Question

Research and development costs can be recorded differently according to International Accounting Standards. Research is recognized as an expense of the period and development expense can be capitalized.

REQUIRED:

With respect to research and development:

a)    Explain how managers can use discretion to record an expense as research rather than development to provide alternative income and balance sheet figures.

b)    How does recording innovation expenses as research rather than development change the income statement and balance sheets figures?

c)    How does recording innovation expenses as research rather than development change important ratios related to the income statement and balance sheet figures?

d) What are the incentives for a manager to report an expense as research rather than development when both methods are justified applying accounting standards?

Answer 1

Ans Required:

a) To Explain how managers can use discretion to record an expense as research rather than development to provide alternative income and balance sheet figures.

Managers can use their own decision to decide on whether to record an expense as research rather than development in order to provide alternative income and balance sheet figures. As we know that research is considered as an expense and development is considered as an asset that is capitalised, hence considering any cost as research will make it necessary to record the cost as expense in the income statements. Managers take such a decision to ensure the following:

I) The asset does not have any amortization or depreciation in laterperiod.

ii) ROE and ROA is lower initially but increases in later years.

iii) Considering a cost as research increases the profitability of the business in subsequent years as compared to capitalisation of expences on considering them as development.

iv) Managers decide to record an expense as research rather than asset when the firm has high revenue in the year of recording the expense and the expense of concern do not form as large part of the total expense of the firm.

b) To show how recording innovation expenses as research rather than development change the income statement and balance sheets figures

Recording innovation expences is normally considered for capitalisation over the years as they serve benits over a long time in future.

But, When a firm records innovation expense as research, then the same amount is deducted as expense in the income statement. It will have the following changes in the income statement and balance sheet figures:

I) The innovation cost will not be shows as asset in the balance sheet.

ii) Since there is no recording of the item in balance sheet as asset, no depreciation or amortisation will be charged in income statement in the later years.

iii) Recording of innovation cost as expense( research) will reduce the gross and net profits in the year of recording as compared to capitalizing the cost.

iv) The gross and net profits in the later years increases as no depreciation or amortization expences are recorded in the later years.

v) Moreover, recording innovation cost as research will reduce Cash flow from operations as the expense of innovation will be considered as Cash Outflow.

c) To explain how recording innovation expenses as research rather than development change important ratios related to the income statement and balance sheet figures

Recording innovation expenses as research rather than development will change the following ratios related to the income statement and balance sheet figures.

i) The debt ratio= total liablities/ total assets

Debt ratio of the firm will be less as no innovation cost is recorded as asset and hence the total assets of the firm falls.

ii) Assets Turnover Ratio= net sales/ average total assets

Assets Turnover Ratio falls with the reduction of total assets.

iii) Gross profit margin= Gross Profit/ net sales

Gross profit margin of the firm shall fall due to increase in expences as we record innovation as expense and not assets for capitalization.

iv) Net profit margin= Net profit/net sales

Net profit margin of the firm shall falls due to increase in expences as we record innovation as expense and not assets for capitalization.

v) Return on Equity ratio= net income/ shareholders equity

Return on Equity ratio will fall with fall in the net income.

d) To explain  the incentives for a manager to report an expense as research rather than development when both methods are justified applying accounting standards

When both the methods of recording i.e. recording an expense as research expense or recording it as development, are justified as per the accounting standard, following incentives induce a manager to report an expense as research rather than development:

i) Prevention of chances of depreciation or amortization in future years by bearing the entire expence in the first year itself.

ii) Prevention of reduction of Net Income of the company in the future years.

iii) Prevention of overinflation of assets in the balance sheet.

iv) Sometime, it is better not to capitalise R&D cost, as the benefits from R&D is uncertain, therefore it is easier to expense the cost.

v) It is recommended to use de minimus rule which suggests that items that are normally capitalized can be expensed if the expense of concern do not represent a large part of the total expences and thus it will not drag the income of the firm to very low levels.