– Financial Reporting
“The requirements of IAS 38 in respect of
Research and Development expenditure are theoretically dubious and practically
unnecessary. All such expenditure should be treated as an expense in the Income
Statement and its amount disclosed in notes to the accounts.”
of IAS 38 4
IAS 38 in modern times refers to “Accounting
for Intangible Assets”. “Research”
is original and planned investigation undertaken with the prospect of gaining
new scientific or technical knowledge and understanding. While, “Development” is 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 before the start of commercial production or use.
With the revolutionizing economy and
advancement in technology starting in late 1970s. The regulatory board of
Accounting in U.K felt a necessity to treat intangible assets in the financial
statements as a separate category. Giant companies in the sector of say
Bio-chemicals, pharmaceuticals, even major companies who were innovating new
products for its consumers and they were spending a material value of assets
from their books in the category of Research and Development (R&D). Problem
was to assess whether an internally generated intangible asset such as Research
and Development meets the criteria for recognition, an entity classifies the
generation of the asset into: a) Research Phase; and b) Development Phase. For
the Research Phase, the Accounting standards direct us to expense everything as
it is incurred in the current year’s profit and loss account. There have been
two broad ways to treat Development expenses, either by capitalizing them in
Non-Current Assets or expensing them in the profit and loss Accounts. Issue
arises when companies expense all the Research and Development Expenditures as
Expense in the yearly profit and loss account, which slashed their profits for
the year substantially resulting in a negative sentiment about the company for
a common person. On the other hand, some companies capitalized all the
expenditures as Non Current Assets as Intangible Asset while increasing Balance
Sheet (Net Assets) of the company. This resulted in a higher balance sheet and
positive sentiment for a common investor for a temporary period only. The problem
with capitalization occurs if the product fails the market expectations or the
management decides not to resume the Development phase of the specific product,
they had to expense it from the books while slashing profits along with a
material decrease in the book value giving a double-negative impact to their
books. Due to these problems relating to treatment of Research and Development,
Accounting Experts from all around the world have been working relentlessly and
making changes to the principles and treatments on how to deal with costs of
Research and Development to make a uniform method of treatment with a set of
rules and regulations to treat these expenses in the financial statements.
History of IAS 38
For this case, the evolving history
of IAS 38 specifically related to Research and Development is as follows:
1978 – Exposure Draft E9 was formulated for “Accounting for Research and
1978 – The draft E9 related to Research and Development was formally published for
the first time, which was made effective from 1st January 1980.
1991 – After usage of IAS 9 (formerly SSAP) for treatment of Research and
Development Activities, Accounting Board kept working to gather and find all
the problems occurring with current methods of treatment, and in result,
published another Exposure Draft E37 for “Research and Development Cost”.
1993 – After all due diligence related to this draft, International Accounting
Standards Board published a formal standard named IAS 9 (formerly SSAP)
“Research and Development Costs” which was made operational for audit purposes
for the period starting after 1st January 1995.
1998 – Accountants noticed a need that treating the Research and Development
Expenditures should be included in a wider category of “Intangible Assets” and
issued another Exposure Draft E59 dealing with wider range of intangible assets
including Research and Development.
2004 – IAS 38 “Intangible Assets” was published by the International Accounting
Standards Board which gave rules and regulation on how to treat various
Research and Development Expenditures which was followed in the period starting
after 31 March, 2004.
2008 – International Financial Reporting Standard achieved a breakthrough by
adding “Advertising and Promotion” in the Research and Development category
which was majorly argued by major companies who used to create marketing
campaigns over a number of years and were puzzled about how to treat them as it
was just expensed no matter what is the period of the promotional activity. For
example, major clothing and beverage brands had problems in how to treat this
expense. Besides this, another major aspect of this issue was addition of
Amortization methods for intangible assets, mainly Research and Development,
which had been capitalized, and needs to be expensed by some sort of criteria.
This paper was made effective for the periods after 1st January
2014 – The latest amendments were issued regarding the Acceptable Methods of
Depreciation and Amortization for Intangible Assets. This last paper clarified
all the ambiguities related to the treatment of how to amortize the Research
and Development expenditure if it has been classified as Non-Current Asset.
This paper is the last issued amendment in IAS 38 to date and was made
effective for the periods starting 1st January 2016. These rules of
treatment in accounting for financial statements are being used worldwide and
are in-line with current changes in the Financial Reporting.
