Question

In: Accounting

Diva Limited is the parent company of a group of global subsidiaries that specializes in the...

Diva Limited is the parent company of a group of global subsidiaries that specializes in the design, production anddistribution of apparel and accessories for extreme sports. The extreme sports industry is defined by youth culture, youthsaged 12 to 24, and is forecasted to grow at a rate of 15% to 18% annually. The industry is made up of several dozens ofgiant global brands and is intensely competitive.

In the company’s quest for product innovation and design to pursue its differentiation strategy, Diva Limited incurredsubstantial research and development costs in the past few years, which amount to $90 million, $105 million, $120 million,and $135 million for the years ended 2012, 2013, 2014, and 2015 respectively. The research and development costs wereexpensed off in the company’s income statement in the years they were incurred.

Required

As part of the accounting analysis process, you decide that Diva’s accounting treatment to expense its research anddevelopment costs does not meaningfully reflect the company’s underlying business economics. You estimate that 40% ofDiva’s research and development costs in each year should be capitalized and amortized on a straight-line basis, from thebeginning of the following year over a three-year period. Compute the effect of capitalizing the research and development costson Diva’s income statements and balance sheets for the financial years 2014 and 2015. Ignore any potential tax effects.Answer the following questions.

  1. After the accounting adjustment, does the net income in 2014 increase or decrease? How much net income should be increased or decreased? Please show calculation.
  2. After the accounting adjustment, does the net income in 2015 increase or decrease? How much net income should be increased or decreased?  Please show calculation.

Solutions

Expert Solution

Working notes
Current Research and development cost Amount $ in million
2012 2013 2014 2015
90 105 120 135
Total Charge to Income Statement under old policy A 90 105 120 135
The whole amount is charged to Income statement and net income is decline by respective amount
Proposed New way is 40 per cost is to be amortized and balance 60 charged to Income statement.
B 2012 2013 2014 2015
90 105 120 135
Capitalized = 40% of B 40% 36 42 48 54
Income Statement 60% of B 60% 54 63 72 81
Amortization Straight line of 40% cost   2012 0 12 12 12
i.e 40 % cost/3, from following year 2013 0 0 14 14
2014 0 0 0 16
Total Charged to Income Statement 2014 & 2015 new proposed policy C (60 % of R& D + Amortized cost)         98 (72+12+14) 123 (81+12+14+16)
Answer 2014 2015
Effect on Income statement of Diva's D Difference Total A -C 22 (120-98) 12 (135-123)
Net Income will be increased by 22 12
Effect On Balance Sheet of Diva's Difference Total A -C 22 22
Fictitious Assets or Mis. Assets will be increased by 22 12

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