September 2003

Toward Research and Development Costs Harmonization

By M. Iqbal Khadaroo and Junaid M. Shaikh

Research and development (R&D) activities have become an increasingly important share of an enterprise’s expenditures and worth. The accounting for R&D costs varies considerably by jurisdiction around the world. The different approaches can distort results and present an obstacle to comparability and international harmonization. The authors studied the approaches in the United States, the United Kingdom, Australia, Japan, Malaysia, and by the International Accounting Standard Board (IASB).

The main debate in the accounting treatment of R&D costs is over their timing and recognition. Proponents of the accrual principle argue that the costs incurred by R&D activities must be matched against the future benefits that can be derived from the new products or processes developed. Proponents of the conservatism principle argue that because future benefits cannot be ascertained with reasonable certainty, R&D expenditures must be expensed as incurred. Figure 1 illustrates the R&D recognition problem.

In many countries the issue of what is research and what is development has been harmonized by the adoption of the Organization for Economic Cooperation and Development (OECD) “Frascati” definitions. All of the standards setters in the aforementioned countries have distinguished between research and development in their accounting standards. The IASB defines research as “the original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.” Development, on the other hand, is “the application 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 or use.”

Research Approach

The approach to accounting for R&D was examined by studying the various definitions, recognition criteria, recommendations for treatment of their value over time, and disclosure requirements as set out in the accounting standards of the United States, the United Kingdom, Australia, Japan, Malaysia, and the IASB. The information collected was grouped according to the three main problems associated with R&D: recognition, accounting for changes in value, and disclosure.
The information contained in all the standards was then summarized. Exhibit 1 summarizes the disclosure requirements, amortization, and impairment test of R&D expenditure. Exhibit 2 summarizes the solutions to the recognition problem.

R&D Accounting Standards

United States. The lack of uniformity in accounting for R&D and the increasing importance of R&D motivated FASB to issue SFAS 2, Accounting for Research and Development Costs, in October 1974. Because of the high degree of uncertainty of any resulting future benefit arising from R&D projects, SFAS 2 directs that all R&D costs be expensed as incurred. FASB settled for this conservative approach, which was already common practice, because of the uncertainty of future product success. SFAS 2 requires companies that acquire R&D from the outside, however, to capitalize and amortize these costs over time. Companies that undertake in-house R&D therefore report such costs earlier than companies that outsource it. SFAS 2 paragraph 13 requires that the amount of R&D expenses for each period be disclosed in the financial statements.

United Kingdom. The development of an accounting standard for R&D in the United Kingdom began in January 1975 with Exposure Draft (ED) 14. ED14 required that all R&D expenditure be written off in the year incurred. In response to strong criticism of the draft, the ASC issued ED 17 a year later, which allowed companies under certain well-defined circumstances to defer the development expenditure against future revenue. The resulting standard, SSAP 13, was subsequently revised in January 1989, November 1997, and December 1998.

SSAP 13 states that both pure and applied research are insufficiently identifiable with future economic benefits to be assets and should be written off as incurred. Capital expenditure on fixed assets that provide facilities for research should, however, be capitalized and depreciated as normal. Development expenditures should be written off in the year incurred, unless they meet certain well-defined conditions for deferral. If all of those conditions are met, the development expenditures may be capitalized and amortized as long as their recovery is reasonably assured.

The deferred development expenditure must be reviewed for impairment at the end of every accounting period. If the conditions that justified the deferral of the expenditure no longer apply, the irrecoverable portion of the deferred expenditure must be written off. As revised in accordance with the 1985 Companies Act, SSAP 13 allows development expenditures previously written off to be reinstated if the conditions that led to their write-off no longer apply.

Australia. The Australian Accounting Standard Board’s (AASB) AASB 1011 deals with R&D activities other than those conducted for others under contract and specialized activities. R&D is defined as “a systematic investigation or experimentation that involves innovation or technical risk and is carried on for the purpose of acquiring new knowledge or developing a new product or bringing about a significant improvement to an existing product.” AASB 1011 states that R&D costs must be expensed as incurred unless they meet the criterion for deferral. R&D costs must be deferred to future financial years to the extent that such costs, together with related unamortized deferred costs, are expected beyond any reasonable doubt to be recoverable.

