Research and Development Costs in Canadian Accounting

13.6 Research and Development Costs

In the realm of accounting, research and development (R&D) costs are a critical area that demands careful consideration and understanding, especially within the Canadian context. This section will delve into the principles and applications of accounting for R&D costs, focusing on the International Financial Reporting Standards (IFRS) and the Accounting Standards for Private Enterprises (ASPE) as they apply in Canada. We will explore the criteria for capitalization versus expensing of R&D activities, provide practical examples, and discuss the implications of these decisions on financial statements.

Understanding Research and Development

Research and Development (R&D) refers to the activities undertaken by companies to innovate and introduce new products or services. It is a crucial component for growth and competitiveness in many industries, including technology, pharmaceuticals, and manufacturing. In accounting terms, R&D costs can be significant and have a substantial impact on a company’s financial statements.

Definitions

• Research: The original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.
• Development: The application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems, or services before the start of commercial production or use.

Accounting Standards for R&D Costs

In Canada, the accounting treatment for R&D costs is governed by two main sets of standards: IFRS for publicly accountable enterprises and ASPE for private enterprises. Each framework has specific guidelines on how to account for these costs.

IFRS Guidelines

Under IFRS, particularly IAS 38 “Intangible Assets,” the treatment of R&D costs is divided into two phases: the research phase and the development phase.

• Research Phase: Costs incurred during the research phase are expensed as incurred. This is because the outcome of research is uncertain, and it is not possible to demonstrate that an asset exists that will generate probable future economic benefits.

• Development Phase: Costs incurred during the development phase can be capitalized if certain criteria are met. These criteria include:

  • Technical feasibility of completing the intangible asset so that it will be available for use or sale.
  • Intention to complete the asset and use or sell it.
  • Ability to use or sell the asset.
  • How the asset will generate probable future economic benefits.
  • Availability of adequate technical, financial, and other resources to complete the development and to use or sell the asset.
  • Ability to measure reliably the expenditure attributable to the asset during its development.

ASPE Guidelines

Under ASPE, specifically Section 3064 “Goodwill and Intangible Assets,” the treatment of R&D costs is similar to IFRS, with some differences in the criteria for capitalization. ASPE allows for the capitalization of development costs when certain conditions are met, similar to those under IFRS.

Capitalization vs. Expensing

The decision to capitalize or expense R&D costs can significantly affect a company’s financial statements. Capitalizing R&D costs results in recognizing an asset on the balance sheet, which is then amortized over its useful life. Expensing R&D costs, on the other hand, results in an immediate reduction in net income for the period in which the costs are incurred.

Factors Influencing the Decision

• Nature of the Project: Projects with a high degree of uncertainty or those in the early stages of research are typically expensed. Projects that have reached a stage where the outcome is more certain and the criteria for capitalization are met may be capitalized.
• Industry Practices: Different industries may have varying practices regarding R&D capitalization, influenced by the nature of their products and the competitive landscape.
• Regulatory Environment: Compliance with accounting standards and regulatory requirements is crucial in determining the appropriate treatment of R&D costs.

Practical Examples

To illustrate the application of these principles, consider the following examples:

Example 1: Pharmaceutical Company

A pharmaceutical company is engaged in the research and development of a new drug. During the research phase, the company incurs costs related to laboratory research and clinical trials. These costs are expensed as incurred. Once the drug reaches the development phase, and the company can demonstrate technical feasibility, intention to complete, and probable future economic benefits, the development costs are capitalized.

Example 2: Technology Startup

A technology startup is developing a new software application. During the initial research phase, costs related to market research and feasibility studies are expensed. As the project progresses to the development phase, and the company meets the criteria for capitalization, costs related to software development are capitalized.

Implications on Financial Statements

The treatment of R&D costs has several implications on a company’s financial statements:

• Balance Sheet: Capitalizing R&D costs results in the recognition of an intangible asset, which increases the total assets on the balance sheet.
• Income Statement: Expensing R&D costs results in a reduction of net income in the period the costs are incurred. Capitalizing costs results in amortization expenses over the useful life of the asset.
• Cash Flow Statement: The treatment of R&D costs affects the classification of cash flows. Capitalized costs are reflected in investing activities, while expensed costs are reflected in operating activities.

Regulatory and Compliance Considerations

Companies must ensure compliance with the relevant accounting standards and regulatory requirements when accounting for R&D costs. This includes maintaining adequate documentation to support the capitalization of development costs and ensuring that the criteria for capitalization are consistently applied.

Challenges and Best Practices

Accounting for R&D costs presents several challenges, including:

• Estimating Future Economic Benefits: Determining the probable future economic benefits of a development project can be challenging, especially in industries with rapid technological changes.
• Documentation and Evidence: Companies must maintain thorough documentation to support the capitalization of R&D costs, including evidence of technical feasibility and the ability to generate future economic benefits.
• Consistency in Application: Ensuring consistent application of the criteria for capitalization across different projects and periods is crucial for accurate financial reporting.

Best Practices

• Establish Clear Policies: Develop clear accounting policies for R&D costs that align with the relevant standards and regulatory requirements.
• Regular Review and Assessment: Regularly review and assess R&D projects to determine whether they meet the criteria for capitalization.
• Documentation and Record-Keeping: Maintain detailed documentation to support the capitalization of R&D costs, including project plans, budgets, and technical assessments.

Conclusion

Accounting for research and development costs is a complex area that requires careful consideration and adherence to the relevant accounting standards. By understanding the criteria for capitalization and expensing, and applying these principles consistently, companies can ensure accurate financial reporting and compliance with regulatory requirements. This knowledge is essential for accounting professionals preparing for Canadian accounting exams and for those working in industries where R&D is a significant component of business operations.

Ready to Test Your Knowledge?