The Treatment of Investments in Intellectual Property at Apple - Research Paper Example

? Accounting Issue Analysis The Treatment of Investments in Intellectual Property at Apple Brian Giuliano Texas A&M Commerce The study is a brief discussion on the accounting treatment of intellectual property research and development at Apple, Inc., commenting on accounts and transactions reported on for the year 2011 and similar matters for the years 2010 and 2009 for comparison. The accounting treatment for R&D has become contentious in the past because of its intangible nature, first and foremost, which allows for variable interpretations as to the nature of R&D undertaken. Another attribute is the innate uncertainty of each R&D undertaking, which causes debate as to the degree of research or development, the possibility of technological feasibility, or the assessment of the likelihood of future economic benefits. While these attributes have become the focus of regulation of SFAS 2 and subsequent standards SFAS 68 and 86, the objective determination thereof remains elusive and indeterminate, and therefore open to managerial discretion. The study also comments on the differences in accounting treatment among standards, such as between the SFAS and the IAS, concerning R&D expenditures. In the past it has been found that regulations allows for large write-offs of acquired R&D in favor of the acquirer, which have been tightened by recently developed standards embodied in SFAS 141 and 142. From published reports, Apple appears substantially and formally compliant with these regulations; however, greater detail and information on specific projects unavailable in the published reports would be required by a sitting and competent body to assess whether these treatments are fully compliant with the letter and spirit of SFAS. Introduction The reason behind any business venture is to create value for its stakeholders – in the form of dividends and stock price appreciation for the shareholders, goods and services to fulfill customer needs and wants, compensation for employees, and income for its suppliers and partners along its value chain. In order to determine the value created by the business it is important to assess the value of its resources incremented by the incomes it earns net of the costs of doing business. The assets of a business comprise its resources, and in the course of doing business these assets get depleted and are supplemented periodically over time. How close to actuality a firm assesses the value of its assets depends upon how faithfully the accounting treatment mirrors the nature of the asset. Tangible assets are easily valued; intangible ones are more ambiguous. Of all intangible assets a technology corporation, the most important – and most difficult to assess – is its intellectual property, and the research and development effort that goes into building it. Research efforts, when successful, lay the foundation for the company’s incomes for the long-term, and therefore should be capitalized; however, since a good amount of R&D efforts are not successful, there is also a possibility that these costs would have short-term implications that does not justify depreciation into the future. This research paper will search for answers to the question: How does a high-technology company with its own proprietary research and development treat its R&D expenditures treat its research and development costs in its financial reports, given that research and development efforts may or may not result in marketable products? The study shall focus on the procedure applied in Apple, Inc., the company of choice because of their high-profile, highly successful new technologies in personal communication devices, for both hardware and software. U.S. GAAP for Research and Development Expenditures The U.S. Generally Accepted Accounting Principles is the body of accounting rules and standards according to which financial statements for companies in the U.S. are prepared, particularly publicly traded and held companies and non-profit organizations. The U.S. GAAP is embodied in the Statement of Financial Accounting Standards (SFAS), which are issued by the Financial Accounting Standards Board (FASB) in the United States. The SFAS differs slightly from the International Financial Reporting Standards (IFRS), the body of accounting rules which is formulated by the International Accounting Standards Board, although there presently is an effort toward convergence and harmonization of the two. The U.S. GAAP treatment for R&D is incorporated in SFAS 2, entitled Accounting for Research and Development Costs, issued in October 1974. This rule applies to two types of activities: research, which is “aimed at discovery of new knowledge” in anticipation of either a new product/service, or a new process/technique, or a significant improvement in and existing product or process; and development, which is “the translation of research findings or other knowledge into a plan or design for a new product or process” or a significant improvement in such, intended for sale or use. Development includes conceptualization, design, testing, prototype construction, and pilot plant operation (SFAS 2, 1974) The general rule in the treatment of R&D costs is for materials, equipment and facilities to be expensed as consumed; however, if there are alternative futures uses, then these items are capitalized and depreciated over their useful lives. Items with no alternative future uses are treated according to the general rule and are expensed as they are acquired or constructed and are never depreciated. The same rule applies in the purchase of intangibles from others: if such have alternative future uses, whether in R&D projects or otherwise, they are to be capitalized and amortized as intangible assets, and the amortization of these intangible assets used in R&D are treated as R&D costs; however, costs of intangibles purchased from others that have no alternative future uses are treated as R&D costs at the time they are incurred, because they have no separate economic values. Finally, contract services and an allocation of the indirect costs that have a clear relation to R&D activities are included as R&D costs (SFAS 