Like the United Kingdom’s SSAP 13, AASB 1011 distinguishes between basic research and applied research. Basic research costs needs to be expensed as incurred on grounds that basic research does not have any practical application. Applied research is directed toward solving practical problems. The costs of applied research activities must be deferred and amortized if they are related to projects with future benefits (SSAP 13 requires that they be written off). Development costs, on the other hand, must be treated as an expense when the expected future benefits are too uncertain to justify carrying the expenditures forward. If expected future benefits are certain, however, then the costs can be deferred to future financial years and amortized to match such costs with related benefits, starting with the production of the product.

Just as in the United Kingdom, unamortized deferred R&D costs need to be reviewed regularly for impairment. If the differed expenditures exceed the recoverable amount at the balance sheet date, then it should be written down or expensed. Unlike under SSAP 13 in the United Kingdom, under AASB 1011 R&D costs which do not meet the criterion for deferral and were already written off cannot be written back in the light of subsequent events. AASB 1011 requires disclosure of the R&D costs only if they are material.

Japan. In Japan, the Japanese Accounting Standard Board (ASB) is now responsible for the development of accounting standards, while the Financial Accounting Standards Foundation (FASF) assumes an oversight role regarding ASB activities. The ASB and FASF took over the standards-setting authority from the Business Deliberation Council (BDC) on July 27, 2001.

The standard that deals with R&D was issued by the BDC in March 1998. The standard covers R&D costs and computer software. It defines research as “a planned search and exploration for discovering new knowledge,” while development is defined as “a process of translation of research findings and other knowledge into a plan or design for new products, services, and processes or a plan or design for bringing significant improvements on the existing products.”

The Japanese accounting standard, like the U.S. accounting standard, requires the expensing of R&D (with certain exceptions for software) because of the uncertainty of future revenues. The BDC argued that if it had adopted an approach where certain qualified costs were required to be capitalized as assets, it should set forth conditions for capitalization. Because of the difficulty in ensuring objectivity in practice, requiring capitalization based on certain conditions would impair interentity comparability. Also, as research has demonstrated, concerns about the reliability of measurement of intangible assets proscribed capitalization. The total amount of R&D costs that is included in current year’s expenses must be disclosed in the financial statement.

Malaysia. The Malaysian Accounting Standards Board (MASB) was established under the Financial Reporting Act of 1997 as an independent authority to develop and issue accounting and financial reporting standards in Malaysia. In Malaysia, the relevant accounting standard that deals with R&D is MASB 4, Research and Development Costs. This standard was issued by the MASB in June 1999 as an approved accounting standard and is operative for financial statements covering periods beginning July 1, 1999. The standard superseded the IASB’s IAS 9, Accounting for Research and Development, previously adopted by the MASB.

The requirements of MASB 4 are consistent, in all material respects, with IASB’s IAS 38 on intangibles. MASB 4, like the United Kingdom’s SSAP 13, requires all research costs to be expensed to the income statement as incurred. The development costs of a project should be recognized as an expense as incurred unless the criteria for asset recognition identified in the standard are met. Similarly, development costs initially recognized as an expense should not be recognized as an asset in a subsequent period. This is contrary to SSAP 13.

Unamortized deferred R&D costs, similar to SSAP 13 and AASB 1011, need to be reviewed regularly for impairment. Deferred expenditures, to the extent that they exceed the recoverable amount at the balance sheet date, must be expensed. MASB 4, similar to SSAP 13, does not prescribe a maximum period of amortization but states that development costs are normally amortized over a period not to exceed five years. This relatively short amortization period is suggested because of possible technological and economic obsolescence and the significant uncertainties involved in estimating future costs and benefits beyond the five-year period.

Development costs recognized as an expense in a prior period cannot be recognized as an asset in the following period even if the asset recognition criteria for those development costs are subsequently met. This rule is similar to that of the AASB 1011 but contradicts the U.K.’s SSAP 13. The MASB 4 R&D disclosure requirements are similar to those stated in the Ninth Schedule of the Malaysian Companies Act, 1965.

