Development costs are costs incurred by an entity in the process of creating an intangible asset, such as software development, product design, and research and development.
According to accounting standards, development costs are recognized as an asset only when the following conditions are met:
- The costs can be reliably measured.
- It is probable that the future economic benefits that are expected to flow from the asset will occur.
- The future economic benefits can be reliably estimated.
Once these conditions are met, the development costs should be capitalized as an intangible asset and recognized as an expense when the asset is sold or is being used.
- Misclassification of costs as development costs when they do not meet the criteria for capitalization.
- Improper recognition of development costs as an expense.
- Inaccurate measurement of development costs.
- Inadequate documentation to support the capitalization of development costs.
- Lack of proper segregation of duties in the development cost process.
- Inadequate control over the approval process for development costs.
- Failure to reassess the capitalization of development costs on a regular basis.
- Lack of proper impairment testing for intangible assets.
- Inadequate disclosures related to development costs in the financial statements.
- Inconsistency in the treatment of development costs across different projects.
- Existence: The development costs exist and are recorded in the appropriate accounts.
- Completeness: All development costs incurred have been recorded in the financial statements.
- Valuation: Development costs have been recorded at the appropriate value and are in accordance with accounting standards.
- Accuracy: The amounts recorded for development costs are accurate and free from material misstatements.
- Rights and Obligations: The entity has the rights to the development costs and the obligations to pay for them.
- Classification: Development costs have been properly classified and recorded in the financial statements.
- Presentation and Disclosure: Development costs have been properly presented and disclosed in the financial statements.
Walkthrough Testing: The auditor performs walkthrough testing to obtain an understanding of the process used to incur and record development costs. This includes reviewing the process for identifying development costs, obtaining management approval, and recording the costs in the financial statements.
Test of Control: The auditor tests the controls over the development cost process to determine their effectiveness in preventing and detecting material misstatements.
This includes testing the segregation of duties, the approval process, and the accuracy of the development cost data entered into the accounting system.
Substantive Audit Procedures
Substantive audit procedures are the specific audit tests and activities that auditors perform in order to obtain sufficient evidence to support their audit opinion on the financial statements. In the context of auditing development costs, the following substantive audit procedures may be performed:
- Understanding the entity’s accounting policies: The auditor should obtain an understanding of the entity’s accounting policies for the recognition and measurement of development costs. This includes understanding the criteria for capitalizing development costs.
- Review of authorization of capitalization: The auditor should review the authorization of capitalization of development costs to ensure that it complies with the entity’s accounting policies and relevant accounting standards.
- Evaluation of the stage of completion: The auditor should evaluate the stage of completion of the development project to determine whether development costs are being recorded correctly. This may involve reviewing documentation such as construction schedules, budgets, and progress reports.
- Review of project costs: The auditor should review project costs, including direct costs (e.g. materials, labor) and indirect costs (e.g. overhead). This may include reviewing invoices, payment records, and other documentation supporting the costs incurred.
- Comparison to budget: The auditor should compare actual costs to the budgeted costs for the project. Any significant variances should be investigated and explained.
- Review of impairment testing: The auditor should review the entity’s impairment testing of development projects to ensure that it is performed in accordance with relevant accounting standards and that any impairment losses are recognized appropriately.
- Confirmation of expected future cash flows: The auditor may consider confirming the expected future cash flows from the development project to support the recognition of revenue from the project.
- Review of contractual terms: The auditor should review any contractual terms related to the development project to ensure that they are being accounted for correctly.
- Assessment of internal control: The auditor should assess the entity’s internal control over the development project, including the segregation of duties and the accuracy of documentation and recording of development costs.
- Substantive testing of transactions: The auditor should perform substantive testing of transactions, including the recording and classification of development costs in the financial statements.
By performing these substantive audit procedures, the auditor can obtain sufficient evidence to support their audit opinion on the financial statements and to ensure that the development costs have been recorded correctly and in accordance with relevant accounting standards.