets such as as
human resources, reputation, customer relationships,
 · Historical Path dependence and lack of effort. Due to lack of effort Woolworths follows the
sample financial reporting template as prior years and does not change the template for a
change in the business model. Woolworths financial report from 2000 is exactly the same as
the 2022 notwithstanding a significant change in the business model. Lazy.

What are the most significant limitations of the reporting on intangibles for assessing the performance of
Woolworths?
To assess performance of both individual assets (such as intangibles) of a firm and the overall
performance of the firm we need unbiased measures two variables: the level of capital investment and the
return on that investment. In turn this gives rise to the following significant limitations:
· The performance of the individual intangible assets is unknown:
o The level of capital investment in internally generated assets such as team work or
customer experience, as it is expensed and not reported, is unknown.
o The return on these intangible assets is not reported because of the difficulty of
identifying the separate impact of each individual intangible assets on the dollar value
of sales
· The overall performance of Woolworths will be biased (discussed further below)
· Lack of comparability. Because the accounting for intangibles is different between the two
methods of acquisition, externally acquired intangibles (capitalized) and internally generated
(expensed) this implies the accounting performance between two firms, such as Woolworths
and Coles, cannot be compared if they have different methods of acquiring intangibles

Overall, the quality of Woolworths financial reporting on its investment in internally generated intangible
assets is very poor.

Does the (lack of) accounting by Woolworths for intangibles give rise to a bias in
ROE?
Compute the ROE for Woolworths for FY 2022.
ROE = Net Income/Average Shareholders’ Equity
• ROE Woolworths in 2018 = 1,795/(10,849 +9,876)/2 )= 17.32%
• ROE Woolworths in 2019 = 2,759/(10,669 +10,849)/2 )= 25.64%
[1]
• ROE Woolworths in 2022 = 1,557/6,104 = 25.50%

Average equity share returns are 10 to 12%. Is a partial explanation for Woolworth’s high return on equity
based on accounting numbers due to a bias in accounting?
Estimate the direction and magnitude of bias in ROE due to unreported intangible assets ?
Under AASB 138 Woolworths expenditure on an intangible assets such as customer and store-led culture
and team will be expensed as incurred.

This gives rise to a potential bias in reported performance as there will be a mismatch between the period
in which the expenditure is expensed and the period in which the benefits arise.
What is the direction and magnitude of the bias? This depends on both direction and relative magnitude
of the biases in both net income and reported shareholders equity (net assets).
What is the direction and magnitude of bias in Shareholders Equity (Net assets)?
This will be biased downward because Woolworths has significant economic assets that are not reflected
on the balance sheet. Woolworths has not disclosed the amount of its expenditure on internally generated
intangible assets. However, our analysis of the magnitude of externally acquired assets suggests the
potential magnitude of internally generated assets could be very large (in 2022 PPE and Intangibles assets
are respectively $M8,231 and $M5,278).
Assuming we know the expenditure an approach to estimating the value of the unrecorded assets and thus
the magnitude of bias downward is simply to estimate the amortized book value of the intangible assets
assuming the expenditure was capitalized as an intangible assets (basically first-year accounting for PPE).
• Unrecorded “culture and team” asset = Past Expenditure less Amortisation
Assume that the benefits from the investment in culture and team are spread evenly over the three years
after the initial expenditure (and thus the amortization period is 3 years). Assume also that all
expenditure is made in the middle of each year. Then at a conceptual level
· Accumulated amortisation “culture and team” asset = (0.5 years/3years) * current-fiscal-year
“culture” expenditure + (1.5 years/3years) * previous-fiscal-year expenditure + (2.5
years/3years) * two-fiscal-year-ago “cultural” expenditure

What is the direction and bias in net income?

