Development cost

What Is Development Cost?

Development cost refers to the expenditures incurred by a company during the creation and refinement phases of new products, processes, or services. These costs typically arise after the research phase has established the technical feasibility and commercial viability of a project. As a critical component within financial accounting and corporate finance, the accounting treatment of development cost significantly impacts a company's financial statements, particularly its balance sheet and income statement. Unlike research cost, which is almost universally expensed as incurred, development cost may be subject to capitalization under certain accounting standards, leading to its recognition as an intangible asset. This distinction is crucial because capitalization affects reported profitability and asset values.

History and Origin

The accounting treatment of development cost has evolved considerably, reflecting differing views on the nature of these expenditures. Historically, many jurisdictions treated all research and development (R&D) outlays as immediate expenses due to the inherent uncertainty of future economic benefits. In the United States, for instance, under Generally Accepted Accounting Principles (GAAP), specifically ASC 730, research and development costs are generally required to be recognized as an expense as incurred, with limited exceptions for certain acquired assets used in R&D activities.⁷ This approach emphasizes conservatism, as the success of R&D efforts is often uncertain.

In contrast, International Financial Reporting Standards (IFRS) adopted a more nuanced approach. International Accounting Standard 38 (IAS 38), "Intangible Assets," distinguishes between research and development phases. While research expenditures are expensed, development expenditure must be capitalized as an intangible asset if specific criteria are met, indicating a probable future economic benefit and reliable measurement of cost.⁶ IAS 38 replaced earlier standards, including IAS 9 "Research and Development Costs," which was issued in 1993, and an even earlier version from 1978.⁵ This shift in IFRS aimed to provide a more accurate representation of assets generated from successful internal development efforts.

Key Takeaways

• Development cost pertains to expenditures in the latter stages of creating new products or processes, after research has proven feasibility.
• Under IFRS (IAS 38), development costs meeting specific criteria for probable future economic benefits and reliable measurement must be capitalized as intangible assets.
• Under US GAAP (ASC 730), most research and development costs, including development costs, are expensed as incurred.
• The accounting treatment of development cost significantly impacts a company's financial statements, influencing reported assets, earnings, and cash flow.
• Capitalized development costs are typically subject to amortization over their useful lives and regular impairment testing.

Formula and Calculation

The calculation of development cost itself is a summation of direct and indirect expenditures attributable to the development project. When development costs are capitalized, the initial value recognized as an intangible asset is the sum of these directly attributable expenses incurred from the point the capitalization criteria are met.

For a capitalized development project, the initial carrying amount is calculated as:

Where:

• Direct Costs: Directly traceable expenditures such as materials, labor for development staff, and specific service fees.
• Attributable Indirect Costs: Indirect costs that can be reliably allocated to the development activity, such as a portion of facility costs, utilities, and administrative overhead directly related to the project.

Once capitalized, this asset is then amortized over its estimated useful life, similar to depreciation for tangible assets.

Interpreting the Development Cost

The accounting treatment of development cost offers insights into a company's investment in future innovation and its financial reporting strategy. When development costs are capitalized under IFRS, it signals that management believes the project has a high probability of generating future economic benefits. Investors might interpret a higher capitalized development cost on the balance sheet as an indicator of significant investment in future growth. This can also affect a company's return on investment metrics, as expensing reduces current period earnings, while capitalization spreads the cost over time.

Conversely, the immediate expensing of development costs under US GAAP leads to lower reported current earnings for companies with significant R&D activities but can provide a more conservative view of profitability, as potential future benefits are not recognized as assets until realized. Analysts often adjust financial statements to reflect a consistent treatment of R&D for better comparability across companies and regions, effectively capitalizing these costs for analytical purposes even if they are expensed for reporting.

Hypothetical Example

Consider "InnovaTech Solutions Inc.," a software company operating under IFRS. InnovaTech invests heavily in a new enterprise resource planning (ERP) software module.

• Research Phase (January-June): InnovaTech spends $500,000 on initial research, feasibility studies, and conceptual design. These costs are expensed as incurred, as the project's success is still highly uncertain.
• Development Phase (July-December): By July, InnovaTech has proven the technical feasibility and market potential of the ERP module. They can reliably measure the costs and intend to complete and sell the product. During this period, they incur the following development costs:
  • Salaries for development engineers: $800,000
  • Software licenses for development tools: $100,000
  • Testing and quality assurance expenses: $150,000
  • Allocated overhead (e.g., dedicated server usage): $50,000

Since these costs meet the IAS 38 criteria for capitalization, InnovaTech records an intangible asset of $1,100,000 ($800,000 + $100,000 + $150,000 + $50,000) on its balance sheet. If the software module has an estimated useful life of 5 years, InnovaTech would amortize this asset by $220,000 per year ($1,100,000 / 5 years) once it is available for use. This contrasts sharply with US GAAP, where all $1,600,000 ($500,000 research + $1,100,000 development) would have been expensed in the year incurred, leading to a much lower reported profit in the short term but no subsequent amortization expense.

