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Case Study

Two Rocks Ltd is a highly successful engineering company that manufactures filters for air-conditioning systems. Due to its dissatisfaction with the quality of the filters currently available, on 1 January 2017 it commenced a project to design a more efficient filter. The following notes record the events relating to that project.

2017

JanuaryPaid $145,000 in salaries of company engineers and consultants who directly and only conducted basic tests on available filters with varying modifications.

FebruarySpent $165,000 on developing a new filter system, including the production of a basic model. It became obvious that the model in its current form would not be successful because the material in the filter was not as effective as required.

MarchAcquired the fibres division of Sand Hill Ltd for $330,000. The fair value of the tangible assets of this division were: property, plant and equipment $180,000; inventories $60,000.

This business was acquired because one of the products it produced was a fibrous compound sold under the brand name Foamy that Two Rocks Ltd considered would be excellent for including in the filtration process. By buying the fibres division, Two Rocks Ltd acquired the patent for this fibrous compound. Tow Rocks Ltd valued the patent at $50,000 and the brand name at $40,000 using a number of valuation techniques. The patent had a further 10 year life but was renewable on application. Further costs of $54,000 were incurred on creating the new filter system during March.

AprilSpent a further $135,000 on revising the filtration process to incorporate the fibrous compound. By the end of April, Two Rocks Ltd was convinced that it now had a viable product because preliminary tests showed that the filtration process was significantly better than any other available on the market.

MayDeveloped a prototype of the filtration component and proceeded to test it within a variety of models of air-conditioners. The company preferred to sell the filtration process to current manufacturers of air-conditioners if the process worked with currently available models. If this proved not possible, the company would then consider developing its own brand of air-conditioners using the new filtration system. By the end of May, the filtration system had proved successful on all but one of the currently available commercial models. Costs incurred were $65,000.

JuneVarious air-conditioner manufacturers were invited to demonstrations of the filtration system. Costs incurred were $25,000 including $12,000 for food and beverages for the prospective clients. The feedback from a number of the companies was that they were prepared to enter negotiations for acquiring the filters from Two Rocks Ltd. The company now believe it had a successful model and commenced planning the production of the filters. Ongoing costs of $45,000 to refine the filtration systems, particularly in the light of comments by the manufacturers, were incurred in the latter part of June.

Required

Explain how costs incurred for research and development activities by Two Rocks Ltd between the months of January to June 2017 should be accounted for under NZ IAS 38. Please justify your decisions with reference to the criteria in NZ IAS 38.