Question

Research and Development:

The Thomas Company is in the process of developing a revolutionary new product. A new division of the company was formed to develop, manufacture, and market this product. As of year‐end (December 31, 2017), the product has not been manufactured for resale; however, a prototype unit was built and is in operation.

Throughout 2017 the division incurred certain costs. These costs include design and engineering studies, prototype manufacturing costs, administrative expenses (including salaries of administrative personnel), and market research costs. In addition, $500,000 in equipment (estimated useful life: 10 years) was purchased for use in developing and manufacturing the preproduction prototype and will be used to manufacture the product. Approximately $200,000 of this equipment was built specifically for the design and development of the product; the remaining $300,000 of equipment will be used to manufacture the product once it is in commercial production.

Required:

1. How is research and development defined in Statement of Financial Accounting Standards No. 2?
2. Briefly indicate the practical and conceptual reasons for the conclusion reached by the FASB on accounting and reporting practices for R&D costs.
3. In accordance with SFAS No. 2, how should the various costs of Thomas just described be reported in the financial statements for the year ended December 31, 2017?

Answer 1

Q.How is research and development defined in Statement of Financial Accounting Standards No. 2?

A: As per Statement of Financial Accounting Standards No. 2 research and development is defined as follows :

''Research is planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service (hereinafter "product") or a new process or technique (hereinafter "process") or in bringing about a significant improvement to an existing product or process.''

''Development is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use. It includes the conceptual formulation, design, and testing of product alternatives, construction of prototypes, and operation of pilot plants. It does not include routine or periodic alterations to existing products, production lines, manufacturing processes, and other on-going operations even though those alterations may represent improvements and it does not include market research or market testing activities.''

Q.Briefly indicate the practical and conceptual reasons for the conclusion reached by the FASB on accounting and reporting practices for R&D costs.

Statement of Financial Accounting Standards No. 2 establishes standards of financial accounting and reporting for research and development costs with the objectives of reducing the number of alternative accounting and reporting practices presently followed and providing useful financial information about research and development costs.

The guidelines in paragraphs 8-10 for activities that should be identified as research and development are designed to accommodate a wide variety of research and development activities. Adherence to those guidelines should result in a reasonable degree of comparability. Differences among enterprises and among industries are so great that a detailed prescription of the activities and related costs includable in research and development, either for all companies or on an industry-by-industry basis, is not a realistic undertaking for the FASB.

In concluding that all research and development costs be charged to expense when incurred, Board members considered the following factors:-

Uncertainty of Future Benefits

There is normally a high degree of uncertainty about the future benefits of individual research and development projects, although the element of uncertainty may diminish as a project progresses.

Lack of Causal Relationship between Expenditures and Benefits

A direct relationship between research and development costs and specific future revenue generally has not been demonstrated, even with the benefit of hindsight. For example, three empirical research studies, which focus on companies in industries intensively involved in research and development activities, generally failed to find a significant correlation between research and development expenditures and increased future benefits as measured by subsequent sales,7 earnings,8 or share of industry sales.

Accounting Recognition of Economic Resources

Not all of the economic resources of an enterprise are recognized as assets for financial accounting purposes. However, criteria for identifying those economic resources that should be recognized as the assets of an enterprise for accounting purposes have not been specified in the official accounting literature. One criterion that has been suggested in published research studies and articles and in position papers, letters of comment, and oral presentations the Board received in connection with the public hearing is that of measurability.

Expense Recognition and Matching

Evidence of a direct causal relationship between current research and development expenditures and subsequent future benefits generally has not been found. Also, there is often a high degree of uncertainty about whether research and development expenditures will provide any future benefits.

Capitalization of All Costs When Incurred

Enterprises undertake research and development activities with the hope of future benefits. If there were no such hope, the activities would not be conducted. Some persons take the position that the accounting treatment for research and development costs should be determined by considering in the aggregate all of the research and development activities of an enterprise.

The Board believes, however, that it is not appropriate to consider accounting for research and development activities on an aggregate or total-enterprise basis for several reasons. For accounting purposes the expectation of future benefits generally is not evaluated in relation to broad categories of expenditures on an enterprise-wide basis but rather in relation to individual or related transactions or projects. Also, an enterprise's total research and development program may consist of a number of projects at varying stages of completion and with varying degrees of uncertainty as to their ultimate success.

Q.In accordance with SFAS No. 2, how should the various costs of Thomas just described be reported in the financial statements for the year ended December 31, 2017?

This Statement requires that R&D costs be charged to expense when incurred. It also requires a company to disclose in its financial statements the amount of R&D that it charges to expense.