Query No. 2

Subject:

Treatment of cost of developing prototypes.¹

A. Facts of the Case

1.A public sector company, under the administrative control of the Ministry of Defence, is engaged in the manufacture and selling of heavy earth moving machinery, railway rolling stock and defence equipments.

2. According to the querist, upto the financial year 2002-03, the expenditure incurred on research phase was treated as revenue expenditure and expenditure incurred on development phase was treated by the company as deferred revenue expenditure as per the then accountingpolicy followed by the company on research and development (R&D) expenses, as reproduced below:

“The development cost on R&D Projects is treated as deferred revenue expenditure to be allocated to future accounting periods by reference either to the sale or use of the projects/products on the basis of techno-commercial assessment. Other expenditure on research and development is charged to revenue in the year of incurrence. Expenditure on fixed assets relating to research and development is capitalised.”

3. The querist has stated that the treatment of research and development expenditure was being dealt with till 31.3.2003, by Accounting Standard

(AS) 8, ‘Accounting for Research and Development’, issued by the Institute of Chartered Accountants of India (ICAI). With effect from 1-4- 2003, Accounting Standard (AS) 26, ‘Intangible Assets’, issued by the ICAI, was made mandatory in respect of listed companies and companies having turnover of above Rs. 50 crore. Consequently, AS 26 has become mandatorily applicable to the company also.

4. The querist has drawn the attention of the Committee to paragraph 6 of AS 26, defining the term ‘Intangible Asset’, as follows:

“An intangible asset is an identifiable non-monetary asset, without physical substance, held for use in the production or supply of goods or services, for rental to others, or for administrative purposes.”

5. The querist has referred to paragraph 41 of AS 26, which states that “No intangible asset arising from research (or from the research phase of an internal project) should be recognised. Expenditure on research (or on the research phase of an internal project) should be recognised as an expense when it is incurred.”

6. The querist has further referred to paragraph 44 of AS 26 which states that “An intangible asset arising from development (or from the development phase of an internal project) should be recognised if, and only if, an enterprise can demonstrate all of the following:

(a) the technical feasibility of completing the intangible asset so that it will be available for use or sale;

(b) its intention to complete the intangible asset and use or sell it;

(c) its ability to use or sell the intangible asset;

(d) how the intangible asset will generate probable future economic benefits. Among other things, the enterprise should demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset;

(e) the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and

(f) its ability to measure the expenditure attributable to the intangible asset during its development reliably.”

7. The querist has also reproduced paragraph 46 of AS 26 as below:

“46. Examples of development activities are:

 

(a) the design, construction and testing of pre-production or pre-use of prototypes and models;

(b) the design of tools, jigs, moulds and dies involving new technology;

(c) the design, construction and operation of a pilot plant that is not of a scale economically feasible for commercial production; and

(d) the design, construction and testing of a chosen alternative for new or improved materials, devices, products, processes, systems or services.”

8. The querist has informed that prototypes developed by the company in question are invariably meant for sale and are not meant for pre- production and pre-use testing only. In other words, the concept of pre- production/pre-use prototypes and models is non-existent in the company, e.g., BH 100 Dump Truck developed during 2002-03 at a cost of Rs. 165 lakh was sold during 2003-04 for Rs. 223.09 lakh. Further, the physical substance, i.e., material content is substantial, viz., 85% of the total cost of production. Thus, there is no element of intangibility in the expenditure incurred on the development of a new product (emphasis supplied by the querist). The development expenditure incurred by the company does not result in the creation of an intangible asset as defined in paragraph 6 of AS 26. On the other hand, the asset developed is either a Dozer or a Dump Truck or an Excavator or a Loader, etc., which is sold by the company. Therefore, these are treated as inventories held for manufacture and sale.

