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 exist
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 capitalizedas an asset, U.S. GAAP requires firms to expense immediately all internal R&D costs. 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.
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 capitalizedas an asset, U.S. GAAP requires firms to expense immediately all internal R&D costs. 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
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
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