43   ASC 730 RESEARCH AND DEVELOPMENT

Perspective and Issues

Subtopics

Scope and Scope Exception

Overview

Definitions of Terms

Concepts, Rules, and Examples

Overview of Research and Development Costs

Example of research and development

Acquired Research and Development Costs

Nonrefundable advance payments related to future R&D activities

Sponsored research and development activities

PERSPECTIVE AND ISSUES

Subtopics

ASC 730, Research and Development, contains two subtopics:

• ASC 730-10, Overall, which provides guidance on the activities, elements, costs, accounting and disclosures for research and development
• ASC 730-20, Research and Development Arrangements, which provides guidance on arrangements used to finance research and development.

Scope and Scope Exception

ASC 730 applies to all entities and to “activities aimed at developing or significantly improving a product or service (referred to as product) or a process or technique (referred to as process) whether the product or process is intended for sale or use.” (ASC 710-30-15-3)

ASC 730 does not apply to the costs of research and development activities conducted for others under a contractual arrangement, indirect costs, activities that are unique to entities in the extractive industries, a process for use in an entity's selling or administrative activities, routine, market research, research and development assets acquired in an acquisition by not-for-profit entity or business combination,

Overview

ASC 730 addresses the proper accounting and reporting for research and development costs. It identifies those activities that are to be identified as research and development, the elements of costs that shall be identified with research and development activities, the accounting for these costs, and the financial statement disclosures related to them.

The central issue in regard to research and development costs is that the future benefits related to these expenditures are uncertain. Given this uncertainty, it is generally difficult to justify classifying them as an asset. Generally, entities should charge them to expense as incurred.

DEFINITIONS OF TERMS

Source: ASC 710-10-20 and ASC 710-20-20

Probable. An event is likely to occur.

Related parties. Related parties can include affiliates of an entity, trusts for the benefit of employees, owners, and managers of an entity, and other parties having significant control over the operating policies of an entity.

Research and development. Research and development (R&D) are defined as follows:

1. Research is the planned search or critical investigation aimed at the discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service or a new process or technique or in bringing about a significant improvement to an existing product or process.
2. Development is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use.

There are three ways in which R&D costs are incurred by a business.

1. Purchase of R&D from other entities
2. Conducting R&D for others under a contractual arrangement
3. Conducting R&D activities for the benefit of the reporting entity.

Sponsor. An entity that provides funding for a research and development project.

Variable interest entity. A legal entity subject to consolidation according to the provisions of the Variable Interest Entities Subsections of Subtopic 810-10.

CONCEPTS, RULES, AND EXAMPLES

Overview of Research and Development Costs

The accounting treatment relative to R&D depends upon the nature of the cost. R&D costs incurred in the ordinary course of operations consist of materials, equipment, facilities, personnel, and indirect costs that can be attributed to research or development activities. These costs are expensed in the period in which they are incurred unless they have alternative future uses. Examples of such R&D costs with alternative future uses include

1. Laboratory research to discover new knowledge
2. Formulation and design of product alternatives
   1. Testing for product alternatives
   2. Modification of products or processes
3. Preproduction prototypes and models
   1. Tools, dies, etc. for new technology
   2. Pilot plants not capable of commercial production
4. Engineering activity until the product is ready for manufacture.

   (ASC 730-10-55-1)

Examples of costs that are not considered R&D include:

1. Engineering during an early phase of commercial production
2. Quality control for commercial production
3. Troubleshooting during a commercial production breakdown
4. Routine, ongoing efforts to improve products
5. Adaptation of existing capacity for a specific customer or other requirements
6. Seasonal design changes to products
7. Routine design of tools, dies, etc.
8. Design, construction, startup, etc. of equipment except that used solely for R&D.

   (ASC 730-10-55-2)

In many cases, entities will pay other parties to perform R&D activities on their behalf. Substance over form must be used in evaluating these arrangements. A financial reporting result cannot be obtained indirectly if it would not have been permitted if accomplished directly. Thus, if costs incurred to engage others to perform R&D activities that, in substance, could have been performed by the reporting entity itself, those costs must be expensed as incurred.

An alternative arrangement is for a business to enter into a limited partnership where the limited partners provide funding and the business conducts the research under a contract with the partnership. Under such an arrangement, the partnership may retain legal ownership of the results of the research. The business may have an option to buy back the results of the research upon payment of a stipulated amount to the partnership.

On the other hand, if the payment is to acquire intangibles for use in R&D activities, and these assets have other uses, then the expenditure is capitalized and accounted for in accordance with ASC 350.