9. The querist has informed that, in the view of the company, Accounting Standard (AS) 2, ‘Valuation of Inventories’, issued by ICAI, is applicable for products produced by the company which are classified as inventories. Accordingly, during the year 2003-04, the company has changed its accounting policy on research and development as follows:

“From 1 st April 2003, development cost on Research and Development Projects for manufacture of products intended for sale are held under inventory at lower of cost and estimated reailsable value. The cost of such products, which are not sold are amortised over a period of five years commencing from the year following the year of completion. Other expenditure on research and development, which does not result in an asset, is charged to revenue in the year of incurrence. Expenditure on fixed assets relating to research and development is capitalised. (Emphasis supplied by the querist.)

Earlier projects completed upto 31st March, 2003, were held under deferred revenue expenditure and amortised over accounting periods by reference either to sale or use of the projects/products on the basis of techno-commercial assessment and in accordance with the then AS 8”.

10. In view of the above change in accounting policy, Rs. 168.04 lakh being the value of expenditure incurred upto 31-3-2003 on R&D Projects, which were not completed, was transferred to work-in-progress and valued at Rs. 90.91 lakh after providing for deration of Rs. 77.13 lakh. The impact of the change in the accounting treatment has been properly disclosed, as per the querist, in the notes to accounts as follows:

“In view of withdrawal of Accounting Standard (AS) 8 dealing with ‘Accounting for Research and Development’, expenses booked under R&D work orders with effect from 1-4-2003, which would have earlier been treated as deferred revenue expenditure are now considered under inventory and balances are carried at lower of cost and net realisable value. Accordingly, R&D Projects under progress as on 31-3-2003 have been reclassified under ‘work-in-progress’. Impact of the change in the method of accounting is that profit for the year is lower by Rs. 77.13 lakh, being the deration effected in the R&D work orders”.

11. The querist has further mentioned that, according to the Statement of Financial Accounting Standards (FAS) No. 2, ‘Accounting for Research and Development Costs’, issued by the Financial Accounting Standards Board (FASB) of USA, materials, equipments or facilities used in R&D activities should be expensed unless there is an alternative future use or benefit. If the company uses its supplies or materials for R&D efforts, such inventory is charged as R&D expense. On the other hand, if R&D activities result in saleable inventory, inventory would be debited and R&D expense credited. Thus, in the view of the querist, the generally accepted accounting principles in U.S.A also support the stand taken by the company.

12. The querist has informed that the change in the accounting policy has also been accepted by the statutory auditors of the company. However, the Comptroller & Auditor General of India, have commented as follows:

“Work in progress includes Rs. 0.91 crore (original value Rs. 1.68 crore derated to Rs. 0.91 crore being realisable value) being the un- amortised balance of R&D expenditure transferred (to the extent not written off) during the year. The classification of this as work in progress is not in order in terms of AS 26 as it is part of R&D expenditure”.

13. In view of the fact that the expenditure incurred on development of prototypes meant for sale has been classified as inventory, the company proposes to modify the accounting policy as follows:

“Development cost on Research and Development Projects for manufacture of products intended for sale are held under inventory at lower of cost and estimated realisable value. Other expenditure on research and development is charged to revenue in the year of incurrence. Expenditure on fixed assets relating to research and development is capitalised.”

14. The querist has expressed his firm view that the company, after detailed examination of the accounting practice followed by it upto 2002-03, has changed/proposed to change the accounting policy on research and development to reflect the accounting practice actually followed and has properly disclosed the change in the accounting policy in the notes to accounts. Therefore, the change/proposed change in accounting policy is properly justified and is in order.