2, 1974). SFAS 2 relates to R&D costs in general (Elliott, et al, 1984). For companies the principal product of which are software products, this rule is further refined by SFAS 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed, released in August 1985. This rule segments the life of a software product into three. The first segment is that which precedes establishment of a product’s technological feasibility; R&D costs incurred at this time are expensed as incurred, pursuant to SFAS 2. The second segment begins when two conditions are fulfilled, that is, when technological feasibility has been established and when all R&D activities for the other components of the product/process has been completed; it ends with product release in the market. During this segment, relevant R&D costs during this time are capitalized. Finally, the last segment begins when the product becomes available to the general public; amortization of capitalized costs begins, and subsequent outlays are expensed as incurred similar to the first segment. The amortization of capitalized costs is computed, either according to the ratio of current gross revenues for the product to the sum of current and anticipated future gross revenues for the product, or by using a straight-line charge-off for the duration of the remaining estimated economic life of the product, whichever is greater (SFAS 86, 1985; Oliver, 2003). Conflicting accounting standards on R&D costs The standard of treatment under the US GAAP on intangible assets (among which are the products of proprietary research and development) differs from that treatment mandated under the World GAAP. International Accounting Standards No. 38, or IAS 38, Intangible Assets, divides R&D into 2 phases rather than the three distinguished by US GAAP. These are the research phase and the development phase. Research is “the original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge” while development is “the application of research findings into…a plan or design for production” (Khadaroo & Shaikh, 2003, p. 50). IAS 38 requires that research costs should be expensed, and allows only development costs to be capitalized and amortized if economic benefits are produced by their results, depending on whether they meet certain criteria. It is important for U.S. multinationals to become familiar with and comply with IAS 38 where they perform R&D outside the U.S. The different approaches of accounting standards across borders tend to introduce distortions and hinder the comparability of financial reports. The main issue lies in the timing and recognition of R&D costs. This is graphically summarized in Figure 1 below: Source: Khadaroo & Shaikh, 2003, p. 54 Essentially, the debate arises from the uncertainty of future benefits which may be derived from R&D efforts at present. Pursuant to the accrual principle, the costs of R&D activities must be matched against the future benefits derived from the new product and processes that result from the R&D. On the other hand, based on the conservatism principle, since future benefits are not certain whilst R&D is being undertaken, then R&D expenditures must be expensed as they are incurred. Treatment of R&D Costs at Apple, Inc. According to the Form 10-K Annual Report of Apple Inc., filed on 26 October 2011 for the year ending 24 September 2011, Apple’s research and development costs are expensed as incurred. However, the development costs of computer software that will be sold leased or marketed are capitalized, beginning at that time when the technological feasibility of the product has been established, and which shall end at that time the product is made available for general release to its customers. During the years 2009 to 2011, Apple capitalized development cost only during the first year, and expensed all R&D costs for succeeding years 2010 and 2011. Costs for some years are not amortized because in most cases, Apple’s products are released within a short period after its technological feasibility has been determined, so the costs incurred within that period are usually not significant, and often the costs are simply expensed as they are incurred. For 2009, R&D costs in the amount of $71 million were capitalized, relating to the development of the Mac OS X Version 10.6 Snow Leopard, which was released in the fourth quarter of 2009. Capitalized costs were amortized to cost of sales on a straight-line basis. The amortization period is three years, consistent with the estimated useful life of the underlying technology. The total amortized costs related solely to software development, amounting to $25 million in 2009, $48 million in 2010, and $30 million in 2011 (Form 10-K Report, 2011). Apple also made several business acquisitions over the years, wherein some of the acquired possessed goodwill and intangible assets including R&D. In 2011 these acquisitions amounted to $244 million, of which $77 million was acquired intangible assets, and the rest goodwill. In 2010, acquisitions amounted to $638 million, $107 million of which was acquired intangible assets. Furthermore, in 2011 Apple was part of a consortium that acquired Nortel Networks Corporation’s patent portfolio which amounted to an overall purchase price of $4.5 billion, $2.6 billion of which was Apple’s contribution. A majority proportion of this price was recorded under intangible assets, which the company is expecting to amortize over seven years, pending approval by the Department of Justice which is reviewing the transaction (Form 10-K Report, 2011, p. 61). Implications One aspect of IPR treatment which in the past has come under close scrutiny for being prone to abuse is the treatment of R&D intangibles relating to acquisitions (Filter, 1971). Potentially large write-offs are possible on financial statements for the purchase of in-process research and development (Patrick, 2005). Companies have been criticized as managing their earnings with excessive IPR&D write-offs, because purchase accounting allows for the fair value of the acquired project to be written off by the acquiring company if such project has not yet reached technological feasibility (Nixon, 1997). It is for this reason a new accounting treatment has been mandated by the FASB, as