(Evaluating the effect of R&D accounting on financial statement analysis, LO 1, 2,3) One controversial accounting issue is accounting for research costs. In Canada research costs must be expensed as incurred. This treatment is an application of the conservatism measurement convention. Some people argue that research is a legitimate asset and requiring that it be expensed results in an understatement of assets and income, violates matching, and makes companies that invest heavily in research appear less successful than they actually are.

Chortitz Ltd. (Chortitz) is a large and successful software development company.

You have been provided with Chortitz’s balance sheets and income statements for 2004 through 2006. In addition, Chortitz expensed (and expended) $7,906,000 for research in 2003 and $6,612,000 in 2002.

Required:

a. Recalculate Chortitz’s net income in 2004, 2005, and 2006, assuming that research is capitalized and amortized over three years. Also calculate total assets and shareholders’ equity, assuming research is capitalized and amortized. What amount would be reported on the balance sheet for research if research were capitalized instead of expensed? (Assume that one-third of the of the amount expended on research is expensed each year, including the year of the expenditure.)

b. Calculate Chortitz’s profit margin, interest coverage ratio, earnings per share, debt-to-equity ratio, ROA, and ROE for 2004, 2005, and 2006 using the information as presented in the company’s financial statements. Calculate the same ratios, assuming that Chortitz capitalizes and amortizes its research costs over three years.

c. Evaluate the performance and solvency of Chortitz under the “expense” and “capitalize” scenarios. What are the implications of the differences between the two scenarios? Do you think there is merit in the criticisms some people have expressed about the current GAAP treatment of research costs? Explain fully.

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Chortitz Ltd. Summarized Balance Sheet Information As of June 30, 2003-2006 (000s) Extracts from the balance sheet 2006 2005 2004 2003 Current assets $47,953 $51,563 $41,102 $34,815 Total assets 90,923 92,441 76,024 70,589 Current liabilities 32,154 33,220 22,233 18,569 Non-current liabilities 11,550 9,240 6,188 4,331 Shareholders' equity 47,219 49,981 47,603 47,689