The initial effects on financial statements depend on whether the acquisition costs can be capitalized and recognized as an asset (i.e., the four conditions for asset recognition and measurement are met) or not, and thus recognized as an expense. If the acquisition costs are initially capitalized, subsequent cost allocation decreases the long-lived asset over its useful life, and the consumption of the cost is treated as an expense. The remaining book value of the asset (its adjusted acquisition cost) is reported on the balance sheet. If the initial cost is deemed to be an expense, the amount of consideration given will be expensed immediately and no balance sheet asset will exis
Because of the very different effects of capitalizing and expensing acquisition costs on balance sheets and income statements, your analysis of the quality of accounting for acquisition costs must focus on several related questions: Are capitalized acquisition costs justified? Were assets created, or should the costs be expensed? Are the firm’s capitalization policies clear and in line with competitors and economic reality? Were some economic assets created even though accounting rules require expense treatment? To inform your analysis, we examine issues related to the financial reporting of expenditures incurred in activities relating to real assets (tangible and intangible). We consider:
Because of the very different effects of capitalizing and expensing acquisition costs on balance sheets and income statements, your analysis of the quality of accounting for acquisition costs must focus on several related questions: Are capitalized acquisition costs justified? Were assets created, or should the costs be expensed? Are the firm’s capitalization policies clear and in line with competitors and economic reality? Were some economic assets created even though accounting rules require expense treatment? To inform your analysis, we examine issues related to the financial reporting of expenditures incurred in activities relating to real assets (tangible and intangible). We consider:
- property, plant, and equipment.
- research and development costs.
- software development costs.
- subsequent expenditures to enhance or maintain property, plant, and equipment.
- costs of self-construction.
- costs of acquiring intangible assets.
- costs of acquiring natural resources
Accounting for the Acquisition of Property, Plant, and Equipment: General Rule
In many cases, it is clear that the costs to acquire a piece of property, plant, and equipment will yield future benefits; thus, asset recognition is warranted. The general rule for recognizing the acquisition of an asset is that it should be recorded at the fair value of what has been sacrificed to acquire the asset (whether it be cash, debt, or equity shares) and to prepare the asset for its intended use (including costs to ship, temporarily store, insure, set up, test, and calibrate). Cash used to acquire property, plant, and equipment is reported as a cash outflow in the investing activities section of the statement of cash flows. If property, plant,and equipment is acquired using debt or equity (both of which are non-cash transactions), the investing activity will be reported as a significant non-cash investing and financing activity in a separate schedule. PepsiCo reports annual capital spending of between $2.7 and $3.3 billion over 2010–2012 in its consolidated statement of cash flows (Appendix A). In addition, acquisition of the intangible ‘‘manufacturing and distribution rights from DPSG’’ represents an additional $2.8 billion in 2010. These investments in tangible and intangible real assets utilize a significant portion of the $8.4–$8.9 billion annual net cash provided by operating activities over the same three-year period.
Accounting for Research and Development Costs
R&D (research and development) is an important activity for many firms. However, because of the inherent uncertainty in determining whether R&D activities will produce sufficient and reliably measurable future economic benefits to warrant being capitalized as an asset, U.S. GAAP requires firms to expense immediately all internal R&D costs.3 Externally acquired R&D from purchasing patents or licenses can be capitalized because the arm’s-length transaction between two market participants provides a reliable measure of acquisition cost and is an indicator of the existence of future economic benefits. For industries with high R&D expenditures, such as the research-intensive biotechnology industry, the U.S. GAAP requirement to expense internal R&D costs rather than capitalize them is especially noteworthy, because a major asset never appears on the balance sheet. A further complication in analyzing R&D activities arises from firms using different strategies to carry out R&D activities. For example, compare the different strategies of
Biogen Idec and Amgen, Inc. Biogen Idec has leading products and capabilities in neurology, hemophilia, and immunology. Revenues for 2012 exceed $5.5 billion. Biogen Idec principally develops drug-related products internally in its research laboratories, and discovers and develops drugs for human health care through genetic engineering. In describing its accounting policy on R&D costs, Biogen Idec states:
Research and development expenses consist of upfront fees and milestones paid to collaborators and expenses incurred in performing research and development activities including compensation and benefits, facilities expenses, overhead expenses, clinical trial and related clinical manufacturing expenses, fees paid to clinical research organizations (CROs), and other outside expenses. Research and development expenses are expensed as incurred
The firm’s 2012 R&D expense was approximately 24% of sales. In accordance with U.S. GAAP, the firm showed no asset on its balance sheet related to this in-house research activity. Biogen Idec also engages in acquisitions of other technology companies, in which it acquires established technologies, patent rights, and R&D work that is in process. Because these acquisitions are transactions with outside parties, Biogen reports a $1,039.6 million intangible asset on its balance sheet for established core technologies and patent rights and the fair value of in-process R&D of $330 million, which included $219 from a single acquisition of Stomedix in 2012
Amgen Inc. is a leading human therapeutics company, generating over $17 billion in revenues in 2012 from a number of top-selling products. The firm follows a strategy of internal development of biotechnology and external development through a series of joint ventures, licensing relationships, and partnerships. Amgen contributes preliminaryresearch findings to obtain its interest in these joint ventures and partnerships. The other participants provide funding to continue development of this preliminary research. In some cases, Amgen contracts with the joint venture or partnership to perform the continued development in its own laboratories. In this case, Amgen receives a fee each period in an amount approximately equal to the R&D costs incurred in conducting the research (resulting in no net R&D cost). In other cases, the joint venture or partnership entity conducts the research, in which case Amgen may show no R&D expense on its books. Amgen generally maintains a right of first refusal for any products developed, in which case it must pay the owners of the joint venture a periodic royalty. Amgen’s R&D expense for 2012 was 20.3% of sales.
