Question

Pharmaceutical firms, oil and gas companies, and other ventures inevitably incur costs on unsuccessful investments in new projects (e.g., new drugs or new wells). For oil and gas firms, a debate continues over whether those costs should be written off as a period expense or capitalized as part of the full cost of finding profitable oil and gas ventures. For pharmaceutical firms. GAAP in the United States is clear that R&D costs are to be expensed when incurred. Pharm-It has been writing R&D costs off to expense as incurred for both financial reporting and internal performance measurement. However, this year a new management team was hired to improve the profit of Pharm-It's Cardiology Division. The new management team was hired with the provision that it would receive a bonus equal to 10 percent of any profits in excess of base-year profits of the division. However, no bonus would be paid if profits were less than 18 percent of end-of-year investment. The following information was included in the performance report for the division. Increase over Base Year This Year $20,500,000 Base Year $20,000,000 Sales revenues Costs incurred R&D Expense Depreciation and other amortization Other costs Division profit End-of-year investment 3,900,000 8,000,000 $ 8,600,000 $45,500,eega 4,000,000 3,750,000 7,750,000 $ 4,500,000 $37,500, eee $ 4,100,000 a includes other investments not at issue here. During the year, the new team spent $5 million on R&D activities, of which $4,500,000 was for unsuccessful ventures. The new management team has included the $4,500,000 in the current end-of-year investment base because "You can't invent successful drugs without missing on a few unsuccessful ones." Required: a. What is the ROI for the base year and the current year? Ignore taxes. a-1. If R&D is expensed: a-2. If R&D is capitalized: b. What is the amount of the bonus that the new management team is likely to claim? c. If you were on Pharm-It's board of directors, how would you respond to the new management's claim for the bonus?

Answer 1

A:

a-1 The ROI if R&D is expensed

For Base Year

Divisional Profit: $4,500,000

End of Year Investment: $37,500,000

ROI for Base Year: $4,500,000/$37,500,000=12.0%

For This Year:

Divisional Profit = 8,600,000

Unsuccessful Venture: 4,500,000 as this need to be subtracted from the division profit to get net ROI

Net Division Profit: $8,600,000-$4,500,000= $ 4,100,000.00

End of Year Investment: $45,500,000

Net Investment: $45,500,000-$4,500,000 = $ 41,000,000.00

ROI for This year: $ 4,100,000.00/$ 41,000,000.00 = 10%

a-2 The ROI if R&D is capitalized

Used by new management hence for ROI% for this year

Divisional Profit: $       8,600,000

End of Year Investment: $    45,500,000

Hence ROI: 8,600,000/45,500,000= 18.9%

B: Amount of Bonus to be claimed

10% × $4,100,000 = $410,000

(c) The Bonus should be rejected

The bonus should be rejected. As the new management changed the accounting policy the return on investment showing as 18.9% if previous accounting method would have used the ROI would have only been 10% hence this is not the actual improvement but manipulating the accounting method.