Invitation: If you are attending the annual meeting of
the American Accounting Association this summer in Chicago, I am participating
in two separate panel presentations on teaching on Monday, August 10. I would love to have you there as several of
us chat about the challenges of becoming a better classroom teacher. To me, that seems like a topic that could
produce hours of fascinating conversation.
Grab me after the panel presentations conclude and we can continue the
discussion.
-----
In
almost every entry written over the years for this blog, I have addressed
topics that I felt were of interest to all college teachers. Struggles with student preparation, testing,
class participation, and the like probably apply to everyone who enters a
classroom each day to encourage and enlighten college students. History teachers, English teachers, science
teachers, accounting teachers and all the rest face similar issues as they
attempt to broaden the perspective and deepen the knowledge of their students.
However,
today’s essay is almost exclusively intended for people who teach
accounting. It is the topic I know the
best. One of the traditional goals of a
college education is the development of each student’s critical thinking
skills. Unfortunately, too much of current education
focuses on memorization. In the age of
Google, the importance of memorization has faded dramatically. In colleges, we face the ongoing
challenge of moving students away from memorization and toward the development
of critical thinking.
In
this blog entry, I want to explain a short exercise that I use each semester to
help students make this transition.
-----
The
reporting of research and development costs provides an excellent topic for the
discussion of the theoretical structure that underlies official accounting
rules because the handling mandated by US GAAP is unambiguous. As most accounting students learn rather
quickly, US GAAP requires virtually all research and development costs to be recorded as expenses when incurred. Memorization of
these few words requires only a few seconds.
Students are likely to feel a sense of euphoria because they have
managed to “understand” an important accounting rule. However, memorization and critical thinking
are two different skills.
The
purpose of this class assignment is to encourage students to go beyond the
simple memorization of a basic rule. I
want to guide them through the analysis necessary to understand the logic that
led to the rule’s designation as “generally accepted” along with the
implications of that decision. By
developing a deeper level of understanding, students will be better able to
evaluate how other similar types of costs might be handled.
Here
is the assignment that I distribute to the students 48 hours prior to our class
discussion which usually
takes place near the midpoint of the semester.
“A
pharmaceutical company develops, manufactures, and sells drugs created to cure
a wide variety of human health problems.
Company officials are constantly searching for new medicines that can be
produced and sold to the public. Such
additions to the approved product line are essential to the ongoing prosperity
of all companies in this industry.
Historically, an average of $10 million in revenue is generated from
each new medicine that is brought to the market successfully. Products that fail to reach the market earn
no revenue. Over the previous 8-10 years, the company has been successful in bringing one product to the market for
every three projects undertaken. This
average is consistent with the industry as a whole.
“At
the start of the current year, the company began working on three potential new
products. Each is being put through the
normal testing process which takes 1 to 4 years to complete. By the end of the year, the company has
incurred $1 million in research and development costs in connection with each
of these three projects. Financial
statements are to be produced. Company officials evaluate the likelihood of
eventual success for each. They believe
that Project A has a 90 percent chance of being brought to the market, Project
B has a 60 percent chance, and Project C has a 30 percent chance. Officials know that a total of $3 million in
research and development costs have been incurred to date. They expect at least one of these projects
to attain success, an event that should bring in future revenue of $10
million. They are now seeking guidance
on the reporting of the $3 million in research and development costs.
“I
am not interested at this time in what US GAAP requires for this cost. Instead, assume you are named ‘Leader of US
GAAP,’ a title that makes you the one person in the world responsible for deciding
how to account for this $3 million.
First, come up with as many alternative reporting possibilities as you
can imagine. Second, evaluate each of
these options and select the one that makes the most sense to you. Explain why you believe this particular
choice should be the required reporting within US GAAP.
“As
just a hint, start this exercise by defining the word ‘asset.’”
In
class, I begin our discussion by asking the students whether the problem seems realistic. I want them to feel that this is a typical situation
for company officials to face in the world of business and not an issue
contrived for a college class. Analysis
and learning go best when students believe they are dealing with a problem they
could encounter after graduation. If any
part of the assignment is thought to be artificial or unreasonable, its
inclusion should be discussed and understood before we grapple with the overall
accounting issues. Here, I do not expect
students to object to any of the factors that were included. The situation was created to be realistic.
