RESEARCH AND DEVELOPMENT COST IN A RESEARCH AND DEVELOPMENT ACTIVITY

PAS 38, paragraph 52, provides that to assess whether an internally generated intangible asset meets the criteria for recognition, an entity classifies the generation of the asset into a research phase and a development phase.

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

Otherwise stated, a research activity is undertaken to discover new knowledge that will be useful in developing new product or that will result in significant improvement of existing product.

Development is the application of research findings or other knowledge to a plan or design for the production of new or substantially improved material, device, product, process, system or service, prior to the commencement of commercial production.

Simply stated, a development activity involves the application of research findings to develop a new product.

Paragraph 53 provides that if an entity cannot distinguish the research phase from the development phase, the entity shall treat the expenditure as if it were incurred in the research phase only.

Research activities include:

1. a.       Laboratory research aimed at discovering or obtaining new knowledge.
2. b.      Searching for application of research finding and other knowledge.
3. c.       Conceptual formulation and design of possible product or process alternatives
4. d.      Testing in search or evaluation of product or process alternatives. 

Development activities include:

1. Design, construction and testing of preproduction prototypes and models
2. Design of tools, jigs, molds and dies involving new technology
3. Design, construction and operation of a pilot plant that is not of scale economically feasible for commercial production
4. Design, construction and testing of a chosen alternative for new or improved product or process

Normally, research and development activities occur prior to the beginning of commercial production and distribution of product or process.

Examples of activities that relate to commercial production do not result to research and development activities include:

1. Engineering follow through in an early phase of commercial production
2. Quality control during commercial production including routine testing
3. Trouble shooting in connection with breakdowns during production
4. Routine on-going efforts to refine, enrich or improve qualities of existing product
5. Adaptation of an existing capability to a particular requirement or customer need
6. Periodic design changes to existing products
7. Routine design tools, jigs, molds and dies
8. Activity, including design and construction engineering, related to construction, relocation, rearrangement or start up of facilities and equipment.

PAS 38, paragraph 54, provides that no intangible asset arising from research or from the research phase of an internal project shall be recognized.

In other words, expenditure on research or on the research phase of an internal project shall be recognized as expense when it is incurred.

The reason is that at the research phase of a project, an entity cannot be certain that future economic benefits would probably flow the entity.

At the research phase, an entity cannot demonstrate that an intangible asset exists that will generate probable future economic benefits.

In contrast, development cost is incurred at a later stage in a project and the probability of success may be more apparent.

Accordingly, development cost may be expensed or capitalized depending on whether certain criteria or conditions are met.

Thus development cost may qualify as intangible asset if and only if the entity can demonstrate all of the following:

1. The technical feasibility of completing the intangible asset so that it will be available for use or sale.

This is achieved when a prototype or model is produced.

The entity has completed the testing of the model and it is now convinced that it has a product to sell or use that is significantly better than any other product available in the market. The entity plans to file a patent application for the product.

1. The intention to complete the intangible asset and use or sell it.
2. The ability to use or sell the intangible asset.
3. How the intangible asset will generate probable future economic benefits. 

Among other things, the entity shall demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself.

1. Availability of resources or funding to complete development and to use or sell the asset.
2. The ability to measure reliably the expenditure attributable to the intangible asset during its development.

Explain the accounting for “acquired in-process R and D project”.

An in-process research and development project acquired separately or in a business combination is recognized as an asset cost, even if a component is research. 

Subsequent expenditure on that project is accounted for as any other research and development cost which may be expensed or capitalized depending on the recognition criteria for an intangible asset.

Accordingly, the subsequent expenditure is recognized as an expense if it is a research expenditure.

The subsequent expenditure is added to the carrying amount of the in-process research and development project if it is a development expenditure that satisfies the recognition criteria for an intangible asset.

Otherwise, the subsequent development expenditure is recognized as an expense.

The AICPA Financial Accounting Standards Board stipulated that expenditures for research and development which have alternative future use, either in additional research projects or for productive purposes, can be capitalized. 

This exception permits the deferral of costs incurred for materials, equipment, facilities and purchased intangibles related to research and development activities but only if an alternative future use can be identified. 

The cost of materials subsequently used, the depreciation on the equipment and facilities, and the amortization of the purchased intangibles would then be charged to research and development expense. 

 Cost incurred in creating an computer software product shall be charged to expense when incurred until a technical feasibility has been established for the product.

