(Effect of capitalizing versus expensing R&D costs, LO 3, 4, 8, 9) Utopia Inc.

(Utopia) is a biotechnology company located in Montréal. Utopia has successfully marketed a number of products since it went public three years ago. Biotechnology is a highly competitive industry and a company’s decline in the marketplace is no further away than a competitor’s dramatic scientific breakthrough. To remain competitive, companies must invest heavily in research and development to ensure that they have a pipeline of new medicines to bring to market.

Utopia prepares its financial statements in accordance with GAAP, so it expenses all research costs and any development costs that do not meet the criteria for capitalization. To date, none of Utopia’s development costs have met the criteria for capitalization. The following information has been summarized from Utopia’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 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 ili. profit margin percentage

f. How would your interpretation of Utopia 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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Summarized from the income statement Revenue Utopia Inc. Extracts from Financial Statements 2006 2005 2004 2003 2002 $ 7,245,000 $ 4,525,000 $3,050,000 $ 850,000 $ 25,000 Expenses* 3,260,000 2,172,000 1,555,000 1,005,000 750,000 Research and develop. expenditures 3,500,000 2,000,000 Net loss 4,500,000 $ (515,000) $(1,147,000) $ (505,000) $ (905,000) $(1,225,000) 750,000 500,000 Summarized from the balance sheet Total assets $12,625,000 $11,235,000 $10,550,000 $3,250,000 $1,400,000 4,923,750 4,044,600 equity 7,701,250 7,190,400 Total liabilities Total shareholders' Summarized from the cash flow statement Cash from operations Cash expended on investing activities 625,000 $ (900,000) $ (410,000) $ (700,000) $(1,500,000) (1,000,500) (1,235,000) (5,350,000) (1,750,000) (950,000) 3,692,500 1,365,000 630,000 6,857,500 1,885,000 770,000