Topic: Research Individual Assignment
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.
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 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.
Requirements
- 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:
This research report is based on evaluation of accounting standard AASB 138 by applying this standard in the situation of the selected company. The company selected for this research report was Technologies Limited. The criteria and requirement of recognizing the cost and development costs have been evaluated in this report by considering the treatment of research and development under AASB 138. The concept of comparability of financial reports has also discussed in the report by applying this concept in Technologies Limited. The accounting treatment under AASB 138 has been practically discussed in the last part of the report by considering research and development costs of $1000000 and $3000000.
Question 1
Treatment of Research and Development expenditures under AASB 138:
To make changes in recharging batteries method, the management of Technology Enterprises Limited decided to conduct a research project in July of the last year 2017. The project was completed by the management by the end of June 2018. The project completion resulted in applying for gaining a patent of new product design. The current target of the company is to make modifications within the next two years in all categories of the products based on new design selected by the management. The company has set the planning regarding financial budgets along with setting a target of the next 10 years for getting economic benefits from its new designed products. New Project R &D account is considering by the management for the accounting purpose of the project. These accounts would be used by the company for recording salaries of the new project of Research.
Description of AASB 138:
AASB 138 is considered as one of the most important standards of accounting because it specified the recognition and measurement of intangible assets of an organization along with the important requirements for providing disclosure of these assets. Some of the examples of intangible assets covered by this standard include market share, the loyalty of customers, mortgage rights of services, copyrights and patents. According to the requirements of AASB 138, it is applied to research and development activities that could take the form of prototype or asset. Important point described in the standard is that the development of knowledge is directed by these research and development activities. By considering the evidence in the case of Technology enterprises, it is confirmed that research and development expenditures often result in patent development that proved that these expenditures are not usually considered as intangible assets. In the case of Technology enterprises, the management filed for gaining patent regarding its latest design for batteries product. Therefore an intangible asset is resulted in having a certain future value from the project of research and development of Technology enterprises. The requirements under AASB 138 pointed out that assessment of qualified internally generated intangible asset in respect of recognition is sometimes difficult. According to paragraph 52 of AASB 138, to assess the criteria of recognition for internally generated intangible assets, the management of the organization has to classify asset generation into two different phases. The first phase is research-based and the second phase is developed based (Cheung et al., 2008).
It is not possible for an entity to demonstrate the existence of intangible asset during the research phase of the project because the entity could not identify the generation of economic benefits from the internal project in the research phase. This is the reason that when this expense is incurred when it is recognized by management as an expense. Certain examples of activities conducted in research phase include those activities that are conducted for gaining any level of new knowledge, the research conducted in respect of identifying alternatives regarding systems, processes, products and device materials and search for knowledge regarding the application of research findings (Steenkamp & Steenkamp , 2016).
When any level of development by management resulted in the generation of an intangible asset by conducting internal project then this intangible asset should be recognized by management if management can identify the following aspects:
- Identification of feasibility at the technical basis for making an asset available for sale or use
- Identification of the entity’s intention of completing the assets in order makes it available for sale or use
- The ability of an intangible asset to be a sale or use
- The ability of an asset to generate probable economic benefits in future
- Ability regarding reliability measurement
Because of the reason that this phase of development is advanced than the phase of research, therefore, it is a phase during which intangible assets are identified by the entity and demonstrate the ability of an asset to generate benefits in future. Some key examples of activities for development include the designing, the process of construction and conduction of test regarding models and pre-use prototypes and the use of new technology for tools designing such as dies and jigs (Fraser, 2018).
How intangible assets that generated internally should be recognized:
It is demonstrated in AASB 138, all those expenses or intangible assets that generated internally which do not fall in the category of development cost should not be considered as assets or capital expenditure. Therefore these costs should be accounted for as expense at the time as they incurred, for example, according to paragraph 68, when payments by the entity have made in advance then it is not required from entity to recognize such prepayment as an asset. While the recognition of all the development expenditure as intangible assets should be carried out if these assets can generate future economic benefits for the company and ability to calculate costs reliably (Denicolai et al., 2015). In respect of recognition of past expense as an asset, paragraph 71, demonstrated that when any cost incurred on the intangible asset and has been recognized in past as expense should not be the part of the cost of that asset afterward date. In existence of active marketplace for such assets, the valuation is done based on asset’s fair value, but due to lack of existence of the active market, such assets were recognized on undervaluation basis in the company’s balance sheet.
The accounting treatment in respect of new research and development project by following AASB 138 is given below in the table:
| Time costs incurred in respect of conduction of research and evaluation of alternatives for materials | $100,000 |
| The number of costs regarding model designing and completion of construction and prototype testing | $700,000 |
| The costs regarding the provision of training to staff in respect of creating new designing. | $200,000 |
| The Design’s Fair Value | $300,000 |
Question 2
Comparability of Financial reports and AASB 138:
The capital market value of an organization is based on the effectiveness of research and development activities. Therefore, the development of the standard was based on providing appropriate guidance regarding the capitalization of intangible assets. The development of AASB 138 by the AASB board was based on the objective of providing the recognition criteria for the intangible assets of the organization. This AASB 138 standard helps incomparability of the financial reports of companies which were an issue because of the reason of existence f substantial difference between the market capitalizations and the financial positioned. The AASB standards are developed for increasing the effectiveness of financial accounting. The provision of accurate and useful information to the users of financial statements is the main goal of financial accounting and its standards. Comparability is considered as important requirements of the standards of financial accounting because the decision-making process could be effective based on comparable financial information. For example, the AASB 138 standard presented a requirement and criteria for recognizing the research and development costs differently. This standard has increased the accuracy of the financial information extracted by the investors by making a comparison of financial reports (Barth, 2015).
