December 14, 2018

How do you account for a new idea in external financial statements? (part 3)

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In the first two blogs in this series, using the example of an entrepreneur’s expenditure on building a prototype and applying for a patent, I discussed firstly the issue of distinguishing capital from revenue expenditure and secondly whether, if it was capital expenditure, it was tangible or intangible and how to include the expenditure in a set of accounts when accounting for the entrepreneur’s idea.

At the close of the last blog, our entrepreneur had developed his prototype (a gizmo that, when switched on, will immediately stop a baby crying, make it happy and send it to sleep) and was ready to road-test the product. His accountant had agreed to include the monies spent on the prototype and the application for patents as an intangible asset on the company’s balance sheet.

Imagine it is now a year later. The entrepreneur has been busy testing the prototype both in the laboratory and with real babies. Results have been mixed. The product developed glitches in all three of its key features – making the baby stop crying, making it happy and sending it to sleep.

A significant amount of modification, further development and enhancement ensued and, at last, a product that functioned as expected was finished, tested and ready for market launch. Initial feedback from the market and press comments seemed favourable.

More money was spent on trying to patent the product. It was discovered that similar patents have already been filed in the US and Asia. Also, the patent granting authorities have said that the technology is not sufficiently different from existing patents for it to grant a new one for the “baby gizmo”.

The entrepreneur has spent £350,000, with no revenue, remains but upbeat.

Design and build of fully functioning “baby gizmo” £270,000
Application for worldwide patent and legal costs £35,000
Product launch at US and UK 2baby product exhibitions” £15,000
Initial inventory of product £20,000
Samples to display and sell to visitors to the exhibitions £10,000

Everything seems to depend on what happens at the two key exhibitions. Will the baby gizmo be a hit or a miss? Uncertainty abounds.

In the meantime, the company’s accounts are now due and the accountant has to make decisions on how to include the expenditure in the company’s accounts without the benefit of seeing the outcome from the exhibitions.

She decides the following, her reasoning in brackets:

Patent and legal costs: Write-off to profit/loss (similar already exists, no long-term value)
Product launch costs: Write-off to profit/loss (one-off costs, no future benefit)
Inventory: Balance sheet asset (inventory to be sold next year)
Samples: Write-off to profit/loss (one-off costs, no future benefit)

The design and build costs give her sleepless nights… it is an asset if the product launches successfully but a write-off if the product is a flop. Eventually she is sufficiently convinced by the initial good noises coming from the market about the product that she agrees to capitalise the costs and to amortise them over the commercial life of the product.

Is the accounting treatment correct? Yes, if the product succeeds, no if it fails. Only time will tell. This is such a subjective area, that it is only with the skills of 20/20 vision and clairvoyance that the correct accounting treatment would be adopted every time.

In our imaginary example, all works out well. The product is a runaway success, patent applications turn out successful and a new brand is created “The Baby Sleeper Gizmo”. The entrepreneur promises more products to follow and asks the accountant, “I am thinking that we should include a value for the brand in our next set of accounts. What do you think of a value of £10m?”

The accountant faints.

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.