Practical Applications

Development cost is a crucial element in various financial contexts, especially in industries driven by innovation such as technology, pharmaceuticals, and manufacturing.

• Financial Reporting: Companies prepare their financial statements in accordance with applicable accounting standards. Under IFRS, the capitalization of development cost allows companies to report a more robust asset base and smooth out the impact of large development expenditures on annual earnings.⁴
• Valuation and Investment Analysis: Investors and analysts scrutinize development costs to understand a company's long-term growth prospects. For instance, in an industry with high R&D intensity, like software and ICT services, which saw nearly 19% R&D spending growth in 2022, understanding how these costs are treated is paramount for accurate valuation.³ A study on the stock market valuation of R&D expenditures highlights that accounting choices can impact how investors perceive a firm's value.²
• Strategic Decision-Making: Management uses an understanding of development costs to make informed decisions about project prioritization, budgeting, and resource allocation. The decision to invest in a development project is often driven by the anticipated cash flow and market share benefits it is expected to generate.
• Industry Benchmarking: Comparing development costs and their accounting treatment across competitors within an industry can provide insights into their innovation strategies and financial health.

Limitations and Criticisms

While capitalizing development costs can present a more accurate picture of a company's investment in future economic benefits, it is not without its limitations and criticisms:

• Subjectivity in Capitalization Criteria: Determining when a project transitions from the research phase to the development phase, and when the criteria for capitalization (e.g., probable future economic benefits, reliable measurement) are met, involves significant management judgment. This subjectivity can potentially lead to inconsistencies in application across companies or even within the same company over different periods.
• Earnings Management Concerns: The discretionary nature of capitalizing development costs under IFRS has been a subject of debate, with some studies suggesting that it can be used for earnings management.¹ For example, managers might choose to capitalize more development expenditure to smooth earnings or meet targets, rather than solely based on the project's economic merits.
• Impairment Risk: Capitalized intangible assets, including development costs, are subject to periodic impairment testing. If a development project fails to meet its expected commercial success, the capitalized asset may need to be written down, resulting in a significant non-cash expense that can negatively impact earnings.
• Comparability Issues: The differing accounting treatments of development costs between US GAAP (primarily expensing) and IFRS (potential capitalization) create challenges for financial statement users trying to compare companies operating under different accounting frameworks.

Development Cost vs. Research Cost

Development cost and research cost are both components of a broader category known as research and development (R&D) expenditures, but they are distinct in their nature and accounting treatment.

Research Cost refers to original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. It is the initial, exploratory phase where the outcome is highly uncertain. Due to this inherent uncertainty regarding future economic benefits, research costs are almost always expensed as incurred under both US GAAP and IFRS.

Development Cost, on the other hand, 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 before the start of commercial production or use. This phase occurs after the technical feasibility and commercial viability of a project have been established. Under IFRS, development costs that meet specific criteria (e.g., technical feasibility, intention to complete, ability to use or sell, probable future economic benefits, and reliable measurement of cost) are capitalized as intangible assets. In contrast, under US GAAP, development costs are generally expensed, similar to research costs, unless they meet very specific criteria, such as costs related to software development for sale after technological feasibility is established.

The key difference lies in the level of certainty regarding future benefits and the resulting accounting treatment. Research is about discovery with uncertain outcomes, leading to immediate expensing. Development, when capitalized, is about translating proven knowledge into a commercial product or process, where future benefits are deemed probable and measurable.

FAQs

What is the primary difference in accounting for development costs under IFRS and US GAAP?

The primary difference is that under IFRS (specifically IAS 38), development costs must be capitalized if certain criteria are met, indicating a probable future economic benefit. Under US GAAP (ASC 730), most development costs, like research costs, are generally expensed as incurred, with limited exceptions.

Why are development costs sometimes capitalized and sometimes expensed?

Development costs are sometimes capitalized when accounting standards deem that the project has a high probability of generating future economic benefits that can be reliably measured. This typically happens after the research phase has proven technical feasibility. When future benefits are uncertain or not reliably measurable, the costs are expensed to provide a more conservative view of current profitability.

How does capitalizing development costs affect a company's financial statements?

When development costs are capitalized, they are recorded as an intangible asset on the balance sheet, increasing a company's assets. Instead of a large expense hitting the income statement immediately, the cost is spread out over the asset's useful life through amortization expense, potentially leading to higher reported net income in the initial periods compared to immediate expensing. This also affects cash flow from operations.

Are all costs related to new product creation considered development costs?

No. Costs incurred during the initial, exploratory "research" phase of a project, where the aim is to gain new scientific or technical knowledge with uncertain outcomes, are typically classified as research cost and are generally expensed immediately. Development costs specifically refer to the later stage of applying that research to design and produce a new or significantly improved item.