The comparability of financial reports of companies was performed by the implementation of AASB 138 standard in 2005 in Australia. The basic objective of that analysis was to evaluate how the standard contributes incomparability of financial reports. The results of the report pointed out that certain requirements under the standard created issues concerning the comparability and compliance of financial reports. The problem that could be created in comparability f financial reports is that use of different accounting policies by the company over some time. Another problem could be faced by the users when comparability of financial reports of different companies in the same industry because of the use of different treatment and accounting policies. AASB 138 standard put attention on use of similar form of the policies and recognizing treatment in order to aid users to analyze the position and performance of one company in relation to standards of particular industry (De Franco et al., 2011) In case of evaluating the intangible assets it becomes difficult for the users to determine the main reason for disparity because the AASB 138 focus on separating the capital expenditures from the expense costs. Before the development of this standard, there were no rules existed for making a comparison between the companies and companies were allowed to use different principles of recognizing the internally generated intangible assets which eventually make the information of financial reports of companies incomparable. It is important to note that the treatment for alternatives and the treatment of intangible assets are also problematical. The comparability of these accounts is not possible because of the reason that different origins were used for the selection of rates of valuation. Another important aspect is that the changes in prices of assets which required considering the development costs incurred for discrepancies in the asset valuation. By considering the requirements of recognition under the standard, the decline in valuation rate occurred because of the deduction done based on depreciation. In comparison to it in respect of considering the allowed alternative treatment, the valuation rates were increased because of revaluation constantly. This was the main reason for the lack of comparability of financial reports of the company over a certain period (Klein, 2018)
Question 3
The requirements under AASB 138 revealed that recognition f internally generated intangible assets is difficult in some situation when management could not identify it clearly as the expense of capital development. If the expenditure is incurring on the intangible asset the treatment of recognition under AASB 138, need to recognize this expenditure as expense in profit and loss as incurred. The circumstances under which intangible asset of the company is expecting to generate a certain level of future economic benefits and the costs of that particular asset could be measured reliably then that intangible asset should be considered as an intangible asset and should be recognized according to the standard requirement. The standard under paragraph 71 guided that once any of the intangible items of the company is charged an expense, it could not be considered as the fraction of cost of an intangible asset in the future.
In this way, the standard provides a guideline regarding the treatment of research and development expenditures. According to the standard, the expenditure incurred at research phase must be recognized as an expense in profit and loss account while in comparison to it the treatment for development phase is that it could be deferred in case management confirm the generation of future economic benefits. By looking the requirement of this treatment $10, 00,000 costs would be charged as an expense in P&L account and the costs of $30, 00,000 that is incurred for the design would be considered as a capital expense and it will be charged in the balance sheet as an asset. The treatment also included the amortization of that asset over the useful life.
Conservative accounting is a way of underestimating the values of assets a Based on analysis of the report; it is noted that the meaning of conservative valuation is not a bad performance of an organization (Glover & Lin, 2018). According to the research conservatively is reported in those companies which have high growth rates for research. According to the concept of the Efficient Market Hypothesis, all important and price sensitive information is reflected by the stock price for any given time. By the concept under this theory, in a much-unbiased way, all the comparative information is aware by the security prices. This is the reason that during certain conditions the strategies developed by the investors beat the market because of efficient market conditions. According to the Efficient Market Theory, the rapid adjustment in the stock prices could be made by the management when the markets are quite efficient.
Recommendation:
It is recommended that management should have to ensure that the accounting treatment of the New Research and Development Project is carried according to the criteria of AASB 138. It is recommended presenting the actual valuation of the company to the investors because it will increase the understanding of project success. Therefore, management should have to charge $3000000 as development and capital assets in balance sheet and $1000000 cost should be account for as an expense.
Conclusion
It is concluded that AASB 138 has provided the treatment of research and development of intangible assets which was an issue for the management. The criteria described in standard help in separating the expense and the capital development cost. It is concluded that the confidence of investors could be increased by following the AASB 138 for all intangible assets. This would help the investors to make decisions by comparability of financial reports.
References:
Barth, M.E., 2015. Commentary on prospects for global financial reporting. Accounting Perspectives, 14(3), pp.154-67.
Cheung, E., Evans, & Wright, S., 2008. The adoption of IFRS in Australia: The case of AASB 138 (IAS 38) Intangible Assets. Australian Accounting Review, 18(3), pp.248-56.
De Franco, G., Kothari, S.P. & Verdi, R.S., 2011. The benefits of financial statement comparability. Journal of Accounting Research, 49(4), pp.895-931.
Denicolai, S., Cotta Ramusino, E. & Sotti, , 2015. The impact of intangibles on firm growth. Technology Analysis & Strategic Management, 27(2), pp.219-36.
Fraser, , 2018. Alternative assets insights: Budget announcements thin capitalisation. Taxation in Australia, 53(2), p.90.
Glover, J.C. & Lin, H.H., 2018. Accounting conservatism and incentives: Intertemporal considerations. The Accounting Review, 93(6), pp.181-201.
Klein, A., 2018. Discussion of “Financial Statement Comparability and the Efficiency of Acquisition Decision. Contemporary Accounting Research, 35(1), pp.203-10.
Steenkamp, N. & Steenkamp , S., 2016. AASB 138: catalyst for managerial decisions reducing R&D spending? Journal of Financial Reporting and Accounting, 14(1), pp.116-30.