The Role of the IASB

The above analysis shows that there are significant differences among countries in the treatment of R&D costs. These differences can seriously limit the comparability of financial statements in an international context, as various researchers have shown. The IASB has an important role to play in harmonizing these accounting differences in order to enable effective cross-border comparisons of financial statements.

IAS 38, Intangible Assets, clearly demonstrates that the IASB has failed in harmonizing R&D costs accounting among countries. This failure is not due to the inability of the IASB to issue a coherent accounting standard on R&D. It is due to the inability of the IASB to enforce those IASs within each country.

In an effort to achieve greater comparability of financial statement information, the IASB has removed the option for companies to capitalize R&D, which was initially present in IAS 9. The original IAS 9 (and the current SSAP 13) gave companies the option to either capitalize or not to capitalize R&D if the conditions for capitalization were met.

The Japanese and U.S. approaches to R&D accounting are considered to be extremely conservative. Many accounting, scholars argue that these countries’ expensing approaches lead to understated assets and net income, and discourage R&D activities. Australia, Malaysia, the United Kingdom, and the IASB take the middle ground between conservatism (immediate write-off) and matching (deferral) principles. However, Australia is unique in that it allows applied research to be deferred and amortized. Regarding impairment, all the three countries require review of the deferred R&D costs so that any impairment loss could be written off. However, as stressed earlier, capitalization of qualified development costs is not mandatory in the United Kingdom’s SSAP 13 (and the original IAS 9), as opposed to Malaysia’s MASB 4, IASB’s IAS 38, and Australia’s ASSB 1011. All the countries under study and the IASB recognize outsourced R&D because it can be readily identified and valued by the market price. This is not the case, however, for internally generated R&D. Exhibit 2 summarizes the different approaches to the recognition problem adopted by the countries under study and by the IASB.

Obstacles to Harmonization

International accounting harmonization would bring benefits not only in terms of reduced costs of appraising financial statements by international fund managers, credit grantors, and other parties, but also in terms of reduced reporting costs by multinational enterprises. International accounting firms whose clients have foreign subsidiaries would find their tasks such as consolidation and international auditing less onerous if accounting practices were harmonized.

Why do international accounting differences persist? First, some countries do not have strong professional accounting bodies. Second, nationalism leads to an unwillingness to follow other countries’ accounting practices and to give up sovereignty. Third, differences in accounting and financial reporting are a product of a variety of longstanding environmental factors of an economic, political, and cultural nature.

The selection of appropriate accounting treatments for R&D costs is not an easy task. In order to allow room for consistency and hence comparability, IAS 38, ASSB 1011, and MASB 4 have required companies to immediately write off their research costs (except for applied research, in the case of Australia) on the grounds of prudence. In the case of development costs (and, in Australia, applied research), the matching concept prevails under certain well-defined conditions; otherwise, all development costs must be written off. The U.K. accounting standard, by giving companies flexibility in development costs accounting, has created an obstacle to the comparability with financial statements prepared under IASB and Malaysian accounting standards.


The IASB’s treatment of R&D costs is the best approach. Although immediate write-off of R&D costs in line with prudence increases the comparability of financial statements, this accounting treatment suffers from serious limitations. Development costs capitalized in the balance sheet are investments from which businesses will surely reap economic benefits. Noncapitalization of these development costs may cause asset figures in the balance sheet to be understated.

The capitalization of development costs also complicates U.S. and Japanese cash flow statements, where these costs are classified as an operating activity. Development costs are really an investment, therefore classification as an investing activity, as is the case with the IASB, the United Kingdom, Australia, and Malaysia, is the proper accounting treatment.

In addition, the current flexibility in accounting treatment acts as an obstacle to the comparability of financial statements. The IASB, by removing this choice present in the original IAS 9, has made one more step in the right direction.

M. Iqbal Khadaroo, ACCA, CA (M), MBA (UM), BBA, is an accounting lecturer, and
Junaid M. Shaikh is the head of the accounting department, faculty of business & law, both at Multimedia University, Melaka, Malaysia.

Robert H. Colson, PhD, CPA
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