Capitalization of expenses for the development of intangible assets within a business entity

For internally generated assets, it is sometimes difficult to assess whether they meet the criteria for recognition as intangible assets due to challenges in determining whether the asset will generate future economic benefits and whether its acquisition cost can be reliably measured. For this reason, in addition to the general requirements for recognition and measurement of intangible assets, there are specific requirements and guidelines for intangible assets generated internally.

The accounting treatment of intangible assets is regulated by the Croatian Financial Reporting Standard 5 – Intangible Assets, and the International Accounting Standard 38 – Intangible Assets.

To determine whether internally generated intangible assets meet the criteria for recognition, it is necessary to separate the research phase and the development phase.

Accounting standards clearly separate the research phase from the development phase, as in the research phase there is still significant uncertainty, and it cannot be determined whether the product will “come to life”, i.e. it cannot be demonstrated that an intangible asset exists which is likely to generate future economic benefits. The standards allow certain costs incurred during the development of intangible assets to be capitalised, but it is essential that they meet the prescribed conditions.

Research is a planned investigation undertaken to gain new scientific or technological knowledge and new conclusions (understanding of the project). According to the standard, costs arising from research are not recognized as assets, but as expenses when incurred.

On the other hand, in the development phase, which, according to the accounting standard represents "the application of research results or other knowledge to a production plan or project before the start of commercial production or use", costs are also incurred that, if appropriate conditions are met, can be recognized as a special form of intangible asset.

What expenses can we capitalize?

• costs of materials and services used or received in creating the asset,
• salaries, wages and other personnel costs directly attributable to creating the asset,
• fees for registering legally protected rights,
• amortisation of patents and licences used in creating the asset,
• borrowing costs (optional).

The table below presents examples of research activities and development activities:

Intangible assets arising from the development phase are recognised only if the entity can demonstrate all of the following:

• the technical feasibility of the intangible asset being completed so that it is available for use or sale;
• the intention to complete the intangible asset and use or sell it,
• the ability to use or sell the intangible asset,
• how the intangible asset will generate probable future economic benefits. 
  Among other things, the entity may demonstrate the existence of a market for the output of the intangible asset or for the intangible asset itself, or its usefulness if it is to be used internally,
• the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset,
• the ability to reliably measure the cost attributable to an intangible asset during development.

To substantiate all the above criteria, the entity must have appropriate documentation. This may include: offers sent to potential clients, signed client contracts, purchase orders, evidence of participation in fairs, seminars, training or conferences, prepared promotional and educational materials, detailed time records of employees working exclusively on the project, signed contracts with external collaborators, the project budget, and similar evidence.

Management, administration and sales, as well as staff training costs for using software, cannot be capitalised. These are expenses that arise in the ordinary course of business regardless of whether the entity invests in the development of certain intangible assets, and they are difficult to link directly to such investment.

The cost of internally generated intangible assets is the aggregate of expenditures incurred from the date when the asset first meets the recognition criteria.

Certain types of internally generated intangible assets must not be recognised as intangible assets (e.g. brands, trademarks, customer lists, etc.) because the related expenditures cannot be distinguished from the overall costs of running the business.

If the research phase cannot be distinguished from the development phase of an internal project to create an intangible asset, the entity shall treat expenditures on that project as if they were incurred in the research phase only, i.e. recognise them immediately as an expense in profit or loss.

Financial statements must present fairly and truthfully the entity’s financial position, performance, and ability to generate positive cash flows. In accordance with the Accounting Act (Art. 18, paragraph 12), the entity that has profit available for distribution to company members on the balance sheet date, in accordance with the provisions of the Companies Act, is obliged to first use such profit to enter into other profit reserves to cover unrecognized development costs in assets.

These reserves may be released depending on the amount of unamortised development costs presented in the balance sheet. In other words, the amount of reserves in equity must equal the amount of intangible assets relating to development costs.

From the above, it follows that profit generated through the capitalisation of development costs cannot be distributed until the value of the related asset has been amortised. The main reason is to prevent the misuse of cost capitalisation, i.e. the recognition of intangible assets for the purpose of inflating profit in the income statement which would then be distributed to the owners.