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Mike. capitalization criteria:
1. commercial viability
2. technical feasibility
3. Ability to complete, use or sell
4. intention to use or sell
5. Adequacy of resources
6. Cost measurable.my question is. all of the 3 criteria should meet to record asset OR any one of these?
“my question is. all of the 3 criteria should meet to record asset OR any one of these?” ?????
Do you mean 3 or should that be 6?
The answer, whatever you meant, is that ALL criteria should be met
mike. in Scitech question. one of the competitor is launching his products in market 6 month before our company product. our products are still in research and development stage. whether it affect commercial viabi9lity of our product? please explain how?
Q2a – December 2007
You are the manager responsible for the audit of Sci-Tech Co, a pharmaceutical research company. You are planning the substantive audit procedures to be used in the forthcoming audit of intangible assets and operating expenses. Relevant extracts from the financial statements are as follows:
30 nov 2007
30 nov 2006
(draft)
balance sheet $000 $000
intangible assets: development costs
cost
2750 2000
accumulated amortisation
-1450 -850
——- ——-
1300 1150
——- ——-
total assets
18500 15000income statement
revenue
4500 3800operating expenses include:
research costs
160 200
amortisation of development costs
600 450
salary expenses
380 400
profit before tax 1800 1530The following is an extract from the notes to the draft financial statements:
‘Expenditure on product development is capitalised as an intangible asset from the point at which it is probable that future economic benefits will result from the product once completed. Any product development costs which do not meet the above criteria are expensed as incurred as research costs.
Two products are currently in the development phase: Medex, an antiseptic cream; and Flortex, a medicine to reduce the symptoms of fever.
Amortisation of development costs commences with commercial production, the amortisation period being the estimated life span of the product. Currently two products are being amortised over the following periods:
1. Plummet Cold Cure five years
2. Blingo Cough Cure three years.’During the initial planning of the audit, the audit senior made the following note on the working papers:
‘Bio-Cert Co is the main competitor of our client. It appears that Bio-Cert Co is developing a rival product to Flortex. This rival product is expected to be launched in June 2008, six months prior to the expected launch of Flortex.’
Sci-Tech Co decided to outsource its payroll function, commencing in June 2007. The service is being provided by ProPay Co, a small local company. All of the accounting records relating to payroll are maintained and kept by ProPay Co. In previous years the audit of salary expenses was performed using a systems based approach with limited substantive procedures.
Sci-Tech Co receives funding from governmental health departments, as well as several large charitable donations. This funding represents on average 25% of the company’s research and development annual expenditure.
The amount of funding received is dependent on three key performance indicator (KPI) targets being met annually. All three of the targets must be met in order to secure the government funding.
Extracts from Sci-Tech Co’s operating and financial review are as follows:
kpi target
draft kpi 2007 actual kpi 2006pharmaceutical products
donated free of charge to
health care charities1% revenue 0·8% revenue 1·2% revenue
donations to, and cost of
involvement with, local
community charities:0·5% revenue 0·6% revenue 0·8% revenue
accidents in the work place:
less than 5 serious accidentsper year
4 serious accidents 2 serious accidentsRequired:
Define ‘outsourcing’ and explain the matters to be considered in planning the audit of salary expense.
Note: requirement (a) includes 2 professional marks. (9 marks)
‘Expenditure on product development is capitalised as an intangible asset from the point at which it is probable that future economic benefits will result from the product once completed. Any product development costs which do not meet the above criteria are expensed as incurred as research costs.
Two products are currently in the development phase: Medex, an antiseptic cream; and Flortex, a medicine to reduce the symptoms of fever.
Amortisation of development costs commences with commercial production, the amortisation period being the estimated life span of the product. Currently two products are being amortised over the following periods:
1. Plummet Cold Cure five years
2. Blingo Cough Cure three years.’During the initial planning of the audit, the audit senior made the following note on the working papers:
‘Bio-Cert Co is the main competitor of our client. It appears that Bio-Cert Co is developing a rival product to Flortex. This rival product is expected to be launched in June 2008, six months prior to the expected launch of Flortex.’
