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There are concerns that financial statements no longer reflect the underpinning drivers of value in modern business. Such concerns are particularly relevant to accounting for ‘intangibles’, including R&D costs.
Many have noted the increasing gap between the values of companies based on their share price and the tangible asset values in their financial statements. One of the major components of this gap is the intangibles that are recognised as valuable by the market but are not recognised as assets by financial reporting.
The value of intangibles
The intangibles may include the value of the workforce, knowhow, customer relationships, brands and a pipeline of new products. International Financial Reporting Standards (IFRS) only allow for a restricted recognition of these assets, which is why there is a gap.
Currently, 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.
Instinctively you assume that, though the IAS 38 criteria may be demanding, much of this expenditure must be commercially viable. Development costs seem to be written off as a matter of company choice, probably on the grounds of simplicity, prudence and to avoid losses.
To capitalise or to expense?
More international and more R&D intensive companies are more likely to capitalise and larger ones more likely to expense. Capitalisation can also be associated with earnings management and target beating. Companies in countries with stronger audit, enforcement and investor protection systems show higher occurrence and extent of capitalisation.
There is a general support for the existing model among stakeholders in terms of asset recognition rather than blanket expensing approach as under US standards, despite their awareness of the inconsistencies in application. IFRS could require, and companies should provide, much better disclosures than currently.
So what does this mean for the intangibles gap?
Some believe that companies should recognise more of their intangibles in their financial statements if those are to remain relevant. Acquisitive companies will be more likely to do so, but those growing organically are much less likely to do so.
However, 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. It seems likely that they would be even more reluctant with the other 'missing' intangibles. No sign of that gap closing.
Research & Development activity reporting
The great majority of companies report no R&D activity at all in terms of
• asset recognition
• specified expense in the financial statements
This is despite the definition of development costs in IAS 38 being widely drawn, including those of
• new products