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by Henry Lunt 30 Nov 2006 Diploma in Financial Management Relevant to Module A

There are many companies for whom expenditure on research and development (R&D) is an essential part of the business. These include pharmaceutical and motor companies and those who manufacture consumer durables such as DVD players. The long-term performance of such companies will depend upon the amount of R&D expenditure and on how successfully it is spent. A full understanding of the financial performance, position and liquidity of such companies will require an understanding of how R&D expenditure is reported in the financial statements, notes to the accounts and other important reports annexed to the accounts.

Accounting concepts

An understanding of the accounting for R&D is important for the reasons stated above. Furthermore, accounting for R&D is an excellent illustration of some of the key concepts in accounting and an understanding of R&D accounting also helps to understand these concepts. Once the key concepts have been understood, this is the key which opens the door to understanding many other areas of accounting, for example stock and fixed assets.

Key issue

There is only one key issue with regards to accounting for R&D expenditure – should the expenditure be included in the profit and loss account or should it be included in the balance sheet? This may appear a strange choice as these seem to be opposites. However, it should be remembered that both, in bookkeeping terms, are ‘debit entries’ and both represent the outflow of resources by a business. The choice will therefore depend on whether this is a debit expense or a debit fixed asset. A debit expense is revenue expenditure, where the expense is charged to the profit and loss account and is treated as a ‘period’ cost totally consumed within that period. This is sometimes referred to as ‘expensing’ an item. A ‘debit fixed asset’ is capital expenditure, defined as expenditure which will benefit more than one period i.e. there is an expected inflow of resources in future periods arising from the outflow of resources in the current period. This is referred to as ‘capitalising’ the expenditure.

Research expenditure and development expenditure

There are two types of research expenditure:

1 Pure research is theoretical work undertaken to acquire new knowledge without being directed towards any practical application.

2 Applied research is undertaken to gain new knowledge which is directed towards a practical application.

Both pure and applied research are speculative – there is doubt over whether any practical application will be developed and whether there will be any future inflow of resources into the business. Research expenditure, of both types, is therefore charged to the profit and loss account as revenue expenditure in the period the expense is incurred.

Development expenditure is incurred to acquire knowledge which will improve existing products. Typically there is an existing product which is currently being sold and development expenditure is incurred to improve the product so that more of the product may be sold, or at a higher price, to make a profit for the company.

Such development expenditure may or may not be successful in producing a profit. If the directors judge that a profit will be made, then the expenditure may be treated as capital expenditure and included in the balance sheet as a fixed asset. If they judge it may not make a profit, then, in a similar way to research expenditure, it is charged to the profit and loss account as revenue expenditure.

Criteria for assessing development expenditure

The directors need criteria to help them decide whether the development expenditure will be successful and lead to future revenue. These criteria are listed as below:

• there must be a clearly defined project to which all expenditure is coded
• the project should be technically feasible
• the product should be viable – evidenced by demand for the product
• further development costs will not exceed future revenues
• the company has adequate resources to complete the project.

Where these criteria are met, the directors have the option to treat the development expenditure as capital expenditure and include it in the balance sheet as an intangible fixed asset. This asset, in common with other fixed assets, should be written off to the profit and loss account. Whilst tangible fixed assets, such as machines, are depreciated over the life of the asset, development expenditure is amortised over the life of the product.

Accounting policies

There has been a subtle change in the rationale for accounting for development expenditure. In the old terminology, the accounting concepts of matching and prudence were invoked. The justification for treating development expenditure as capital expenditure was based on the argument that expenditure and income should be matched and therefore development expenditure should be matched with the income from the sale of the product when it arises.

Development expenditure should be regarded as ‘deferred revenue expenditure’, ie it becomes revenue expenditure at some point in the future, and should be included in the balance sheet until that time. The concept of prudence could override the accruals concept where it was judged not prudent to anticipate this future income.

The new terminology would concentrate on asking the question of whether an asset, which is defined as an item which gives rise to a future income stream, had been created and whether this can be reliably valued. If a future income stream was reasonably certain as a result of development expenditure, then the development expenditure met the definition of an asset and could be capitalised.

This focus on the creation of assets (and liabilities) are the key concepts which are helpful in understanding many other topics, for example pensions and goodwill.

Disclosure

When reading a set of accounts it is important to know where to find what is being reported on R&D expenditure.

You should look for the following:

• accounting policies – this will include a description of the company’s policy with regards to R&D expenditure
• profit and loss account – this will disclose both expenditure incurred in the current year on R&D and expenditure previously capitalised as development expenditure, now being amortised
• balance sheet – this will show the movement on the intangible fixed asset ‘development expenditure’ i.e. opening balance, plus development expenditure capitalised during the current year, less development expenditure amortised in the current year, to give the closing balance. A note will state the period over which costs are being amortised and the reasons for treating development expenditure as capital expenditure
• directors’ report – this will give a brief description of the R&D activities of the company
• operating and financial review (OFR) – this report will usually have a heading ‘Operating Review’, with a sub-heading on ‘investment for the future’, this will often include a description of R&D activities and expenditure.

Conclusion

R&D expenditure permeates the financial statements of many companies. You should obtain a set of accounts of a well-known company, for example GlaxoSmithKline plc, and trace through all references to R&D and try to understand its impact on the financial performance, position and liquidity of the company.

Henry Lunt is a lecturer and author

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