Although these firms have similarly (large) R&D expenses as a percentage of sales, Amgen’s expense ratio does not capture the extent of its R&D activities, and its balance sheet might not capture the possibility of future cash inflows from using the future technologies in production. Amgen reports no R&D asset although it is a company that, in the past, has turned R&D assets into successful products and future cash flows. Further, its R&D expenses do not adequately capture its R&D activities because many of those activities are performed by its joint ventures and not shown as R&D expense on Amgen’s income statement. Biogen’s R&D expense captures its own R&D efforts to a greater extent and its balance sheet captures significantly more R&D activity cash flow potential because it is allowed to capitalize its fair value estimates of established core technologies and in-process R&D.
You could address this issue by choosing a single method to account for all R&D expenditures and modify financial statements by capitalizing and subsequently amortizing all expenditures on R&D that have future service potential, whether a firm incurs the R&D cost internally or purchases in-process or completed technology externally, and immediately expense all R&D costs that are not likely to have future service potential. This approach would also require the consolidation of the firm’s share of the assets, liabilities, revenues, and expenses of R&D joint ventures or partnerships. Unfortunately, you would quickly discover that the inherent uncertainty about future benefits that led accounting standard setters to require all internal R&D expenditures to be expensed creates difficulties in judging future service potential from financial statement disclosures alone. Reliance on firm disclosures of scientific and other information outside the financial reporting model is necessary. Also, the consolidation of joint ventures also might prove to be difficult because only some R&D joint venture data will be present in notesto the financial statements.
Even when modification of the financial statements is not possible because of lack of data, you should be aware of the effects of the R&D expensing rule on profitability analysis. The effects on ROA are countervailing between numerator and denominator. Missing assets understate total assets in the denominator. The numerator of ROA, net income (adjusted), is understated when all R&D is classified as current expense and is overstated when the amortization of R&D assets from prior successful R&D efforts is excluded. When R&D expenditures are growing, the net effect on the numerator will be understatement because current R&D expenses exceed the amortizations. A mature firm may reach a steady state where current R&D expense equals total amortization, which would have taken place if R&D had been capitalized. If that happens, the ROA numerator would be unaffected, but the denominator would still be understated due to the omission of the R&D asset. IFRS rules mitigate the likely overstatement of ROA because research costs are expensed and product development costs (the costs incurred after the research yields a product or process that is technologically feasible) are capitalized.6 In general, capitalization and amortization (relative to immediate expensing) results in a smoother income series and thus produces net income that is theoretically easier to predict. Although managers and others view R&D as a necessary investing activity, statement of cash flow reporting treats R&D as an operating activity because it does not result in a balance sheet asset. R&D reduces current period net income and thus reduces current period cash flows from operating activities
In many cases, it is clear that the costs to acquire a piece of property, plant, and equipment will yield future benefits; thus, asset recognition is warranted. The general rule for recognizing the acquisition of an asset is that it should be recorded at the fair value of what has been sacrificed to acquire the asset (whether it be cash, debt, or equity shares) and to prepare the asset for its intended use (including costs to ship, temporarily store, insure, set up, test, and calibrate). Cash used to acquire property, plant, and equipment is reported as a cash outflow in the investing activities section of the statement of cash flows. If property, plant,and equipment is acquired using debt or equity (both of which are non-cash transactions), the investing activity will be reported as a significant non-cash investing and financing activity in a separate schedule. PepsiCo reports annual capital spending of between $2.7 and $3.3 billion over 2010–2012 in its consolidated statement of cash flows (Appendix A). In addition, acquisition of the intangible ‘‘manufacturing and distribution rights from DPSG’’ represents an additional $2.8 billion in 2010. These investments in tangible and intangible real assets utilize a significant portion of the $8.4–$8.9 billion annual net cash provided by operating activities over the same three-year period.
