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11.4 Accounting for Research and Development
At the end of this section, students should be able to meet the following objectives:
- Define the terms “research” and “development.”
- Explain the problem that uncertainty creates for accountants in reporting research and development costs.
- Understand the required method of reporting research and development costs according to U.S. GAAP.
- Discuss the advantages of reporting research and development costs in the manner required by U.S. GAAP.
- Recognize that many companies report asset totals that are vastly understated as a result of the authoritative handling of research and development costs.
Reporting Research and Development Costs
Question: Many companies create internally developed intangibles such as copyrights and trademarks. One common intangible of this type is a patent, the right to make use of an invention. The creation and nurturing of an idea so that it can eventually earn a patent and be offerred for sale often takes years. The monetary amounts spent in this way to arrive at new marketable products are often enormous. The risk of failure is always present.
Such expenditures are essential to the future success of a great many companies. In 2010 alone, Intel reported spending $6.6 billion on researchThe attempt to find new knowledge with the hope that the results will eventually be useful in creating new products or services or significant improvements in existing products or services; these costs are expensed as incurred according to U.S. GAAP. and developmentThe translation of new knowledge into actual products or services or into significant improvements in existing products or services; these costs are expensed as incurred according to U.S. GAAP. in hopes of discovering new products to patent and sell. During the same one-year period, Bristol-Myers Squibb incurred costs of $3.6 billion on research and development. Those are clearly not inconsequential amounts. What is meant by the term “research”? What is meant by the term “development”? If a company such as Intel or Bristol-Myers Squibb spends billions on research and development each year, what accounting is appropriate? Should an asset or expense be recognized or possibly some combination? The outcome is uncertain, but the money was spent under the assumption that future economic benefits would be derived.
For example, assume that a technological company or a pharmaceutical company spends $1 million in Year One to do research on Future Product A. The company then spends another $1 million during the same period on development costs for Future Product A. At the end of this year, officials believe that a patent is 80 percent likely for Future Product A. If the patent is received, sales can be made.
Also during that time, the company spends another $1 million in research and $1 million in development in connection with Future Product B. However, at year’s end, the same officials are less optimistic about these results. They believe that only a 30 percent chance exists that this second product will ever receive a patent so that it can be used to generate revenues. According to U.S. GAAP, what reporting is appropriate for the cost of these two projects?
Answer: Definitions are easy to recite.
- Research is any attempt made to find new knowledge with the hope that those results will eventually be useful in creating new products or services or significant improvements in existing products or services.
- Development is the natural next step. It is the translation of that new knowledge into actual products or services or into significant improvements in existing products or services.
In simple terms, research is the effort expended to create new ideas; development is the process of turning those new ideas into saleable products.
However, the reporting of research and development costs poses incredibly difficult challenges for the accountant. As can be seen with Intel and Bristol-Myers Squibb, the quantity of these expenditures is often massive because of the essential role that new ideas and products play in the future success of many organizations. Unfortunately, significant uncertainty is inherent in virtually all such endeavors. The probability that any research and development cost will eventually lead to a successful product can be impossible to determine for years. Furthermore, any estimation of the outcome of such work is open to manipulation. Often the only piece of information that is known with certainty is the amount that has been spent.
Thus, except for some relatively minor exceptions, all research and development costs are expensed as incurred according to U.S. GAAP. The probability for success is not viewed as relevant to this reporting. Standardization is very apparent. All companies provide the same information in the same manner. The total cost incurred each period for research and development appears on the income statement as an expense regardless of the chance for success.
Consequently, the accounting for Future Product A and Future Product B is identical. Although one is 80 percent likely to be successful whereas the other is only 30 percent likely, all research and development costs for both are expensed as incurred. No asset is reported despite the possibility of future benefits. The rigidity of this rule comes from the inherent uncertainty as to whether revenues will ever be generated and, if so, for how long. Rather than trying to anticipate success, the conservatism found in financial accounting simply expenses all such costs as incurred. The percentages associated with the likelihood of receiving a patent and generating future revenues are ignored.
Two major advantages are provided by this approach. First, the amount spent by a company on research and development each period is easy to determine and then compare with previous years and with other similar businesses. Most decision makers are interested in the amount invested in the search for new ideas and products and that information is readily apparent. Second, the possibility for manipulation is virtually eliminated. No distinction is drawn between a likely success and a probable failure. No reporting advantage is achieved by maneuvering the estimation of a profitable outcome.
