School of Management

MANG 6031 : Financial Accounting II

Proposed Accounting Standard

For Research and Development
To RASB
Introduction

Research and development (hereafter, R&D) is the main concern of interests as we

have been asked by the Ruritanian Accounting Standards Board (RASB) for advice on
their proposed accounting standard for R&D. Therefore, in the first section we will
provide a general definition, overview of R&D and identify and explain the principal
problems relating to R&D that should be addressed by RASB. In the second section,
we will identify and explain the appropriate accounting concepts that should be
applied in dealing with the problems and issues relating to R&D. Finally, in the third
section, we will apply these accounting concepts to provide advice and
recommendations to the RASB on its proposed accounting standard for R&D.

Overview of R&D and its Principal Problems

The standard setters in many countries have distinguished and separated the definition
of research from development in their accounting standards. For instance, in the UK,
the Standard Statement of Accounting Practice (SSAP) 13, classified R&D
expenditure into 1) pure research as an experimental/theoretical research to gain new
knowledge, 2) applied research as an original or critical investigation to acquire new
knowledge for entities’ own purposes and for a direct objective and 3) developments
activities as the use of scientific or technical knowledge to produce or improve new
products and services. On the international level, the International Accounting
Standard Board (IASB) defines research as “the original and planned investigation
undertaken with the prospect of gaining new scientific or technical knowledge and
understanding.” Development, on the other hand, is “the application of research
findings or other knowledge into 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.” (Khadaroo and Shaikh,
2003).

R&D is a major element of sustainable innovation-led growth as it involves creating

new products or helps to increase the value added products and improve services on
which the future of any company increasingly depends1. In this context, the Business
Accounting Deliberation Council, hereafter BADC, (1998) argued that the R&D
activities are very important activities for the current and future companies’ profits, as
the current business product life cycle has become shorter, and the need for new
technology to catch-up with these conditions is increasing. Thus the need for R&D
activities is growing rapidly and the expenditures on these activities have reached to
significant amounts and become more challenging and important in the business world
(BADC, 1998). In academia, Zhao (2002) argued that R&D costs were a fast growing
phenomenon in accounting research and for standards setters during recent years, as a
result of the increasing significance of intellectual property rights. Furthermore, the
information relating to the total amounts of R&D costs and the details of these
activities have become increasingly an important source for investors' decision making
in understanding the company's management policies and future profitability (BADC,
1998). Therefore, the need for accounting treatments and regulations for R&D costs
are an important concern to accounting jurisdiction around the world. However, there
are several principal problems relating to R&D that have been addressed in the
accounting literature and need to be considered in the contexts.

1
Source : http://www.innovation.gov.uk/rd_scoreboard/index.asp

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The first principal problem is the discussion focusing on whether the costs incurred by
R&D should be capitalised as assets or written off as an expense. The fundamental
issue herein is related to asset recognition and criteria thereof. An asset is defined as
“rights or other access to future economic benefits controlled by an entity as a result of
past transactions or event” (Statement of Principles, Accounting Standards Board).
What has to be ascertained is whether assets will result from R&D activities. Standard
setters approached this issue in different ways, for instance UK and IAS GAAP require
all research costs and most development costs to be expensed immediately as they
were incurred in the current accounting period. Except for some portions of
development cost those have a clear defined project of commercial value to which
those costs can be reasonably matched against their related future economic benefits;
then, these portions of development costs incurred are allowed to capitalise. For US
GAAP, on the other hand, the standard setters apply even more conservative approach
which requires for all R&D costs to be written off as expenses.

Related to this discussion, a further principal problem faced by many accounting

setters and jurisdiction around the world is the main debate between the advocates of
the accrual principle and the advocates of the conservatism principle in the accounting
treatment of R&D costs at the time of recognition. The former suggests that the costs
incurred by R&D activities must be matched against the future economic benefits that
can be derived from the new products or processes developed or new services rendered.
The latter suggests that as future benefits cannot be ascertained with reasonable
certainty, the costs incurred by R&D activities must be immediately expensed as
incurred (Khadaroo and Shaikh, 2003). For example, much attention has been given to
the treatment of R&D costs in the oil and gas industry (Dopuch and Sunder, 1980).