Accounting for Research and Development Costs
R&D (research and development) is an important activity for many firms. However, because of the inherent uncertainty in determining whether R&D activities will produce sufficient and reliably measurable future economic benefits to warrant being capitalized as an asset, U.S. GAAP requires firms to expense immediately all internal R&D costs.3 Externally acquired R&D from purchasing patents or licenses can be capitalized because the arm’s-length transaction between two market participants provides a reliable measure of acquisition cost and is an indicator of the existence of future economic benefits. For industries with high R&D expenditures, such as the research-intensive biotechnology industry, the U.S. GAAP requirement to expense internal R&D costs rather than capitalize them is especially noteworthy, because a major asset never appears on the balance sheet. A further complication in analyzing R&D activities arises from firms using different strategies to carry out R&D activities. For example, compare the different strategies of
Biogen Idec and Amgen, Inc. Biogen Idec has leading products and capabilities in neurology, hemophilia, and immunology. Revenues for 2012 exceed $5.5 billion. Biogen Idec principally develops drug-related products internally in its research laboratories, and discovers and develops drugs for human health care through genetic engineering. In describing its accounting policy on R&D costs, Biogen Idec states:
Research and development expenses consist of upfront fees and milestones paid to collaborators and expenses incurred in performing research and development activities including compensation and benefits, facilities expenses, overhead expenses, clinical trial and related clinical manufacturing expenses, fees paid to clinical research organizations (CROs), and other outside expenses. Research and development expenses are expensed as incurred
The firm’s 2012 R&D expense was approximately 24% of sales. In accordance with U.S. GAAP, the firm showed no asset on its balance sheet related to this in-house research activity. Biogen Idec also engages in acquisitions of other technology companies, in which it acquires established technologies, patent rights, and R&D work that is in process. Because these acquisitions are transactions with outside parties, Biogen reports a $1,039.6 million intangible asset on its balance sheet for established core technologies and patent rights and the fair value of in-process R&D of $330 million, which included $219 from a single acquisition of Stomedix in 2012
Amgen Inc. is a leading human therapeutics company, generating over $17 billion in revenues in 2012 from a number of top-selling products. The firm follows a strategy of internal development of biotechnology and external development through a series of joint ventures, licensing relationships, and partnerships. Amgen contributes preliminaryresearch findings to obtain its interest in these joint ventures and partnerships. The other participants provide funding to continue development of this preliminary research. In some cases, Amgen contracts with the joint venture or partnership to perform the continued development in its own laboratories. In this case, Amgen receives a fee each period in an amount approximately equal to the R&D costs incurred in conducting the research (resulting in no net R&D cost). In other cases, the joint venture or partnership entity conducts the research, in which case Amgen may show no R&D expense on its books. Amgen generally maintains a right of first refusal for any products developed, in which case it must pay the owners of the joint venture a periodic royalty. Amgen’s R&D expense for 2012 was 20.3% of sales.
Although these firms have similarly (large) R&D expenses as a percentage of sales, Amgen’s expense ratio does not capture the extent of its R&D activities, and its balance sheet might not capture the possibility of future cash inflows from using the future technologies in production. Amgen reports no R&D asset although it is a company that, in the past, has turned R&D assets into successful products and future cash flows. Further, its R&D expenses do not adequately capture its R&D activities because many of those activities are performed by its joint ventures and not shown as R&D expense on Amgen’s income statement. Biogen’s R&D expense captures its own R&D efforts to a greater extent and its balance sheet captures significantly more R&D activity cash flow potential because it is allowed to capitalize its fair value estimates of established core technologies and in-process R&D.
You could address this issue by choosing a single method to account for all R&D expenditures and modify financial statements by capitalizing and subsequently amortizing all expenditures on R&D that have future service potential, whether a firm incurs the R&D cost internally or purchases in-process or completed technology externally, and immediately expense all R&D costs that are not likely to have future service potential. This approach would also require the consolidation of the firm’s share of the assets, liabilities, revenues, and expenses of R&D joint ventures or partnerships. Unfortunately, you would quickly discover that the inherent uncertainty about future benefits that led accounting standard setters to require all internal R&D expenditures to be expensed creates difficulties in judging future service potential from financial statement disclosures alone. Reliance on firm disclosures of scientific and other information outside the financial reporting model is necessary. Also, the consolidation of joint ventures also might prove to be difficult because only some R&D joint venture data will be present in notesto the financial statements.
Even when modification of the financial statements is not possible because of lack of data, you should be aware of the effects of the R&D expensing rule on profitability analysis. The effects on ROA are countervailing between numerator and denominator. Missing assets understate total assets in the denominator. The numerator of ROA, net income (adjusted), is understated when all R&D is classified as current expense and is overstated when the amortization of R&D assets from prior successful R&D efforts is excluded. When R&D expenditures are growing, the net effect on the numerator will be understatement because current R&D expenses exceed the amortizations. A mature firm may reach a steady state where current R&D expense equals total amortization, which would have taken place if R&D had been capitalized. If that happens, the ROA numerator would be unaffected, but the denominator would still be understated due to the omission of the R&D asset. IFRS rules mitigate the likely overstatement of ROA because research costs are expensed and product development costs (the costs incurred after the research yields a product or process that is technologically feasible) are capitalized.6 In general, capitalization and amortization (relative to immediate expensing) results in a smoother income series and thus produces net income that is theoretically easier to predict. Although managers and others view R&D as a necessary investing activity, statement of cash flow reporting treats R&D as an operating activity because it does not result in a balance sheet asset. R&D reduces current period net income and thus reduces current period cash flows from operating activities
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