At first glance it may appear that immediate expensing of expenditure on intangibles such as customer
experience and team-led culture creates a downward bias in net income.
However, the answer will depend on both the rate of growth of investment in a customer and store-led
culture and team and the timing of the realization of the future benefits. In this case it appears
Woolworths is increasing its investment in this asset. For example reviewing prior reports shows
according to the 2017 Annual Report (page 5) “ We are committed to continually improving our offer for
our customers with further planned investments in service FY18” and on Outlook page 23 the main focus
of Woolworths is " improving the customer experience".
Therefore, assuming the investment is growing then there is a downward bias in net income. The
downward bias occurs because the expenditure in this period is greater than the benefits realized in the
current period from prior periods investment in “culture and team”. Therefore, we can assume a
downward bias but because of poor disclosure it is difficult to quantify the magnitude of the bias.
Overall then there is a downward bias in both net assets and a downward bias in net income.
Because there is a bias downward in both net assets and net income the overall effect on ROE will depend
on the relative magnitude of the two effects.
In general, it can be assumed the % effect of the bias is greater on net income (the numerator) than net
assets (the denominator) and thus in turn we can conclude that the reported ROE of Woolworths of 26%
may be biased downward. In Week 5 we will examine other factors that may explain why the ROE of
Woolworths is so high.

Based on you analyses of Woolworths discuss how you think firms should report on
intangibles? What principles and concepts in the current accounting reporting
framework need to be changed to give rise to more informative reporting of
intangibles?

How should firms report on intangibles?

An analysis of Woolworths financial reporting on intangibles reveals two significant failings:
· Amount of expenditure on internally generated intangibles is not reported
· The performance of many of these intangible assets, which the firms argue are there primary
value drivers, is not reported. This performance could be non-monetary metrics such as:
employee turnover, employee well-being, measures of customer satisfaction, the % of
successful drug trials).

These two failures underpin the suggested changes that need to be made to financial reporting made by a
number of commentors.
Lev is one of the leading critics of the current accounting for intangibles and he argues Lev (2017) that
there are three main changes need to made to the way we report on intangibles:
1. Capitalize and Report Intangibles as Assets in Financial Reports
2. Improve Disclosure of Intangibles (including having a scorecard of success such as %
successful drug trial)
3. Leave Valuation to Investors.

Each of these points is expanded on in an extract from Lev (2017) below.

What principles and concepts in the current accounting reporting framework need to be changed to give
rise to more informative reporting of intangibles?
To make the changes suggested by Lev and others the following limitations in the current accounting
framework need to be addressed:
· the definition of an intangible asset;
· the recognition criteria for an asset; and
· the lack of emphasis on the importance of disclosure.

The definition of an intangible asset – particularly the criterion of “separability” eliminates a number of
economic resources from being defined as an asset. Requiring separability means that potential assets
such as human resources, reputation, customer relationships, labour relations cannot be recognised as
intangible assets.
The recognition criteria of future benefits being probable precludes the recognition of a large number of
intangible assets which have low probability but high pay-offs. The recognition criteria of reliability also
precludes the recognition of a large number of intangible assets as uncertainty is an inherent characteristic
of these assets.
Finally, both the conceptual framework and standards have as their main focus the recognition and
measurement of assets in the financial statements. However, a rigorous conceptual framework over
disclosure could provide investors with information to enable them to estimate the benefits (and thus the
value) of the investment in intangible assets.
A potential way forward requires both a revision of the conceptual framework in regard to the criterion
for recognition and a greater focus on disclosure

A “proposed” way forward to report on intangible assets.

Below is an extract from Lev (2017) as a way forward to report on intangible assets. Note that this is just
a point of view.

Extract from Lev and Gu (2017)

1. Treat Intangibles as Assets in Financial reports

Treat intangibles as assets and recognize and measure them in financial reports. Intangibles are uncertain
and notoriously difficult to value, so how can we report their values on the balance sheet? A possible
approach is as follows:

We don't suggest to value intangibles by their current purchase or sale prices (fair values). Rather, in line
with the treatment of these assets in the national income accounts, we propose to capitalize the investment
in these intangibles, using their objective original costs. We leave intangibles' valuation to appraisers and
just propose properly accounting for the facts—that is, the costs of intangibles. After all, that's exactly
what's done in accounting for tangible, physical assets. But, you'll riposte (we know, because we heard
these arguments for years): what good will it do to report the historical values of intangibles on the
balance sheet? What can investors learn from these numbers? Answer: What they learn now from balance
sheet values of tangible assets (property, plant & equipment): the original spending on these resources.
Not much, we admit, but better than the complete absence of intangibles from the balance sheet.
Importantly, the main reason to capitalize intangibles isn't to enhance the realism of the balance
sheet—very few, if any, investment decisions are based on asset values anyway—rather, its aim is to
restore the income statement to the status of a meaningful indicator of operating results, by properly
separating investments from current expenses, thereby substantially improving the measurement of
business performance.6