Students
often want to identify the appropriate treatment required by US GAAP. Hands fly up to provide that answer. It is the one possible handling of the $3
million cost that they know for certain.
It is spelled out in the textbook.
I refer to this response as a “no-risk answer” because it cannot be
incorrect. However, simply parroting
what FASB has mandated does not help develop a student’s critical thinking
skills. For that reason, I forbid them
from listing “expense all $3 million” until after every viable alternative has
been identified. In learning accounting
beyond memorization, students need to consider all possibilities and not be
distracted by current US GAAP.
I continue the class conversation by asking a student to provide the definition of
“asset.” By this point in the semester,
they should all have a working knowledge of the definition: A probable future economic benefit obtained
or controlled by a particular entity as a result of past transactions or events.
I next
ask why any company chooses to spend $3 million on research and development
costs. Whether Google, Apple, or a pharmaceutical company, this is not a random action.
The obvious answer is that officials expect to create one or more new
products that can be brought to market successfully to generate additional
revenue of sufficiently more than $3 million in order to compensate for the
risk.
Then,
I ask if the probable economic benefit to be derived from the $3 million
expenditure is in the past or in the future:
Based on industry averages and the company’s own historical evidence
(and the individual evaluations of the three projects in-process), all benefit are expected in the future when one or more of the projects is added to the
market. At this point, none of the
three projects has yet generated any revenue.
That
leads the students to the essential class question: How could a company report this $3 million in
research and development costs if not restricted by the rules of US GAAP? Students usually list a number of
possibilities without much prompting.
• The $3 million is reported as an
asset because the entire amount is spent with reasonable hopes of generating expected
future revenue of at least $10 million.
It is a normal and necessary cost that is expected to lead to a probable
future economic benefit. Available
information shows a high likelihood that sufficient revenue will be earned to
more than cover the costs incurred to date.
All revenue from these projects will be earned in the future. Therefore, expense recognition should be deferred
until that same future time period.
• Of the total cost, $2 million is
reported as an asset because two projects have greater than a 50 percent
likelihood of success whereas the other $1 million is an expense because the final project
is thought to have less than a 50 percent chance of success. Reporting here is based on what is most
likely to happen. Financial statements are
created to reflect reality and this is reality.
• Of the total cost, $1 million is
capitalized as an asset because the company traditionally has been successful
on one out of every three projects. The
remaining $2 million is an expense. This
reporting is based on historical evidence which is a common approach in many
areas of financial reporting such as the recognition of bad debt expense, sales
returns, and depreciation.
• Of the total cost, $1.8 million is
reported as an asset based on a weighted-average determination of the
likelihood of success: 90 percent, 60
percent, and 30 percent. The individual
chances of success are included for every project. The other $1.2 million cost is an expense.
• And, finally, the entire $3 million
is reported as an expense because of the inherent uncertainty of anticipating
eventual success in research and development projects.
At
this point, critical thinking starts to play a role in the conversation. Students are asked to select and justify the
alternative that makes the most sense to them and, therefore, should be
required by US GAAP. Based on their
understanding of the financial reporting process, which alternative is the fairest reflection of the operations and financial condition of the pharmaceutical company?
Student
responses vary from class to class but common arguments usually include the
following.
•
A
popular choice is to capitalize the $3 million as an asset. Students reason that the entire expenditure
is a normal and necessary cost of creating new products to generate
revenue. For a pharmaceutical company, research
for and development of new medicines is a required step in maintaining the
company’s future. If officials did not
anticipate earning revenue of more than $3 million, they would never have spent
this money. No evidence appears to
indicate that the company will fail to recoup its investment. Therefore, the entire amount is a required
sacrifice necessary to develop new products for the market.
•
Another
likely choice is reporting an asset of $2 million with the remaining $1 million
shown as an expense. In judging whether
a probable future economic benefit exists, a likelihood of success in excess of
50 percent is compelling. The first two
projects are more likely than not to produce revenue in excess of the cost that
has been incurred. They meet the
criterion for asset recognition whereas the third project does not.
