Final answer:
The costs related to R&D activities performed under contract should be expensed in the income statement as expenses. This aligns with accounting principles due to the speculative nature of the potential benefits from R&D. R&D can create spillover benefits, resulting in positive externalities for society.
Step-by-step explanation:
The student is asking about how a company should account for the costs related to research and development (R&D) activities that it performs under contract. When it comes to accounting for R&D costs, the general principle, according to the Financial Accounting Standards Board (FASB), is to expense these costs as they are incurred. This means that the correct answer to the student's question would be that the company should capitalize the R&D costs in the income statement as expenses. This reflects the uncertainty associated with the future benefits of the R&D work which, given its speculative nature, are not guaranteed.
Using the example of the Big Drug Company planning its R&D budget, we can see that investments in R&D have both private benefits to the company and broader social benefits, known as positive externalities. The company estimates the rate of return on potential R&D projects to determine which investments to make. The demand for financial capital is depicted by a downward-sloping curve representing the firm's willingness to borrow for these projects at various interest rates. By investing in R&D, a company like Big Drug can contribute to overall societal progress through innovations and advancements that benefit other firms and the public—a concept known as creating a spillover benefit.
Companies typically finance their R&D activities through different sources of financial capital such as early-stage investors, reinvested profits, loans, or stock sales. R&D investments can lead to new products, processes, or technologies, providing benefits that extend beyond the investing company, thereby contributing to economic growth and societal well-being.