Question

Explain the accounting treatments for Development Expenditure as required by International Accounting Standard (IAS) 38: Research and Development

Answer 1

Research is original and planned investigation, undertaken with the prospect of gaining new scientific or technical knowledge and understanding. An example of research could be a company in the pharmaceuticals industry undertaking activities or tests aimed at obtaining new knowledge to develop a new vaccine. The company is researching the unknown, and therefore, at this early stage, no future economic benefit can be expected to flow to the entity.

Development is the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems, or services, before the start of commercial production or use. An example of development is a car manufacturer undertaking the design, construction, and testing of a pre-production model.

Treatment of R&D

IAS 38 states that an intangible asset is to be recognised if, and only if, the following criteria are met:

• it is probable that future economic benefits from the asset will flow to the entity
• the cost of the asset can be reliably measured.

The above recognition criteria look straightforward enough, but in reality it can prove to be very difficult to assess whether or not these have been met. In order to make the recognition of internally-generated intangibles more clear-cut, IAS 38 separates an R&D project into a research phase and a development phase.

Research phase
It is impossible to demonstrate whether or not a product or service at the research stage will generate any probable future economic benefit. As a result, IAS 38 states that all expenditure incurred at the research stage should be written off to the income statement as an expense when incurred, and will never be capitalised as an intangible asset.

Development phase
Under IAS 38, an intangible asset arising from development must be capitalised if an entity can demonstrate all of the following criteria:

• the technical feasibility of completing the intangible asset (so that it will be available for use or sale)
• intention to complete and use or sell the asset
• ability to use or sell the asset
• existence of a market or, if to be used internally, the usefulness of the asset
• availability of adequate technical, financial, and other resources to complete the asset
• the cost of the asset can be measured reliably.

Treatment of capitalised development costs
Once development costs have been capitalised, the asset should be amortised in accordance with the accruals concept over its finite life. Amortisation must only begin when commercial production has commenced (hence matching the income and expenditure to the period in which it relates).

Each development project must be reviewed at the end of each accounting period to ensure that the recognition criteria are still met. If the criteria are no longer met, then the previously capitalised costs must be written off to the income statement immediately.