Consider: A fundamental tenet of accounting used to be that enterprise performance, reflected by periodic
income or earnings, is properly measured if revenues are carefully matched against all the costs
(expenses) incurred in the process of generating the revenues. This matching principle ensures properly
measured performance. But if, for example, Verizon's total acquisition costs of a new wireless customer
(commission paid to retailers) who is expected to contribute to the company's revenues over the next
three-to-four years are charged (expensed) against this year's revenues, an obvious revenue–cost
mismatch occurs (four years of cost charged against one year of revenue), leading to an earnings
distortion.7 Similarly with the installation of a major software security system, expected to be used over
the next four to five years, whose total costs are charged to current revenues. R&D is, of course, an
extreme case of such revenue–cost mismatch: The costs of R&D are typically larger than most other
intangible investments, and the duration of benefits longer. Accordingly, the immediate expensing of
R&D for a company with a positive R&D growth rate burdens current revenues with an expense (R&D)
whose benefits will be reflected by future revenues—a serious distortion of both current and future
earnings.8 Even more seriously, such understatement of reported earnings, from the expensing of R&D,
likely has an adverse effect on the actual R&D expenditures by companies. Indeed, a recent study on UK
data shows that companies that switched from R&D expensing to capitalization increased significantly
their R&D outlays.9 Improved accounting has positive consequences.
Thus, the immediate expensing of intangible investments plays havoc with reported earnings as indicators
of enterprise performance, particularly for growing or declining enterprises, namely most businesses in a
dynamic economy

2. Improve Disclosure of Intangibles

The capitalization of certain intangible investments, just proposed, will undoubtedly improve the quality
of reported earnings, but much more is needed to provide relevant information on intangibles to investors.
Most companies provide extensive footnote disclosure to reveal information on physical and financial
assets, so, why aren't any details provided on the far more consequential intangible assets? Why isn't even
the cost of most intangibles separately reported, rather than buried in large expense items, such as cost of
sales and SG&A? Wouldn't you like to know how much the company spent on information technology,
brand enhancement, employee training, customer acquisition, or the development of unique business
processes, and wouldn't you like to be able to track the trends in these investments (e.g., is the workforce
quality being run down?) and benchmark the data against competitors? Of course you would, but you
can't from current financial reports.
Many companies have large patent portfolios, the details of which are sorely missing. For example,
investors will find it very useful to obtain the classification of the company's patents by technological
17
areas (e.g., measuring electrical variables, radio direction finding, conductive master, etc.), allowing
them a rare glimpse at the technological strategy of the company: which new areas are penetrated and
18
which are abandoned. And within technological areas, patents should be classified according to
remaining life, patents underlying products and development efforts, patents sold or licensed out, and
those allowed to expire. For many companies, their patent portfolio is their most important asset, but,
strangely, GAAP doesn't require any meaningful disclosure about patents.
See Lev Chp 11 (attached) for proposed reporting disclosure framework.

3. Leave Valuation to Investors

Accountants should avoid the periodic valuation of assets/liabilities that are not traded in active markets.
Such assets should be reported at original costs, and their essential attributes (ages, nominal values,
description of properties) should be adequately disclosed in financial report footnotes, allowing investors
23
who are interested in current values to estimate them. This will come as a shock to accounting
regulators who spent most of the past two decades mandating such valuations, but truth be told,
accountants have no special expertise in valuation. If there is a strong and sustained investor demand for
current values of nontraded corporate assets/liabilities, appraisers and information vendors will surely
24
step in and provide them. Financial reports should stick to facts and “near facts,” namely, highly
reliable and verifiable estimates. After all, that's what accounting, derived from counting (of facts), is all
25
about. A positive byproduct of eliminating unreliable assets/liability valuations: Mitigating the
detrimental effect on the informativeness of earnings (sheer noise) from the gains/losses of such periodic
valuations
Q1 Case study Accounting for intangible assets (Mags Ltd)

Mags Ltd is an Australian mail-order company. Although the sector in Australia is growing slowly,
Mags Ltd has reported significant increases in sales and net income in recent years. While sales
increased from $50 million in 2009 to $120 million in 2015, profit increased from $3 million to $12
million over the same period. The stock market and analysts believe that the company’s future is
very promising. In early 2016, the company was valued at $350 million, which was three times 2015
sales and 26 times estimated 2016 profit.