Accounting for Research and
Development has always been in question among different industries, and
consideration of different aspects has been taken into account in the decision
of how to treat those expenses. Many Accounting experts have managed to write
their own analysis after their tests on how the subject companies treated their
Research and Development Expenditures along with the conditions they met for
treating those expenditures. Major excerpts from the some of the following
studies will widely explain the methodology to treat Research and Development
Expenditures according to principles of IAS 38.
Oswald’s paper examines the causes
and value relevance effects of the accounting method choice for development
expenditures for firms with research and development (R&D) programs in the
United Kingdom (UK). Under UK Generally Accepted Accounting Principles, certain
development expenditures may be either capitalized or expensed, with the choice
left to the discretion of management. Using the reported disclosures of firms in
UK, he assessed two questions related to the capitalizing vs. expensing decision:
(1) What factors distinguish
expensing firms from capitalizing firms? And
(2) Conditional on the choice to
expense or to capitalize, does the accounting treatment of development
expenditures affect the value relevance of these firms’ financial statement
information, as captured by the contemporaneous association between security
prices and earnings and book value of equity?
UK Generally Accepted Accounting Principles
authorizes, but does not require, the capitalization and subsequent amortization
of development expenditures if the five following conditions are met:
is a clearly defined project.
related expenditure is separately identifiable.
outcome of the project is examined for its technical feasibility and its
ultimate commercial viability considered in the light of factors such as likely
market conditions (including competing products), public opinion, and consumer
and environmental legislation.
aggregate of deferred development costs, any further development costs, and
related production, selling and administrative costs is reasonably expected to
exceed related future sales or other revenues.
Adequate resources exist, or are reasonably expected to be available, to enable
the project to be completed and to provide any consequential increases in
If conditions (1)–(5) are met, UK Generally
Accepted Accounting Principles does not require capitalization, which means
that firms “may” choose to expense these costs in the period incurred. Therefore,
his investigations assume a fact that UK firms which meets the conditions to
capitalize the development expenditures and still they choose not to.
Oswald, in his journal also
mentioned about Aboody and Lev’s (1998) examination of the determinants of US
firms’ choices of the amount of software development costs to expense or capitalize.
Using data from 163 software companies over 1987–1995, Aboody and Lev identify
variables that are significantly related with the amount of software
development costs, that have been capitalized and the major one is if “size and
profitability” are positively associated with the annual amount of capitalized
development cost. The findings of these studies generally support the claim
that intangible assets are value significant. These studies generally conclude
that capitalizing Research and Development expenditures increases the value
relevance of firm’s financial statements.
According to Elisabeth Dedman in her
journal named “Accounting, Intangible Assets, Stock Market Activity, and
Measurement and Disclosure Policy—Views From the U.K” she claimed that before
the amendments released in the standards in 2005, Research and Development
expenditures were generally expensed, with the option to capitalize and
subsequently amortize certain development expenditures, subject to them fulfilling
the applicable criteria. Research and development expense and any associated
capitalized assets were usually disclosed in the financial statements.
Advertising expenditures and expenditures on human capital development were
expensed, and their amount was “not” necessarily disclosed.
Hope and Gray (1982), in their
analysis of the evolution of Statement of Standard Accounting Practice chapter
13 “Accounting for Research and Development” produced by Accounting Standards
Committee (ASC) in 1978, suggest that there was little difference from
respondents to the initial exposure draft ED 14, Accounting for Research and
Development (ASC, 1975), which proposed
the expensing of all research and development expenditures which required
amendments to the standards as mentioned earlier in the history of IAS 38.
When ED 17, Accounting for Research
and Development (ASC, 1976), then
proposed the compulsory capitalization of all development expenditures
satisfying certain criteria, there was sufficient objection from respondents to
produce the eventual solution of optional capitalization of qualifying
development expenditures found in SSAP 13 (ASC, 1978) which was made
operational in starting 1st January, 1980.
The chief recommendation from this
paper regarding the note disclosure of any Material Research and Development
expenditure was that, when ‘releasing information publicly on a product which
is the subject of research and development, companies must ensure that it is just
and accurate, and without material omissions, which will provide a fair and unbiased
picture of the accounting treatment for relevant expenditures.
