Task Details:
Technology Enterprises Ltd, a listed company, commenced a research and development (R&D) project in July 2017 to modify the method of recharging batteries used in its products. The project was successfully completed in June 2018 and the company applied for a patent for the design.
Technology Enterprises Ltd plans to modify all products in its consumer range over the next two years and has incorporated these plans into its financial budget. The entity expects to derive economic benefits from the new battery recharging technology over the next 10 years.
The accountant was unsure how to account for the project, so they used the New Project R&D account to accumulate the salaries of all engineers involved in the project during the year ended 30 June 2018. The following analysis of the salaries expenditure is based on the engineers’ time sheets.
ACC701
The value in use of the design, estimated using present value techniques, is $4 000 000. However, the fair value of the design is estimated to be only $3 000 000 because the only potential buyer would need to modify the design to adapt it to its own products.
The following conversation took place between the chief executive officer (CEO) and the accountant (ACC).
CEO: That ‘R&D asset’ should make our financial statements look great this year. We can show it is worth $4 000 000 in the balance sheet and add an extra $3 000 000 to the profit because it cost only $1 000 000.
ACC: I haven’t finalised accounting for it yet but I am quite sure the accounting standard requires us to measure it at historical cost, and some of it will probably have to be recognised as an expense.
CEO: It isn’t fair. These conservative accounting rules make it impossible to show investors that our project was successful — and expensing any of it will cause our share price to go down because the investors will think it didn’t work.
Required
- How should the project be accounted for in the financial statements for the year ended 30 June 2018? Justify your answer with reference to relevant paragraphs of AASB 138/IAS 38.
- To what extent might the rules or restrictions in AASB 138/IAS 38 reduce the comparability of financial statements?
- Write a response to the CEO, drawing on your understanding of AASB 138/IAS 38 and the efficient market hypothesis (refer to chapter 2 of Loftus). Include a recommendation as to how the company might mitigate their concerns about investors’ interpretation of the information reported in the financial statements
Solution
Executive Summary:
The report shows the implementation of AASB 138 Standard and its application on Technology Enterprises Ltd. The analysis only shows the lack of comparability arising from compliance with AASB 138 as well. The efficient market theory and the application of the AASB 138 are explained for the right recognition of the intangibles. The recommendation for expensing the account for research costs of $1000000 and deferring the development costs of $3000000 and recognizing it as an intangible asset on the financial statement with amortizing it on its useful life of 10 years is given. Furthermore, it is also advised that the company provides a detailed preview of the accounting without compliance with AASB 138 showing the actual value of the New Research and Development Project. This can help to educate the investors with the successful completion of the Research project.
Question 1– How should the project be accounted for in the financial statements for the year ended 30 June
Accounting Treatment for Intangibles and Research and Development Costs:
The company Technology Enterprises Limited commenced a research project in July 2017 for the aim of the modification of the recharging batteries method that is used in the products. By the end of June 2018, the project was completed which led the company to apply for the patent of the new design. The company has now planned to modify all of its products as per the new design in its consumer range within the next two years. The company has also incorporated these plans in its financial budget. The economic benefits of the new battery are expected to be gathered over the next 10 years. The accounting for the project is expected to be done under the account of New Project R &D account. The company is expecting to record all the salaries of the new project of Research as accumulated under these accounts.
AASB 138:
As per the AASB 138, the standard is applied to the activities under Research and development which are aimed at towards the knowledge development that may result in any form of asset or prototype however the main asset if the knowledge received from this process.
The costs from Research and Development are usually themselves not intangible assets. However, they often result in the development of patents, as evident in the case of Technology enterprises who have filed for the patent for their new design of the batteries of products. These research and development projects have resulted in an intangible asset which has future value. As per AASB 138 and paragraph 51, it is hard to evaluate if the internally generated asset is qualified for recognition. For assessing if the internally produced intangible asset is as per the recognition criteria, the company needs to classify its asset generation into two stages. Firstly, the research stage and second is the development stage (Hunter et al., 2012).
Research Phase:
The research phase for an internally produced asset is the one in which the company cannot show that the intangible asset would result in future economic profits. This is therefore identified as the expense at the time it is incurred. The illustration for such research activities includes the ones directed for gaining new knowledge, the hunt for a substitute for devices, products, systems and materials, and the formation, designing, assessment and selection of the likely alternative for the improved or new material, device, process, and system.
