(Effect of capitalizing versus expensing R&D costs, LO 3, 4, 8, 9) Florze Software Inc. (Florze) is a software development company located in Kanata, Ontario.

Software is a highly competitive industry and the life of a software product is usually quite short. To remain competitive, companies must invest heavily in research and development to keep their existing products up to date and to develop new ones.

Florze expenses all research costs and any development costs that do not meet the criteria for capitalization. Florze has never capitalized any development costs. The following information has been summarized from Florze’s financial statements:

Required:

a. Recalculate net income for 2004 through 2006, assuming that research and development costs were capitalized and expensed over three years.

b. What would total assets be at the end of 2004 through 2006 if research and development costs were capitalized and expensed over three years?

c. What would shareholders’ equity be at the end of 2004 through 2006 if research and development costs were capitalized and expensed over three years?

d. What would cash from operations and cash expended on investing activities be for 2004 through 2006 if research and development costs were capitalized and expensed over three years?

e. What would the following ratios be, assuming that (1) research and development costs were expensed as incurred and (2) research and development costs were capitalized and expensed over three years?
i. return on assets ii. debt-to-equity ratio iii. profit margin percentage

f. How would your interpretation of Florze differ depending on how research and development costs are accounted for? Which accounting approach do you think is more appropriate? Explain. Your answer should consider the objectives of the users and preparers of accounting information, as well as the accounting concepts discussed in Chapter 5.

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Florze Software Inc. Extracts from Financial Statements 2006 2005 2004 2003 2002 Summarized from the income statement Revenue Expenses Research and development expenditures Net loss Summarized from the balance sheet Total assets Total liabilities Total shareholders' equity Summarized from the cash flow statement Cash from operations Cash expended on investing activities $2,898,000 $1,810,000 $1,220,000 $340,000 $290,000 1,324,500 1,052,500 905,000 685,000 672,500 1,125,000 875,000 500,000 187,500 125,000 $ 448,500 $ (117,500) $ (185,000) $(532,500) $(507,500) $3,156,250 $2,808,750 $2,637,500 $ 812,500 $350,000 1,294,063 983,063 791,250 1,862,187 1,825,687 1,846,250 235,625 87,500 576,875 262,500 150,000 $ (250,000) $ (75,000) $(350,000) $(750,000) (450,000) (350,000) (1,750,000) (500,000) (285,000)