IAS 38

IAS 38, Intangible Assets, is the International Financial Reporting Standard that governs how companies account for assets without physical substance, such as software, patents, licenses and customer lists. For technology, its most important role is setting the rules for when the cost of developing software can be recorded as an asset. Companies that report under IFRS, which includes most listed companies outside the United States, apply IAS 38 rather than US GAAP standards such as ASC 350-40 and ASC 985-20.

Under IAS 38, development of an intangible asset is divided into a research phase and a development phase. Research costs are always expensed. Development costs must be capitalized once the company can demonstrate six specific criteria. For IT financial management, IAS 38 determines how much software development spending appears as an asset for IFRS reporters, which affects profit, assets and comparisons with US companies.

Definition of IAS 38

IAS 38 is an international accounting standard, issued by the International Accounting Standards Board, that prescribes the accounting treatment for intangible assets not covered by other standards. An intangible asset is an identifiable non-monetary asset without physical substance that the entity controls and from which future economic benefits are expected.

Software can be an intangible asset under IAS 38, whether acquired or internally developed. Software that is an integral part of hardware, such as an operating system embedded in a machine, is accounted for as part of that hardware instead.

Research and Development Phases

The research phase covers activities aimed at obtaining new knowledge, evaluating alternatives and exploring options. All costs in this phase are expensed as incurred, because the organization cannot yet demonstrate that an asset will result.

The development phase covers applying knowledge to a plan or design for producing a new or substantially improved product or system. Development costs are capitalized when, and only when, all six recognition criteria are met. If the research and development phases cannot be distinguished, all costs are treated as research and expensed.

Unlike US GAAP, which sets separate rules for internal-use software and software to be sold, IAS 38 applies the same research and development framework to both.

The Six Criteria

An entity must capitalize development costs when it can demonstrate all of the following: the technical feasibility of completing the asset; its intention to complete the asset and use or sell it; its ability to use or sell the asset; how the asset will generate probable future economic benefits; the availability of adequate technical, financial and other resources to complete it; and its ability to measure reliably the expenditure attributable to the asset during development.

Capitalization is required, not optional, once the criteria are met. Costs incurred before the criteria are met cannot be capitalized retrospectively.

Capitalized software is amortized over its useful life, typically on a straight-line basis, and reviewed for impairment when there are indications of loss of value.

Importance of IAS 38 in IT Financial Management

For organizations reporting under IFRS, IAS 38 determines how software development costs are reported, which affects profit, assets and key measures such as EBITDA.

It also creates differences with US GAAP that matter for multinational groups and comparisons between companies.

Because capitalization is required once the criteria are met, IFRS reporters cannot simply choose to expense development costs for simplicity.

Software Development and SaaS

Internal software development, such as a new customer platform, is capitalized under IAS 38 once the six criteria are met. In practice, organizations need to show that the project is technically feasible, funded and expected to deliver benefits.

For cloud computing arrangements such as SaaS, the IFRS Interpretations Committee concluded in 2021 that a customer usually does not control the software, so configuration and customization costs generally do not create an intangible asset and are expensed, either when incurred or over the contract term in some cases. This differs from US GAAP, where ASU 2018-15 allows qualifying implementation costs to be capitalized.

These differences can lead a SaaS implementation to be reported very differently by IFRS and US GAAP reporters, even when the underlying project is the same.

Differences From US GAAP

Under US GAAP, internal-use software follows ASC 350-40, and software to be sold follows ASC 985-20, each with its own threshold for capitalization. IAS 38 applies one framework to both, based on the six criteria.

Multinational groups that report under US GAAP but have subsidiaries reporting locally under IFRS, or the reverse, may need to track development costs under both frameworks. IT finance teams should understand which framework applies to each entity.

Comparisons of R&D spending and margins between US and international companies can be distorted by these differences, which investors and analysts often adjust for.