Development Phase:
The development phase is the phase starting from the time the organization can identify the use of the intangible asset and can establish the future economic profits of the intangible assets (Australian Government, 2018). The example for the development phase of the internally produced intangible asset includes the designing, construction, and testing of the pre-production and prototypes, the designing, building, and testing of selected option for the improved or new devices, or products or systems.
Recognition of internally generated intangibles:
It is stated that all internally produced intangibles other than the development expenditure need to be recorded as an expense when it is incurred. As per the AASB 138 clause of Intangible assets, the internally produced intangible assets except for the development expenditures cannot be carried as the account of assets. The intangible assets which can be identified are the development costs which have probable future economic profits, and whose costs can be calculated reliably. Furthermore, as per paragraph 71 of AASB 138, once an intangible item is expensed it shall not be documented as a fraction of the cost of the intangible asset at any afterward date. However, it can revalue for fair value if there is an active marketplace for these assets. However, there are probably no active markets available for the intangible assets which are one reason for the undervaluation of the assets in the statement of the balance sheet (Bakker, 2014).
This shows that the research stage of the project is to be expensed as incurred. While the development phase of the research expenses can be deferred if the company can establish its economic profits in the future, can use it, and can calculate the expenditure during its growth.
As per AASB 138, the accounting treatment for the New Project R&D would be.
| Cost of time spent on searching for and evaluating the alternative materials | $100,000 | Expense as incurred |
| Cost of time designing the models and constructing and testing prototypes | $700,000 | Expense as incurred |
| Cost of time spent on the training maintenance workers for the new design | $200,000 | Expense as incurred |
| Fair Value of the Design | $300,000 | Deferred Development Cost recognized as an asset to be Amortized over future periods |
(Accounting Standards Board, 2016)
Question 2– To what extent might the rules or restrictions in AASB 138/IAS 38 reduce the comparability of financial statements?
The AASB 138 and its Comparability with other Financial Statements:
Research and development activities are an important activity for any company’s income and its capital market value. The discussion on the capitalization of the intangible asset has always been rather vigorous in the literature of accounting. The AASB deals with the intangible assets in the AASB 138 that proposes the treatment and identification criteria for the intangible assets. As per the standard, the idea of financial accounting is to make the information helpful in decision making for financiers and financial information users. For making the accounting information useful, the information needs to be understandable, relevant, comparable and reliable. Comparability is one of these requirements which need to be fulfilled to make this information useful. It means that the investor needs to be able to compare the reports of the firms though time and with other firms. This means that the investors need to have information which is consistent over time and among all relevant competitive firms at the least (Tsalavoutas et al., 2014).
The standard of AASB 138 was applied to promote comparability of the financial reports in Australia in 2005 (Federal Register of Legislation, 202017). A report on the analysis of the compliance with this standard and its comparability has shown that there are certain areas within this standard which has posed problems in the context of the compliance and comparability of the financial statements (Mindermann & Brösel, 2009). The report shows that without specific guidance on how and when to disclose items, companies usually differ in terms of their disclosed information which results in lack of comparability of the statements. In terms of the perspective of the users, it is often not easy to determine if the disparity is because of the companies understand the requirements, or they are considering the intangible assets as material or are not complying with the regulations specifically. Furthermore, in terms of comparability, it can only be warranted if all of the entities interpret the capabilities similarly. As there are no rules on the interpretation of the enterprise, and on how the companies would show the extra recognition criteria used for the internally produced intangibles, it is predictable that the businesses can go on in different direction and thus result in incomparable information in their financial statements. Furthermore, in terms of comparability, the option of the standard treatment of the intangibles and the allowed alternative treatment is also problematic. The rates for valuation are also derived from different origins which show that the comparison of these accounts is certainly not suitable. Furthermore, as with time, the asset prices increasingly deviate that enables the development of discrepancies in the valuation of the asset as well. In terms of the standard treatment, the depreciation deductions are done, and this causes the valuation rate to be declined. The allowed alternative treatment, however, on the other hand, includes constant revaluations which ultimately lead to increased valuation rates causing the lack of comparability in the financial statements of the company.
Question 3– Write a response to the CEO, drawing on your understanding of AASB 138/IAS 38 and the efficient market hypothesis (refer to chapter 2 of Loftus). Include a recommendation as to how the company might mitigate their concerns about investors’ interpretation of the information reported in the financial statements
As per the AASB 138 Standard for Intangible Assets.
