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Study: R&D Rule Threatens Future Earnings

In the year of an acquisition, however, it should boost net income and help some companies swing reported losses into a profit.

Marie Leone, | US
May 20, 2008

Research and Development in Basket Purchases Industry Specific

If I understand the accounting rule correctly, as recited in the article, both research and development acquired in a business combination will be capitalized. That is not entirely correct theoretical accounting in practice unless we consider a very specific industry. Research for products and services to bring to market have no proof of concrete commercial viability. However, when it does, it becomes development. Thus, under theoretically correct accounting in practice for entities for which research is a support, back office, or derivative activity, research and development should be assessed at fair values on the business combination and separately identified in the basket purchase, but the research should be expensed at acquisition since it does not provide a probable asset until development occurs. For instance, what if the parent entity decides not to continue the research of the acquired entity? Then the capitalized asset would be expensed when that decision is made. However, while that is correct, the capitalizing still should not occur due to too much uncertainty. Thus, contingent assets should not be capitalized and that rule is followed under International Standards. The research should be expensed when incurred, under matching, since it is not generating future cash flow and revenues as the economic benefit until the development phase. Conversely, some might say that research should be considered as an intangible asset. That definitely depends on the industry. A company built on research as its mandate might best be represented economically if it derives revenues from research. Then, capitalization would be warranted since capitalization and amortization achieves the matching principle of research revenues to research expenses. Perhaps a good example would be an institution similar to a University. If its research was marketable and revenues were generated then capitalizing and amortizing research makes economic representational faithfulness sense. However, companies that depend on research merely to bring products and services to production should expense research as previously mentioned. The fair value of development activities should be capitalized in a business acquisition and amortized over the period, which best matches, the inflow of economic benefits such as revenues and cash flows, regardless of the industry.

Posted by David Newman | May 20, 2008 06:55 pm

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