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

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Introduction

Intangible assets under development refer to projects or assets in progress that lack a physical form but are expected to generate future economic benefits. These typically include software, research and development (R&D) projects, patents, and trademarks in progress. They are classified as “Intangible Assets Under Development” until they reach a stage where they are ready for use or commercialization. Auditing intangible assets under development is crucial because it ensures the correct valuation, classification, and compliance with relevant standards and legal requirements, protecting the accuracy of the company’s financial statements.

Legal Framework

1. Companies Act, 2013:
   • Section 128: Mandates companies to maintain proper books of account, including records of intangible assets under development.
   • Section 129: Requires companies to prepare financial statements in line with prescribed accounting standards, ensuring accurate classification and reporting.
   • Schedule III: Specifies the format of the balance sheet, which includes a section for intangible assets under development under non-current assets. This requires specific disclosure on the nature of these assets, their development costs, and anticipated timelines.
   • Section 134: Obligates the Board of Directors to approve financial statements with full disclosure regarding intangible assets under development.
2. Indian Accounting Standards (Ind AS):
   • Ind AS 38 – Intangible Assets: Governs the recognition, measurement, and disclosure requirements for intangible assets, including those under development.
     • Recognition: Costs should only be recognized as an intangible asset if it is likely to generate future economic benefits, there is technical feasibility, and the company has the intention and ability to complete the asset.
     • Measurement: Only directly attributable costs, such as labor, materials, and technology, are capitalized. Other expenses, like administrative or training costs, must be expensed.
     • Impairment: Ind AS 36 – Impairment of Assets requires that intangible assets under development be tested for impairment if there is an indication that they may not realize the intended benefits.
3. Accounting Standards (AS):
   • AS 26 – Intangible Assets: For companies not covered under Ind AS, AS 26 guides the treatment of intangible assets under development.
   • AS 10 – Fixed Assets: Provides general guidance on the capitalization of development costs if the assets meet the definition and recognition criteria for intangible assets.
4. Income Tax Act, 1961:
   • Section 35: Allows certain deductions for R&D expenses, including capital expenditure, if the project qualifies as scientific research.
   • Section 32: Permits depreciation on intangible assets, although only after they are capitalized, not while they are under development.
5. ICAI Guidance Notes:
   • The Institute of Chartered Accountants of India (ICAI) issues guidance on auditing intangible assets under development, emphasizing accurate measurement, capitalization, and disclosure of costs.

Detailed Audit Procedures

1. Understanding the Nature of Intangible Assets Under Development
   • Identify and document the nature and purpose of each intangible asset under development.
   • Review management’s rationale for each project, its intended economic benefit, and the stage of completion.
2. Verification of Recognition and Measurement
   • Ensure that only capitalizable expenses (direct costs) are recorded under intangible assets under development.
   • Review invoices, contracts, and project documentation to substantiate the nature and accuracy of recorded costs.
   • Confirm that general administrative or training costs are expensed, not capitalized.
3. Review of Project Viability and Feasibility
   • Evaluate whether the project is technically feasible, and there is an intention to complete it. Verify management’s plans and budgets to ensure realistic future economic benefits.
   • Review supporting documentation, such as feasibility studies or development schedules.
4. Examination of Capitalized Costs
   • Verify that only costs directly attributable to the asset’s development phase are capitalized, such as labor, materials, and specific technology.
   • Ensure expenses are systematically recorded and classified, excluding any incidental or indirect costs.
5. Review of Capitalization and Transfers
   • Verify the capitalization of intangible assets once they are completed and ready for use or commercialization.
   • Ensure that once transferred to the intangible assets category, depreciation or amortization begins.
6. Impairment Testing
   • Assess impairment indicators for intangible assets under development, such as project delays, market changes, or budget over-runs.
   • Ensure compliance with Ind AS 36, conducting impairment tests when necessary and recording any losses accurately.
7. Physical Verification and Progress Assessment
   • Conduct regular assessments to ensure the projects are progressing as planned and verify with management that no costs are prematurely capitalized.
   • Evaluate any deviations in cost estimates, timeline, or project scope.
8. Review of Management Estimates and Assumptions
   • Evaluate the assumptions used in estimating future economic benefits, reviewing any projections or valuations of completed intangible assets.
   • Ensure assumptions are reasonable and documented, aligning with industry standards.
9. Disclosure and Compliance
   • Confirm disclosures related to intangible assets under development, ensuring they comply with Schedule III and relevant accounting standards.
   • Verify information provided in the financial statements, including project descriptions, development costs, and completion timelines.

