1.1  Query:          

  Accounting for research and development costs.

1.A professionally managed engineering consultancy house has, in the recent past, successfully developed and commissioned two kinds of industrial filters for the chemical industry which, as per the querist, were hitherto not made in India. The company has now decided to go in for developing sophisticated filters to be used in several industries, mainly pharmaceuticals and chemicals, which are hitherto imported into India, and the technology for which is available with only a few companies all over the world. As per the querist, in several industries, the manufacturing process often requires different liquids to be filtered, so that the output satisfies certain parameters. Since filter manufacturing is a very highly specialised job, and most plants set up around the globe obtain these filters from specialist filter manufacturers, there is great scope for filter manufacture specialisation. The technology for these filters is closely guarded the world over. There are some companies in India manufacturing such filters but either under a foreign collaboration or under licence from a foreign manufacturer. The areas of use for these filters are, however, numerous. Almost all chemical industries, organic as well as inoraganic, and the pharmaceutical, food processing, cosmetic and health care industries need such filters.

2.The querist has stated that the cost of importing the know-how through collaboration agreements is prohibitively high. Typically, access to the detailed drawings of a filter of one kind would cost around rupees one crore. Technology for at least 10-15 kinds of filters is necessary to be purchased, so that the filter specialists can offer a range of filters useful for most industrial filtration needs. However, the size of the Indian market does not justify such a large outlay. The company, however, has already developed two kinds of filters on its own, without making a prototype and without even a factory of its own. It has managed to successfully commission three-four filters, working mostly at third-party fabricators’ units and at the clients’ sites. With its earlier extensive experience in this field, the company feels confident of developing on its own know-how for several types of filters. However, working at third-party locations entails the serious risk of piracy of the drawings. Which is a valuable intellectual property. However, as per the querist, it is extremely difficult to convince project managers that the company is capable of developing, fabricating and erecting filters which, if imported, would cost much more. This is because, very often, these filters are critical to the success or failure of the entire plant. To bridge this credibility gap, the company has to develop working prototypes of the filters it intends to sell, preferably at its own fabrication and testing facility.

3. The querist has further stated that the initial cost of developing working prototypes of new types of filters from scratch is very high, and is highly risk-prone. For example, the company may spend about Rs.5 lakhs for making a particular filter, and the end-result may be a total failure. However, if successful, the working prototypes would enable the company to sell that type of filter over a considerable time period. The prototypes developed and the associated drawings thus become valuable assets. The value of these assets may be significantly more than the actual expenditure incurred. Further, large part of the cost of the prototypes is incurred in the form of office overheads, salaries and other expenses related to the employment of experienced engineers who work on state-of-the-art computer systems to generate the drawings from which the prototypes can be fabricated. Since these costs are basically revenue in nature, and would normally be charged to revenue account, the true cost and value of the prototypes will never be reflected in the balance sheet as such. The inability to convert filter development costs into an asset in the balance sheet adversely affects company’s ability to raise resources by way of debt. Weighed against this is, however, the problem of paying higher taxes today if these development costs are not expensed fully but capitalised and amortised over a period.

4. The querist feels that one must not make any distinction between purchased know-how and internally developed now-how. The general practice is to capitalise purchased know-how and write off to revenue, expenses on developing know-how internally. This, as per the querist, is illogical. That the cost of the former is easier to determine is not justification enough to treat it differently. The querist feels that its expenditure on developing filter know-how needs to be capitalised. The querist, therefore, proposes to defer the filter prototype development cost (both capital and revenue) and amortise the same over the estimated life-span of the products developed. If no product results from any particular development effort, the entire cost would be fullyamortised in the year in which the effort is given up. For income-tax purposes, the querist proposes to claim a deduction under section 35 of the Income-tax Act, 1961, in the year in which the costs are incurred, as they are expenditure for scientific research and development related to the business of the company. The know-how thus capitalised would, however, not be at a figure higher than the costs which the company would incur to perfect it.

5. As per the querist, the following views have been taken in various pronouncements with regard toamortisation/deferral of the research and development costs.

Accounting Standard (AS) 8 on Accounting for Research and Development, issued by the Institute of Chartered Accountants of India.

