Implications of Capitalizing Development Costs
Why U.S. companies may need to consider the systems that are in place with a view to upgrading the level of data captured many years before the transition to IFRS.
September 28, 2009
The impact of transitioning to International Financial Reporting Standards (IFRS) may have serious consequences for technology and other companies that invest heavily in research and development. While the concept of research is not dissimilar between the two accounting bases, the requirement to capitalize development costs if certain criteria are met under IFRS could significantly effect profit and have far reaching effects within the whole organisation.
U.S. Generally Accepted Accounting Principles (GAAP) has many pronouncements governing the accounting for research and development costs, which allow for specific accounting treatment in certain limited scenarios, however the general rule is to expense research and development costs when they arise. Under IFRS, there is only one accounting standard, IAS 38, which covers the accounting for research and development costs. (Note: exploration and evaluation costs relating to extractive industries are subject to different accounting rules contained in IFRS 6).
Development Costs — When to Capitalize
In accordance with IAS 38, rese — arch costs are expensed in the period that they arise, but development costs are required to be capitalized when certain criteria included in the standard are met.
In practice the point at which companies meet the capitalisation criteria will vary. For instance, from an industry perspective, it is likely that pharmaceutical and biotech companies will only meet the recognition criteria late in the development phase because drug approvals (from FDA etc) would need to be received before commercial feasibility of the drug could be demonstrated. Companies that do not require legislative approval on a product are likely to have a comparatively earlier recognition date to capitalize development costs.
Extracted below from pharmaceutical company AstraZeneca PLC’s 2008 annual report is their accounting policy describing how they account for research and development expenditure:
Development Costs — What to Capitalize
The cost of an internally generated intangible asset comprises all directly attributable costs necessary to create, produce and prepare the asset to be capable of operating in the manner intended by management. The following list is included in IAS 38 as examples of directly attributable costs:
Equally, the following list is also included in IAS 38 as examples that are not components of the cost of an internally generated intangible asset:
IFRS have a standard dedicated to first-time adoption of IFRS. The general requirement for first-time adoption of IFRS is to apply the accounting standards retrospectively, however, IFRS 1 contains certain exemptions, some mandatory and some elective, that reduces the burden of retrospective application for first time adopters. IFRS 1 does not provide any transitional exemptions for the accounting for research and development costs.
Fully retrospective application will mean that for all development costs that were expensed prior to the date of IFRS transition (that would have met the IAS 38 capitalisation criteria), will require to be reversed. These capitalized costs would then be subject to amortisation over the estimated useful life of the asset. It should be noted that there is no fair value or deemed cost exemption for accounting for development costs as these intangible assets do not meet the criteria in IAS 38 for revaluation (i.e. including the existence of an active market).
Depending on the length of the development project, companies will have to start looking at the costs that they incur on projects at an early stage in order to effectively measure the intangible asset arising at the date of transition to IFRS. IFRS prohibits the use of hindsight, therefore any impairment or change in useful life of the asset in current years, would not be permitted to impact the carrying value of the asset in previous years.
Impact on Results
Although IAS 38 will result in more costs being capitalized, the effect on profit should equalise over the period from development of asset to the end of its useful life. At the date of transition to IFRS, the impact on the individual entity will therefore depend on where that company was in the lifecycle of the development project.
Apart from the impact that IAS 38 will have on the financial statements, there are wider implications that this standard will have on the company. These include:
The effect that the requirement to capitalize development costs on each company will vary depending on the nature of the company and the quantum of development projects undertaken.
IAS 38 will affect those companies with mid to long-term research and development contracts and those companies in the technology sector the most. These companies may need to consider the systems that are in place with a view to upgrading the level of data captured many years before the transition to IFRS in order to provide the retrospective information required on the transition to IFRS.
Steven Brice, is a technical partner in the financial reporting advisory group for Mazars in the U.K For U.S. IFRS, you can contact Remi Forgeas, CPA, who is an audit and assurance partner for Mazars in the U.S.
* The views expressed in this article are the author’s own.