On its income statement for the current year, the Acme Corporation reported an expense for research and development of $236 million. What information is conveyed by this balance?
- It is an amortization expense associated with patents, copyrights, and other intangible assets.
- It is the amount spent on projects that failed during the year.
- It is the amount spent on all research and development activities during the year.
- It is the amount spent on all projects during the year that did not become at least 50 percent likely of achieving status as an asset.
The correct answer is choice c: It is the amount spent on all research and development activities during the year.
All research and development costs are expensed as incurred. No asset balances are recognized. In that way, the amount invested by a company each year in connection with this vital activity is evident to decision makers.
Research and Development Costs and the Impact on the Balance Sheet
Question: Billions of dollars are spent each year on research and development in hopes of creating new products that could be sold in the future. Company officials would never risk this money unless they believed that a reasonable chance existed for recouping such huge investments. However, whether success is 100 percent likely or only 2 percent, no assets are reported on the balance sheet for these costs. That is U.S. GAAP.
Because all amounts spent on research and development are expensed automatically, are the assets reported by companies in industries such as technology and pharmaceuticals not omitting many of their most valuable future benefits? If a company spends $5 billion to develop a new drug or electronic device that becomes worth $11 billion, does the reporting of no asset make sense? Does that approach provide a fair portrait of the company?
Answer: Even a student in an introductory accounting course can quickly recognize the problems created by a rule requiring that all research and development costs be expensed as incurred. Companies in technology, pharmaceutical, and many other industries must exclude items of significant value from their balance sheets by following U.S. GAAP. While this approach is conservative, consistent, and allows for comparability, the rationale is confusing. The balance sheet hardly paints a fair portrait of the assets being held. Expensing research and development costs also violates the matching principle. These expenditures are made in the hopes of generating future revenues but the expense is recorded immediately before any revenues have been earned.
Capitalizing these costs so that they are reported as assets is logical but measuring the value of future benefits is extremely challenging. Without authoritative guidance, the extreme uncertainty of such projects would leave the accountant in a precarious position. The temptation would be to tailor the reporting to make the company look as good as possible. U.S. GAAP “solves” the problem by eliminating the need for any judgment by the accountant. All costs are expensed. No rule could be simpler to apply.
Consequently, any decision maker evaluating a company that invests heavily in research and development needs to recognize that the assets appearing on the balance sheet are incomplete. Such companies spend money to create future benefits that are not being reported. The wisdom of that approach has long been debated but it is the rule under U.S. GAAP. Difficult estimates are not needed and the possibility of manipulation is avoided.
Talking with an Independent Auditor about International Financial Reporting Standards
Following is a continuation of our interview with Robert A. Vallejo, partner with the accounting firm PricewaterhouseCoopers.
Question: Virtually without exception, U.S. GAAP requires that all research and development expenditures must be expensed as incurred. This requirement has existed for over thirty years. Does IFRS handle research and development costs in the same manner?
Robert Vallejo: This is one of the best examples of differences between IFRS and U.S. GAAP. If specified criteria are met, IFRS requires the capitalization of development costs. These guidelines help determine when a project moves from the research stage into the development stage. However, once the development stage commences, the costs are capitalized and amortized over the anticipated useful life. When companies first adopt IFRS, this change will require some effort, particularly if development costs are significant. Changing to IFRS will have a substantial impact on reported net income. This issue will need to be considered early in a conversion to IFRS, as recasting prior period information taking into account the capitalization of development costs will be difficult.
The difference between U.S. GAAP and IFRS is not a question of right or wrong but rather an example of differing yet valid viewpoints. U.S. GAAP prefers not to address the uncertainty inherent in research and development programs but rather to focus on comparability of amounts spent (between years and between companies). IFRS, on the other hand, takes a view that the expenses should be matched with the benefits to be obtained in future periods.
Research and development costs include all amounts spent to create new ideas and then turn them into products that can be sold to generate revenue. Because success in these endeavors is highly uncertain, accounting has long faced the challenge of determining whether such costs should be capitalized or expensed. U.S. GAAP requires that all research and development costs (with a few minor exceptions) be expensed as incurred. This official standard does prevent manipulation and provides decision makers with the monetary amount spent by management each year for this essential function. However, this method of accounting means that companies (especially in certain industries) often fail to show some of their most important assets on their balance sheets. Despite the obvious value of these assets, the cost is expensed entirely.