Actually, this the research stage where there is so much uncertainty about the future economic benefits. Accordingly, all the research costs shall be expensed outright.

As a minimum, technological feasibility is established, capitalizable software costs include the cost of coding and testing and the cost to produce masters. 

The costs incurred to actually produce the software from masters and package the software for sale shall be charged as inventory. 

The amortization method for a computer software shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity.

If such pattern cannot be determined reliably, the straight line method is used.

1. As a rule, computer software is classified as an intangible asset.

Under US GAAP, a computer software is classified as technology-based intangible asset.

1. Computer software purchased for resale shall be treated as inventory.

1. A computer software purchased as an integral part of a computer controlled machine tool that cannot operate without the specific software shall be treated as property, plant and equipment.

However, if the computer software is not an integral part of the related hardware, if it classified as an intangible asset.

Under SIC 32, a web site that has been developed for the purpose of promoting and advertising an entity’s products and services does not meet the requirement to be recognized as an intangible asset.

Therefore, web site development cost shall be expensed when incurred. 

IDEAS ABOUT REVENUE RECOGNITION OF INSTALLMENT SALES

Installment sales method is used and allowed by General Accepted Accounting Principles (GAAP) when receivables are collected over an extended period of time, and when there is no reasonable basis for estimating the degree of collectibility. Revenue shall be recognized at the time of collection and installment sales method allows revenue to deferred and recognized each year in proportion to the receivables collected during that year.

We can determine gross profit rates for prior years and current year, recognition of gross profit, and determining deferred gross profit using the T-Account.

Determining gross profit rates:

Prior year sales: Deferred Gross Profit, beginning of current year / Installment Accounts Receivable, beginning of current year

Current year: Gross Profit / Installment Sales

Realized Gross Profit on installment sales = Collections X Gross Profit Rate or Installment Accounts Receivable (IAR), beginning of the current year less IAR, end of the current year equals Decrease in IAR less Defaults, unpaid balance (if any) equals Collections in current year multiply by Gross Profit Rate.

Deferred Gross Profit, end of the current year = Installment Accounts Receivable, end of the current year X Gross Profit Rate or Deferred Gross Profit before adjustment for RGP Less Realized Gross Profit on Installment Sales

Moreover, you can use the T-Account form in analyzing and solving problems related to Installment Sales in general.

LOAN RECEIVABLE: INITIAL AND SUBSEQUENT MEASUREMENT

A loan receivable is a financial asset arising from a loan granted by a bank or other financial institution to a borrower or client.

Initial measurement – Fair value plus transaction costs that are directly attributable to the acquisition of the financial asset.

Fair value of the loan receivable at initial recognition - transaction price, meaning the amount of the loan granted.

Transaction costs – are directly attributable to the loan receivable include origination fees.

Direct origination costs – included in the initial measurement of the loan receivable.

Subsequent measurement – A loan receivable is subsequently measured at amortized cost using the effective interest method.

Amortized cost – is the amount at which the receivable is measured initially minus principal payment, plus or minus the cumulative amortization of any difference between the initial amount recognized and the principal maturity amount, minus reduction for impairment or uncollectibility.

If the amount recognized is lower than the principal amount, the amortization of the difference is added to the carrying amount.

If the initial amount recognized is higher than the principal amount, the amortization of the difference is deducted from the carrying amount.

Origination fees – The fees charged by the bank against the borrower for the creation of the loan. It include compensation for activities such as evaluating the borrower’s financial condition, evaluating guarantees, collateral and other security, negotiating the terms of the loan, preparing and processing documents and closing the loan transaction.

The origination fees received from borrower are recognized as unearned interest income and amortized over the term of the loan.

The direct origination fees are not chargeable against the borrower, the fees are known as “direct origination costs”.

The direct origination costs are deferred and also amortized over the term of the loan. Preferably, the direct origination costs are offset directly against any origination fees received.

If the origination fees received exceed the direct origination costs, the difference is unearned interest income and the amortization will increase interest income.

If the direct origination costs exceed the origination fees received, the difference is charged to “direct origination costs” and the amortization will decrease interest income.

Accordingly, the origination fees received and the direct origination costs are included in the measurement of the loan receivable.

PAS 39, paragraph 58, provides that an entity shall assess at every end of reporting period whether there is objective evidence that a financial asset or group of financial assets is impaired.

If such evidence exists, the entity shall determine and recognize the amount of any impairment loss.

