ABC Ltd manufactures and distributes a wide range of medical products to hospita
ID: 2572232 • Letter: A
Question
ABC Ltd manufactures and distributes a wide range of medical products to hospitals and clinics. Suppose you are the auditor of ABC Ltd. The CEO of ABC Ltd calls you and asks your opinion on the possibility of carry-forward research and development expenses. After reading the draft financial statements of 2016, the CEO finds that the total research and development expenditure for the year ended 31 December 2016 is substantially higher than that of 2015 and this significantly affects the reported profits. The CEO discloses the following research and development expenses to you:
a The cost to test a new bacteria-free dispenser pack for the company’s main product ($500,000). The new packs will be introduced in Hong Kong in Spring 2017.
b Experimental costs to convert a line of headache powder to liquid form ($60,000). The company hopes to replace the powder form with the liquid form if the test is successful.
c Quality control improvements ($1 million) required by law on all the products of the company.
d Costs of a time and motion study ($30,000) aimed at improving production efficiency for an existing machine.
e Construction and testing of a new prototype machine for producing syringe needles ($300,000). Testing has been successful to date and is near completion. Syringe needles account for 3% of total sales in 2016. It is expected that the company’s market share will increase after the introduction of this new machine
Required:
Write an email to the CEO to suggest the proper accounting treatment for each of the above items. In your response, you must provide valid reasons to support your view
Explanation / Answer
Answer:
Background;
Costs to perform research and development (R&D), including internal development costs, should be expensed as incurred regardless of past history with similar drugs or regulatory authority approval expectations. There is no capitalization of internal costs for R&D under US GAAP. Under FAS 2 issued in 1974, all R & D costs covered by this statement shall be charged to expense when incurred.
However, the revised IAS 38, allowas capitalisation of intangible asset arising from development or from the development phase of an internal project ionly if following can be demonstrated:
1. The technical feasibility of completing the intangible asset, so that it will be available for use or sale;
2. Its intention to complete the intangible asset and use or sell it;
3. Its ability to use or sell the intangible asset;
4. How the intangible asset will generate probable future economic benefits; among other things, the enterprise should demonstrate the existence of a market for the intangible asset or for the output of the intangible asset, or the internal usefulness of the intangible asset;
5. The availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and
6. Its ability to reliably measure the expenditure attributable to the intangible asset during its development.
The expenditure on research is always recognized as an expense.
Noe lets take each item one by one:
a The cost to test a new bacteria-free dispenser pack for the company’s main product ($500,000). The new packs will be introduced in Hong Kong in Spring 2017.
Response: Testing of a pre-production model falls under the dfinition of development and it also fulfills the criteria given above and hence can be capitalised under IAS 38
b Experimental costs to convert a line of headache powder to liquid form ($60,000). The company hopes to replace the powder form with the liquid form if the test is successful.
Response: Experimental costs falls under the definition of Research and hence should be charged off as incurred.
c Quality control improvements ($1 million) required by law on all the products of the company.
Response: Quality control improvements does not fall under the development cost and hence should be charged off as incurred.
d Costs of a time and motion study ($30,000) aimed at improving production efficiency for an existing machine.
Response: The Time and motion study fall under the activities aimed at obtaining new knowledge i.e research phase and hence should be charged off as incurred.
e Construction and testing of a new prototype machine for producing syringe needles ($300,000). Testing has been successful to date and is near completion. Syringe needles account for 3% of total sales in 2016. It is expected that the company’s market share will increase after the introduction of this new machine
Response: Testing of a pre-production model falls under the dfinition of development and it also fulfills the criteria given above and hence can be capitalised under IAS 38