In general, required disclosures
with respect to R, and other intangibles, are insignificant, whether
under the old Accounting Standards Board regime or the new International Accounting
Standards regime. As a result, it is clear that the ability of the market to
value these activities originates from disclosures outside the financial
statements, as opposed to a systematic manipulation of accounting numbers,
prior accounting research proves the point that the treatment and disclosures
of Research and Development Expenditures will remain dubious and unclear.
It is widely believed that
expenditure on intangibles is an increasing source of firm value. However, it
is not possible to verify this perception because under Generally Accepted
Accounting Principles (GAAP), the resources expensed on intangibles are recorded
separately in the financial statements in only a limited way. 3 available
evidence on the role of intangibles in generating output comes from noisy or
incomplete measures including: (1) The gap between the market value of equity
and the book value of R, (2) Incomplete GAAP measures of intangible
assets, and (3) Surveys undertaken for the national accounts.
According to Hunter, the research
and development expenditure, only the development expenditure that meets the
intangible asset definition and recognition rules plus the six tests in AASB
are recognizable as intangible assets. In particular, there are only three
broad ways the expenditure on intangibles is disclosed separately: purchased
and business combination intangible assets, development intangible assets and
R expenses. All other expenditure on intangibles is included in costs of
sales or operating expenses. Included in R are labor costs, discovery and
problem solving R, external consultants, materials and plant,
pre-production and computing, and travel.
After all the observations and
relevant studies, I gathered some evidence to prove my understanding of the
Research and Development phases, and how to treat their expenses. According to
analysis, no intangible asset will arise from the research phase of the
project. Expenditure on research or on the research phase of the project shall
be recognized as an expense when it is incurred. For the Development phase, I
came up with a list of conditions to be met from various studies if the firm
intends to capitalize the expense as an intangible asset. The conditions are as
of the technical feasibility
to complete and use or sell it
to use or sell
generate probable future economic benefits
availability of adequate technical, financial and other resources to complete.
to measure reliably the expenditure attributable.
If the above-mentioned conditions
are met, the firm can recognize this expense as a capital expenditure. But even
if the criteria for capitalization is met – internally generated brands,
publishing titles, customer lists, and items similar in substance shall not be
recognized as intangible assets.
Once the criteria are met for
capitalization of Development phase, the firm can capitalize the asset as an
intangible asset in Non-Current Asset category. After capitalization, the firm
needs to assess the future economic benefits to be received from the asset
using the IAS 36 Impairment of Assets principles. But, the choice of
capitalization even after meeting the criteria relies on the specific firm’s
management undertaking the project. The disclosure of all material information
related to the Research and Development should provide a clear picture to the
stakeholder. If the firm in relation to their Research and Development expenses
is following these relevant procedures, firms will be able to treat those
expenses in a manner as prescribed in the International Financial Reporting
Oswald, Dennis R. “The Determinants
and Value Relevance of the Choice of Accounting for Research and Development
Expenditures in the United Kingdom.” Journal of Business
Finance &Amp; Accounting, Blackwell Publishing Ltd, 20 Dec. 2007.
IAS 38 – Intangible Assets, International Financial Reporting
Standards, 30 July 2012.
Dedman, Elisabeth, et al.
“Accounting, Intangible Assets, Stock Market Activity, and Measurement and
Disclosure Policy: Views from the U.K.” By Elisabeth Dedman, Sulaiman Mouselli,
Yun Shen, Andrew Stark :: SSRN, 8 Oct 2009.
Hunter, Laurie, et al. “Accounting
for Expenditure on Intangibles.” Abacus, Blackwell Publishing Asia, 13 Mar.
Aboody. D and B Lev. “The Value
relevance of intangibles: The case of software capitalization.” Journal of
Accounting Research, Wiley Blackwell, 1 Jan 1998.
IAS 38 – Impairment of Assets,
International Financial Reporting Standards, 30 July 2012.
Hope, Tony, and Rob Gray. “Power and
Policy making. The Development of and R&D Standard.” Journal of Business
Finance & Amp; Accounting, Blackwell Publishing Ltd, 7 Dec 2006.
1 Statement of Standard Accounting Practice (SSAP) No. 13, 1989
2 The Australian
Accounting Standards Board made Accounting Standard AASB 138 Intangible
section 334 of the Corporations
Act 2001 on
14 August 2015.