Peeling away financial reporting issues one layer at a time

EITF 07-03: Which Part of ‘Nonrefundable’ Doesn’t EITF Understand?

EITF Consensus 07-03, Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities, is very straightforward and basic; so much so that it might require less than one class period of Accounting 101 to discuss thoroughly. 

Here is a typical fact pattern: Entity A outsources R&D activities to Entity B, who requires a nonrefundable advance payment.  Should Entity A capitalize or expense the advance payment?  Proponents of the asset/liability view (i.e., expense measurement based only on changes in assets and liabilities) would support immediate expensing; proponents of the competing revenue/expense view (i.e., ‘matching’) would capitalize the expenditure and subsequently transfer it to expense as services are performed. 

The SEC and FASB have stated they are committed to the asset/liability approach to accounting standard setting, at minimum implying strong resistance to creation of new categories of deferred costs. The policy was officially established in 2003, as the SEC fulfilled its responsibilities under the Sarbanes-Oxley Act to report on the possibility of implementing principles-based accounting in the U.S. In its report, the SEC took the position that the revenue/expense view would be inappropriate in an objectives-oriented regime, and further stated that the FASB should maintain the asset/liability view in continuing its move to an objectives-oriented setting regime.  The FASB published a response, which agreed with the SEC study on this point. 

In a nutshell, matching had been dead for over a decade, and the SEC’s SOX report should have been the last nail in the coffin.  Or so it seemed, as the EITF reached a consensus that nonrefundable advance payments for future R&D activities should be initially capitalized and subsequently transferred to expense as the goods are delivered, or services performed.  As justification, the EITF claims, without citing a source, that customers who agree to nonrefundable advance payments nonetheless have a legal right to receive a refund in the event of nonperformance.  Huh?  Are they saying that ‘nonrefundable’ means ‘refundable’!  You say refundable, I say nonrefundable; let’s call the whole thing off. 

One can only guess what forces were at play on the EITF (my money is on drug companies) as Issue 07-03 was deliberated.  As if it weren’t obvious enough that the fix was in, a telltale sign is provided by the statement that the Consensus may not be applied by analogy to facts and circumstances outside of its narrow scope. 

PS – For those of you numerologist/accountants out there, you may be interested to note that my birthday is July 3rd.  Some dark force surely decreed that I should write about EITF 07-03. 

1 Comment

  1. Reply Chris Merritt August 7, 2007

    Howdy Tom —
    Great blog … you continue to be the *only* person who can get me interested in arcane accounting issues.
    In re this post, I have to wonder if the rationale is in fact not that the fee is *unrefundable* but that under certain circs (e.g., non-performance) the monies can in fact be recouped. Just a thought …
    BTW, Happy Birthday.

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