•
Some
students argue (often vehemently) that capitalizing $1 million is the best
reflection of probable future economic benefit with the remaining $2 million
recorded as an expense. The $1 million
cost should be recognized as an asset because verifiable historical evidence
indicates that, on the average, one in three projects proves successful. Students like having evidence as proof to under-gird the financial reporting.
•
Other
students support a weighted-average approach that leads to a capitalized cost
of $1.8 million and an expense of $1.2 million.
They believe that all potential products should be included in the
computation of the probable future economic benefit. A 90 percent chance of success simply means
that more cost is capitalized than if the chance of success is only 30 percent.
•
A
few students advocate for what I refer to as the “super conservative” approach
and expense the entire $3.0 million immediately. When in doubt, accountants take the approach
that makes the company look poorest as a way to shelter outside decision-makers
from being overly optimistic.
At the end of the debate, we always take a class vote so we can make a selection. Recording all costs as an expense as incurred—the approach mandated by US GAAP
for more than 40 years—usually receives the least amount of support. Once alternatives have been considered,
automatically expensing costs that are freely spent to arrive at new products likely
to generate significant amounts of revenue seems questionable. Students can memorize the approved method of
reporting but that does not mean they understand or agree with it.
After
considering the problems with immediately recording research and development
costs as expenses, the class is asked two questions to stimulate further discussion: Did FASB make a theoretical mistake when it passed this
authoritative standard? Were the
members of the board just not as smart as a bunch of college freshmen?
Students
realize that a logical reason must exist for this handling of research and development
costs. Although a different approach
might seem better, FASB will not require a rule that does not exhibit sufficient
theoretical merit. Students are then challenged
(often working in teams of two or three) to come up with possible
justifications for the Board’s decision.
Here again, their critical thinking skills are called on but, this time,
to unravel the logic of the authoritative approach. With a bit of thought, students usually
propose several reasons why recording virtually all research and development
costs as an expense is most appropriate. Their
primary suggestions usually include the following.
• As mentioned, recording all costs as an expense is a
conservative approach. Students have
often heard that financial accounting is conservative in nature. The official reporting of research and
development costs fits with that stereotype.
However, this rationale usually does not gain overwhelming support from
students because, in studying other topics such as contingencies and bad debts,
they have come to realize that financial accounting is not obsessively
conservative. For example, contingent
losses are not recognized at all until they become both probable and subject to
reasonable estimation. Potential losses
are disclosed (or omitted) rather than recognized if they fail to meet these
criteria. That is different from
reporting virtually all research and development costs as expenses (rather than
assets) when incurred. Conservatism might
influence this handling but it does not seem to be a sufficient justification.
• Uncertainty is an inherent problem in
all research and development activities.
Students often ask how reliable any estimate of future success can be in
such cases as these. To say that the
success of a specific research and development project is 90 percent likely or
30 percent likely might not be considered a reasonable estimate. Are such figures legitimate judgments or
merely wild guesses? Even if 1/3 of all
projects in the past have proven successful, does that necessarily indicate the
likely outcome of the current work?
Does a valid connection exist between success on past projects and
success in the future for such projects?
• Manipulation of the reported figures
is possible. Even first-year students quickly
realize that assessments of the possible success of a research and development
project can be raised or lowered arbitrarily to improve a company’s reported
figures. To illustrate, I typically
describe the following hypothetical situation:
“Assume that a company is allowed to capitalize all research and
development costs for projects that are more than 50 percent likely to be
successful. The company spends $1
million on a project where future success is judged to be 49 percent
likely. Shortly before financial
statements are to be prepared, company officials raise this estimate to 51
percent. How large is the actual change
being made and how large is the reported change in net income?” A seemingly insignificant 2 percent increase
in the possibility of success creates an immediate $1 million jump in reported
net income. Students realize that the
possibility of such manipulations must be avoided if decision-makers are to have
confidence in reported figures.
Through
these discussions, students start to gain an appreciation for the rule-setting
process and how specific standards impact a reporting entity’s financial
appearance. While considering the
mandated rule, a basic question can be considered: What do decision-makers really want to know
about a company’s research and development activities? As a basis for this discussion, students are
asked to search the Internet for the research and development balances most
recently reported by both Apple and Google.
