Research and Development - Capitalization of Development Costs - Case Study Example

Research and development: capitalization of development costs al Affiliation) Key words: IFRS, capitalization, goodwillINTRODUCTION Many companies on the corporate world spend a significant amount of their resources on research and development. The objective of this activity is to develop a product or service that will earn significant amounts of revenue for the future periods. Expenditure on research and development falls into the category of intangible assets. Research and development has been a ‘gray area’ due to the ambiguity of whether to expense or capitalize costs (Ordosch, 2012). The probability that conducting a research activity will yield a future benefit to a company is considered uncertain. The costs incurred are expensed. These costs cannot be retroactively capitalized in a case where the results subsequently lead to a development activity. Development activities are conducted with the objective of achieving future benefits (Desai, & Potter, 2006). Transitioning to International Financial Reporting Standards that capitalize development costs has material effects on profit and accounting ratios. For a company, such as Jaguar Land Rover PLC, that invests heavily in research and development, this transition may prove to have serious consequences on its operations. This transition is important so as to harmonize the treatment of assets; both tangible and intangible assets. There is need to capitalize development costs when certain criteria are met. The general rule is to expense research and capitalize development costs when they arise (Brice, 2009). DISCUSSION According to IAS 38; Intangible Assets, intangible assets are non-monetary and have no physical substance. Goodwill is an intangible asset (Hand, & Lev, 2003). Goodwill and intangible assets are only recognized in a company’s financial statement if they are obtained through a business combination. A purchase equation is used to allocate the value of goodwill and identifiable intangible assets (Hague, 2004). Goodwill is not amortized, it is tested for impairment. The two steps involved in testing goodwill for impairment are; 1. Establish whether goodwill is impaired 2. Evaluate the degree of the impairment. Identifiable intangible assets should be measured at cost, using the revaluation model, and amortized over their useful lives. Development costs need to be capitalized; as stipulated under the IAS 38 ‘Development capitalization criteria.’ An intangible asset is measured at its acquisition cost. The acquisition cost is the amount of resources given up to obtain or develop the asset. These are costs that can be directly attributed to installation and preparation of the asset for productive use (Landry, & Callimaci, 2002). An intangible asset arising from development activities shall be considered if a company can illustrate that; It is able to measure the expenditure attached to the intangible asset, The intangible asset is capable of generating future economic benefits, It has the ability to dispose or use the intangible asset, Technical and financial resources that can complete the development of the intangible asset are present, and It is capable of completing the intangible asset and either use it or sell it. Intangible assets should be amortized over their entire useful life. The useful life of these assets is determined by considering their legal, contractual, economic, and regulatory nature. These assets are subject to impairment. Impairment is computed only if the asset has a definite useful life. The impairment loss is not reversed if the fair value increases in the future. The period in which companies meet the capitalization criteria differs in terms of the market regulations (Koole, 2009). Jaguar Land Rover PLC would meet these recognition criteria earlier as compared to a drug company. Drug approvals would have to be received, from FDA, before commercial feasibility of the drug could be revealed. Cars do not require legislative approval this means that Jaguar Land Rover PLC will have earlier recognition date to capitalize development costs. Intangible assets ought to be amortized in regard to the accruals concept, after capitalizing the development costs. Amortization should begin immediately after commercial production of the asset commences. This assists in matching the income and expenses to the period in which the asset relates (Spector, 2012). All development projects are reviewed at the end of the accounting period to check whether they comply with the recognition criteria. If there is no compliance, the previously capitalized development costs should be written off to the statement of comprehensive income. The major problem lies on the ambiguity of this requirement. Companies know that, under IAS 38, development costs need to be capitalized (Friedrich, Spector, & Friedrich, 2011). The inherent question is; ‘Which costs are subject to capitalization?’ This standard should also offer provisions for asset impairment. This standard should aim at reducing the ambiguity and explain the development costs that require capitalization, and the resulting impairment of the subsequent assets. Resources are required to create, produce, and prepare an asset so that it can operate in a manner as intended by the management (Kvaal, & Nobes, 2011). The following costs ought to be capitalized, as they are attributable to the development of intangible assets: Amortization of licenses and patents used to generate the intangible asset, Cost of employee benefits accrued from the development of the intangible asset, Total cost of materials utilized in generating the asset, and Any fees charged to register a legal right. Accounting for research and development costs should be fully retrospective on transition to this change in IAS 38 requirements. This means that, all development costs that were expensed prior to this change will be reversed. All development costs should meet the above IAS 38 capitalization criteria. The capitalized costs will then be subjected to amortization over the speculated useful life of the asset. This change will ensure that fair value is not exempted when accounting for development costs. This requirement is attributable to the fact that intangible assets do not satisfy the revaluation criteria as stipulated in IAS 38 (Spiceland, 2009). This change in requirement is desirable since companies will have to account for all costs incurred in the early stages of a project’s cycle. IFRS does not allow the use of hindsight. Any impairment in the useful life of an asset in current years would not affect its carrying value in previous years. This change will result in more costs being capitalized. The effect on a company’s profit would be distributed over the asset’s useful life. This will depend on the company’s position in the project’s lifecycle before the change applied (Mard, & Hitchner, 2010). Capitalization of development costs will have an effect on assessing asset impairment. These costs will be subjected to impairment testing under an indicator of impairment. The technique employed will ensure that sufficient information is obtained to allow the asset to be