Six Tests Under IAS 38 Separate Expensed Research From Capitalized Development on Corporate Balance Sheets

When a corporation spends $150 million developing a new software platform, the accounting treatment of that outlay can swing reported annual profit by the entire $150 million margin. The mechanism governing this is International Accounting Standard 38 (IAS 38), which dictates whether the cash is immediately expensed or capitalised as an asset.

For investors and analysts, the distinction is critical. Expensing the development costs depresses current earnings but leaves future margins unburdened. Conversely, capitalising them inflates current profit but creates an amortisation drag that will weigh on earnings for years.

The International Accounting Standards Board designed IAS 38 to prevent companies from artificially inflating their balance sheets with speculative projects. To achieve this, the standard strictly separates the creation of an intangible asset into two distinct periods: a research phase and a development phase.

"If an entity cannot distinguish the research phase from the development phase of an internal project to create an intangible asset, the entity treats the expenditure on that project as if it were incurred in the research phase only," the IFRS Foundation states in its official guidance.[1]

The Research Phase: Mandatory Expensing

Under IAS 38, the research phase encompasses any original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge. This includes the search for alternative materials, the formulation of new product designs, and the evaluation of potential processes.

The accounting rule for this phase is absolute: all research costs must be recognised as an expense when they are incurred. The rationale is that during the research phase, a company cannot demonstrate that an intangible asset exists that will generate probable future economic benefits.

Consequently, the millions spent on early-stage drug discovery or initial software prototyping flow directly through the income statement. This reduces net income and earnings per share in the exact period the cash is spent, as no intangible asset arising from research can be recognised on the balance sheet.

"In the research phase of an internal project, an entity cannot demonstrate that an intangible asset exists that will generate probable future economic benefits," notes PwC in its application guidance for the standard. "Therefore, this expenditure is recognised as an expense when it is incurred."

Crossing the Threshold: The Six Criteria

The transition from the research phase to the development phase is the pivot point for corporate accounting. Development is defined as the application of research findings to a plan or design for the production of new or substantially improved materials, devices, or software before commercial production begins.

However, entering the development phase does not automatically trigger capitalisation. Paragraph 57 of IAS 38 specifies that development costs can only be capitalised as an intangible asset if, and only if, the entity can demonstrate six specific criteria simultaneously.[1]

These six tests form a rigid gatekeeping mechanism. If a project fails even one of the criteria, the associated costs must continue to be expensed as incurred, dragging down current-period profitability despite the project's advancement.

"There is no definitive starting point for the capitalisation of internal development costs," PwC advises. "Management must use its judgement, based on the facts and circumstances of each project," mapping internal milestones to the statutory criteria.

Technical Feasibility and Intention

The first and often most difficult hurdle is demonstrating the technical feasibility of completing the intangible asset so that it will be available for use or sale. For a software project, this might mean reaching a working beta; for pharmaceuticals, it typically requires regulatory approval.

"A strong indication that an entity has met all of the above criteria arises when it obtains regulatory approval," PwC notes regarding pharmaceutical development. "It is the clearest point that the technical feasibility of completing the asset is proven, and this is the most difficult criterion to demonstrate."

The second criterion requires the entity to demonstrate its intention to complete the intangible asset and either use it internally or sell it. This prevents companies from capitalising costs for projects that have been technically proven but effectively abandoned by management.

Closely linked is the third test: the ability to use or sell the asset. A company might have the intention to sell a new medical device, but if it lacks the necessary distribution network or faces insurmountable legal restrictions in its target markets, it fails this criterion.

Proving the Economic Benefit

The fourth criterion demands proof of how the intangible asset will generate probable future economic benefits. The entity must demonstrate the existence of a market for the output of the asset, a market for the asset itself, or its internal usefulness.

This requires robust financial modeling and market analysis. A technically brilliant software tool that solves a problem no one is willing to pay for cannot be capitalised, as it fails the economic benefit test and must be written off as an expense.

The fifth test evaluates the availability of adequate technical, financial, and other resources to complete the development and to use or sell the asset. A cash-strapped startup might have a feasible product and a willing market, but if it cannot secure the funding to finish the build, it cannot capitalise the costs.

Finally, the sixth criterion requires the ability to measure reliably the expenditure attributable to the intangible asset during its development. This necessitates sophisticated cost-tracking systems that can isolate the specific hours and materials dedicated to the viable project, separating them from general overhead.

The US GAAP Divergence

The strictness of IAS 38 creates a notable divergence from United States Generally Accepted Accounting Principles (US GAAP), particularly regarding internal-use software. This transatlantic split forces multinational companies to maintain dual accounting ledgers to satisfy different regulatory regimes.

Under US GAAP's ASC 350-40, internal-use software costs are capitalised once management funds the project and completion is probable. This threshold is generally lower and relies more heavily on management commitment than the rigid technical milestones demanded by IFRS.[2]

"Regardless of the type of cost and industry, an entity capitalizes development costs only when it can demonstrate all the following criteria," notes Deloitte in its comparative analysis, highlighting the universal application of the six IAS 38 tests against the more fragmented US GAAP rules.[2]

Consequently, a European company reporting under IFRS might be forced to expense millions in software development costs that its American competitor, reporting under US GAAP, is allowed to capitalise. This depresses the European firm's reported earnings relative to its US peer, despite identical underlying economics.

The Impact on Corporate Valuation

The timing of when a project crosses the IAS 38 threshold fundamentally alters a company's financial profile. Delaying capitalisation keeps the balance sheet lean but punishes the income statement, potentially alarming investors who focus narrowly on short-term earnings per share.

Conversely, aggressive capitalisation boosts current profits and inflates asset values, but it sets up a future drag on earnings through amortisation. If the capitalised project ultimately fails, the company faces a sudden, massive impairment charge to wipe the phantom asset off the books.

"Intangible assets meeting the relevant recognition criteria are initially measured at cost, subsequently measured at cost or using the revaluation model, and amortized on a systematic basis over their useful lives," the IFRS framework dictates, ensuring the costs eventually flow through the income statement.[1]

The rigorous application of these rules requires constant vigilance from auditors. They must routinely challenge management's assertions regarding technical feasibility and market demand, ensuring that the transition from expensed research to capitalised development is grounded in verifiable evidence rather than executive hope.

Ultimately, the six tests of IAS 38 serve as a vital reality check on corporate optimism. By forcing companies to prove technical viability, market demand, and financial capacity before recognizing an asset, the standard protects investors from balance sheets bloated by unfinished and unmarketable ideas.[3]

As the global economy becomes increasingly reliant on intellectual property, software, and data, the mechanics of IAS 38 will only grow in importance. The standard remains the definitive filter separating the speculative costs of innovation from the tangible assets that drive long-term corporate value.[3]