Expenditure on research must always be written off in the period in which it is incurred.
Development costs are also usually written off. However, if the criteria laid down by IAS 38 are satisfied, development expenditure can be capitalised as an intangible asset. If it has a finite useful life, it should then be amortised over that life.
2.1 Introduction to R & D
Large companies may spend significant amounts of money on research and development (R & D) activities. Obviously, any amounts so expended must be credited to cash and debited to an account for research and development expenditure. The accounting problem is how to treat the debit balance on R & D account at the reporting date.
There are two possibilities.
(a) The debit balance may be classified as an expenseand transferred to the income statement. This is referred to as 'writing off' the expenditure. The argument here is that it is an expense just like rent or wages and its accounting treatment should be the same.
(b) The debit balance may be classified as an assetand included in the statement of financial position. This is referred to as 'capitalising' or 'carrying forward' or 'deferring' the expenditure. This
argument is based on the accrual assumption. If R & D activity eventually leads to new or improved products which generate revenue, the costs should be carried forward to be matched against that revenue in future accounting periods.
So the main question surrounding research and development (R & D) costs is whether they should be treated as an expense or capitalised as an asset. This question is dealt with in IAS 38 Intangible assets.
2.2 Definitions
The following definitions are given by the standard.
x An intangible asset is an identifiable non-monetary asset without physical substance . The asset
must be:
– controlled by the entity as a result of events in the past; and
– something from which the entity expects future economic benefits to flow
x Researchis original and planned investigation undertaken with the prospect of gaining new
scientific or technical knowledge and understanding.
x Developmentis the application of research findings or other knowledge to a plan or design for the
production of new or substantially improved materials, devices, products, processes, systems or services prior to the commencement of commercial production or use.
x Amortisation is the systematic allocation of the depreciable amount of an intangible asset over its
useful life. Amortisation period and amortisation method should be reviewed at each financial year end.
x Depreciable amountis the cost of an asset, or other amount substituted for cost, less its residual
value.
x Useful lifeis:
(a) the period over which an asset is expected to be available for use by an entity; or (b) the number of production or similar units expected to be obtained from the asset by an
entity. IAS 38 (revised) Although these definitions are usually well-understood, in practice it may not be so easy to identify the activities encompassed by R & D and the dividing line between the categories may be indistinct. Identification often depends on the type of business involved, the projects it undertakes and how it is organised.
Key terms
The standard gives examples of activities which might be included in either research or development, or which are neither but may be closely associated with both.
x Research
– Activities aimed at obtaining new knowledge
– The search for applications of research findings or other knowledge – The search for product or process alternatives
– The formulation and design of possible new or improved product or process alternatives
x Development
– The design, construction and testing of pre-production prototypes and models – The design of tools, jigs, moulds and dies involving new technology
– The design, construction and operation of a pilot plant that is not of a scale economically feasible for commercial production
– The design construction and testing of a chosen alternative for new/improved materials
2.3 Components of research and development costs
Research and development costs will include all costs that are directly attributable to research and development activities, or that can be allocated on a reasonable basis.
The standard lists the costs which may be included in R & D, where applicable (note that selling costs are excluded).
x Salaries, wages and other employment related costs of personnel engaged in R & D activities x Costs of materials and services consumed in R & D activities
x Depreciationof property, plant and equipment to the extent that these assets are used for
R & D activities
x Overhead costs, other than general administrative costs, related to R & D activities; these cost are
allocated on bases similar to those used in allocating overhead costs to inventories (see IAS 2
Inventories)
x Other costs, such as the amortisation of patents and licences, to the extent that these assets are
used for R & D activities
2.4 Recognition of R & D costs
The relationship between the R & D costs and the economic benefit expected to derive from then will determine the allocation of those costs to different periods. Recognition of the costs as an asset will only occur where it is probable that the cost will produce future economic benefits for the entity and where the costs can be measured reliably.
(a) In the case of research costs, this will not be the case due to uncertainty about the resulting benefit from them; and so they should be expensed in the period in which they arose.
(b) Development activities tend to be much further advanced than the research stage and so it may be possible to determine the likelihood of future economic benefit. Where this can be determined, the development costs should be carried forward as an asset.
2.4.1 Research costs
Research costs should be recognised as an expense in the period in which they are incurred. They should not be recognised as an asset in a later period.
2.4.2 Development costs
Alternative treatments are given for development costs, the use of which depends on the situation. Most of the time, development costs will be recognised as an expense in the period in which they are incurred
Development expenditure should be recognised as an asset only when the business can demonstrate all
of the following. Where the criteria are met, development expenditure mustbe capitalised.
x The technical feasibility of completing the intangible asset so that it will be available for use or sale x Its intention to complete the intangible asset and use or sell it
x Its ability to use or sell the intangible asset
x How the intangible asset will generate probable future economic benefits. Among other things, the
entity should demonstrate the existence of a market for the output of the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset
x The availability of adequate technical, financial and other resources to complete the development
and to use or sell the intangible asset
x Its ability to measure reliably the expenditure attributable to the intangible asset during its
development
There is also an important point about the carrying amount of the asset and recoverability. The
development costs of a project recognised as an asset should not exceed the amount that it is probable will be recovered from related future economic benefits, after deducting further development costs, related production costs, and selling and administrative costs directly incurred in marketing the product.
2.5 Amortisation of development costs
Once capitalised as an asset, development costs must be amortisedand recognised as an expense to match the costs with the related revenue or cost savings. This must be done on a systematic basis, so as to reflect the pattern in which the related economic benefits are recognised.
It is unlikely to be possible to match exactly the economic benefits obtained with the costs which are held as an asset simply because of the nature of development activities. The entity should consider either: (a) The revenue or other benefits from the sale/use of the product/process
(b) The period of time over which the product/process is expected to be sold/used If the pattern cannot be determined reliably, the straight-line method should be used. The amortisation will begin when the asset is available for use.
If the intangible asset is considered to have an indefinite useful life, it should not be amortised but should be subjected to an annual impairment review.
2.6 Impairment of development costs
As with all assets, impairment (fall in value of an asset) is a possibility, but perhaps even more so in cases such as this. The development costs should be written down to the extent that the unamortised balance (taken together with further development costs, related production costs, and selling and administrative costs directly incurred in marketing the product) is no longer probable of being recovered from the expected future economic benefit.
2.7 Disclosure
The standard has fairly extensive disclosure requirements for intangible assets. The financial statements should disclose the accounting policies for intangible assets that have been adopted.
Foreach class of intangible assets (including development costs), disclosure is required of the following.
x The method of amortisation used
x The useful life of the assets or the amortisation rate used
x The gross carrying amount, the accumulated amortisation and the accumulated impairment losses as at the beginning and the end of the period
x A reconciliation of the carrying amount as at the beginning and at the end of the period (additions,
retirements/disposals, revaluations, impairment losses, impairment losses reversed, amortisation charge for the period, net exchange differences, other movements)
x The carrying amount of internally-generated intangible assets