H is a major electronics company. It spends a substantial amount on research and development.

The company’s latest annual report included a page of voluntary disclosures about the effectiveness of the company’s research programme. This indicated that the company’s prosperity depended on the development of new products, and that this could be a very long process. In order to maintain its technical lead, the company often funded academic research studies into theoretical areas, some of which led to breakthroughs that H was able to patent and develop into new product ideas. The company claimed that the money spent in this way was a good investment because for every twenty fruitless projects there was usually at least one valuable discovery that generated enough profit to cover the whole cost of the research activities. Unfortunately, it was impossible to tell in advance which projects would succeed in this way.

A shareholder expressed dismay at H’s policy of writing off research costs in this manner. He felt that this was unduly pessimistic given that the company earned a good return from its research activities. He felt that the company should depart from the requirements of IAS 38 in order to achieve a fair presentation.

Required:

1. Explain why it might be justifiable for H plc to capitalise its research costs.
2. Explain why IAS 38 imposes a rigid set of rules that prevent the capitalisation of research expenditure and make it difficult to capitalise development expenditure.
3. Explain whether the requirements of IAS 38 are likely to discourage companies such as H from indulging in research activities.
4. Describe the advantages and disadvantages of offering companies the option of departing from the detailed requirements of standards in order to achieve a fair presentation.
5. H’s 20X6 year-end trial balance includes the following costs incurred on new projects started during the year. Explain whether each of these projects should be capitalised.
   • Project A – new music player. Expected to cost a total of £800 000 to develop. Expected total revenues £2 000 000 once work is completed – probably late 20X7. Costs incurred to date = £280 000.
   • Project B – new mobile telephone. Expected to cost a total of £3 000 000 to complete. Future revenues are likely to exceed £5 000 000. The completion date is uncertain because external funding will have to be obtained before research work can be completed. Costs incurred to date = £150 000.
   • Project C – investigation of a new microprocessor recently developed in the aerospace industry. If this proves effective, then the company may well generate significant savings by using it in place of existing microprocessors. Costs incurred to date = £110 000. The company has successfully applied for a patent for the use of this microprocessor in conjunction with other fabrication techniques.