Practical Examples

1. Scenario 1: Capitalization of Non-Eligible Costs
   • Scenario: A software company capitalizes general administrative expenses under intangible assets under development.
   • Audit Approach: Review invoices and expense records to ensure only eligible costs are capitalized.
   • Practical Insight: Reclassify non-capitalizable expenses to operating costs, maintaining the accuracy of intangible assets.
2. Scenario 2: Project Delays and Impairment Indicators
   • Scenario: A pharmaceutical company faces delays in R&D due to regulatory issues.
   • Audit Approach: Assess whether project delays indicate impairment, and perform impairment testing if necessary.
   • Practical Insight: Recognize impairment losses if the project’s expected benefits are reduced due to delays, ensuring fair representation.
3. Scenario 3: Unused Patent Development Project
   • Scenario: A company has spent heavily on patent development, but the patent is unlikely to generate anticipated returns.
   • Audit Approach: Test for impairment based on revised future cash flows and anticipated returns.
   • Practical Insight: If the patent is unlikely to realize expected benefits, recognize an impairment loss.
4. Scenario 4: Feasibility and Economic Viability Check
   • Scenario: A company capitalizes costs for an AI project without sufficient proof of feasibility.
   • Audit Approach: Request feasibility studies and verify technical and commercial viability.
   • Practical Insight: Ensure only technically feasible projects are capitalized, excluding speculative projects.
5. Scenario 5: Incorrect Transfer to Intangible Assets
   • Scenario: Costs for a software project under development are transferred to intangible assets before completion.
   • Audit Approach: Verify project status, completion certificates, and milestones before transferring to intangible assets.
   • Practical Insight: Only capitalize completed projects to avoid premature amortization.
6. Scenario 6: Inadequate Documentation for Capitalized Costs
   • Scenario: The company lacks detailed records for certain costs capitalized under intangible assets under development.
   • Audit Approach: Ensure each cost is substantiated by invoices, time sheets, or contracts.
   • Practical Insight: Maintain proper documentation for all capitalized costs to support financial statement accuracy.
7. Scenario 7: External Consultant Fees Capitalization
   • Scenario: A company capitalizes consulting fees related to software development.
   • Audit Approach: Verify that the consulting services are directly related to asset development.
   • Practical Insight: Include consulting fees only if they are directly attributable to asset creation, excluding general consulting.
8. Scenario 8: Misclassification of Research and Development Costs
   • Scenario: A company capitalizes all R&D costs without differentiating between research (which should be expensed) and development.
   • Audit Approach: Review project documentation to separate research from development phases.
   • Practical Insight: Only capitalize development costs once feasibility is established, improving cost accuracy.
9. Scenario 9: Unexplained Increases in Project Budget
   • Scenario: Significant budget overages appear on an intangible asset project, with no explanation from management.
   • Audit Approach: Review budget reports, assess reasons for overages, and ensure they are aligned with project progress.
   • Practical Insight: Large deviations may require impairment testing or reclassification if not attributable to project scope.
10. Scenario 10: Failure to Recognize Project Abandonment
    • Scenario: A company continues to capitalize costs for a project that has been suspended.
    • Audit Approach: Confirm project status with management, ensuring costs for abandoned projects are expensed.
    • Practical Insight: Only capitalize costs if the project is active; otherwise, recognize expenses.

Conclusion

Auditing intangible assets under development requires a thorough understanding of the nature and purpose of each project, proper classification and capitalization of costs, and compliance with Indian accounting and legal standards. Auditors must ensure that projects classified as intangible assets under development are truly expected to provide future economic benefits and that costs are appropriately capitalized only during the development phase. Regular testing for impairment, careful evaluation of management’s assumptions, and thorough documentation are essential for ensuring that intangible assets are fairly represented on the balance sheet.

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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