            The standard lays down the following norms:

(i) Research and development costs of a project may be deferred if following criteria are satisfied:

(a) product or process is clearly  defined and costs attributable to it can be separately identified;

                        (b) its technical feasibility has been demonstrated;

(c) the management has indicated its intention to produce or market it;

(d) there is a reasonable indication of the future revenues/benefits exceeding R & D cost together with expected production, selling and administration costs; and

(e) adequate resources exist or are reasonably expected to be available to complete the project and market the product or process. [para 9]

(ii) Where costs are deferred, legal requirements should be considered. [para 10]

(iii) Where a policy of deferral of research and development expenses is adopted, it should be applied to all projects satisfying the criteria specified in para 9. [para 11]

(iv) Deferred costs should be allocated to future periods on the basis of sale or use of the product of the time period over which the product is sold or used. [para 12]

(v) Deferred expenditure should be separately disclosed in the balance sheet under the head “Miscellaneous Expenditure”. [para 16]

International Accounting Standard (IAS) 9 on Accounting for Research and Development Activities issued by the International Accounting Standards Committee.

This standard lays down the criteria for deferral of research and development expenses which are, as per the querist, the same as those specified by AS 8. [Para 17 of IAS 9]

The basis of deferral and the disclosure requirements are also the same as those specified under AS 8. [Paras 20 and 24 of IAS 9]

Exposure Draft 32 on Comparability of Financial Statements, issued by the International Accounting Standards Committee.

This Exposure Draft designed to amend IAS 9 had proposed to permit the following treatment as ‘Allowed alternative treatment’

“Development costs that satisfy the criteria in paragraph 17 may be recognised as an asset provided the information required by paragraph 18A of the International Accounting Standard 5 on Information to be Disclosed in Financial Statements, is disclosed.” [proposed para 16A]

Statement of Intent regarding Comparability of Financial Statement, issued by the International Accounting Standards Committee.

After the Exposure Draft 32 was issued, there was worldwide rethinking on this matter which culminated in the International Accounting Standards Committee issuing this Statement of Intent wherein it made the following proposal:

Recognition of development costs

Required treatment – Development cost should be recognised as an asset when they meet the criteria in paragraph 17 of IAS 9 and it is probable that these costs will be recovered. Such costs should be allocated on a systematic basis to future periods in accordance with paragraph 20 of IAS 9.

Eliminated treatment – The Exposure Draft will propose the development costs which meet the criteria in paragraph 17 of IAS 9 should not be charged as an expense in the period in which they are incurred.

Exposure Draft on Research and Development Activities, issued by the International Accounting Standards Committee.

The Exposure Draft has, vide para 8 (b), given by way of example the following cost which would be treated as a Development Cost:

“the design, construction and testing of pre-production prototypes and models”.

It lays down in paras 16 and 17, the circumstances in which development costs can be recognised as an asset. In paras 18, 22, 25 and 26, it deals with how the development expenses have to be accounted for and expensed in different situations. Para 28 lays down norms for disclosure.

Expert Advisory Committee of the Institute of Chartered Accountants of India in one of their earlier opinions, published in ‘The Chartered Accountant’ July 1992 Issue, had also expressed similar views with regard to the software development costs.

6. The querist has further stated that Accounting Standard (AS) 8. Issued by the Institute of Chartered Accountants of India, has been made mandatory for compliance by chartered accountants in the course of their attest functions. The Companies Bill, 1993, also proposed to make accounting standards mandatory for all companies. Therefore, in the view of the querist, compliance with the accounting standards is mandatory and inescapable.

7.The querist is of the view that both the Indian and International Accounting Standards dealing with the subject, favour capitalising of the prototype development costs, provided the five norms specified in para 9 of AS 8, para 17 of IAS 9 are met. As per the querist, the company in question satisfies the above-mentioned criteria as:

(a) Each filter prototype is a distinct product. It will be fabricated and developed at a Filter Development Facility (FDF) and hence, its costs can be separately identified. The designs and drawings will be made by engineers who though not stationed at the FDF, are engaged whole-time in the development of designs for new prototypes and improvement of design of existing filter prototypes. Therefore, their entire salary costs can be separately accumulated with ease.

 

(b) Each filter product is technically feasible as it is already being manufactured by more than one manufacturer elsewhere then in India, and is not based on a totally new engineering principle. The feasibility of the product is also demonstrated by the fact that several companies are importing these types of filters at costs which are much higher than the prices at which the company expects to be able to develop and manufacture them. Informal queries to potential users have shown that several users are eager to indigenise the filters if the technology can be demonstrated as being workable.