Within
a matter of minutes, students have discovered that Apple’s statement of operations for the
year ending September 27, 2014, reports research and development as an expense
of $6.041 billion. They also learn that
Google’s statement of income for the year ending December 31, 2014, reports
research and development as an expense of $9.832 billion. Apple’s research and development is
approximately 3.3 percent of the company’s net sales number whereas Google’s
research and development is 14.9 percent of its reported revenue number.
Students
are asked several key questions.
• Is this information hard to locate?
• How understandable is the research
and development figures reported by these two companies? Is a decision-maker forced to consult the
notes to the financial statements to gain a clearer explanation?
• What do decision-makers now know
about these two companies?
Students
have little trouble answering these questions.
Information for each company is evident on the face of the income
statement. Because virtually all
research and development costs are put to expense as incurred, decision-makers should
not be confused by the available figures.
With an adequate knowledge of US GAAP, they will understand the meaning
of each reported number. They know the
amount that these two companies spent on research and development activities
during the reporting period. No
estimations of success were involved.
No uncertainty exists. No
manipulation is likely.
That
is likely why this rule has remained a part of US GAAP for over four
decades: It meets the needs of financial
statement users. Many decision makers
are wary of guesses made about success.
Instead, they are interested in knowing the portion of a company’s
financial resources that company officials chose to invest in research and
development activities. Because of the
requirement of US GAAP, this amount is easy to ascertain and also to compare
between companies.
My
students often decide that the best justification for recording virtually all
research and development costs as expenses is that this approach provides users of
financial statements with the information they desire. Judging a company’s research and development
activities based on each new product’s chance for success is too uncertain and
open to manipulation. Reporting the
amount of financial resources allocated to this essential activity is less
problematic and allows for immediate and valid comparisons to be drawn between
companies such as Apple and Google.
As
class conversation comes to a close, students can be warned that most
accounting rules come with their own inherent limitations. That is another important part of the
learning process. Transactions and
other financial events are often complicated.
Accounting standards rarely provide perfect answers. For example, any company that spends
significant amounts of money on research and development is likely to report a
balance sheet that undervalues its total assets by a considerable amount when
US GAAP is applied. Pharmaceutical companies,
technology companies and the like control scores of valuable patents that
represent significant probable future economic benefits. However, virtually all of the
research and development costs spent by the company to create these products
are omitted from related asset balances.
Those costs were expensed as incurred and never capitalized. Consequently, reported asset figures found
on the balance sheet are likely to be out of line with any reasonable
approximation of actual value.
I
usually end this discussion of the balance sheet by reminding students that the auditor’s report
does not state that financial statements are presented fairly. No one ever makes that claim. Instead, if unmodified, the report specifies
that the statements are presented fairly in conformity with US generally
accepted accounting principles. For
research and development activities, US GAAP requires that virtually all such
costs are expensed when incurred so that the capitalized cost reported for valuable
patents and other legal rights will frequently be less than fair value. However, the financial information is still
being presented fairly in conformity with US GAAP. And, hopefully, that provides decision
makers with information they actually want.
For
more advanced classes, this entire discussion can be extended into a deeper analysis
in a couple of ways.
• Students can be asked to compare IFRS reporting of research and development costs with that of US GAAP. This discussion requires an additional explanation of
research costs as separate from development costs but that distinction is not
especially complicated. As one possible
approach, students can be divided into two teams to argue in favor of the US
GAAP handling or in favor of the IFRS handling of these costs. Such evaluations are also essential steps in the
development of critical thinking skills.
• Students can be asked to
consider the proper reporting process when one company buys another that
currently has research and development activities in process. That is a common occurrence. A portion of the cost of the acquisition is
allocated to the research and development activity. The acquiring company is paying for the
results of the work done to date. Is
this amount of the acquisition price appropriately reported as a capitalized
asset or as a research and development expense?
The
discussion of accounting for research and development can be used at the
introductory level or expanded for use in upper-level courses. In either case, students are asked to do more
than simply memorize a mandated accounting rule. They come up with alternatives and
discuss the reasons why a particular method might be the best possible
presentation. They finish up by
looking at related problems that arise from the approach required by US GAAP.