Company management and many investors attribute the company’s success to its marketing flair
and expertise. Instead of competing on price, Mags Ltd prefers to focus on service and innovation,
including:
• free delivery
• a free gift with orders over $200.

As a result of such innovations, customers accept prices that are 60% above those of competitors,
and Mags maintains a gross profit margin of around 40%.

Nevertheless, some investors have doubts about the company as they are uneasy about certain
accounting policies the company has adopted. For example, Mags Ltd capitalises the costs of its
direct mailings to prospective customers ($4.2 million at 30 June 2015) and amortises them on a
straight-line basis over 3 years. This practice is considered to be questionable as there is no
guarantee that customers will be obtained and retained from direct mailings.

In addition to the mailing lists developed by in-house marketing staff, Mags Ltd purchased a
customer list from a competitor for $800 000 on 4 July 2016. This list is also recognised as a
non-current asset. Mags Ltd estimates that this list will generate sales for at least another 2 years,
more likely another 3 years. The company also plans to add names, obtained from a phone survey
conducted in August 2016, to the list. These extra names are expected to extend the list’s useful life
by another year.

Mags Ltd’s 2015 statement of financial position also reported $7.5 million of marketing costs as
non-current assets. If the company had expensed marketing costs as incurred, 2015 net income
would have been $10 million instead of the reported $12 million. The concerned investors are
uneasy about this capitalisation of marketing costs, as they believe that Mags Ltd’s marketing
practices are relatively easy to replicate. However, Mags Ltd argues that its accounting is
appropriate. Marketing costs are amortised at an accelerated rate (55% in year 1, 29% in year 2,
and 16% in year 3), based on 25 years’ knowledge and experience of customer purchasing
behaviour.

Required
Explain how Mags Ltd’s costs should be accounted for under AASB 138/IAS 38 Intangible Assets,
giving reasons for your answer.

AASB 138 definitions

 · Asset: A resource:
(a) controlled by an entity as a result of past events; and
(b) from which future economic benefits are expected to flow to the entity.
· Intangible asset: An identifiable non-monetary asset without physical substance.
· Identifiable: An asset is identifiable when it:
(a) is separable – i.e. can be separated or divided from the entity and sold, transferred,
licensed, rented or exchanged, either individually or together with a related contract, asset
or liability; or
(b) arises from contractual or other legal rights.
Costs of direct mailings to prospective customers (capitalised and amortised)
· Under AASB 138 internally generated customer lists and items similar in substance shall not be
recognised as intangible assets.
· Accordingly, Mags Ltd should:
- Write off all costs capitalised to date; and
- Expense all such costs as incurred from now on.
Purchased customer list (capitalised and amortised)
· It meets the asset definition. Mags Ltd has control as it has the power to obtain the future
economic benefits flowing from it and can restrict the access of others to it. Future economic
benefits exist in the form of potential sales.
· It also meets the intangible asset definition, as it is non-monetary, has no physical substance, and
is identifiable as it can be sold.
· Assuming that it is probable that future economic benefits will be obtained from this list, Mags
Ltd.’s treatment is correct – i.e. recognise it as an intangible asset at cost and then, as the
question indicates that Mags Ltd has chosen the cost model, amortise it.

Cost of phone survey conducted after customer list purchased (to be capitalised)
· Under AASB 138 subsequent expenditure on customer lists and items similar in substance
(whether externally acquired or internally generated) is always expensed as incurred.
· Hence, Mags Ltd should expense the cost of the phone survey.

Marketing costs (capitalised and amortised)

· They do not meet the asset definition. Mags Ltd cannot demonstrate control over the future
economic benefits flowing from them, as it cannot restrict the access of others to those benefits.
AASB 138 states that control normally arises from legal rights (e.g. restraint of trade
agreements). Without such rights it is difficult to demonstrate control.
· Mags Ltd.’s marketing practices and flair are known to competitors and accordingly could be
replicated.
· Hence, Mags Ltd should:
- Write off all costs capitalised to date; and
- Expense all such costs as incurred from now on.
Woolworths P&L from 2002 (same expense classification as 2022)
Note how the classification of expenses has not changes across a 20 year window.