By PwC Sri Lanka:
In an era where there is a continuous change in the business environment, innovation is imperative to success, whether it’s a small, medium, or large-scale enterprise. Even when businesses are crippled by the COVID-19 pandemic, companies have not forgotten the necessity for innovation. Innovations in industries such as pharmaceuticals, retail, and banking are prominent. While change and innovation is the path for growth, a question may arise whether an entity has thought about the accounting process, which requires identifying all their hard work in the books of accounts. Many companies spend vast sums of money in the research and development only to find that all their hard-earned money can only be shown as an expense in the Profit and Loss Statement.
Is this the way to proceed? Is there an alternative accounting method to capitalize research and development expenses?
First, let us define what is meant by research and development expenses?
1. Research expenses
So, what is the difference between research and development costs? As per PwC’s Manual of Accounting, research is defined as “original or planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.”
Since this definition may be daunting for some readers, let’s look at some examples; activities aimed at obtaining new knowledge; searching for suitable applications of research findings or other knowledge; evaluating the applications and making a final selection; and searching for alternatives for materials, devices, products, processes, systems or services. A possible industry example would be searching for suitable applications of research findings is, determining whether the discovery of the effect of a particular interaction of chemicals might be used in developing a treatment for a specific disease.
2. Development costs
The PwC’s Manual of Accounting defines development expenses as “the application of research findings or other knowledge to 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.”
Some examples of development activities include; designing, constructing, and testing pre-production or pre-use prototypes and models; designing tools, jigs, and molds involving new technology; and designing, constructing, and testing a selected alternative for new or improved materials, devices, products, processes, systems, or services.
What is the accounting treatment for Research expenses?
Having understood what’s research and development activities are, let’s deep dive into the accounting treatment. The accounting techniques used are fascinating to explore. Let’s look at a sample research process followed by an innovation company.
In a typical innovation company, the research phase is broken down into 3 phases – pre-scope, scope, and discovery. The research process initiates with a business idea generation and completes by obtaining approval for the Proof of Concept.
So, what is the appropriate accounting treatment? As per International Accounting Standard 38 (IAS 38), all expenditures incurred on the research phase of the project should be expensed and taken to Profit and Loss Statement.
But why do we do so? Well, an entity cannot demonstrate that there will be future economic benefits during the research phase. The absence of the probability of future economic benefits means that the expenditure does not meet the definition of an intangible asset, nor does it meet the criteria for recognition.
What is the accounting treatment for Development costs?
The development phase of a project consists of two stages: Discovery and validation phase. In an innovation environment, the development process may start by developing a prototype. Conducting lab testing, development of the Minimum viable product (MVP), and test launch are important phases in this development phase. Let’s look at a sample process map.
So, what is the appropriate accounting treatment that’s required to capitalize the expenses incurred during the development phase of the project? Let’s discuss this in more depth.
The future economic benefits might become more apparent as a project progresses into the development stage. The development phase of a project is more advanced than the research phase. An entity can, in some instances, identify an intangible asset in the development phase.
An entity can capitalize its development expenses and recognize an intangible asset in their books of accounts only if below conditions are satisfied:
- The technical feasibility of completing the intangible asset so that it will be available for use or sale.
- Its intention to complete the intangible asset and use or sell it.
- Its ability to use the intangible asset or to sell it.
- The way in which the intangible asset will generate probable future economic benefits. Among other factors, the entity must be able to demonstrate the existence of a market for the intangible asset’s output or for the intangible asset itself; or, if the asset is to be used internally, it must be able to demonstrate the usefulness of the intangible asset.
- The availability of adequate technical, financial, and other resources to complete the development and to use or sell the intangible asset.
- Its ability to measure reliably the expenditure attributable to the intangible asset during its development.
What can’t be capitalized?
It’s important to remember that certain development expenses cannot be capitalized. The main reason behind this is that these expenditures are extremely difficult to distinguish from the costs of developing the business as a whole. IAS 38 prohibits recognition of internally generated brands, mastheads, publishing titles, customer lists, and items similar in substance.
Examples of the types of cost that are indistinguishable from the costs of developing the business as a whole and that should be expensed include:
- Start-up costs that include preliminary expenses of establishing a legal entity, expenditure on opening a new facility or business (pre-opening costs), and expenditure on starting up a new operation or launching a new product or process.
- Training costs.
- Advertising and promotion costs, including mail-order catalogs.
- Relocation expenses.
- Re-organization costs for all or part of an entity.
PwC Sri Lanka can help you with your innovation journey in many ways. As subject matter experts in accounting, valuation, and strategy development, we can help you with aligning your innovation process with accounting standards, giving strategic direction on how you can capitalize the development costs, help you with capitalizing your intellectual property such as patents, trademarks, and copyrights. In addition, we can help you design a business plan that meets the development evaluation criteria and provide expert advice on the valuation of intangible assets after the initial recognition and help you with the impairment of intangible assets on a periodical basis.