Research and Development at the Thomas Company

Research and Development at the Thomas Company

ACT480- Accounting Research and Analysis

Colorado State University-Global Campus

Wendy Achilles

May 16, 2018

Research and Development at the Thomas Company

Research and development (R&D) refer to the innovation and improvement of products or procedures of a business.  It is the process of analyzing activities to improve existing methods and products or the development of new systems and merchandise.  R&D is different from most business activities, in that, its performance is without any expectation of immediate profit or the possibility of no earnings whatsoever.  Companies that dedicate departments to R&D must commit significant capital to the project with a high risk of no reward. If a business uses the accrual basis accounting method, then the matching principle must be implemented.  The matching principle requires that revenue and related expenses must be recognized (matched) in the same period they occurred (AccountingCoach, n.d.).  The accounting of R&D can be complicated because the expenses are difficult to associate with revenue or an asset.

The Thomas Company established a new department to produce and market a new innovative product they are in the process of developing.  As of December 31st, the product is still unavailable for sale to the public, but the prototype was built and is operational.  Throughout the year, the department incurred administration expenses, prototype manufacturing and market research expenses and design and engineering studies expenses.  The equipment purchases for developing and manufacturing the prototype with an estimated useful life of 10 years cost $500,000, but it can also be used for producing the finished product.  The breakout of cost from the equipment is approximately $200,000 for the design and development of the prototype, and the remaining $300,000 is for commercial production of the new product.  This essay will explore the differences in how development costs are expensed under the US generally accepted accounting principles (GAAP) versus how development costs are capitalized under the International Financial Reporting Standards (IFRS).  

In both GAAP and IFRS, R&D costs are expensed as they are incurred, not using the matching principle as with most expenses.   However, IFRS allows certain development cost to be capitalized once established economic expectation criteria are met, while all research costs are expensed each year.  R&D expenses are significant economically, and the refusal to allow these expenses to be capitalized impairs the relevance of the financial statements.  Without capitalizing R&D, earnings can be understated because of the company’s investment in R&D as part of the operating investment. R&D investment is a long-term investment in future cash flow (Corporate Finance Institute, n.d.). R&D expenditures have more impact on future operating income than current operating income. In the paper, The Impact of Different Accounting Reporting Methods on the Informativeness of Research and Development cost: IFRS compared to U.S. GAAP, the authors believed that the ability to capitalize the expense of R&D were beneficial for the amortization rates and stock returns and stock prices.  They concluded that the results of their study were significant enough that US companies should consider adopting the IFRS’ treatment of R&D.