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The next principal problem concerning R&D costs, also related to the above, is the
loose of a direct relation between R&D costs and specific future revenue or benefits.
Such relation will impact on the company reliability, objectivity, and value relevance,
given that the relation between R&D costs and future earnings will show the extent of
the future growth of a company (Zhao, 2002). Consequently, FASB has arrived at its
decision in 1974 to require more stringent recognition criteria than of IASB. Research
and development costs should be expensed as incurred, making the recognition of
internally generated intangible assets rare. However, separate rules apply to
development costs for computer software that is to be sold. Here, capitalisation (and
amortisation) applies one technological feasibility is established. Capitalisation ceases
when the product is available for general release to customers. Similar rules apply to
certain elements of development costs for computer software developed for internal
use.

Nevertheless, accounting bodies in some countries allows entities choose to expense

or capitalise their R&D costs, which can be used to manage earnings as it has an effect
on these (Zhao, 2002).

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Accounting Concepts to Deal with the Problems

The main argument in R&D accounting concept is whether R&D costs should be
capitalised or expensed at the time of costs incurred. Currently, there are three major
approaches 1) full expensing; charge all costs to expense immediately when incurred
(e.g. US and Germany). 2) Full capitalisation; capitalise all cost as assets when
incurred (e.g. Switzerland and Netherlands). This approach is adopted by Switzerland
GAAP and Netherlands GAAP and 3) Selective capitalisation; some portions of cost
incurred would be capitalised upon certain conditions are met and the remaining
portions are charged to expense (e.g. IFRS and UK).

Upon an individual R&D project is implemented, there is usually a high degree of

uncertainty about the future benefits. In particular, Ruritania is a rapidly developing
developing country with many unpredictable events may come along, which could
make the complex situation. For instance, to minimise the potential of complicated
problem perhaps arising, a full expensing as advocated by conservatism principle is
seem to be more appropriate; whereas, a full capitalisation as supported by
revenue-expense matching principle appear not to be a proper approach. Nevertheless,
a major inevitable flaw of full expensing approach “revenue-expense mismatching” as
R&D costs incurred now are not only associated with the current revenues but also the
possible future revenues (Willmott, Puxty, Robson, Cooper & Lowe, 1992). This flaw
leads to the conflict with the accrual principle. Furthermore, precluding all
captialisation of R&D costs may remove entity's most valuable assets from the balance
sheet, which might cause reported asset figures to be understated and make the
financial figures less attractive (Gornik-Tomaszewski & Miguel, 2005). Besides, the
research conducted by Oswald and Zarowin in 2004 unveils capitalization of R&D
provides more information about future earnings to the market”2.

2
Oswald, D. and Zarowin, P. (2004), “Capitalization of R&D and the Informativeness of Stock Prices”

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Ruritania has an active stock market; thus, reasonably reliable and predictable
financial figures reported in financial statements are needed by investors and other
financial report users.

As a result, the selective capitalisation approach is eventually adopted by us to cope

with the problem arising from the conflict between conservatism and revenue-expense
matching principle in order to trade off between advantages of full capitalization and
full expensing. This approach is currently adopted by IFRS and UK GAAP by
separating the definition and recognition of research costs from development costs,
and treats them independently. However, for the case of Ruritanian, we have
inaugurated some modification to this approach by introducing a thought of
intertwining research activities with development activities. Said differently, in our
opinion, research and development costs incurred are interconnected activities; as
research activities are a precondition of the success of development activities – barring
from research costs incurred, the activities relate to developments will never be
accomplished. Therefore, research costs are inseparable from development costs.

In consideration of the selective capitalisation in combination with indivisibility of

R&D costs feature aforementioned, we arrived at our rudimentary accounting concept
of R&D costs recognition by; first, we need to connect particular portions of research
costs with their consequential portions of development costs (the concept of
indivisibility feature). In essence, this is to match a particular portion of research costs
with their consequential development costs.

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Thereafter, the concept of selective capitalisation is implemented. That is when some
certain consequential portions of development costs are warranted for captialisation;
then, the portions of research costs that are previously connected with must be also
capitalised. On the contrary, the remaining portions of development costs that are not
qualified for capitalisation; thus, the related portion of research must not be also
capitalised.

