CONTEMPORARY ISSUES IN ACCOUNTING-1

CONTEMPORARY ISSUES IN ACCOUNTING - FINANCIAL REPORTING - RESEARCH

AND DEVELOPMENT EXPENDITURE

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Contemporary Issues in Accounting - Financial Reporting - Research and Development

Expenditure

Introduction

Many firms around the world spend huge amounts of money annually to support the

research and development of products and services. The aim of the business while spending on R

& D is to develop a good or a service that will generate significant returns and continually in

future periods. As such, the managers of the firm may face difficulty classifying the costs

incurred in R & D as either an expense to be charged in the income statement or a capital

expenditure (intangible asset). To assist the accountants and managers, IASB framework

provides them with more information that helps clarify the situation and make the right decision.

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 capitalize 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 (Nixon, 1997, p.276). The treatment of

R&D expenditure for financial reporting purposes is set out in FRS-13. The FRS-13 notes

explains that R&D activity must be differentiated from non-research based activity by the

presence or absence of an appreciable element of innovation.

FRS-13 distinguishes costs incurred on research from product development costs and

how each of the costs are treated. As per the guidelines, costs on research are to be treated as an

operating expense incurred during the period or year of operation (Tsoligkas and Tsalavoutas
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2011, p.962). FRS-13 requires development costs to be recognized as an asset (meaning they are

not immediately expensed) when, and only when, all of the following criteria are met:

 There is a clear definition of the product or the process and the costs relevant or

associated to the product or the process are separately identifiable and a high degree of

reliability can be expressed when measuring them,

 It is possible to demonstrate the technical feasibility of the product or process
 The intention of the firm is to produce and sell, or use, the product or process,
 There is a clear illustration that a market for the firm’s product or process exists, a clear

demonstration that the product or the process is useful to the firm and if the product is for

internal consumption, such use can be demonstrated with clarity (Nixon, 1997, p.265).
 That there is existence of adequate resources, or it is possible to demonstrate their

availability, to oversee the completion of the project and sell the product or the process or

consume the product or process internally.

If development costs are projected to exceed the future economic benefits realized from

the R&D, such costs are to be treated as expense and charged in the income statement regardless

of whether they meet the criteria outlined in paragraph 5.3. If the above is not met, FRS-13

stipulates that development costs be charged in the profit and loss account as an expense (Nixon,

1997, p.272). When there is compliance with the outlined criteria, the FRS-13 calls for

amortization and recognition of development costs incurred at from such a point as an expense

on a systematic basis. Such treatment helps to reflect the particular pattern through which

recognition of the associated economic benefits is done (Tsoligkas and Tsalavoutas 2011, p.965).

Amortizing the costs should always start when the product or the process is made available for

sale or internal consumption.

Current R&D Treatment

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Research expenditure is recognized in the income statement in the period in which it is

incurred. Development expenditure, including the cost of internally developed software, is

recognized in the income statement in the period in which it is incurred unless it is probable that

the cost of the asset can be reliably measured and technical feasibility can be demonstrated, in

which case it is capitalized as an intangible asset on the balance sheet. Capitalization ceases

when the asset being developed is ready for use. Research and development costs include direct

and indirect labor, materials and directly attributable overheads (BT Annual Report, 2015,

p.155). Also, capitalized 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 (BT Annual Report, 2015, p.155).

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 capitalization. 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 BT’s financial

statements will be somewhat affected, and below I will attempt to outline what those effects will

be.

Predicted Changes
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Expensing R&D costs will affect both the financial position and the reported profits of a firm. In

2015 capitalized 330 million pounds of development costs (BT Annual Report, 2015, 161)). If

BT Corporation were to practice the proposed treatment of R&D in the exposure draft, the

following changes to reported figures would occur:

Operating Corporation Fixed Assets Gearing Return on

Profit Tax @ 19,9% Turnover Ratio Capital
Employed
Current R&D 2541 631 1.17 30.82 59%
Treatment
Proposed R&D 2211 566 1.20 52.10 56%
Treatment
Increase/Decreas Decrease Decrease Increase Increase Decrease
e
See Appendix 1 for relevant calculations

