Interest Can Fly Under the Radar

Screen Shot 2013 09 23 at 8 50 36 AM
Image source: http://www.bombardier.com/en/home.html

Bombardier is one of Canada’s larger manufacturers and has frequently made the news recently as the production of its new C-Series commercial jet gets tantalizingly close. The C-Series jet is apparently key to Porter Air’s expansion plans out of the Toronto Island Airport (YTZ), and it is obviously very important to the future success of Bombardier.

Bombardier (BBD.B) already has 177 firm orders in place with hopes of another 150 orders a year or two from now. The development costs of this new jet are close to $4 billion. When Bombardier sells a C-Series jet to Porter (or any other airline), the price of the aircraft must include a portion of these development costs in addition to the direct labour and materials involved in building the plane itself. As the development costs creep higher, Bombardier really only has two options: (1) charge more for each jet once they start selling, or (2) give up any hope of recovering the development costs. Under IFRS (IAS 38), it is important to distinguish research costs from development costs. The distinction is important: development costs can be capitalized as an asset while research costs much be expensed. IAS 38.57 defines the development phase of a project to be when six criteria are met:

  • technical feasibility can be demonstrated
  • there is intention to complete the project for use or for sale
  • there is ability to use or sell the asset
  • there is existence of a market for the output (sale)
  • there are adequate resources ($$) to complete the project
  • the expenditures for the project can be accurately tracked

Obviously the C-Series jet is in the development phase. Bombardier also has other aircraft in the development phase but does not provide a breakdown of development costs by jet-type. The chart below shows how much the development cost asset has grown over the past three years. We will assume the bulk of this growth is due to the C-Series.

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These development costs include the costs of the prototypes, scientists’ salaries as they figure out aerodynamics, retooling costs, building and tweaking engines, testing prototypes, etc. All of these costs are capitalized up to the time that Bombardier starts actually selling C-Series jets. Then, Bombardier must start amortizing its development cost asset, in this case on a per-unit basis calculated on a best-guess for the number of jets to be sold.

If you’re in introductory financial accounting, or you are like 90% of the population and just dabble (or less) in accounting, I suspect this idea of capitalizing development costs may seem strange. Recall that an asset is a cost that has been incurred that has future benefit. A very common asset is a company’s property, plant, and equipment (PPE). We allow companies to capitalize PPE (i.e., set it up as an asset) because the PPE will hopefully generate a future stream of cash flow through product sales or service sales. Development costs aren’t all that much different, except they are intangible. The development costs related to a new jet allow the company to sell a new product and keep current with technology. Without spending money on development, Bombardier would find itself using outdated technology while trying to compete with other plane manufacturers that have new technology. This is unlikely to be a successful strategy.

Now that we have a decent understanding of development costs, we can explore Bombardier’s costs a bit more. According to the September 17, 2013 Globe and Mail article, Bombardier doesn’t seem to clearly understand how much it has actually spent on developing the C-Series. This is not really true; some accountant inside Bombardier knows exactly how much the company has spent. The issue here is whether Bombardier should be including the interest cost in its development costs. This is covered in IAS 23 (Borrowing Costs) and is an intermediate to advanced topic. The basic idea is that if Bombardier borrowed money to fund development costs, then the interest related to the borrowed money should be included in the capitalized development costs, hence increasing the development costs. There are only a few instances where interest costs are not immediately expensed, so if capitalizing interest seems odd to you, you’re not alone.

Another example of when interest can be capitalized is building a new factory. Assume for a second that you are building a new factory and borrow $1 million to fund the construction costs. Interest related to your loan should be capitalized during construction and is hence considered part of the overall cost of the factory. That cost will be amortized over the useful life of the factory. Interest incurred on the construction loan after the factory is put into use would be immediately expensed. The same is true for Bombardier’s development costs. So in the Globe and Mail article, the confusion stems from one Bombardier executive speaking about direct costs related to development while another, likely with more accounting experience, included interest costs related to the development. The second person is technically correct.

So what is the quick synopsis for us?  First, development costs, when they meet the definition, can be capitalized. Second, interest costs can also be capitalized in certain circumstances. And third, planes are bloody expensive!!

Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)