Objective evidence of impairment may result from the following “loss events” occurring after the initial recognition of the financial asset:

1. Significant financial difficulty of the issuer or obligor.
2. Breach of contract, such as default or delinquency in interest or principal payment.
3. Debt restructuring – The lender, for economic or legal reason relating to the borrower’s financial difficulty, grants to the borrower a concession that the lender would not otherwise consider.
4. Probability that the borrower will enter bankruptcy or other financial reorganization.
5. The disappearance of an active market for the financial asset because of financial difficulty.
6. Observable data indicating that there is a measurable decrease in the estimated future cash flows from a group of financial assets since the initial recognition of those assets, although the decrease cannot yet be identified with the individual financial assets in the group. 

PFRS 9, paragraph 5. 2. 2, provides that if there is evidence that an impairment loss on a loan receivable carried at amortized cost has been incurred, the amount of the loss is measured as the “difference between the carrying amount of the loan receivable and the present value of estimated future cash flows  discounted at the original effective rate of the loan.”

The carrying amount of the loan receivable shall be reduced either directly or through the use of an allowance account.

The amount of the impairment loss shall be recognized in profit or loss.

Cost-volume-profit (CVP) relationships and analysis

Cost-volume-profit (CVP) analysis is one the most powerful tools that managers have at their command. It helps them understand the interrelationship between cost, volume, and profit in an organization by focusing on interactions between the following five elements:

1. Prices of products
2. Voume or level of activity
3. Per unit variable cost
4. Total fixed cost
5. Mix of products sold

Contribution margin per unit is the excess of unit selling price over unit variable costs and the amount each unit sold contributes toward

1. Covering fixed costs and
2. Providing operating profits

Formula:              CM per unit = Unit selling price – unit variable costs

Contribution margin ratio is the percentage of contribution margin to total sales. This ratio is computed as follows:

                               CM ratio = Contribution Margin / Sales

The CM ratio is very useful in that it shows how the contribution margin will be affected by a given peso change in total sales. For instance, if a company’s CM ratio is 35%, it means that for each peso increase in sales, total contribution margin will increase by P0.35. Net income likewise will increase by P0.35 assuming that there are no changes in fixed costs. 

Break-even point (unit) = Total Fixed Costs / Contribution Margin per unit

Break-even point (pesos) = Total Fixed Costs

                                                1 – Variable Costs or CM %

                                                               Sales

Break-even sales for multi-products firm (combined units) = Total Fixed Costs / Weighted Average Contribution Margin per unit 

Weighted Contribution Margin per unit = Unit CM x No. of units / mix + Unit CM x No. of units / mix / Total number of units per Sales Mix 

Break-even sales for multi-products firm (combined pesos) = Total Fixed Costs / Weighted CM ratio 

Weighted CM ratio = Total Weighted CM (P) / Total Weighted Sales (P) 

Target sales volume to earn a desired amount of profit.

This is the amount of sales needed to earn a desired amount of profit.

The equation that may be used to compute for this follows:

Sales (units) = Total Fixed Cost + Desired Profit / Contribution Margin per unit 

Sales (pesos) = Total Fixed Cost + Desired Profit / Contribution Margin Ratio

 Margin of Safety (MS) 

This is the excess of actual or budgeted sales over break-even sales and indicates the amount by which sales could decrease before losses are incurred.

Margin of Safety Ratio 

Once the margin of safety is determined, the MS ratio may be computed as follows:

MS ratio = Margin of Safety (P) / Actual or Budgeted Sales 

How is operating leverage computed? What is its significance? 

The potential effect of the risk that sales will fall short of planned levels, as influenced by the relative proportion of fixed to variable manufacturing costs, can be measured by operating leverage. Operating leverage is the ratio of the contribution margin to profit. Assume the following data :

                                                                                2011                   2012                    Change

Sales                                                                      P180,000             P195,000       P15,000

Variable costs                                                         84,000                91,000             7,000

Contribution margin                                           96,000             104,000              8,000

Fixed costs                                                                60,000               60,000                      0

Profit                                                                          36,000               44,000              8,000

Operating leverage = Contribution margin / Profit

                                                P96,000/P36,000 = 2.667 

Operating leverage of 2.667 means that since  sales increased 8.33 percent (P15,000 / P180,000) from 2011 to 2012, profits should increase by 22.22 percent (2.667 x 8.33%). A quick calculation demonstrates that profit has increased by 22.22 percent (P8,000/P36,000).

