Chemo Ltd. (Chemo) is developing a new drug for arthritis. The expenditure does not meet the requirements for deferral as an asset and must be expensed in the current period. The amounts involved are material: the trial balance shows salaries for chemists of $5 million; depreciation of laboratory equipment, $5.5 million; supplies, consumed in the laboratory, $4.5 million; and amortization of related patents, $9.0 million. Chemo expects that further development of the drug will allow commercial production and product sales to commence in another three years.
The main difficulty faced by the auditor is deciding whether the expenditure should be classified as research and development expenses or as general administrative expenses. In addition, the auditor is concerned about the accuracy of the amounts claimed by the client.
Required
(a) Explain why the classification of the expenditure is important and needs to be tested.
(b) Suggest to the auditor some techniques for substantiating the expenditure amounts.