Steven Brice
Steven Brice

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
by Steven Brice

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.

IAS 38 Development Capitalisation Criteria

An intangible asset arising from development (or from the development phase of an internal project) shall be recognised if and only if, an entity can demonstrate all of the following:

(a) The technical feasibility of completing the intangible asset so that it will be available for use or sale.

(b) Its intention to complete the intangible asset and use or sell it.

(c) Its ability to use or sell the intangible asset.

(d) How the intangible asset will generate probable future economic benefits. Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset.

(e) The availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset.

(f) Its ability to measure reliably the expenditure attributable to the intangible asset during its development.

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:

Research expenditure is recognized in the income statement in the year in which it is incurred.

Internal development expenditure is capitalized only if it meets the recognition criteria of IAS 38 ‘Intangible Assets’. Where regulatory and other uncertainties are such that the criteria are not met the expenditure is recognised in the income statement. This is almost invariably the case prior to approval of the drug by the relevant regulatory authority. Where, however, the recognition criteria are met, intangible assets are capitalized and amortised on a straight-line basis over their useful economic lives from product launch. As of December 31, 2008, no amounts have met the recognition criteria. Payments to in-license products and compounds from external third parties, generally taking the form of up-front payments and milestones, are capitalized and amortised, generally on a straight-line basis, over their useful economic lives from product launch. Under this policy, it is not possible to determine precise economic lives for individual classes of intangible assets. However, lives range from three years to twenty years.

Intangible assets relating to products in development (both internally generated and externally acquired) are subject to impairment testing at each balance sheet date. All intangible assets are tested for impairment when there are indications that the carrying value may not be recoverable. Any impairment losses are recognised immediately in the income statement.

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:

  • Costs of materials and services used or consumed in generating the intangible asset;
  • Costs of employee benefits arising from the generation of the intangible asset;
  • fees to register a legal right; and
  • Amortization of patents and licences that are used to generate the intangible asset.

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:

  • Selling, administrative and other general overhead expenditure unless this expenditure can be directly attributed to preparing the asset for  use;
  • Identified inefficiencies and initial operating losses incurred before the asset achieves planned performance; and
  • Expenditure on training staff to operate the asset.

First-Time Adoption

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.

Other Considerations

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:

  • Setting operational milestones. Practical milestones will be required to be set in order to determine the stage at which the development project meets all of the criteria within IAS 38 and therefore when the costs should start to be capitalized.
  • Assessing impairment. Capitalized development costs will be subject to impairment testing when an indicator of impairment is present. A methodology will be required to ensure that sufficient data is captured to enable the asset to be tested for impairment.
  • Systems. It will be necessary for companies to implement a time-tracking and costing system in order to obtain reliable development cost information. IAS 38 includes the cost of employee benefits in the development costs. It also includes the costs of material and services used or consumed in generating the intangible asset.


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.

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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.