R&D EXPENDITURE ACCOUNTING ----- Capitalize or Charge off????

        Research and development is lifeline of many businesses.  It helps them discover new and better processes, methods, techniques and products to make the business more competitive by being more efficient in terms of costs, better products, better delivery systems, etc.  Accounting for R&D expenses has been a challenge for accountants. The challenge is to decide whether to charge it off in the income statement immediately as it is incurred, or to create an intangible asset out of this expenditure.

Why R&D Accounting is a Challenge???

            Accounting for R&D expenses has been a challenge for accountants. In fact this is one of the areas on which convergence has not yet been achieved between US GAAP and IFRS. The accounting challenge arises from the very nature of this expenditure. R&D can involve quite substantial amount of expenditure. This expense, if the R&D program is successful, can yield huge economic benefits to the business. However, if the program is not successful, there can be virtually no economic benefit in spite of huge outgo.
            The challenge with the accounting of research and development expense is to decide whether to charge it off in the income statement immediately as it is incurred, or to create an intangible asset out of this expenditure. If the expenditure is huge and is charged off to income statement in the period it is incurred and the program turns out to be successful earning huge economic benefits in the later periods, then, there will be mismatch between the periods in which benefits are recorded and their related expenses are booked. This can be construed as failing the Matching Principle of accounting. This will also pull down the operational income of the business for the period, which in a way may not be fair reflection of the operational performance of the business for the period. However, conversely, if we do not charge off the expenditure in the income statement in the period in which it is incurred and carry forward the same as an asset and the R&D program fails without yielding any benefit, then the asset carried in the balance sheet will not have any value and is impaired from the start. This challenges the Principle of Conservatism.

US GAAP Guidance of R&D Accounting

            US GAAP has taken a very conservative approach to R&D accounting. Statement of Financial Accounting Standards [SFAS] 2.12 recommends charging off the entire R&D expenditure as and when incurred to the income statement. However, a study of the appendix attached to SFAS 2 clarifies the background analyses before this conclusion was arrived at. Financial Accounting Standards Board [FASB] considered four different alternatives for R&D accounting before finalizing on one of them. [SFAS 2.37]

• Charge off all expenses as and when incurred
• Capitalize all expenses
• Charge off or capitalize expenses based on specific conditions
• Accumulate costs separately until the issue of future benefits can be determined.

           From the reading of SFAS it appears that as far as FASB was concerned the clincher for determining R&D accounting for it the uncertainly involved in the likely future benefits of any R&D program. [SFAS 2-39&40]

            The FASB did consider the idea of capitalizing the R&D expense selectively that is identifying the programs that can be capitalized and the programs that can be charged off. [SFAS2.53&54] However, it could not be satisfied with the idea of selective capitalization.
            To overcome this capitalize v/s charge off decision, FASB even considered the idea of parking these expenses as a separate item in the financial statements, this idea seemed to challenge the basic structure of financial statements and as is very apparent this was rejected. [SFAS 2.59]

Indian GAAP and IFRS Guidance on R&D Accounting

            The guidance on accounting for R&D in Indian GAAP is in AS 28.IFRS covers the same under IAS 38. Under these GAAP, to assess for the purpose of accounting, R&D has been broken into two parts- Research Phase and Development Phase. [IAS 38.52] [AS 26.39]
 Part 1- Research At this stage an entity gains new knowledge or is in the process of doing so, hence it is very difficult for it to demonstrate it is acquiring in the research phase. IAS 38.54 recommends that the expenditure on Research should be charged off to income statement as and when incurred. Indian GAAP is the same.[As 26.41] Part 2- Development This stage is where the knowledge gained in the Research phase is applied to design and develop a product, process, method, technique, etc, which can going forward be commercialized for economic gain. There are two ways of accounting for Development Expenses. If the entity is still not able to demonstrate that it is capable of and also has the intention to generate future economic benefits out of the output of these Developmental Expenses then it has to charge these expense as well. However, if the entity satisfies the six conditions mentioned in IAS 38.57 [Indian GAAP AS 26.44] it can create an intangible asset out of this development Expenditure.

Conclusion- Research and Development expenses are very unique in nature. They are in a way necessary to sustain the business in the competitive market place. They can generate tremendous assets for the business however; there is a great deal of uncertainty regarding the success of these programs in generating the economic benefits for the business. Whereas Research expenses can be charged off to Income statements in the period in which they are incurred as they are very “far off” from possible commercial benefit, development expenses should be carefully reviewed before charging them off or capitalizing them as intangible assets.                                                            

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