percentageofexpenser-largeimage-1There are things that can drop on your foot: anvils, skyscraper girders, motherboards, to name a few. And then there are things that can’t, such as the Game of Thrones plot, the workforce’s training in the Toyota Production Method, and your company’s research and development.

This second class of ‘intangible’ things, once just a sliver of the world’s asset base, has grown to dominate the former class of ‘tangible’ assets, especially in the world’s largest enterprises.

Consultancy Brand Finance calculated that at the start of 2016, US$388 billion (or 61%) of Apple’s then US$640 billion market capitalisation reflected intangibles. Yet just US$9 billion of intangible assets were set out on Apple’s balance sheet.

This ‘intangibles gap’ between what’s on an entity’s balance sheet and its market capitalisation may now be so large that it is distorting the world economy. In their book Capitalism Without Capital: The rise of the intangible economy, economists Jonathan Haskel and Stian Westlake argue that the world needs to build a more intangibles-friendly financial architecture that will encourage intangibles investment.

R&D and intangibles are problems for accountants

At the moment, accounting effectively discourages investment in intangibles, at least those generated inside the company. Buy intangibles as part of a corporate acquisition, and you can put them in the books at purchase value under IFRS 3 Business Combinations. But create those same intangibles internally, and current accounting standards require them to clear tough hurdles before going on the balance sheet.

Research and development (R&D) presents special problems. Many economists and finance experts, such as Stern School of Business academic Aswath Damodaran in his 2009 paper “Valuing companies with intangible assets”, argue that R&D expenses are really capital expenses. Yet companies must write off most such spending when they incur it. You can capitalise the development costs of new products and services only when they meet six separate conditions set out in the intangible assets standard, IAS 38.

Richard Martin, head of corporate reporting at the Association of Chartered Certified Accountants (ACCA), notes that in 2018 Samsung recognised less than 5% of its hefty R&D spend as an asset. Its accounts, therefore, suggested that 95% of the company’s R&D spend added no value.

So how do companies decide whether to expense? That’s hard to see, since IAS 38 requires only that the bare capitalised and expensed totals be disclosed.

The capitalisation debate

New research by ACCA and Deloitte puts some numbers on the way that businesses treat R&D costs. The final report, The Capitalisation Debate, drew on research conducted in three phases.

Phase 1: Who expenses, who capitalises

In this phase, the researchers counted evidence – 20,475 separate yearly observations of firms’ results from 20 countries. In those observations, firms’ R&D costs were:

• Fully expensed 62% of the time
• Fully capitalised 10% of the time
• Partially capitalised 28% of the time.

The researchers found that more R&D-intensive firms capitalised more of their R&D activity. So did more globalised firms and those with management incentives in place – an indication of just how management can fine-tune accounting decisions. Countries with tougher audit and enforcement mechanisms also saw more capitalisation. But larger firms capitalised less than smaller firms.

Phase 2: Patterns in the data

Here the researchers analysed R&D-related disclosures using 116 keywords in annual reports. That analysis shows most companies don’t provide much good R&D data, especially in the financial statements themselves. Firms that have higher R&D intensity, and those that are younger, bigger, riskier or more international, are likely to provide more information about their R&D treatments.

Phase 3: What users say

In this final phase, the researchers spoke to 16 key stakeholders preparing and auditing accounts and investing in companies. The stakeholders were concerned about the apparent inconsistency between the treatment of acquired assets and internally-generated assets. They agreed on the need for a principles-based accounting standard on when costs should be capitalised. The current reporting of R&D costs “appears to be dominated by prudence rather than faithful representation,” the researchers conclude.

Hurdles to capitalising R&D costs

A string of professional bodies and financial regulators is examining the treatment of intangibles. The findings in the ACCA-Deloitte report support the idea that firms find it hard to meet IAS 38’s hurdle for capitalising R&D costs. They also raise the possibility that companies are worried about either the future impairment of capitalised R&D costs, or the assurance of capitalised costs.

The researchers say cautiously that relaxing IAS 38’s capitalisation criteria “could be the way forward”: it could make financial information more relevant, give companies less room for “earnings management” and make it easier for auditors to assure capitalised amounts.

They also say preparers and auditors could be encouraged to disclose more about their decisions on intangibles. If that isn’t written into IAS 38, the researchers say, then annual reports should say more about companies’ R&D spend.

ACCA’s Martin suggests the decision on whether to capitalise may be driven by factors outside IAS 38. He says the survey “shows that companies generally seem reluctant to recognise as assets the one sort of intangible they should – their investment in new products or processes – or even discuss them at length in the narrative sections.”

“Companies generally seem reluctant to recognise as assets the one sort of intangible they should – their investment in new products or processes…”

Says Martin: “At present, meeting the criteria of what is recognised as an asset can be a matter of judgement, giving management considerable scope to decide whether they prefer to expense these costs as incurred or to capitalise them. IFRS could require, and companies should provide, much better disclosures than currently.”

Percentage of expensers and capitalisers by country (Click image to enlarge). Source: The Capitalisation Debate, ACCA and Deloitte, 2019.

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