 

(c) The investment intended to be made in the development of prototypes and the results of the informal survey carried out clearly indicate the intention of the management to produce and market the filter products. The intent will also very soon be made known to the company’s bankers for the purpose of revising a loan to set-up the filter development facility.

 

(d) The filter products expected to be developed will have a very long economic life and can be upgraded continuously in the light of experience so that risk of obsolescence is minimised.

 

(e) The resources to complete the project and market the new filter products are expected to be available on account of the high retained earnings intended to be earmarked for this major development effort and loans proposed to be raised.

8. The querist accordingly proposes to adopt the following accounting treatment in respect of various research and development costs:

(a) Revenue costs on prototype development: Revenue costs on prototype development and on creation of any intangible asset allied thereto will be accumulated and treated as ‘miscellaneous expenditure’ and will be disclosed in the balance sheet under head, “Miscellaneous Expenditure (to the extent not written of or adjusted)” as Prototype Development Expenditure.

 

(b) Amortisation of miscellaneous expenditure:  Miscellaneous expenditure will be amortised either on product sales basis or on sales volume per annum basis, the actual amount of amortisation depending on an educated estimate resulting from an analysis of the market for the particular product concerned and an annual review of the same. In the first case, the annual amortisation will be the ratio that the units sold during the year bears to the expected total future unit sales. Where the alternative treatment is adopted, the amount amortised would be the ratio that current gross revenue bears to the expected total future revenue.

 

(c) Capital costs on creation of intangible assets: Capital costs which result in the creation of intangible assets ancillary/allied to the prototypes willl be treated in the same manner as revenue costs.

 

(d) Capital costs on tangible assets with no alternative use:  Capital costs resulting in the acquisition of tangible assets ancillary/allied to the prototypes and having no alternative use will be capitalised under the head ‘Fixed Assets’ under appropriate sub-heads as per Schedule VI to the Companies Act, 1956. Depreciation thereon will be provided as per Schedule XIV to the said Act, or as per the law then prevailing in that regard.

 

(e) Capital costs on tangible assets with alternative use:  Capital costs resulting in the acquisition of tangible assets ancillary/allied to the prototypes and having alternative use will be treated in the same manner as costs in respect of assets having no alternative use, to the extent they are used for research and development activity. The extent of use for research purposes will be made on as logical, practical and rational basis as possible.

 

For example, the Filter Development Facility (FDF) will have all the infrastructure necessary to manufacture even full-scale filters. Thus, the FDF will be divided into two distinct areas: The Development Area and Fabrication Area. The costs incurred on setting up the FDF would then be apportioned between the two areas based on the proportion of the built-up area consumed by each. That portion of the costs thus apportioned to the development area would be treated as ‘Capital costs on research and development’.

 

Though the fabrication area would also be used for fabricating the prototypes, that would constitute a relatively small proportion of the use of the fabrication area. Similarly, the developmental area would have certain facilities like hydraulic pumps and compressors, which will be used for testing the final filters manufactured in the fabrication area. These small deviations may be ignored for the purpose of apportionment of costs, as they would largely cancel each other out.

(f) Disclosure:

 

(i) Suitable disclosure regarding prototype development expenses, both revenue and capital, will be made in the annexure to the directors’ report as required by the Companies (Disclosure of Particulars in the Report of Board of Directors) Rules, 1988.

 

(ii) Development expenses deferred would be shown under the head ‘Miscellaneous Expenditure’ in the balance sheet as ‘Filter Prototype Development Costs’.

 

(iii) When the product(s) become saleable, the same would be transferred to ‘Fixed Assets’ under the relevant sub-head of ‘Drawings and Designs’.

 

(iv) The total developmental costs, including amortised portion of deferred costs, which are charged as expense will be disclosed in the profit and loss account for the period in which they are so charged as ‘Development costs written off’.

9. The querist has stated that for income-tax purposes, the full amount of the capital expenditure on tangible assets acquired/created and having no alternative use will be written off in the first year itself under section 35(1)(iv) read with section 35(2)(ia) of the Income-tax Act, 1961. In respect of assets having alternative use, that proportion of capital expenditure apportioned to use for development of new filters would be treated in the same manner as assets having no alternative use other than development (except to the extent of cost of land, which section 35 does not permit to be written off). The remainder would be treated in the same manner as non-research and non-developmental capital expenditure for business purposes.

