Statutory Audit of Intangible Assets in Indian Companies [Company Law]

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Introduction

Intangible assets represent non-physical assets that have value due to the rights, privileges, and competitive advantages they provide to a company. These assets include patents, trademarks, copyrights, goodwill, and software. Auditing intangible assets is critical because of their complex nature, the difficulty in valuation, and the potential for significant impact on a company’s financial statements.

Legal Framework:

The statutory audit of intangible assets in India is governed by various legal and regulatory frameworks that ensure the proper recognition, measurement, and disclosure of these assets:

1. Companies Act, 2013:
   • Section 128: Requires companies to maintain proper books of accounts, which should include detailed records of intangible assets.
   • Section 129: Financial statements must be prepared in accordance with the prescribed accounting standards, ensuring accurate representation of intangible assets.
   • Schedule III: Provides the format for the balance sheet and profit & loss account, specifying how intangible assets should be presented and disclosed.
   • Section 134: Mandates the Board of Directors to approve the financial statements, ensuring they include all necessary disclosures related to intangible assets.
2. Indian Accounting Standards (Ind AS):
   • Ind AS 38 – Intangible Assets: This standard prescribes the accounting treatment for intangible assets that are not specifically dealt with in another standard. Key aspects include:
     • Recognition: An intangible asset should be recognized only if it is probable that future economic benefits attributable to the asset will flow to the entity, and the cost of the asset can be measured reliably.
     • Measurement: Intangible assets should initially be measured at cost. Subsequent to initial recognition, they can be carried at cost less any accumulated amortization and impairment losses, or revalued amounts.
     • Amortization: Intangible assets with a finite useful life should be amortized over their useful life, while those with an indefinite useful life should not be amortized but tested annually for impairment.
     • Impairment: Ind AS 36 – Impairment of Assets provides guidelines for impairment testing of intangible assets. If there is any indication of impairment, the asset’s recoverable amount should be estimated, and any excess of the carrying amount over the recoverable amount should be recognized as an impairment loss.
     • Disclosure: Detailed disclosures regarding the nature, carrying amount, useful lives, and amortization methods of intangible assets should be made.
3. Accounting Standards (AS):
   • AS 26 – Intangible Assets: Similar to Ind AS 38, this standard is applicable to companies not covered under Ind AS. It provides guidelines for the recognition, measurement, amortization, and disclosure of intangible assets.
   • AS 28 – Impairment of Assets: Provides guidelines for impairment testing of intangible assets.
4. Income Tax Act, 1961:
   • Section 32: Governs the calculation and deduction of depreciation on intangible assets for tax purposes. It specifies that certain intangible assets, such as know-how, patents, copyrights, trademarks, licenses, franchises, or any other business or commercial rights of similar nature, are eligible for depreciation at the prescribed rates.
5. Institute of Chartered Accountants of India (ICAI) Guidance:
   • Guidance Note on Audit of Intangible Assets: Provides auditors with a comprehensive framework for auditing intangible assets, emphasizing the importance of understanding the entity’s business, assessing the internal controls over intangible assets, and ensuring proper valuation and disclosure in the financial statements.

Detailed Audit Procedures

1. Understanding the Business and Nature of Intangible Assets
   • Gain an understanding of the company’s business model and the role of intangible assets in generating revenue or providing competitive advantage.
   • Identify the major categories of intangible assets held by the company, such as patents, trademarks, goodwill, and software.
2. Review of Internal Controls
   • Evaluate the company’s internal controls over the acquisition, development, maintenance, and disposal of intangible assets.
   • Assess whether the controls are designed effectively to prevent and detect errors or fraud related to intangible assets.
3. Verification of Recognition and Measurement
   • Review the company’s policy for recognizing intangible assets and ensure it complies with Ind AS 38 or AS 26.
   • Verify that intangible assets are recognized only when it is probable that future economic benefits attributable to the asset will flow to the company and the cost can be measured reliably.
   • Examine supporting documentation for intangible assets to verify the accuracy of initial measurement at cost.
4. Amortization and Useful Life Testing
   • Review the company’s amortization policy for intangible assets with finite useful lives and ensure it complies with Ind AS 38 or AS 26.
   • Recalculate amortization for a sample of intangible assets to ensure accuracy.
   • Verify that the useful lives of intangible assets are consistent with the company’s accounting policy and industry practices.
5. Impairment Testing
   • Assess whether there are any indicators of impairment for intangible assets, such as changes in market conditions, technology, or business operations.
   • If impairment indicators exist, review the impairment testing conducted by management and ensure it complies with Ind AS 36 or AS 28.
   • Verify that any impairment losses are recognized and properly disclosed.
6. Revaluation of Intangible Assets
   • If the company follows the revaluation model, ensure that the revaluations are carried out by qualified and independent valuers.
   • Verify that revaluation gains or losses are properly accounted for in accordance with Ind AS 38 or AS 26.
7. Review of Disposals
   • Verify that disposals of intangible assets are recorded correctly and that any gains or losses on disposal are accounted for appropriately.
   • Ensure that assets no longer in use or whose useful life has ended are removed from the intangible assets register.
8. Examination of Internally Generated Intangible Assets
   • Review expenditure on research and development to ensure that costs related to research are expensed and those related to development are capitalized if the criteria for recognition are met.
   • Verify that internally generated intangible assets are capitalized only if it is probable that the project will be completed and will generate future economic benefits.
9. Verification of Software Licenses
   • Review the company’s software licenses to determine whether they are classified as intangible assets or expensed as per the applicable accounting standards.
   • Ensure that software licenses with significant value and long-term use are capitalized as intangible assets.
10. Disclosure and Presentation
    • Ensure that the disclosures related to intangible assets in the financial statements are complete and comply with the requirements of Schedule III of the Companies Act, 2013.
    • Verify that the financial statements provide a true and fair view of the company’s intangible assets, including information on capital commitments, revaluation, and impairment.

