According to IAS 38 (previously IAS 9), companies must expense research costs, and capitalise development costs, provided the technical and commercial feasibility for use of the asset has been established. Therefore, all research costs are charged to the income statement, and capitalising the development costs is only permitted if the identifiability and recognition criteria of intangible assets are fulfilled. The identifiability criterion states that an intangible asset must be:
Separable - This means that the asset can be separated from the business entity. It therefore can be sold, rented, disposed of, etc.
Arises from contractual or other legal rights - Examples of intangible assets cited from IFRS 3 are:
Marketing-related (Trademarks, internet domain names)
Customer-related (Customer lists, order/production backlogs)
Artistic-related (Plays, operas/ballets, books)
Contract-based (Licences, lease agreements, permits, franchise agreements)
Technology-based (Software, databases, trade secrets)
The recognition criterion, the second criteria with which an intangible asset must comply, states that the asset must:
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Provide expected future economic benefits to the entity - i.e. Cash flows attributable to the asset must flow to the entity
Be capable of having its cost measured reliably - i.e. The cost of the asset to the firm must be measured as accurately as possible by a method which is deemed trustworthy
In order for the intangible asset to be recognised it must provide expected future economic benefits to the entity. Expected future economic benefits can be interpreted as 'likely' or 'probable', but the question of where one draws the line between 'probable' and 'possible' arises. Economic benefits could be in the form of future cash flows, increased profits, higher sales volume, stronger share price, or even a more successful product or service. Despite any inside knowledge, private information or trade secrets which may be available to management, future economic viability of the firm alone remains an uncertainty, let alone the generation of future economic benefits. In an attempt to eliminate some of the subjectivity, IAS 38 revisions state a further six criteria in regards to intangible assets arising from development (See Appendix A). However these criteria are no less subjective than the original recognition criteria, and merely provide technical guidance to how development costs should be treated.
Even if future economic benefits do flow to the entity, how can one directly attribute them to the R&D expenditure? It is true that no asset, tangible or intangible can guarantee a flow of future benefits to the entity. However, if development costs were of guaranteed economic use to a firm, why do lenders not allow R&D to be used as a security for loans? Due to their intangible nature they have more uncertainty about their usefulness than other tangible assets such as plant, property and equipment (Kothari et al., 2002). Although IAS 38 states research must be expensed and 'feasible' development must be capitalised, capitalisation arguably remains optional to the firm's managers, and this flexibility has unfortunately been mitigated by the standard (Palepu et al., 2000). Even when the accountants' treatment of the R&D is challenged by other stakeholders such as external auditors, they will be unable to dispute the usefulness of the R&D since only managers have experience of the firm's performance, and therefore are in a better position to make such a decision (Callimaci & Landry, 2003).
Potentially, managers can capitalise development even if it is unlikely of being any use to the firm. A study by Cazavan-Jeny and Jeanjean (2006) found that companies who practise the capitalisation of R&D are smaller, less-profitable, riskier, more highly-geared companies with less growth opportunities. Cazavan-Jeny and Jeanjean (2006) also argued that capitalised R&D expenditure is not value relevant, and that while it can convey information it can also mislead. Oswald (2008) and Healy et al. (2002) both concluded that when R&D expenditure is capitalised there is a trade-off between relevance and reliability. Different motives exist to managers for capitalising development costs. The motives could be either short-term or long-term, a point I will illustrate below.
The financial reporting of a firm is the main channel of communication between themselves and investors. If potentially unsuccessful development is capitalised, then this is deceptive to shareholders, and can affect the investment decisions they make. When the development costs are capitalised rather than expensed, the retained earnings will be higher, since the development is not being charged to the income statement. In turn, these retained earnings will boost to the equity of the firm thus improving gearing levels. This argument is supported by White, Sondhi and Fried (2003). Other gearing calculations give the debt-to-assets ratio, using the net book value (NBV) of assets, which can also be deceptive when the assets include R&D which is unlikely to bring future benefits (White, Sondhi and Fried, 2003).