10. The querist has sought the opinion of the Expert Advisory Committee on the following issues:

(a) Whether the accounting treatment as stated in para 8 above, is in conformity with generally accepted accounting principles and accounting standards and is in sufficient compliance with the Companies Act, 1956, and the Companies Bill, if passed, in the form known latest. If not, what is the most appropriate accounting treatment for each of the items indicated above?

 

(b) What documentation and evidences would be necessary to effectuate the above accounting system?

1. The opinion of the Committee expressed herein is restricted to the accounting aspects of the query only. In view of Rule 2 of the Advisory Service Rules, the Committee has not considered the purely legal and taxation aspects of the query.

2.The Committee notes paragraphs 7 to 16 of Accounting Standard (AS) 8 on ‘Accounting for Research and Development’ issued by the Institute of Chartered Accountants of India, which state as under:

“7.    Research and development costs should include:

 

(i) salaries, wages and other related costs of personnel engaged in research and development;

 

(ii) costs of materials and services consumed in research and development;

 

(iii) depreciation of building, equipment and facilities which have alternative economic use, to the extent that they are used for research and development;

 

(iv) an appropriate amortisation of the cost of building, equipment and facilities which have no alternative economic use, to the extent that they are used for research and development;

 

(v) overhead costs related to research and development;

 

(vi) payment to outside bodies for research and development projects related to the enterprise; and

 

(vii) other costs related to research and development such as amortisation of patents and licences.

8. Amount of research and development cost described in paragraph 7 should be charged as an expense of the period in which they are incurred except where such costs may be deferred in accordance with paragraph 9.

9. Research and development costs of a project may be deferred to future periods, if the following criteria are satisfied;

(i) the product or process is clearly defined and the costs attributable to the product or process can be separately identified;

 

(ii) the technical feasibility of the product or process has been demonstrated;

 

(iii) the management of the enterprise has indicated its intention to produce and market, or use, the product or process;

 

(iv) there is a reasonable indication that current and future research and development costs to be incurred on the project  together with expected production, selling and administration costs are likely to be more than covered by related future revenues/benefits; and

 

(v) adequate resources exist, or are reasonably expected to be available, to complete the project and market the product or process.

10. Wherever research and development costs are deferred, the appropriate legal requirements should also be taken into account.

11. If an accounting policy of deferral of research and development costs is adopted, it should be applied to all such projects that meet the criteria in paragraph 9.

12. If research and development cost of a project are deferred, they should be allocated on a systematic basis to future accounting periods by reference either to the sale or use of the product or process or to the time period over which the product or process is expected to be sold or used.

13. The deferred research and development costs of a project should be reviewed at the end of each accounting period. When the criteria of paragraph 9, which previously justified the deferral of the costs, no longer apply, the unamortised balance should be charged as an expense immediately. When the criteria for deferral continue to be met but the amount of unamortised balance of the deferred research and development costs and other relevant costs exceed the expected future revenues/benefits related thereto, such expenses should be charged as an expense immediately.

14. Research and development costs once written off should not be reinstated even though the uncertainties which had led to their being written off no longer exist.

Disclosure

15. The total of research and development costs, including the amortised portion of deferred costs, charged as expense should be disclosed in the Profit & Loss Account for the period.

16. Deferred research and development expenditure should be separately disclosed in the Balance Sheet under the Head “Miscellaneous Expenditure.”

3.The Committee further notes that paras 16.3 and 37 of Accounting Standard (AS) 10 on ‘Accounting for Fixed Assets’, issued by the Institute of Chartered Accountants of India, state as follows:

“16.3 Patents are normally acquired in two ways: (i) by purchase, in which case patents are valued at the purchase cost including incidental expenses, stamp duty, etc., and (ii) by development within the enterprise, in which case identifiable costs incurred in developing the patents are capitalised. Patents are normally written off over their legal term of validity or over their working life, whichever is shorter.”

“37. The direct costs incurred in developing the patents should be capitalised and written off over their legal term of validity or over their working life, whichever is shorter.”

