ACCA Technical Article : IAS 38 on R&D
This article is reprinted from ACCA's website
Reporting on intangibles is all a bit of a muddle
There is a large and widening gap between the market values of companies and their book values. Companies’ net book values may, according to one estimate, account for just 15% of market capitalisation. This is the ‘intangibles gap’ that some assume is made up of intangibles that accounting doesn’t recognise as assets.
The gap correlates with the modern trend in many economies away from investment in property, plant and equipment and inventory, and towards building businesses around intangible items such as brands, know-how, software or workforce talent.
While financial statements have never claimed to be business valuations, the extent of the difference raises the question of whether current financial statements recognise fewer intangible assets than they should.
Of course, many of these intangibles may not even be controlled by an entity, their costs are difficult to track and their values hard to assess – all very good reasons for not recognising them as corporate assets on the balance sheet. Accordingly, we should not get carried away and conclude it would be a good idea if financial statements started revaluing brands or a company’s workforce from year to year.
But what about the intangibles that financial statements can recognise? The current IFRS Standards deal with similar intangibles very differently, depending on whether they are internally generated or are purchased/acquired in a business combination.
Internally generated intangibles are restricted to the development costs of new products and services – everything else has to be written off as incurred, whether that is research, marketing campaigns or staff training.
In IAS 38, Intangible Assets, there are six tests to meet before even development costs can be recognised as an asset. This gives considerable discretion to companies that spend on research and development (R&D) as to the degree to which development costs are expensed.
Finally, even when the six tests are met, the accumulation of the cost of the investment begins only at that point, and any past expenditure getting it to that point must remain written off.
On the other hand, if intangibles are purchased directly or as part of a business combination, they may be recognised as an asset at their fair value at the date of acquisition. As a result, under IFRS 3, Business Combinations, not only are licences and R&D recognised, but customer-related intangibles such as brands, relationships and customer lists are also often included on the balance sheet.
Two examples should suffice to indicate the current state of affairs. In 2016 Samsung spent heavily on R&D but recognised less than 5% of that spend as an asset; therefore 95% of the company’s R&D spend seemingly added no value. And pharma company Novartis spent over US$9bn on internal R&D (none of which was capitalised) while including over US$38bn of acquired product-related intangibles.
Calling it what it is
ACCA has been doing research to get a better picture of the situation, looking at listed companies worldwide that have used IFRS since 2005. While the study is not yet complete, some early findings have emerged. For a start, only a distinct minority report any R&D expenditure at all. Most companies either don’t spend to improve their products or services, or (more likely) call it something else.
Of the companies in the sample that do disclose R&D, 62% write all of it off as an expense; only 38% report it as any kind of asset. This implies that all that expensed spend creates no value for the company, which seems unlikely. Alternatively, the tests in IAS 38 have set the bar so high it is difficult to recognise assets. Or perhaps management finds immediate write-off the most convenient way of accounting, and the six tests allow them to do this every time. The indications from the research are that most of these companies could capitalise to some extent.
Indeed the decision to capitalise or not seems to be driven by factors other than those set out in IAS 38. So, for example, we find that larger companies tend not to capitalise, as do those where R&D is most material and, significantly, where there is an association with earnings management.
In short, all does not seem well with IAS 38. The indications are that many companies that should capitalise do not do so, and that some of those that do should not. So you might conclude that reporting outside of the financial statements will be more effective at communicating the development of a business in terms of R&D.
Certainly the research shows that there is a good deal of coverage of the issues in the narrative sections of the annual report. There seems little difference in the quantity of reporting between the ‘expensers’ and the ‘capitalisers’. The former do not say much more in the front half of the annual report to make up for the lack of assets in the financial statements.
Some of the requirements or systems for wider corporate reporting encourage companies to talk about the development of new products and processes in their reports. For instance the Integrated Reporting Framework emphasises the need to look beyond financial and manufactured capital to the development of intellectual and human capital and their contribution to the business’ value creation.
So there seems to be another issue besides the intangibles gap. The R&D costs of new products and processes are intangible assets and should already be helping to fill the gap, but there may be much less than there should be.
The International Accounting Standards Board (IASB), which sets IFRS Standards, should be addressing the implications, the anomalies in the accounting for intangibles and whether or not standards are overly restrictive on the recognition of certain intangibles.
Richard Martin, ACCA head of corporate reporting