Expensing versus capitalizing research and development costs. Pfizer, a pharmaceutical company, plans to spend $90 million on research and development (R&D) at the beginning of each of the neat several years to develop new drugs. As a result of the R&D expenditure for a given year, it expects pretax income (not counting R&D expense) to increase by $36 million a year for three years, including the year of the expenditure itself. Pfizer has other pretax income of $34) million per year. The controller of Pfizer is curious about the effect on the financial statements of following one of two accounting policies with respect to R&D expenditures:
(1) Expensing the R&D costs in the year of expenditure the policy required in the United States).
(2) Capitalizing the R&D costs and amortizing them over three years, including the year of the expenditure itself.
Assume that the company does spend $90 million at the beginning of each of four years and that the planned increase in income occurs. Ignore income tax effects.
a. Prepare a four-year condensed summary of income before income taxes, assuming that Pfizer follows policy (1) and expenses R&D costs as incurred.
b. Prepare a four-year condensed summary of income before income taxes, assuming that Pfizer follows policy (2) and capitalizes R&D costs, then amortizes them over three years. Also compute the amount of Deferred R&D Costs (asset) appearing on the balance sheet at the end of each of the four years.
c. In what sense is policy (1) a conservative policy?
d. Ascertain the effect on income before income taxes and on the balance sheet if Pfizer continues to spend $90 million each year and the pretax income effects continue as in the first four years.