Research and development (2024)

WHY SPEND MONEY ON R&D?

Many businesses in the commercial worldspend vast amounts of money, on an annualbasis, on the research and development ofproducts and services. These entities do thiswith the intention of developing a product orservice that will, in future periods, providesignificant amounts of income for years to come.

THE ACCOUNTING PREDICAMENT

If, in the future, economic benefit is expected toflow to the entity as a result of incurring R&Dcosts, then it can be argued that these costsshould be treated as an asset rather than anexpense, as they meet the definition of an assetprescribed by both the Statement of Principlesand the IASB Framework for the Preparationand Presentation of Financial Statements.

Equally, the argument exists that it may be impossible to predict whether or not a projectwill give rise to future income. As a result, boththe UK and International Accounting Standardsprovide accountants with more information inorder to clarify the situation.

INTANGIBLE ASSETS

Intangible assets are business assets that haveno physical form. Unlike a tangible asset,such as a computer, you can’t see or touch anintangible asset.

There are two types of intangible assets:those that are purchased and those thatare internally generated. The accountingtreatment of purchased intangibles is relativelystraightforward in that the purchase price iscapitalised in the same way as for a tangibleasset. Accounting for internally-generatedassets, however, requires more thought.

R&D costs fall into the category ofinternally-generated intangible assets,and are therefore subject to specificrecognition criteria under both the UK andinternational standards.

R&D – DEFINITIONS

Research is original and planned investigation,undertaken with the prospect of gainingnew scientific or technical knowledge andunderstanding. An example of researchcould be a company in the pharmaceuticalsindustry undertaking activities or tests aimedat obtaining new knowledge to develop anew vaccine. The company is researching theunknown, and therefore, at this early stage,no future economic benefit can be expected toflow to the entity.

Development is the application of researchfindings or other knowledge to a plan or designfor the production of new or substantiallyimproved materials, devices, products,processes, systems, or services, before thestart of commercial production or use. Anexample of development is a car manufacturerundertaking the design, construction, andtesting of a pre-production model.

UK TREATMENT OF R&D

So far we have established that expenditureon R&D can fall into the category of intangibleassets. Under UK accounting standards,intangible assets are accounted for using therules from FRS 10, Goodwill and Intangibles.

Even though R&D can be an intangibleasset in the UK, accounting for R&D isgoverned by its own accounting standard– SSAP 13, Accounting for Research andDevelopment.

Recognition

Research
SSAP 13 states that expenditure on researchdoes not directly lead to future economicbenefits, and capitalising such costs does notcomply with the accruals concept. Therefore,the accounting treatment for all researchexpenditure is to write it off to the profit andloss account as incurred.

Development
As a basic rule, expenditure on developmentcosts should be written off to the profit and lossaccount as incurred, as with the expenditureon research. However, under SSAP 13, there isan option to defer the development expenditureand carry it forward as an intangible asset ifthe following criteria are met:

• there is a clearly defined project
• expenditure is separately identifiable
• the project is commercially viable
• the project is technically feasible
• project income is expected to outweigh cost
• resources are available to completethe project.

If these criteria are met, the entity may chooseto either capitalise the costs, bringing them‘on balance sheet’, or maintain the policyto write the costs off to the profit and lossaccount. Note that if an accounting policy ofcapitalisation is adopted it should be appliedconsistently to all development projects thatmeet that criteria.

Treatment of capitalised development costsSSAP 13 requires that where developmentcosts are recognised as an asset, they shouldbe amortised over the periods expected tobenefit from them. Amortisation should beginonly once commercial production has startedor when the developed product or servicecomes into use.

Every capitalised project should bereviewed at the end of every accountingperiod to ensure that the recognition criteriaare still met. Where the conditions no longerexist or are doubtful, the capitalised costsshould be written off to the profit and lossaccount immediately.

Problems with SSAP 13SSAP 13 is not in line with the newerInternational Accounting Standard coveringthis area. As seen previously, the UK allowsa choice over capitalisation; this can lead toinconsistencies between companies and, assome of the criteria are subjective, this ‘choice’can be manipulated by companies wishing tocapitalise development costs.

INTERNATIONAL TREATMENT OF R&D

One notable difference between the UK and international treatment is that the UK has aseparate standard for the treatment of R&D(SSAP 13), whereas under InternationalAccounting Standards the accounting for R&Dis dealt with under IAS 38, Intangible Assets.

Recognition
IAS 38 states that an intangible asset is to berecognised if, and only if, the following criteriaare met:

• it is probable that future economic benefitsfrom the asset will flow to the entity
• the cost of the asset can be reliablymeasured.

The above recognition criteria lookstraightforward enough, but in reality it canprove to be very difficult to assess whetheror not these have been met. In order tomake the recognition of internally-generatedintangibles more clear-cut, IAS 38 separatesan R&D project into a research phase and adevelopment phase.

Research phase
It is impossible to demonstrate whether ornot a product or service at the research stagewill generate any probable future economicbenefit. As a result, IAS 38 states that allexpenditure incurred at the research stageshould be written off to the income statementas an expense when incurred, and will neverbe capitalised as an intangible asset.

Development phase
Under IAS 38, an intangible asset arising fromdevelopment must be capitalised if an entitycan demonstrate all of the following criteria:

• the technical feasibility of completing theintangible asset (so that it will be availablefor use or sale)
• intention to complete and use or sellthe asset
• ability to use or sell the asset
• existence of a market or, if to be usedinternally, the usefulness of the asset
• availability of adequate technical,financial, and other resources to completethe asset
• the cost of the asset can be measuredreliably.

If any of the recognition criteria are not metthen the expenditure must be charged tothe income statement as incurred. Note thatif the recognition criteria have been met,capitalisation must take place.

Treatment of capitalised development costs
Once development costs have beencapitalised, the asset should be amortised inaccordance with the accruals concept overits finite life. Amortisation must only beginwhen commercial production has commenced(hence matching the income and expenditureto the period in which it relates).

Each development project must bereviewed at the end of each accounting periodto ensure that the recognition criteria are stillmet. If the criteria are no longer met, then thepreviously capitalised costs must be written offto the income statement immediately.

EXAMPLE
A company incurs research costs, duringone year, amounting to $125,000, anddevelopment costs of $490,000. Theaccountant informs you that the recognitioncriteria (as prescribed by both SSAP 13 and IAS 38) have been met. What effect willthe above transactions have on the financialstatements when following either the UK orInternational Accounting Standards? (See'Related links' for the solution.)

Bobbie Retallack is a lecturer at KaplanFinancial in Birmingham, UK