When R&D costs are incurred as a result of contractual arrangements, the nature of the agreement dictates the accounting treatment of the costs involved. The key determinant is the transfer of the risk associated with the R&D expenditures. Risk is not transferred to the other parties if there is a commitment by the business to repay the other parties. Examples of commitments to repay are:

• The entity guarantees repayment regardless of the outcome
• The other parties can require the entity to purchase their interests
• The other parties receive debt or equity securities issued by the entity upon completion of the project, irrespective of the outcome.

If the business receives funds from another party to perform R&D and is obligated to repay those funds regardless of the outcome, a liability must be recorded and the R&D costs expensed as incurred. To conclude that a liability does not exist, the transfer of the financial risk must be substantive and genuine.

Acquired Research and Development Costs

Intangible assets acquired in a business combination that are used in research and development activities are to be recognized as indefinite-lived intangibles until the associated research and development efforts are either completed or abandoned. This treatment is afforded R&D assets irrespective of whether they are considered to have an alternative future use.

While these assets are considered to have an indefinite life, they are not to be amortized but rather are to be tested for impairment annually, or more frequently if events or changes in circumstances indicate the assets might be impaired. Upon completion or abandonment of the R&D efforts, management is to determine the remaining useful life of the assets and commence amortization in accordance with the guidance in ASC 350.

Temporarily idling of R&D assets is treated consistently with other temporarily idled assets; that is, they are not to be accounted for as abandoned.

To operationalize these changes, ASC 805 provides a scope exception for tangible and intangible R&D assets acquired in a business combination. The following accounting rules are provided for R&D assets after their initial recognition, based on whether they are tangible or intangible:

1. Tangible assets acquired in a business combination that are used in R&D activities are to be accounted for in accordance with their nature.
2. Intangible assets acquired in a business combination that are used in R&D activities are accounted for in accordance with ASC 350.

Nonrefundable advance payments related to future R&D activities.

Entities conducting R&D activities may make payments in advance for goods or services to be used in R&D activities. Often, these payment arrangements involve a specific R&D project and the R&D activities to be performed generally have no alternative future use at the time the arrangements are entered into. All or a portion of the advance payment may be nonrefundable to the entity conducting the R&D activities. For example, if the R&D project does not advance to a stage where the goods or services that were paid for in advance are necessary, the entity conducting the R&D activities will not recover its advance payments.

Nonrefundable advance payments are to be deferred and capitalized. As the related goods are delivered and services performed, the capitalized amounts are to be recognized as expense. On a continuous basis, management is to evaluate whether it expects the goods to be delivered or services rendered and to charge the capitalized advance payments to expense when there no longer is an expectation of future benefits.

This is limited to nonrefundable advance payments for goods to be used or services to be rendered in future R&D activities pursuant to an executory contractual arrangement where the goods or services have no alternative future use.

Sponsored research and development activities.

ASC 810-30-55 discusses the accounting for a transaction in which a sponsor creates a wholly owned subsidiary with cash and rights to certain technology originally developed by the sponsor, and receives from the newly created subsidiary two classes of stock. The sponsor then distributes one of the classes of stock (e.g., Class A) to its stockholders. This class of stock has voting rights. Under a purchase option, the sponsor has the right, for a specified period of time, to repurchase all the Class A stock distributed to the stockholders for an exercise price approximating the fair value of the Class A shares. The class retained by the sponsor (e.g., Class B) conveys essentially no financial interest to the sponsor and has no voting rights other than certain blocking rights. The certificate of incorporation prohibits the subsidiary from changing its capital structure, from selling any significant portion of its assets, and from liquidating or merging during the term when the purchase option is outstanding.

The sponsor and the subsidiary enter into a development contract that requires the subsidiary to spend all the cash contributed by the sponsor for research and development activities mutually agreed upon with the sponsor. The subsidiary has no employees other than its CEO. The subsidiary contracts with the sponsor to perform, on behalf of the sponsor, all of the research and development activities under the development contract.

The sponsor accounts for the research and development contract as follows:

• The sponsor reclassifies the cash contributed to the subsidiary as restricted cash when the Class A shares are distributed to its stockholders.
• The distribution of the Class A shares by the sponsor to its stockholders is accounted for as a dividend based on the fair value of the shares distributed.
• In the financial statements of the sponsor, the Class A shares are presented similar to a minority interest.
• The sponsor recognizes research and development expense as the research and development activities are conducted.
• The research and development expense recognized by the sponsor is not allocated to the Class A shares in determining net income or in calculating earnings per share.
• If the Class A purchase option is exercised, the sponsor accounts for the purchase as the acquisition of a minority interest.
• If the Class A purchase option is not exercised by its expiration date, the sponsor reclassifies the Class A stock to additional paid-in capital as an adjustment of the original dividend.

The effect of the above guidance is quite similar to what would be achieved by consolidating the subsidiary. The consolidation of many special-purpose entities used in R & D arrangements is discussed and illustrated at length in Chapter 17.