15. The querist has explained in detail the activities carried on with regard to R&D as follows:

(a) Research and Development (R&D) Unit of the company was established in 1969. The basic purpose of setting up the R&D unit was to absorb technology from foreign collaborators which are globally renowned. 100% transfer of technology (TOT) has taken place in respect of all the Bulldozers ranging from 66 HP to 770 HP, all the Dump Trucks ranging 35 Ton to 120
Ton, all Excavators from 22 Ton range to 160 Ton range, the Loaders like WA 200 & WA 400 (i.e., 2 CUM & 4 CUM bucket capacity) and all the diesel engines ranging from 100 HP to 600 HP. TOT encompasses transfer of design, drawings, tooling, jigs, fixtures and other manufacturing processes and also quality standards. The collaborators had also initially provided technical support in manufacturing activities. Initially, completely built units were imported in semi-knocked down condition and assembled at the shop floor. Over the years, the manufacturing process was absorbed in stages. Even now, complete indigenisation has not been achieved. Thus, in respect of collaborators’ model, on receipt of the TOT and various other supports, production of items is undertaken. Modifications are carried out depending on the requirement of the customers.

(b) In the case of defence and railway products, Ministry of Defence, Ministry of Railways, Defence Research Laboratories and the Design Organisations of the Railways provide the drawings and designs. Thereafter, the prototypes are built. These prototypes are inspected thoroughly by the respective Inspecting Agencies (i.e., RITES in case of Railways, CQA and SQAA in case of Defence). Once the prototype is cleared, batch/bulk production commences and the items including the prototype are delivered to the customer as per the terms of the purchase order.

(c) The prototypes developed by the company are of life size and are very costly ranging from Rs. 10 lakh to Rs. 470 lakh per unit. Hence, these are not kept for demonstration purposes. These equipments are capable of being used in the customer’s premises and are sold. However, these products are subject to extensive and intensive field trial at the customer’s premises. During the field trial, snags, if any, are rectified by the company’s R&D unit. Thereafter, on the acceptance of the product by the customer (as sale), bulk production is undertaken after carrying out the necessary modifications/removing the snags (if any) observed during the field trials. In view of this, life size prototypes are required to be manufactured at the first instance and these prototypes are meant for sale.

(d) On the basis of market survey, (in the case of earth moving machineries) development of a prototype is undertaken. After the prototype is developed in-house, intensive in-house trials are carried out. Thereafter, the prototype is tested intensively
(generally for 2000 hours) at the customer’s premises and customer’s acceptance is obtained for sale. To regularise the sale, the customer raises a formal purchase order.

16. The querist has further informed that the expenditure incurred on testing of the prototypes in-house as well as in the premises of the customers was treated as revenue expenditure. However, w.e.f. 1-4-2003, the expenditure in producing the prototype is treated as inventory.

17. The querist has also informed that the cost of production of prototypes and their cost of production on commencement of commercial production are as follows:

The querist has drawn the attention of the Committee to the fact that the cost of production on commencement of commercial production is more
or less the same as that of the cost of production of the so-called prototypes.

B. Query

18. The querist has sought the opinion of the Expert Advisory Committee on the following issues arising from the above:

(a) Whether treating the expenditure incurred on development of life size prototypes that are manufactured for sale, where the material content is very high and which are also sold on completion of development as work-in-progress is correct especially when, as per the querist, the definition of the term
‘Intangible Asset’ contained in paragraph 6 of AS 26 is not satisfied (emphasis supplied by the querist).

(b) Consequent to the change in the company’s accounting policy whether the modified accounting policy of the company, as stated in paragraph 13 above, is in conformity with AS 2.

C. Points considered by the Committee

19. The Committee notes the definitions of the terms ‘Research’ and ‘Development’ as per Accounting Standard (AS) 8, ‘Accounting for Research and Development’ and Accounting Standard (AS) 26, ‘Intangible Assets’, issued by the ICAI, as reproduced below:

AS 8

“(i) Research is original and planned investigation undertaken with the hope of gaining new scientific or technical knowledge and understanding;

(ii) Development is the translation of research findings or other knowledge into a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services prior to the commencement of commercial production.”

AS 26

“Research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.

Development is 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 prior to the commencement of commercial production or use.”