4. The Committee is of the view that the research and development costs which are revenue in nature and are related to the development of an industrial filter should be expensed in the period in which they are incurred if all the conditions referred to in para 9 of Accounting Standard (AS) 8, as reproduced at para 2 above, are not met. However, in case all the conditions referred in para 9 of Accounting Standard (AS) 8 are met, these costs may be deferred and disclosed in the balance sheet under the head ‘Miscellaneous Expenditure’. For this purpose, each project for development of a filter should be considered separately and not in a generalised manner as indicated by the querist in para 7 of the query. The evidence as to satisfaction of the conditions referred to in para 9 of Accounting Standard (AS) 8, may be obtained from feasibility studies, market surveys etc., undertaken by the company. The Committee is also of the view that on the date filter is commercially ready to be sold or otherwise marketed, and it becomes a patent of the company, the relevant deferred research and development costs incurred and accumulated till that date should be capitalised under an appropriate sub-head, under the head ‘Fixed Assets’, and should be written-of over their legal term or over their useful working life, whichever is shorter. However, in case the company does not take patent of the design of filter developed by it, the relevant deferred research and development costs should continue to be shown under the head ‘miscellaneous expenditure’ as per para 16 of AS 8, and these should be amortised on a systematic basis as suggested in para 12 of Accounting Standard (AS) 8, as reproduced at para 1 above.

5. The Committee is also of the view that the expenditure related to development of an industrial filter which results in acquisition of tangible or intangible assets should be capitalised and shown under the head ‘Fixed Assets’. Such assets should be appropriately depreciated/amortised as per ‘Guidance Note on Accounting for Depreciation in Companies’ and Accounting Standard (AS) 6 on ‘Depreciation Accounting’, issued by the Institute of Chartered Accountants of India.

6.  On the basis of the above, the Committee is of the following opinion in respect of the issues raised in para 10 of the query:

A. The company may defer costs relating to a filter development project, as per paras 4 and 5 above only and in this context, the specific accounting treatment for various costs mentioned in para 8 of the query should be as follows:

 

(i) Revenue costs on prototype development: (a) Only such revenue costs, as enumerated in para 7 of AS 8 should be deferred and treated as ‘miscellaneous expenditure’, and (b) costs incurred on creation/acquisition of any intangible asset to be used in development of filters, should be capitalised and shown under appropriate sub-head, under the head ‘fixed assets’. An appropriate amortisation of such costs should only be treated as revenue costs as per para 7 (iii) of AS 8. The revenue costs so deferred should be accumulated under the head ‘miscellaneous expenditure’ (to the extent not written off or adjusted), in the balance sheet.

 

(ii) Amortisation of miscellaneous expenditure: On the date the filter developed by the company becomes commercially ready to be sold or otherwise marketed, and it becomes a patent of the company, the relevant deferred research and development costs should be capitalised as patents under the head ‘fixed assets’. Such costs should be written-off over the legal term or over useful working life of the patent, whichever is shorter. However, if the company does not take any patent of the design of the filters, the relevant deferred research and development costs should continue to be shown under the head ‘miscellaneous expenditure’ as per para 16 of AS 8, and these should be amortised on a systematic basis as per para 12 of AS 8.

 

(iii) Capital costs on creation of intangible assets: Capital costs which result in creation of intangible assets ancilliary/allied to the prototype of filters should be treated as per (i) (b) above.

(iv) Capital costs on tangible assets with no alternative use:  Capital costs incurred for acquisition/creation of any tangible assets to be used for the purpose of filter development and having no alternative use should be capitalised under the head ‘fixed assets’, and should be depreciated as stated in para 5 above. Depreciation provided on such assets should be deferred as part of research and development cost as per para 7 (iv) of AS 8.

 

(v) Capital costs on tangible assets with alternative use:  Capital costs resulting in the acquisition/creation of tangible assets ancilliary/allied to the development of the prototype of filters and having an alternative use to the company, should be treated as per (iv) above, except that only such part of the depreciation provided on such assets should be deferred as relates to the research and development activities, as per para 7 (iii) of AS 8.

 

(vi) Disclosure: The disclosures suggested by the querist in para 8 (f) of the query are proper, except that the deferred costs, when the filter is ready to be commercially marketed, can be transferred to and shown under the head ‘fixed assets’, only if the company gets a patent for it. In other cases, it should continue to be disclosed under the head ‘miscellaneous expenditure’.

 

B. The Committee is also of the opinion that nature of documentation and evidences required in respect of accounting for filter development costs will depend upon facts and circumstances of each case. In case the research and development cost are deferred, documents should be kept which justify the fulfillment of the conditions laid down in para 9 of AS 8. The documents can be market survey reports, technical feasibility report, financial arrangements etc.

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