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- 6 Marks
Question
Zunka Ltd (Zunka) is a private pharmaceutical company in Ghana, which imports medical equipment manufactured under a patent. Zunka subsequently adapts the equipment to fit the market in Ghana and sells the equipment under its own brand name. Zunka originally spent GH¢6 million in developing the know-how required to adapt the equipment, and, in addition, it costs GH¢100,000 to adapt each piece of equipment. Zunka has capitalised the cost of the know-how and the cost of adapting each piece of equipment sold as patent rights.
Zunka is being sued for patent infringement by Sajida Ltd (Sajida), the owner of the original patent, on the grounds that Zunka has not materially changed the original product by its subsequent adaptation. If Sajida can prove infringement, the court is likely to order Zunka to pay damages and stop infringing its patent. Zunka’s lawyers are of the view that the court could conclude that Sajida’s patent claim is not valid.
Sajida has sued Zunka for GH¢10 million for using a specific patent and a further GH¢16 million for lost profit due to Zunka being a competitor in the market for this product. Zunka has offered GH¢14 million to settle both claims but has not received a response from Sajida.
As a result, the directors of Zunka estimate that the damages it faces will be between the amount offered by Zunka and the amount claimed by Sajida. The directors of Zunka would like advice as to whether they have correctly accounted for the costs of the adaptation of the equipment and whether they should make a provision for the potential damages in the above legal case in the financial statements for the year ended 31 March 2021.
Required:
Advise the directors of Zunka on how the above transaction should be accounted for in its financial statements for the year ended 31 March 2021 in accordance with relevant International Financial Reporting Standards (IFRS).
Answer
In accordance with IAS 38: Intangible Assets, the three features to intangible assets are:
- Identifiability: The asset must be separable or arise from contractual or other legal rights.
- Control: The entity controls the future economic benefits of the asset.
- Future Economic Benefits: The asset will generate probable future economic benefits.
In addition, the cost of the intangible asset should be capable of reliable measurement. Development costs are capitalised only after the technical and commercial feasibility of the asset have been established. The entity must intend and be able to complete the intangible asset, and either use it or sell it, and be able to demonstrate how the asset will generate future economic benefits.
It appears in principle that the above criteria may have been satisfied in the case of the costs of adapting the medical equipment imported by Zunka Ltd. However, only the costs incurred in developing the initial know-how of GH¢6 million may be capitalised, as these are the costs of establishing the technical and commercial feasibility of the equipment.
The costs of adapting each piece of equipment of GH¢100,000 are simply production costs to be included in cost of sales, and if the equipment is not sold, they should be included in the inventory valuation of the equipment.
Provisions under IAS 37:
IAS 37: Provisions, Contingent Liabilities, and Contingent Assets requires that a provision be recognised if the following conditions are met:
- There is a present obligation (legal or constructive) due to a past event.
- It is probable that an outflow of economic resources will be required to settle the obligation.
- The amount of the obligation can be estimated reliably.
An outflow of economic resources is deemed probable when the outflow of resources is more likely than not to occur. For an estimate of the amount of the obligation to be reliable, it is sufficient if a range of probable outcomes can be determined.
The amount recognised as a provision should be the best estimate of the expenditure that an entity would rationally pay to settle. Zunka Ltd’s lawyers feel that the court could conclude that the patent claim is not valid. However, Zunka Ltd has offered GH¢14 million to settle both claims without going to court. Therefore, this implies that Zunka Ltd believes that it is more likely than not that a present obligation exists, resulting from a past event.
The amount of the provision may not correspond to the amount which has been offered to Sajida Ltd, as there is no certainty that Sajida Ltd will accept the offer. Therefore, as it is difficult to determine the amount of the provision within a range of probable outcomes, IAS 37 states that where a continuous range of possible outcomes exists, and each point in that range is as likely as any other, the mid-point of the range should be used.
Thus, Zunka Ltd should recognise a provision of GH¢10 million in its financial statements at 31 March 2021 and disclose the uncertainties relating to the amount or timing of these cash outflows.
- Tags: Capitalization, Contingent Liabilities, IAS 37, IAS 38, Intangible Assets, Legal Cases, Patent Infringement, Provisions
- Level: Level 3
- Topic: IAS 38: Intangible assets
- Series: NOV 2021
- Uploader: Theophilus