October 27, 2020

How do you account for a new idea in external financial statements? (part 1)

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The answer to this is perhaps not as easy as one might imagine…

Entrepreneurship can be described as a process by which an individual (or a team):

  • identifies a business opportunity
  • acquires and deploys the necessary resources to exploit it
  • manages the associated risks

with the ultimate aim of making a profit.

If, for example, the business opportunity concerns a new way of selling an existing product or service, then accounting for this should pose few problems. The product or services bought and sold should be readily identifiable and can be accounted for as such.

If, however, the entrepreneur has identified a market gap and has an idea for an entirely new, as yet undeveloped product to take advantage of this opportunity, then how should the money expended on the acquisition and deployment of the resources required to exploit this perceived opportunity be accounted for?

The term ‘expenditure’ refers to a payment for something, like a benefit or product received, an asset purchased, a service consumed etc. Take, for example, the initial expenditure on the entrepreneur’s idea, let’s say designing and building a prototype. Is this expenditure creating an asset or is it simply like wages and stationery and therefore money spent running the business on a day-to-day basis?

The former type of expenditure is known in accounting parlance as ‘capital’ expenditure whilst the latter is referred to as ‘revenue’ expenditure. Whichever type the accountant determines that it is will impact the business’s financial statements.

If the design and prototype expenditure is regarded as ‘revenue’ expenditure, then profit is reduced and there is no asset, whereas the opposite is true if it is regarded as ‘capital’ expenditure (i.e. profit is increased and there is an asset).

In essence, any proposed new product or service is only at the ‘seed’ stage of its development. It still requires to be designed, made into a prototype, ‘road-tested’, marketed and so on before any revenue will be earned. Much money will be required to be expended on these pre-revenue phases. And even after all this development expenditure is incurred, potential consumers may reject it on any number of grounds like functionality, price, quality and so on.

A decision is needed as to how and where to include this in the external financial statements. Therefore, an evaluation will be required by the accountant as to whether money spent before there is any revenue generation has a long-term benefit for the business and can be classified as an asset, or whether it is nothing other than immediate consumption or benefit and should therefore be written off as revenue expenditure. This evaluation will include taking a subjective view on the ultimate viability of the proposed new product. Is the accountant qualified to do this? I simply pose the question.

If the decision is that the expenditure is seen as an asset, the next question might be to consider whether or not the expenditure is ‘tangible’ (something that can be seen, touched, heard) or whether it is ‘intangible’ (something that cannot be seen, touched, heard).

This will be the subject of my next blog.

Colin Garvie, Teaching Fellow About Colin Garvie, Teaching Fellow

Teaching Fellow and Chartered Accountant, delivers Accounting to on-campus students in Edinburgh, Malaysia and Dubai.