20. From the above, the Committee notes that the definitions of the terms ‘research’ and ‘development’ are virtually the same in AS 8 and AS 26. Accordingly, the activities which are classified as research and development activities under AS 8 would continue to be classified as research and development activities under AS 26; the only difference being that whereas under AS 8, the amount of research and development expenditure could be carried forward to future periods as deferred revenue expenditure if the criteria specified in paragraph 9 of that Standard were satisfied, in case of AS 26, the development costs would have to be recognised as intangible asset if such costs meet the definition of the term ‘Intangible Asset’ (reproduced in paragraph 4 above) and the criteria specified in paragraph 44 of the Standard (reproduced in paragraph 6 above) are satisfied. If the aforesaid criteria/definition of the term ‘Intangible Asset’, are not met then, in both cases, the expenditure on research and/or development is to be recognised as an expense when incurred as per paragraph 41 of AS 26 (reproduced in paragraph 5 above).

21. The Committee notes that the querist has argued that the prototypes developed by the company do not involve significant element of research and development costs since in case of defence and railway projects, the designs and drawings are provided by the concerned customers and in certain cases only some modifications are carried out depending upon the requirements of customers. The prototype is tested by the company as well as by the customers extensively before it is accepted and, thereafter, the batch/bulk production commences. The querist has also stated that the material content of the prototype is substantial. In this connection, the Committee also notes that the cost of production of a prototype as compared to the cost of the product after commencement of commercial production is less, which gives an indication that in the production of the prototype, the R&D effort involved is not significant. In other words, it appears that the company’s business involves taking up jobs from defence and railways and the first job is taken up as a kind of sample which involves minimal R&D effort. If that be so, in the view of the Committee, it would be appropriate to treat the prototypes so developed as items of inventory within the meaning of AS 2 and accounted for accordingly. In such a case, in the view of the Committee, the accounting policy proposed by the querist in paragraph 13 is not appropriate since the costs are not of the nature of development costs on research and development project, rather these are the costs to manufacture the sample product and, therefore, should be described as such. The Committee is, therefore, of the view that in the accounting policy, it should only be stated that the prototypes of this nature are treated as inventories and other relevant accounting policies as per AS 2 also need to be disclosed.

22. The Committee also notes from paragraph 15(d) above that the company also develops prototypes based on market surveys. With regard
to such prototypes, since the drawings, designs etc., do not appear to be provided by the customers, it is possible that the R&D effort is significant and, therefore, the cost of the prototype developed, considering the design costs, etc., may be more than the cost of the product when commercial production begins. If this is so, then the first unit should be considered as an R&D effort and treated as intangible asset in case the definition of intangible asset is met and the criteria stated in paragraph 44 of AS 22 are met. If the criteria are not met, the said costs should be expensed, i.e., charged to the profit and loss account when incurred. In case the intangible asset is recognised as aforesaid, the prototype should be considered as inventory to the extent of the cost of materials, labour and overheads used in the production of the final product, i.e., excluding the intangible element representing research and development, when the customer accepts the prototype. Thus, in case of prototypes of this nature also, the accounting policy proposed by the querist in paragraph 13 is not appropriate.

D. Opinion

23. On the basis of the above, the opinion of the Committee on the issues raised by the querist in paragraph 18 is as below:

(a) Treating the expenditure incurred on prototypes of the nature specified in paragraph 21 above as inventories within the meaning of AS 2 would be appropriate. Further, a prototype of the nature dealt with in paragraph 22 should be treated as intangible asset if the definition for intangible asset is met and the criteria stated in paragraph 44 of AS 26 are satisfied. If it is not so, the development costs should be charged to the profit and loss account when incurred. Where the intangible asset has been recognised as aforesaid, the prototype should be considered as inventory to the extent of the cost of materials, labour and overheads used in the production of the final product, i.e., excluding the intangible element representing research and development, on acceptance of the item by the customer.

(b) The accounting policy stated in paragraph 13 above is not appropriate.

¹ Opinion finalised by the Committee on 15.3.2005