A higher value for operating leverage indicates a higher risk in the sense that a given change in sales will have a relatively greater impact on profits. When sales volume is strong, it is desirable to have a high level of leverage, but when sales begin to fall, a lower level of leverage is preferable. Each firm chooses the level of operating leverage that is consistent with its competitive strategy. For example, a firm with dominant position in its market might choose a high level of leverage to exploit its advantage. In contrast, a weaker firm might choose the less risky low-leverage strategy.

Moreover, the CVP analysis can be done through the Income Statement approach to  avoid memorizing of formulas.

FACTORS TO BE CONSIDERED IN CAPITAL BUDGETING DECISIONS

Capital budgeting is the process of planning and controlling investments for long-term projects and programs.

The costs that are considered in capital budgeting analysis include:

1. Avoidable cost – cost that may be eliminated by ceasing an activity or by improving efficiency.
2. Common cost – cost that is shared by all options and is not clearly allocable to any one of them.
3. Weighted-average cost of capital – is the weighted average of the interest cost of debt (net of tax) and the implicit cost of equity capital to be invested in long-term assets. It represents a required minimum return of a new investment to prevent dilution of owners’ interest.
4. Deferrable or Postponable cost – cost that may be shifted to the future with little or not effect on current operation.
5. Fixed cost – cost that does not vary with the level of activity within the relevant range.
6. Imputed cost – cost that does not entail a specified peso outlay formally recognized by the accounting system, but its nevertheless relevant to establishing the economic reality analyzed in the decision-making process.
7. Incremental cost – is the difference in cost resulting from selecting one option instead of another.
8. Opportunity cost – is the benefit forgone by not selecting the best alternative use of scarce resources.
9. Relevant cost – future differential cost that vary with the action.
10. Sunk cost – cost that cannot be avoided because expenditure or an irrevocable decision to incur the cost has been made.
11. Taxes – tax consequences of an investment. 

Net investment is the net outlay, or gross cash requirement, minus cash recovered from the trade or sale of existing assets, with any necessary adjustments for applicable tax consequences.

Net cash flow is the economic benefit or cost, period by period, resulting from the investment.

Economic life is the time period over which the benefits of the investment proposal are expected to be attained, as distinguished from the physical or technical life of the asset involved.

Depreciable life is the period used for accounting and tax purposes over which cost is to be systematically and rationally allocated. It is based upon permissible or standard guidelines and may have no particular relevance to economic life.

Techniques that may be applied in evaluating capital investment proposals:

Discounted cash flow approaches:

Discounted or Internal rate of return. This is an interest rate computed such that the net present value (NPV) of the investment is zero. Hence the present value of the expected cash outflows equals the present value of the expected cash inflows.

Investment = Annual cash inflow x Present value factor

Net Present Value – this is the difference between the present value of the estimated net cash inflows and the present value of the net cash outflows.

Excess Present Value or Profitability Index – this is the ratio of the present value of the future net cash inflows to the present value of the initial investment.

PV Index = Present value of Cash Inflows / Present value of Cash Outflows

Nondiscounted Cash Flow Approaches

Payback Period – this is the number of years required to complete the return of the original investment. It is computed as follows:

Payback period = Investment / Annual cash inflows

Accounting Rate of Return (ARR) – this is the increase in accounting net income divided by the required investment. This is computed as follows:

ARR = Average cash inflow – Depreciation

                                Investment

Under the time-adjusted rate of return capital budgeting technique, it is assumed that cash flows are reinvested at the rate earned by the investment.

The net present value capital budgeting technique can be used when cash flows from period to period are uniform and uneven.

Time-adjusted rate of return is a capital budgeting techniques that assumed that cash flows are reinvested at the rate actually earned by the investment.

The net present value and internal rate of return methods of capital budgeting are superior to the payback method in that they: consider the time value of money.

The payback method measure: how quickly investment pesos may be recovered.

The capital budgeting method that divides a project’s annual incremental net income by the initial investment is the : Simple (or accounting) rate of return method.

The relevance of a particular cost to a decision is determined by: potential effect on the decision.

The term that refers to costs incurred in the past that are not relevant to a future decision is sunk cost.

DISCOUNT AND PREMIUM ON BONDS PAYABLE

Under PFRS 9, using the effective interest method or scientific method or simply known "interest method" is required in the amortization of discount on bonds payable, premium on bonds payable and bond issue cost.

