Accounting for research and development costs: a comparison of U.S. and international standards

Review of Business, Spring, 2005 by Sylwia Gornik-Tomaszewski, Miguel A. Millan

Abstract

Accounting for research and development (R & D) activities is an area of divergence between U.S. Generally Accepted Accounting Standards (U.S. GAAP) and International Financial Reporting Standards (IFRS). Under U.S. GAAP, all R & D expenditures are charged to expense when incurred. According to IFRS, an intangible asset arising from development is recognized if specific criteria are met. Little progress has been achieved towards convergence on this issue.

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Introduction

The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) continue their efforts to converge their accounting standards into a single set of high-quality financial reporting standards. These efforts, which started in earnest in 2002, have lead to the identification of areas where the accounting models for similar transactions differed. Accounting for research and development (R & D) activities is one of the areas of divergence between the two accounting frameworks. This paper focuses on the differences between Generally Accepted Accounting Principles in the United States (U.S. GAAP) and International Financial Reporting Standards (IFRS or IAS) when accounting for R & D activities and covers the progress being made towards convergence.

Common Definition of R & D Activities in FASB and IASB Standards

Many costs have characteristics similar to those resulting from R & D activities: for example; start-up costs for a new plant or new retail outlet; marketing research costs; promotion costs of a new product or service; and costs of training new personnel. To differentiate R & D costs from other similar costs, the FASB and the IASB defined R & D activities in their respective standards, which are: International Accounting Standard (IAS) No. 38, Intangible Assets (IAS 38) and Statement of Financial Accounting Standards (FAS) No. 2, Accounting for Research and Development Costs (FAS 2). The definitions and examples of R & D activities are presented in Exhibit 1.

The definitions of "research and development" in FAS 2 and IAS 38 are almost identical. These two standards also share common examples of research and development activities. Accounting treatment of these intangible assets, however, differs between U.S. GAAP and IFRS.

Differences in the Accounting for R & D Activities Under FAS 2 and IAS 38

According to FAS 2, issued in 1974, all R & D costs encompassed by this statement shall be charged to expense when incurred. These costs include: (1) costs of materials, equipment and facilities that have no alternative future uses; (2) salaries, wages and other related costs of personnel engaged in R & D activities; (3) purchased intangibles that have no alternative future uses; (4) contract services; and (5) a reasonable allocation of indirect costs, except for general and administrative costs, which must be clearly related to be included and expensed. The total R & D costs charged to expense should be disclosed in the financial statements in each period for which an income statement is prepared. Also, under FASB Interpretation No. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method, in-process R & D costs should be written off to expense on the day they are acquired.

The FASB dismissed the alternative R & D accounting and reporting practices, including capitalization, which had been followed by business practice before 1974. In concluding that all R & D costs should be charged to expense, the Board considered such factors as uncertainty of future benefits of individual R & D projects and lack of causal relationship between expenditures and benefits. The Board considered an accounting method of selective capitalization, which is to capitalize R & D costs when incurred only if specific conditions are fulfilled and to charge to expense all other R & D costs. This method, requiring establishment of conditions that must be fulfilled before R & D costs are capitalized, has been practiced in many countries. For example, capitalization of selected R & D costs has been allowed under certain conditions in Japan and France, while capitalization of development costs has been practiced in the United Kingdom and, as discussed below, is required under international accounting standards.

The selective capitalization method requires prerequisite conditions that are based on such factors as technological feasibility, marketability and usefulness. FASB members argued that considerable judgment is required to identify the point in the R & D process at which a new or improved product is defined and determined to be technologically feasible, marketable or useful. The FASB decided to reject this method because, in practice, no set of conditions that might be established for capitalization of costs could achieve comparability among enterprises. In addition, selective capitalization is applied only to costs incurred after fulfillment of the specified conditions, and the capitalized amount would not indicate the total costs incurred to produce future benefits, nor would the amount of periodic amortization of capitalized costs represent a matching of costs and benefits.