It is stated that all internally produced intangibles other than the development expenditure need to be expensed as it is incurred. As per the AASB 138 clause of Intangible assets, the internally produced or developed intangible assets except for the development expenditures cannot be carried forward as the account of the assets. The intangible assets which can be identified are the development costs which have probable future economic profits, and whose costs can be measured reliably. Furthermore, as per paragraph 71 of AASB 138, once an intangible item is recorded as expense, it shall not be documented as a fraction of the cost of the intangible asset at any other date.
This shows that the research stage of the project is to be expensed as incurred. While the development phase of the research expenses can be deferred if the company can establish its economic profits in the future, can use it, and can calculate the expenditure during its development.
This will result in expensing the $10, 00,000 costs as an expense in the profit and loss statement and the recognition of the $30, 00,000 expenditure value of the design as deferred development costs as assets in the balance sheet and it is to be amortized over its useful life.
It is true that the direct expensing of the intangibles is considered as conservative accounting as it underestimates the value and earnings of the assets than overestimating it. However, reports have shown that conservative valuation necessarily does not mean that the company is not doing well. Research shows that companies with higher Research growth rates usually report conservatively.
Furthermore, the Efficient Market Hypothesis states that the stock prices for any given time are reflective of all available price sensitive information. As per this theory, the security prices are insightful of the relevant information immediately and in a much-unbiased manner. Therefore, this shows that there would be any situation in which investors can plan investment strategies which beat the market consistently except by chance. Evaluating this, it can be said that Efficient Market Theory states that the markets are quite efficient. Therefore, the rapid adjustment in the prices of the stocks is in response to the information that has been received, and this is one important element of the efficient market. As per Fama (2015), the efficient capital markets show that assets and their prices are fully reflective of all the available information.
Moreover, there are ways in which the investors can be educated on the undervaluation of the intangibles due to standard compliance. There are examples of companies who have done that as well. Companies usually show the financial position without and with compliance with certain standards depicting the probable undervaluation of their assets. This is one way through which the company can show how the research project has been a success and is undervalued in the financial statement as most of its value is expensed as incurred. Thus, as per the efficient market hypothesis, delivering this information effectively would be important to educate the investors and make them respond reflecting on this information as well.
Recommendation:
Thus, it is recommended to expense the account for research costs of $1000000 and defer the development costs of $3000000 and recognize it as an intangible asset on the financial statement with amortizing it on its useful life of 10 years. Furthermore, it is also advised that the company provides a detailed preview of the accounting without compliance with AASB 138 showing the actual value of the New Research and Development Project. This can help to educate the investors with the successful completion of the Research project.
References:
Accounting Standards Board, 2016. Accounting for Research and Development Costs. [Online] Available at: https://www.aasb.gov.au/admin/file/content102/c3/AAS13_3-83.pdf [Accessed 10 May 2019].
Australian Government, 2018. Intangible Assets AASB 138. [Online] Available at: https://www.aasb.gov.au/admin/file/content105/c9/AASB138_08-15_COMPoct15_01-18.pdf [Accessed 10 May 2019].
Bakker, G., 2014. Money for nothing: How firms have financed R&D-projects since the Industrial Revolution. Research Policy, 42(10), pp.1793-814.
Fama, E.F., 2015. Efficient Capital Markets. The Journal of Finance, 46(5).
Federal Register of Legislation, 202017. Intangible Assets. [Online] Available at: https://www.legislation.gov.au/Details/F2005B00689 [Accessed 10 May 2019].
Hunter, L., Webster, E. & Wyatt, A., 2012. Accounting for Expenditure on Intangibles. Abacus, 48(1), pp.104-17.
Mindermann, T. & Brösel, G., 2009. Does the capitalization of internally generated intangible assets according to IAS 38 really provide useful information? Ekonomia Menedżerska, 6(2), pp.7-16.
Tsalavoutas, O., André, P. & Dionysiou, D., 2014. Worldwide application of IFRS 3, IAS 38 and IAS 36, related disclosures, and determinants of non-compliance. [Online] Available at: https://www.accaglobal.com/content/dam/acca/global/PDF-technical/financial-reporting/rr-134-001.pdf [Accessed 10 May 2019].