embodied in SFAS 141 and 142. SFAS 141 requires that intangible assets of an acquired company should be segregated and the corresponding purchase price attributed to that asset be recognized separately. Categories of intangibles other than goodwill comprise of marketing-related, customer-related, artistic-related, contract-related, and technology-related intangibles. Patents and software which are the product of R&D efforts are included in this last category. SFAS 142 further mandates that the intangible assets be identified as either finite-lived or indefinite-lived assets. Finite lived assets are booked at fair value and amortized over their remaining useful lives. Indefinite-lived assets are booked at fair value and subjected to an annual impairment test instead of amortization (Martin & Drews, 2006). Studies are currently still underway to investigate alternatives to improving present financial accounting treatment of R&D expenditures particularly in publicly-held corporations (Nix, et al., 2002). Looking as how Apple had, according to its Form 10-K report, amortized acquired intangible assets, it appears on its face that there had been sufficient compliance with SFAS 141 and 142, however it will be noted that the details are not available, and could not be available, from either this or the annual report to shareholders. This is understandable, since going through the details necessary to show full compliance would be too voluminous to publish. For each acquisition of Apple, there are several R&D projects in various stages of research (i.e., initial discovery) or development (application). As to how many of these projects have been determined to be commercially viable also requires explanation as to the criteria by which this is decided, which likewise defies publication on a case-by-case basis, not only due to volume but also because such information would require technical detail and the expert knowledge to appreciate it. Only an indepth investigation by regulatory and legal authorities, such as the acquisition of Nortel Networks Corporation’s patent portfolio which case is currently before the Department of Justice. Conclusion The treatment of R&D costs by Apple appears to adequately comply with the requirements of SFAS 2, 68, 86, 141 and 142, as briefly examined in this study and more thoroughly discussed in the company’s Form 10-K report and its annual report to shareholders. Be that as it may, there are several controversies which remain relegated to the company’s discretion by present standards. First is the identification of R&D costs themselves, which though defined by SFAS allow for some margin of interpretation, as seen from the discrepancies between the different accounting standards. The categorization of the costs as either research or development clashes with SFAS’s distinction as to the stage of research or development. This also allows for discretion, as the determination of technological feasibility or the attribute of possessing future economic benefits, though again defined, is essentially subjective and open to debate on a project-by-project basis. While these issues are already contentious for in-house R&D, they become more problematic for acquired R&D, or R&D in other companies subject of acquisition, because large write-offs have been possible in the past and continue to remain plausible in the present given certain conditions. The determination of fair value of these acquisitions (which differs from fair market value) is also another issue worthy of study. Continuing refinement of current standards promise to address the uncertainties in these matters, as well as the attempt to harmonize the different standards to create one global set of rules. For the meantime, however, software development companies such as Apple, as well as other R&D reliant businesses, will continue to assert those approaches that provide the most advantageous accounting treatment (albeit in the grey area left open by the standards) for their company’s image to its shareholders, as far as regulations will allow. Bibliography Apple, Inc. (26 Oct 2011) Form 10-K Annual Report. Retrieved 8 September 2012 from http://investor.apple.com/secfiling.cfm?filingID=1193125-11-282113&CIK=320193 Drebin, A. R. (1966). Accounting for Proprietary Research. Accounting Review, 41(3), 413-425. Elliott, J., Richardson, G., Dyckman, T., & Dukes, R. (1984). The Impact of SFAS No. 2 on Firm Expenditures on Research and Development: Replications and Extensions. Journal Of Accounting Research, 22(1), 85-102. Filter, E. M. (1971). Accounting Practices Of Major Computer Companies. Financial Analysts Journal, 27(3), 44-52. Financial Accounting Standards Board (1974) Statement of Financial Accounting Standards No. 2, Accounting for Research and Development Costs. Financial Accounting Foundation, Norwalk, Connecticut Financial Accounting Standards Board (1985) Statement of Financial Accounting Standards No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed. Financial Accounting Foundation, Norwalk, Connecticut Khadaroo, M., Shaikh, J. M., & Colson, R. H. (2003). Toward Research And Development Costs Harmonization. CPA Journal, 73(9), 50-55. Martin, D & Drews, D (2006) The Impact of SFAS 141, 142 on Intangible Asset Management. IP Frontline. May 25, 2006. Retrieved 10 September 2012 from http://www.ipfrontline.com/depts/article.aspx?id=11092&deptid=3 Nix, P. E., de Magalhaes, R., & Wilcox, W. (2002). The Management Of Research And Development And The Relevance Of Financial Accounting. Journal of Applied Business Research, 18(1), 95. Nixon, B. (1997). The accounting treatment of research and development expenditure: views of UK company accountants. European Accounting Review, 6(2), 265-277. doi:10.1080/096381897336809 Oliver, J.R. (2003) Accounting and Tax Treatment of R&D: An Update. The CPA Journal/ NYSSCPA, July, Retrieved 9 September 2012 from http://www.nysscpa.org/cpajournal/2003/0703/dept/d074603.htm Patrick, T. (2005). Accounting for IPR&D -- a work still in progress. Accounting Today, 19(1), 12-23. World GAAP Info (2008) International Accounting Standard No. 38 (IAS 38), Intangible Assets. Retrieved 11 September 2012 from http://www.worldgaapinfo.com/pdf/IAS/IAS38.pdf Read More