Notwithstanding, one impediment is still remain as research costs and development

costs are usually not concurrent. Research costs incurred precede development costs
incurred. Hence, so as to match a particular portion of research costs with their
resultant portion of development in due course, we need to defer the recognition of
research costs by recording them as neither asset nor expense until their resultant
development costs are verified to be either asset or expense. Once their resultant
development costs are verified, the research costs are matched with their resultant
development costs and can be recorded as either asset or expense according to the
classification of their resultant development costs. In other words, upon the research
costs incurred, they are temporarily recorded (deactivated) in the shareholders’ equity
section as a “contra-equity account”. This practice is the same as the concept of
unrealised losses. Once the resultant development costs are capitalised or expensed,
this contra-equity account is immediately removed and transferred to either asset or
expense follow on their resultant development costs.

In addition to concept of asset recognition, some certain important issues should be

addressed. Firstly, in compliance with the matching principle, the capitalised R&D
costs should be amortised systematically to be an expense shown on profit and loss
statement based on the pattern of their associated future benefits over the foreseeable
future period. In addition, from an economic perspective, the allocation process should

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enable the income reported each accounting period to reflect the rate of return earned
by the asset.3 Secondly, historical cost, although highly reliable, may have little
relevance. It is the old adage as to whether it is better to be “precisely wrong” or
approximately right”. Judgment is required to provide the appropriate balance.
Nevertheless, from the perspective of auditors and preparers, they prefer to be
concerned with reliability (and legal liability) than relevance and have often opposed
the inclusion of less reliable data in financial statements. The concept applies to
revaluation of R&D costs. Lastly, in accordance with the definition of asset and
matching principle, the portion of capitalised R&D costs that are deemed no longer
future economic benefit should not be remained as unexpired costs (assets) and should
be cut down or eliminated to expired costs (expenses). This concept is applicable to
impairment and written-off of R&D costs.

3
Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried. “The Analysis and Use of Financial Statements”, Third
Edition, Willey, pp 259

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The Recommended Accounting Standard for R&D

Scope of the Accounting Standard for R&D

The scope of this statement of accounting standard for research and development is
covered both internally generated costs of research and development activities
conducted by an organisation itself and external costs of research and development
incurred as a result from other organisations is hired by the organisation to conduct
research and development. Any costs incurred and reimbursed as a result from
research and development activities conducted for others under a contractual
arrangement is beyond the scope of this statement.

First-time Adoption

Accounting principles must be consistent with financial information presented in

comparative financial statements. First-time adoption of this accounting standard for
research and development requires full retrospective application by prior period
adjustment and restatement.

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Initial Recognition and Measurement

Upon research costs incurred, a “contra-equity account” namely “Unrealised Loss

from Research Expenditures” must be created to locate these costs. This account must
be held until development processes are completed and all costs incurred from
development are identified. Once the development phase is ended, the following 6
criterions must be evaluated before a decision about whether to capitalise or expense
incurred costs related to research and development will be made4

1. The technical feasibility of completing the products or processes must be

established;
2. Management has the intention to complete the products or processes.
3. The plans or designs as a result from development are able to be used or sold.
4. The entity can demonstrate the certain future economic benefits of products
or processes arising from the development.
5. There are adequate resources available (technology, financial and production
resources) to complete the development of products or processes.
6. The entity is able to measure reliably the expenditure attributable to the
intangible asset during its development phases.

The portions of development costs that meet all these 6 criteria must be capitalised.
Again the portions of previous research costs incurred, which have a significant
contribution to the success of the development costs that have been capitalised, must
be also capitalised as they cannot be separated. The remaining portions of both
research and development costs incurred that fail to meet all these 6 criterions stated
above must be expensed in a current accounting period.

4
Source : IAS 38; Intangible Assets

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Again, research and development costs initially recognised as expenses cannot be
capitalised in a subsequent period.

The following accounting entries are provided below as a guideline for the R&D costs
recognition and measurement

When research costs incurred :

Dr Unrealised Loss from Research Expenditures

Cr Various accounts paid for research

When the development is completed (research is translated into plans or designs) :

Dr Research and Development Costs (Assets)

Cr Unrealised Loss from Research Expenditures
Cr Various accounts paid for development

(For the portions of R&D costs that meet 6 criterions)

Dr Research and Development (Expense)

Cr Unrealised Loss from Research Expenditures
Cr Various accounts paid for development

(For the portions of R&D costs that do not meet 6 criterions)

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Amortisation and Impairment

After R&D costs are capitalised as assets, they are subject to amortisation and
impairment.

