Question

Question: (Accounting for Research and Development Costs) Cuevas Co. is in the process of developing a revolutionary new product. A new division of the company was formed to develop, manufacture, and market this new product. As of year-end (December 31, 2017), the new product has not been manufactured for resale. However, a prototype unit was built and is in operation.

Throughout 2017, the new division incurred certain costs. These costs include design and engineering studies, prototype manufacturing costs, administrative expenses (including salaries of administrative personnel), and market research costs. In addition, approximately \(900,000 in equipment (with an estimated useful life of 10 years) was purchased for use in developing and manufacturing the new product. Approximately \)315,000 of this equipment was built specifically for the design development of the new product. The remaining $585,000 of equipment was used to manufacture the pre-production prototype and will be used to manufacture the new product once it is in commercial production.

Instructions

1. How are “research” and “development” defined in the authoritative literature (GAAP)?
2. Briefly indicate the practical and conceptual reasons for the conclusion reached by the Financial Accounting Standards Board on accounting and reporting practices for research and development costs.
3. In accordance with GAAP, how should the various costs of Cuevas described above be recorded on the financial statements for the year ended December 31, 2017?

Short answer

Answer

FASB concluded that the first two principles of expense recognition do not apply, but rather that the “immediate recognition” principle of expense recognition should apply. The cost of equipment produced solely for the development of the product is $315,000.

Step-by-step solution

Meaning of Research and Development Costs

Research and development are the costs referred to as the expenses incurred to manufacture new goods and processes. These expenses are often charged as expenses because they may not produce practical results.

(a) Explaining the “research” and “development” that is defined in the authoritative literature (GAAP)

Research, as defined in GAAP (FASB ASC 730-10-25), is a “planned search or critical investigation aimed at the discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service or a new process or technique or in bringing about a significant improvement to an existing product or process.”

Development, as defined in GAAP (FASB ASC 730-10-25), is “the translation of research findings or other knowledge into a plan or design for a new product or process, or for a significant improvement to an existing product or process whether intended for sale or use.”

(b) Indicating the practical and conceptual reason

FASB adopted current accounting and reporting procedures for research and development expenditures in order to decrease the number of options previously available and to offer valuable financial information about research and development costs.The FASB investigated four different accounting methods:

1. Charge all expenses to expenses when they occur,
2. capitalize all costs when they occur,
3. Selective capitalization, and
4. Accumulate all costs in a distinct category until future benefits can be established.

All research and development expenses should be charged to expenses as incurred, according to the FASB. (The authoritative R&D advice (FASB ASC 730-10-25) does not relate to activities peculiar to extractive industries businesses.) Accounting for the costs of research and development activities performed for others within a contractual agreement is covered in other publications, such as FASB ASC 730-20-5.)

The FASB evaluated three fundamental principles of expenditure recognition in making this decision:

(1) Linking cause and effect,

(2) Systematic and logical allocation, and

(3) Rapid recognition. The FASB discovered little or no evidence of a direct causal link between present R&D spending and future benefits. The FASB also indicated that the considerable degree of uncertainty surrounding future benefits, if any, of particular research and development projects makes it unlikely that capitalizing on expenses and distributing them across future years will serve any beneficial purpose.

I give the foregoing; the FASB determined that the first two principles of expenditure recognition do not apply and that the "instant recognition" concept should be used instead.

The FASB rejected the alternatives of capitalization, selective capitalization, and accumulation of costs in a special category due to the high degree of uncertainty about whether research and development expenditures will provide any future benefits, the lack of objectivity in setting criteria, and the lack of usefulness of the resulting information.

(c) Explaining In accordance with GAAP, the various costs of Cuevas described above be recorded on the financial statements for the year ended December 31, 2017

Costs incurred only for research and development should be expensed when they have incurred:

Engineering and design studies.

Costs of prototyping administrative expenditures only for R&D.

The expense of equipment created specifically for product development ($315,000).

The remaining $585,000 in the equipment should be capitalized and reported at cost, minus accrued depreciation, on the statement of financial position. The current year's depreciation expense is included in the year's research and development expense. The direct expenditures of market research and related administrative charges are not considered research and development expenses. These expenses are recorded as current income statement expenditure items and are handled as period costs.