“mike. in Scitech question. one of the competitor is launching his products in market 6 month before our company product. our products are still in research and development stage. whether it affect commercial viabi9lity of our product? please explain how?”
Well, that was a difficult post to read but here’s what I think in answer to your question
“How may the launch of a competitor’s product affect the commercial viability of our own product still in development stage?”
A number of possible points spring to mind:
1) instead of finding our own exclusive niche in the market for fever symptom reduction medicine, it looks like we’re going to have to share that market with our competitor
2) but we’re going to be the ones chasing market share because the competitor’s going to be in there first and, with some aggressive marketing, they could well become firmly established before we get launched
3) I could see this as a major reduction in the proposed / anticipated revenues from Flortex to the extent that those revenues may be reduced to a level where profits fail to exceed capitalised development costs
4) the mere existence of a direct rival to our product could cause such a material shift in the projected revenues and profits anticipated from Flortex that commercial viability is now heavily under the microscope
5) if the Sci-Tech directors determine that Flortex is no longer commercially viable (or even simply suspect that it isn’t!) then further capitalisation should cease and expenditure on Flortex should be expensed
6) the directors may even decide to abandon the Flortex project in which case all previously deferred expenditure should be immediately written off
7) if the decision is made to continue to develop Flortex, and in so far as the existing balance in Deferred Development Costs relate to Flortex, an assessment should be made as to the likelihood that future revenues will cover that deferred balance and, if not, that too should be impaired down to the level that is projected to be recoverable
Does that do it? How many marks was this part worth?
Requirement: part b
(i) Explain the matters you should consider to determine whether capitalized development costs are
appropriately recognized; (5 marks)
(ii) Describe the evidence you would seek to support the assertion that development costs are technically
feasible. (3 marks)The answer I have given relates to part i) only of part b) of the question
I assume that you’re ok with part ii)
If Sci-Tech is going to continue to develop Flortex, the maximum amount available to be capitalised is the estimated revenue from the future sales
If the development expenditure so far capitalised exceeds that estimate, we need to impair those capitalised development costs down to the level of assured recovery …. and make sure that n more is capitalised
OK?
Mike: Thank you for the flow in your answer.Flow often pose a challenge for me.
Could you kindly complete
(ii) Describe the evidence you would seek to support the assertion that development costs are technically
feasible. (3 marks)“Describe the evidence you would seek to support the assertion that development costs are technically feasible”
This is a tricky one and I’m not totally convinced in my own mind that the question makes sense. Surely it’s the project, Flortex, that should be technically feasible rather than the “development costs”.
Sorry to ask this, but are you sure that you have copied the question correctly?
However …..
….. again, from the top of my head, without a lot of thought, you could include:
– (you can almost always work in to an answer) board minutes to review the directors’ assessment of the current position
– market research reports commissioned both before and after the announcement of the competitor product
– review of scientific analysis of any tests carried out on Flortex by Sci-Tech’s own laboratory (probably unlikely that independent laboratories have been consulted) to confirm that no adverse side-effects have been identified
– if any such side-effects have been suspected, determine what action has been taken by Sci-Tech to address that problem and whether the steps taken involve additional costs (this will affect the anticipated profitability of Flortex and could, in an extreme case, result in losses being forecast)
– review of the directors’ estimated time-scale for the launch of Sci-Tech’s Flortex to determent whether it is reasonable and achievable in our view
– review the Flortex development budget to confirm that actual expenditure correlates closely with budgeted costs
– review previous experience (last and previous years’ files) we have seen with reference to management’s estimation of time-scales and budgeted expenditure with actual launch dates and costs of previous projects to determine whether management has a history of over-optimism
Will that do for you – it’s only 3 marks so this is rather more than I could expect to write under time pressure
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