This method differentiate two kinds of interest rate, namely the nominal rate known as coupon or stated rate and effective rate known as the yield rate or market rate.

The effective rate is the rate that exactly discounts estimated cash future payments through the expected life of the bonds payable or when appropriate, a shorter period to the net carrying amount of the bonds payable.

When bonds are sold at face value, the effective rate and the nominal rate are the same. But when bonds are sold at a premium, the effective rate is lower than the nominal rate. And when the bonds are sold at a discount, the effective rate is higher than the nominal rate.

Under this method, the effective interest expense is computed by multiplying the effective rate by the carrying amount of the bonds. The carrying amount of the bonds changes every year as the amount of premium or discount is amortized periodically.

Under the effective amortization of discount, the interest expense is higher than the interest paid. The difference between the interest expense and interest paid is the discount amortization which is added in the carrying value or amount of the bonds.

While, the effective amortization of premium, the interest expense is lower than the interest paid. The difference between the interest paid and interest expense is the premium amortization which is deducted in the carrying value or amount of the bonds.

Interest expense is determined by multiplying the effective interest rate by the carrying amount of the bonds. Interest paid is computed by multiplying the nominal rate by the face value of the bonds. Actually, it can be presented using the schedule of amortization table.

The market price or issue price of bonds payable is equal to the present value of the principal bond liability plus the present value of future interest payments using the effective or market rate of interest.

The present value of the principal bond liability is equal to the face value of the bond multiplied by the present value of 1 factor at the effective rate for a number of interest periods.

The present value of the future interest payments is equal to the periodic nominal interest multiplied by the present value of an ordinary annuity of 1 factor at the effective rate for a number of interest periods.

Under bond issue cost, PFRS 9 provides that "transaction costs" that are directly attributable to the issue of a financial liability shall be included in the initial measurement of the financial liability.

Transaction costs are defined as fees and commissions paid to agents, advisers, brokers and dealers, levies by regulatory agencies and securities exchange, and transfer taxes and duties. Clearly, transaction cost include bond issue costs.

Bond issue costs will increase discount on bonds payable and will decrease premium on bonds payable.

Under the effective interest method, bond issued cost must be "lumped" with the discount on bonds payable and "netted" against the premium on bonds payable.

The effective rate cannot be computed algebraically but by means of trial and error or the "interpolation process".

The calculation of the effective rate requires the use of mathematical table of present value of a single payment and present value of an ordinary annuity. Actually, the effective rate can easily be determined through the use of a financial calculator.

Reference: Financial Accounting Volume 2 2012 edition - Effective Interest Method by Conrado T. Valix, et. al

THE STATEMENT OF AFFAIRS IN CORPORATE LIQUIDATION

In corporate liquidation, a Statement of Affairs is prepared for the corporation to provide information about the current financial position of the company and aids the trustee in liquidating the corporation. It is prepared under a quitting-concern assumption and presents the classifications of assets and liabilities as follows:

Assets

Assets pledged to fully secured creditors – the realizable value of the asset is equal to, or more than the secured claim (secured liability).

Assets pledged to partially secured creditors –the realizable value of the asset is less than the secured claim (secured liability).

Free assets – assets not used as security for the payment of any liabilities and available for distribution to unsecured liabilities. Total free assets -  Free assets plus the excess, if any, of the assets pledged to fully secured creditors.

***Net Free assets - is the Total free assets less the Unsecured liabilities with priority.

***Estimated deficiency - Unsecured liabilities without priority  less Net Free assets.

***Estimated deficiency rate - Estimated deficiency divide by Unsecured liabilities without priority

Liabilities

Unsecured liabilities with Priority – are liabilities specified in the Insolvency law which must be settled before any secured debts (e.g., administrative expenses of the receiver, accrued salaries, wages, taxes, etc.) 

Fully-secured liabilities – the realizable value of the pledged asset is at least equal to the amount of the claim

Partially secured liabilities – the realizable value of the pledged asset is less than the amount of the claim. Every partially secured claim has a secured portion and unsecured portion, the latter being covered by free assets based on a recovery percentage.

Unsecured liabilities without priority – liabilities for which the creditor has no lien on any asset of the corporation. These can be recovered pro-rata by the free assets when there is asset deficiency.

The Statement of Affairs is prepared as the start of corporate liquidation of the company.