The amortisation of R&D costs must be commenced upon the R&D costs are put in a
commercial production or application of their consequential products and services.
R&D costs should be allocated on a systematic basis to each accounting period based
on the pattern of their associate future benefits over the foreseeable future period as the
more units of product are manufactured (or the more units of service are rendered), the
more amortisation of R&D costs are recorded. Therefore, the primary recommended
method of amortisation is “unit of output method”. The amortisation expense in each
accounting period is calculated using the following formula:

The entity must set salvage value equal to zero except its value can be reasonably
estimated with certainty and ability to sell at the end of its useful life then a certain
estimated salvage value can be brought to deduct from the value of R&D costs.

In case the entity is unable to estimate the total number of products/services units to be
manufactured or rendered as a result from R&D activities, the secondary
recommended method of amortisation is either straight-line or accelerated method
such as sum-of-the-year digit method or declining balance method. The choice
between straight-line and accelerated method depends upon the pattern of income

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generating from products or services. If products or services are expected to generate
the majority of income during the early stages of their life cycle such as technological
products or services, then accelerated methods of amortisation are recommended.

In some circumstances, economic benefits from R&D costs are considered parts of
costs of products manufactured rather than being a period expense. Consequently,
amortisation expenses must be deemed parts of inventoriable costs and included in the
carrying value of inventory accounts (Debit Work-in-Process Inventory and Credit
Research and Development costs).

Again, R&D costs are subjected to impairment. Upon there are impairment indicators
existed, the procedures for impairment of R&D costs must be applied pursuant to IAS
36.

Subsequent Expenditures

Additional research and development costs incurred after the original or previous
research and development costs have been recorded on the balance sheet must be
capitalised subsequently only if both two conditions as follows are met

1. There is a high probability that additional subsequent expenditures spent on

existing development project will be able to generate higher future economic
benefits than the existing future economic benefits that had been estimated.
2. There is a high degree of correspondence between the additional subsequent
expenditures spent on existing development project and their additional
resultant future benefits from existing development project.

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Otherwise, all additional research and development costs incurred must be expensed.

Revaluation (Subsequent Measurement)

Revaluation to fair value is not permitted because research and development costs are
internally generated assets by the entity for their specific purposes, which are hardly
able to find comparable assets in the marketplace to measure a reliable fair value.
Accordingly, research and development costs must be carried at cost net of all
amortisation and impairment loss.

Written-Off

When there are no longer benefits of products or services arising from research and
development costs, entire research and development costs must be written off as an
expense in the current accounting period.

Conclusion

The recommendations in this paper are primarily based on the current situation in
Ruritania. In the process of setting the standards, we referred to many accounting
standards in some countries as well as some academic papers in combination with our
thoughts to eclectically arrive at the standards that are considered the most appropriate
to Ruritania. Nonetheless, the proposed standards herein may not be a quintessence as
Ruritania does not currently have its own conceptual framework and thereby there is
no forerunner in this area. In consequence of implementing these proposed standards;
standard setters must keep an eye with the potential problems arising and make
necessary revisions.

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 References

“Accounting Standards for Research and Development Costs” (13 March 1998). The
Business Accounting Deliberation Council. 13 April 2006. Available from
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Ampofo, A. A. and Sellani R. J. (2005), “Examining the differences between United

States Generally Accepted Accounting Principles (U.S. GAAP) and International
Accounting Standards (IAS): implications for the harmonization of accounting
standards”, Accounting Forum, Vol. 29, pp. 219–231.

ASB (1989), “SSAP 13 Accounting for Research and Development (Revised January
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Chan, L. K.C., Lakonishok, J., and Sougiannis, T., (2001) “The Stock Market
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Deloitte Touche Tohmatsu (2006), “IAS Plus International Accounting Standards IAS
38, Intangible Assets”, 13 April 2006 Available from
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Dopuch, N. and Sunder, S., (1980) “FASB’s Statement on Objectives and Elements of
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FASB (1974), “Statement No. 2, Accounting for Research and Development Costs”,
13 April 2006 Available from http://www.fasb.org/pdf/fas2.pdf

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Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried. “The Analysis and Use of
Financial Statements”, Third Edition, Willey

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and Development Costs: a Comparison of U.S. and International Standards."
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Willmott, H., Puxty, A., Robson, K., Cooper, D. & Lowe, E. (1992), “Regulation of
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