Teaching Critical Thinking by Studying Research and Development Costs

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.

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