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Other motives for capitalising development were highlighted in a study by Markarian and Pozza (2007), which analysed the treatment of R&D in Italian listed firms. This is very relevant, since Italian GAAP (generally accepted accounting principles) is similar to UK GAAP, in that it permits the capitalisation of R&D costs. The study found that managers are encouraged to falsely capitalise useless development so they can manipulate the earnings of the firm. This is done for income smoothing purposes (i.e. smoothing fluctuations in profits over years). Again, this 'impression management' deceives investor as it 'window-dresses' the financial reporting to make the firm look more attractive to investors. Zarowin & Oswald (2005) found that UK firms which practise R&D capitalisation deliberately change the percentages of R&D expenditure which is capitalised in order to meet profit targets. Another motive which may exist to managers for falsely capitalising R&D is opportunistic earnings management (Botosan & Plumlee, 2002). Managers may practise R&D capitalisation in pursuit of their own personal interests, since it reduces costs thus increasing reported profits. They may receive executive compensation or other benefits as a result.
Not all firms that capitalise R&D expenditure practise the corporate misconduct which has been discussed above, however necessary action must be taken in order not to mitigate such activities. My recommendation is that all R&D costs should be expensed and therefore directly debited to the income statement. This removes any uncertainty and subjectivity, and allows easier comparison for users of financial statements. It promotes accountability and transparency within firms, and enhances comparability of firms for investors and other stakeholders.
I look forward to hearing your feedback on my recommendation.
Part B - Report for CEO of Nokia Corporation
President and CEO
P.O. Box 226
FIN-00045 Nokia Group
11th January 2011
Based on a suggestion made by a university student to Sir David Tweedie, chairman of the IASB, an exposure draft has been released including proposed changes to IAS 38 - Intangible Assets. This report aims to analyse the implications such a change would cause for Nokia Corporation, as well as my own personal recommendation or whether or not to support the proposed change. The letter sent by the student to Sir David has been attached for your reading.
I look forward to hearing your response
The IAS 38 exposure draft published by the IASB treats research and development (R&D) costs differently to the current treatment. Whereas the current treatment is to expense research costs and capitalise development costs, the new proposed treatment is that all R&D costs be written off to the income statement. This is similar to the US GAAP treatment of R&D, which treats all R&D expenditure as operating expenses.
Current R&D Treatment
From the annual reports it is evident that Nokia's policy is to only capitalise development costs when it is probable that a development project will be successful, and when certain criteria have been met. These costs are amortised systematically over the expected useful life of the project. This is usually between two and five years, but if technical and commercial feasibility is not met then excess costs may be written off in future periods (Nokia Annual Report, 2009, p85). Also, capitalised development costs often have a higher net-book-value than recoverable amount, at which point they are impaired. Therefore during the impairment review the recoverable amount must be estimated, and generally it is the higher of either of the asset's net-selling-price or its value in use. Value in use is obtained by calculating the present value of discounted future cash flows that will yield as a direct result of that asset, both during its useful life and upon its disposal (Nokia Annual Report, 2009, p85).
The proposal in the IASB exposure draft is that regardless of whether development projects are likely to be successful these costs are to be expensed to the income statement, without any capitalisation. Asset recognition criteria become irrelevant, and development costs incurred during the period will receive the same treatment that research costs currently do, i.e. to be debited to the income statement. Consequently the results reported in Nokia's financial statements will be somewhat affected, and below I will attempt to outline what those effects will be.
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Expensing R&D costs will affect both the financial position and the reported profits of a firm. In 2009 Nokia capitalised â‚¬143m of development costs (See Appendix C). If Nokia Corporation were to practise the proposed treatment of R&D in the exposure draft, the following changes to reported figures would occur: (See Appendix D for calculation)
Current R&D Treatment
Proposed R&D Treatment
Corporation Tax @ 26% (Finland's statutory rate)
Fixed Assets Turnover
Return on Capital Employed
The above table shows the effects on reported results of employing the proposed R&D accounting treatment. The effects are quite adverse, especially on profitability. Although there is a decrease in corporation tax charge and an increase in fixed assets turnover, these are very insignificant increases in comparison with the decreases in other more important figures. Fixed assets turnover only shows that Nokia is making efficient use of its assets in terms of generating sales, and is not deemed a vital ratio. It would have more importance in industries of a retail nature, but not technology. Nokia has suffered financially in 2009, and this can be attributed to several aspects. Turnover was 19.2% lower than that of 2008 (see Appendix B), and there were numerous expenses that adversely affected profit. One such expense was a huge non tax-deductible impairment of â‚¬908m for goodwill which arose from the acquisition of Siemens in 2007. Although the taxable amount for the Finnish 26% tax regime was â‚¬250m (Nokia Annual Statement, 2009, p11), an extra â‚¬450m was paid because of deferred tax payments resulting from losses in previous years, totalling â‚¬702m, which is 73% of the profit before tax. Therefore, the adverse affects of expensing R&D are arguably understated, as the year in consideration was one of much economic turmoil and poor financial performance. Also Nokia seems to be reducing the R&D expenditure year on year. In a typical trading year with normal activity, the adverse effects would be much greater and more evident.