tested for impairment. Assets are impaired when their net carrying value exceeds the future undiscounted cash flow (Shim, & Siegel, 2012). Once they are impaired, a company may choose to write it down or dispose it. Under this change, write-downs will be included as part of restructuring costs. Write-downs are non-cash expenses. Capitalization of development costs is a major determinant of asset impairment. Development costs are included in the acquisition costs of assets. This cost is then subjected to a depreciation cost over the asset’s useful life; to derive the net carrying cost. If the net carrying cost is greater than the future undiscounted cash flow that the asset can provide and be disposed for, the asset must be impaired (King, 2011). Impairment occurs if; Development costs form a great portion of an asset’s value, Speculation of a reduction in the long-term profitability of the asset, The asset’s usage rate reduces, and There are changes in the business climate. Development costs that do not meet the IAS 38 recognition criteria are written off as expenses. Asset write-downs affect previously reported incomes. This loss, which is an element of continuing operations, should be reported on the income statement before. Asset impairment recognized should not be deducted for tax purposes; deferred tax asset. IFRS uses a single step technique for impairment write-downs. This technique is employed in regard to the assets fair value less costs to sell. When this impaired for the long-term assets is measured, the impairment is reversed if it meets the IAS 38 recognition requirements for development costs (Coe, & Delaney, 2013). Impairment of assets has effects on financial statements and ratios. The financial statements of Jaguar Land Rover PLC indicated that the capitalization of development costs has implications equity and non-current assets. When capitalization of development costs leads to a higher net carrying value of asset, past income statements are not restated. From Jaguar Land Rover PLC financial statements, the revenue is not affected by the capitalization of development costs. The current statement of comprehensive income includes an impairment loss in income. Net income is reduced due to the impairment loss. On the statement of financial position, non-current assets are reduced by the impairment. This reduction is attributable to a deferred-tax asset created. Any deferred tax liability should be reduced. The impairment loss has a negative effect on the shareholder’s equity. The impairment loss reduces both the non-current asset and equity with the same amount. From the financial ratios; the debt-to-asset ratio increases from 48.26% to 60.06%. This reduction can be attributed to the impairment loss subjected to equity. There are no material changes on the current assets; that is, no cash implications. A reduction in equity means that return on capital employed and return on equity reduce from 24.75% to 18.555 and from 34.33% to 24.67% respectively. Impairment write-downs distort previous ratios that evaluated fixed assets and depreciation (Bull, 2008). Internal development expenses are capitalized when they meet the IAS 38 recognition criteria. Like in the Jaguar Land Rover PLC scenario, intangible assets are capitalized and amortized on a straight-line basis over their economic useful lives. These assets are then subjected to impairment testing as at the balance sheet date. Impairment testing is attributable to the fact that the net carrying value of the assets has exceeded the future undiscounted cash flow; development costs have been capitalized to the acquisition costs. The carrying value of the intangible assets may not be recoverable. The impairment losses are reflected in the statement of comprehensive income. Capitalizing development costs has a causal and effect relationship on a company’s financial statement and financial ratios (Shaves, 2011). The current IAS 38; Intangible Assets, does not provide a platform for impairing intangible assets when development costs are capitalized. The effect of the change in this standard on each company will depend on its business nature and the quantity of development projects undertaken. IAS 38 will have an effect on companies that engage in long-term research and development projects. For a company such as Jaguar Land Rover PLC, research and development activities qualify for a huge allocation of resources. Research costs ought to be expensed as they incur. Development costs are capitalized and the subsequent intangible asset impaired throughout its useful economic life. Companies should review their systems with the aim of upgrading the level of data obtained before the transition to the change. Previous information on the treatment of research and development costs would offer retrospective information required on the transition to the revised IAS 38 (Shamrock, 2012). CONCLUSION Impairing intangible assets after considering development costs would require operational milestones to be set. Practical milestones are necessary for companies to establish the level at which the development activities meet all the criteria as stipulated within IAS 38. This means that companies ought to establish when they should start capitalizing development costs. From the financial statements of Jaguar Land Rover PLC, it is evident that the short-term effects of the additional requirement are adverse. Companies are focused on long-term benefits of research and development activities. This means that this change would be welcomed by most companies that invest heavily in research and development activities. Development activities subsequently lead to realization of intangible assets. These assets are then subjected to impairment. This process has long term benefits for the company. Future financial ratios would indicate that the transition is desirable for most companies. Future return on equity (ROE) and return on capital employed (ROCE) will increase. This increase will be attributable to an increase in profit and the deferred tax asset. The gearing ratio would significantly reduce since the stockholders’ equity will be lower. This means that the subsequent debt to equity ratio will be lower; an advantage to the company (Bull, 2005). Future financial statements would also indicate that the transition is favorable for companies that invest heavily on research and development activities. On the statement of financial position, long-term assets will be reduced by the impairment. The subsequent deferred-tax asset will increase and the (if any) deferred-tax liability reduced. The stockholders’ equity will reduce as a result of the impairment loss recorded in the income statement. The degree of leverage for the company will, therefore, reduce. IFRS should consider revising the IAS 38 standard to ensure that a comprehensive treatment of intangible assets is undertaken. The effects resulting from the treatment should be clearly indicated on the financial statements to enhance a good interpretation of the standard; by the users of financial information (King, 2008). REFERENCES A.C.C A. 2007. Research and Development. Student Accountant, 7, 42-45. 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