Practical Examples

1. Scenario 1: Incorrect Capitalization of Research Costs
   • Scenario: A company capitalized research costs related to a new product development project.
   • Audit Approach: Review the nature of the costs capitalized, distinguish between research and development phases, and ensure only development costs meeting recognition criteria are capitalized.
   • Practical Insight: Adjust the financial statements to expense research costs, ensuring only qualifying development costs are capitalized.
2. Scenario 2: Impairment of Goodwill
   • Scenario: The company’s goodwill from a past acquisition is impaired due to a decline in market share.
   • Audit Approach: Evaluate the impairment testing performed by management, review assumptions, and ensure compliance with Ind AS 36.
   • Practical Insight: Confirm that any impairment loss is recognized, and the carrying amount of goodwill is adjusted accordingly.
3. Scenario 3: Revaluation of a Trademark
   • Scenario: The company revalued its trademark and recorded a significant upward revaluation.
   • Audit Approach: Review the valuation report by an independent valuer, assess the reasonableness of the assumptions used, and ensure proper accounting of the revaluation surplus.
   • Practical Insight: Verify that the revaluation surplus is correctly reflected in the other comprehensive income and not in the profit and loss account.
4. Scenario 4: Non-compliance with Amortization Rates
   • Scenario: The company used an amortization rate lower than what is reasonable for its intangible assets.
   • Audit Approach: Review the amortization policy, compare the rates with industry practices, and ensure compliance or justification for using different rates.
   • Practical Insight: Adjust the amortization charge if the rates used are not justified, ensuring the financial statements reflect true and fair value.
5. Scenario 5: Software License Misclassification
   • Scenario: The company expensed a significant software license that had a useful life of more than one year.
   • Audit Approach: Examine the software license agreement, determine its useful life, and ensure that it is capitalized as an intangible asset.
   • Practical Insight: Reclassify the software license as an intangible asset and amortize it over its useful life.
6. Scenario 6: Misstatement of Internally Generated Software
   • Scenario: The company capitalized internally generated software without assessing its future economic benefits.
   • Audit Approach: Review the project documentation, assess the software’s expected future economic benefits, and ensure compliance with recognition criteria.
   • Practical Insight: Reassess the capitalization and, if necessary, adjust the financial statements to reflect only the assets that meet the recognition criteria.
7. Scenario 7: Derecognition of Expired Patents
   • Scenario: The company failed to derecognize expired patents, leading to an overstatement of intangible assets.
   • Audit Approach: Review the patent register, ensure that expired patents are derecognized, and verify the financial impact of the derecognition.
   • Practical Insight: Ensure that expired or non-performing intangible assets are removed from the balance sheet to present a true and fair view.
8. Scenario 8: Amortization of Brand Name
   • Scenario: The company amortized a brand name with an indefinite useful life, contrary to accounting standards.
   • Audit Approach: Review the justification for classifying the brand name as having an indefinite useful life, and ensure that it is tested for impairment instead of being amortized.
   • Practical Insight: Reclassify the brand name as an asset with an indefinite useful life if justified and ensure appropriate impairment testing.
9. Scenario 9: Incorrect Useful Life for Customer Relationships
   • Scenario: The company assigned an arbitrary useful life to customer relationships without proper analysis.
   • Audit Approach: Review the analysis used to determine the useful life of customer relationships, assess the reasonableness of the assumptions, and ensure compliance with accounting standards.
   • Practical Insight: Adjust the useful life and amortization schedule if the initial assessment was incorrect, ensuring the carrying amount is accurate.
10. Scenario 10: Misclassification of License Fees
    • Scenario: The company classified recurring license fees as intangible assets instead of operating expenses.
    • Audit Approach: Review the nature of the license fees, distinguish between one-time payments and recurring expenses, and ensure proper classification.
    • Practical Insight: Reclassify recurring license fees as operating expenses to prevent overstatement of intangible assets.

Conclusion

The statutory audit of intangible assets is a complex process that requires auditors to thoroughly understand the legal framework, accounting standards, and specific characteristics of these assets. By following detailed audit procedures and considering practical scenarios, auditors can ensure the accuracy, completeness, and proper valuation of intangible assets, providing confidence in the financial statements.

Author

CA Sourabh Kothari (C.A., B.Com)
He is currently working as Partner – Risk and Transaction advisory with a renowned firm in Jaipur having experience in Internal Audit, IFC Audit, Business consultancy, Due Diligence and Management consultancy.
E-mail: Sourabh.kothari@jainshrimal.in | LinkedIn: Sourabh Kothari

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