Implications of the changes
If development costs were treated as operating costs instead of being capitalised, the operating profit would decrease by 11.9%. Although this would result in a lower taxable amount of profit, the tax saving would be marginal, and it would mean that no tax advantages could be gained on the writing down of intangible R&D assets in the future. Also, it would result in a lower profit after tax, which means the profit to be spread among the shareholders in the form of capital gains/earnings-per-share (EPS) and dividends would be reduced. This could have an adverse impact on the share price of Nokia Corporation, since the investment would not yield as high returns to investors. This would not only reduce the market capitalisation/value of the firm, but it would also deter investors from buying shares in Nokia Corporation, since other firms who offer higher EPS would be a more attractive investment for them. Therefore, the volume of shares in issue would decrease, which in turn would reduce the market value of the firm. This inequity and decrease in market liquidity is a threat to Nokia's future profitability and economic viability.
Moreover, the fact that development projects which are likely to be successful in yielding future cash flows to the organisation would become off-balance sheet, meaning that investors would have little knowledge of related profits which may be reported in the future. R&D is a type of capital expenditure, which means future economic benefits will flow to the entity as a result of those expenses. If this information is kept hidden from the shareholders then this undermines the value relevance of the financial statements, since investors will be blind to crucial information regarding the future benefits of the firm. Not recognising development costs as assets also undermines to the efficiency and fair nature of the stock market, since only some investors will have knowledge of the R&D which is being conducted off-balance sheet, and of its future benefits. However, all investors are meant to have equal opportunity to access the same information about a firm's operations, R&D included.
Another implication of expensing development costs rather than capitalising them is that no assets can be generated as a result of the R&D expenditure. For example, internally generated patents from R&D cannot be capitalised and therefore will not appear on the balance sheet. In the case of R&D partnerships funding the R&D conducted by Nokia Corporation, they will not only receive rights to the R&D if successful in terms of launching a successful brand/product/service, but they will also receive royalties and large payoffs as a result of the success. This will be totally unaccounted for, and investors will be unaware of the credit due to Nokia Corporation since the R&D was never shown on the balance sheet.
The lower profit margins reported as a result of expensing R&D is also a deterrent to potential investors, since they will be concerned about the future profitability of the organisation. Likewise, lenders of finance such as banks and holders of other debt instruments will be less convinced by the lower reported profits and return on capital employed (ROCE). ROCE is a vital profitability ratio and is a commonly used method of performance measurement. An 11.3% decrease in ROCE could have serious implications on the firm's position in the capital markets for raising equity finance. Another deterrent to lenders of finance could be the increase in gearing levels. Although Nokia's is not particularly highly geared, had the existing capitalised development costs held a higher book value, the gearing would have increased and in future could become unacceptable to some lenders, which could make raising debt finance difficult for Nokia corporation.
I do not recommend that Nokia support the proposed change. Not only are the benefits to Nokia Corporation negligible, but the many disadvantages it brings will threaten the financial strength and competitive edge of the firm. The current policy should be kept as it does not endanger the interests of the company.
Part C - Reflective Learning Statement
This assignment was a great source of knowledge for me. The Financial Reporting (FR) module in the first semester was very informative and beneficial, yet I felt I had only grasped the basics of FR, and had not developed my understanding to the level I desired. I often felt unsure about how the theoretical aspects of FR would apply in practice. The contemporary issues in FR module filled in those gaps for me, especially the coursework assessment. It encouraged me to read into the topics which were available and select the one which interested me most. Therefore, not only did I learn a lot about R&D in accounting, but also about investment properties, share-based payments and real time reporting. It allowed me to put my understanding to the test and apply it to a practical situation. I feel much more confident about discussing the topics now, as oppose to before when my approach was more passive, participating only in a classroom environment. When I received my mark for the draft of part A, it was very encouraging. I had proved to myself that I could produce a good piece of work on the topic. The feedback from the tutor was helpful and insightful, and it definitely directed me in the right path to improving the work and continuing to write the report in part B. Issues such as management pursuing their own interests comes under the agency problem, which I can relate to as my dissertation topic is corporate governance. Overall I feel very satisfied with the skills and knowledge I have gained during this assignment, whether accounting-related or purely academic.