The above table shows the effects on reported results of employing the proposed R&D

accounting treatment. The profitability of the firm is negatively influenced be the proposed

changes. Despite a reduction in corporation tax due and a considerable improvement in fixed

assets turnover, the improvements are not significant when compared to the decreases in other

more important figures. Increase in fixed assets turnover only indicates that BT is utilizing its

assets more effectively and efficiently in terms of generating revenues, and is not considered as a

vital ratio. The ratio would have a major impact in industries engaging in retail business, but not

technology. BT has suffered financially in 2014, and this can be attributed to several aspects. The

total shareholders’ equity reported was an unfavorable figure of negative £592 million lower than

that of 2013, and there were numerous expenses that adversely affected profit. One such expense

was a huge non tax-deductible impairment for goodwill which arose from the acquisition of

subsidiaries and joint ventures in 2013-2014 financial year. Although the taxable amount for the
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UK tax regime was 20% in 2015 (BT Annual Statement, 2015, p 87), the company’s effective

adjusted rate was 19.9% (due to non UK losses), which was significantly lower compared to

period ending 31st march 2014. Deferred tax payments and other tax adjustments were

significantly higher (negatively) in 2013-2014 financial year resulting from losses in previous

years. Therefore, the adverse effects of expensing R&D are arguably understated sine the firm’s

financial performance is not at its best. The BT plc seems to be increasing its R&D expenditure

every year. In a typical trading year with normal activity, the adverse effects of expensing the

expenditure would be much greater and more evident.

Implications of the Changes

If development costs were treated as operating costs instead of being capitalized, the

operating profit would decrease by 12.99%. 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 BT Corporation, since the investment would not yield as

high returns to investors. This would not only reduce the market capitalization/value of the firm,

but it would also deter investors from buying shares in BT Corporation, since other firms who

offer higher EPS would be a more attractive investment for them (Cazavan and JeanJean, 2006,

p.45). 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 BT's future

profitability and economic viability.

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Moreover, the fact that development projects which are likely to be successful in yielding

future cash flows to the organization 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 recognizing 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 (Goodacre, & McGrath, 1997, p.177). However, all investors are meant to have

equal opportunity to access the same information about a firm's operations, R&D included.

Expensing development costs rather than capitalizing them, means that no asset can be

generated as a result of the R&D expenditure. For instance, internally generated patents from

R&D cannot be capitalized and therefore will not appear on the balance sheet. In the case of

R&D partnerships funding the R&D conducted by BT Company, 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 (Oswald & Zarowin, 2007, p.

719). This will be totally unaccounted for, and investors will be unaware of the credit due to BT

Corporation since the R&D values had been excluded from on the balance sheet.

The reduced profit margins reported due to expensing R&D may also deter future and

potential investors from investing in the company, since they will be concerned about the ability

of the company to operate profitably in the foreseeable future (Oswald and Zarowin, 2007,

p.707). As a result of decreased reported profits and return on capital employed (ROCE), it will
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be hard for the company to convince banks and others financiers-holders of instruments of debt-

that the company will be able to repay them the amount awed and interest in time. In the eyes of

the lenders, the creditworthiness of the firm becomes doubtful. ROCE is a very important

profitability ratio which is commonly as a way measuring a firm’s performance (Cazavan and

JeanJean, 2006 p.65). A 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 ratio. Although BT's is not particularly highly geared, had the

existing capitalized development costs held a higher book value, the gearing would have

increased at a very high rate and in future could become unacceptable to some lenders, which

could make raising debt finance extremely hard for BT corporation. More importantly, increment

in gearing ratio means that the cost of raising financing for the company will increase

significantly raising the overall cost of operations (Goodacre, & McGrath, 1997, p.163).

Conclusion and Recommendation

Reporting on R & D expenditure of a company have an invaluable effect on the financial outlook

and performance of a firm. The decision on whether to expense or capitalize R & D costs should

not be taken lightly since a single mistake could significantly hurt the firm’s position and

profitability in future. Research costs should be expensed whereas product development costs

that could generate the firm incomes in future should be capitalized. As such, it is only prudent

that BT does not adopt the proposed change. The benefits realizable to BT Corporation from

adopting the changes are negligible compared to the many disadvantages such changes will bring

including threatening the financial strength and competitiveness of the firm. BT should retain

current policy as it safeguards the corporation’s interests.

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Appendix 1

1. Operating profit changes

Current R &D treatment= 2541

Proposed change in R & D treatment= (2541-330)

= 2211

Percentage change = 330/2541*100

= 12.99%

2. Corporation taxes

Current R & D treatment, T = (3172*19.9%)

= 631

Proposed R & D changes, T = ((3172-330)*19.9%)

= £ 566 million

3. Fixed asset turnover ratio

Fixed asset turnover ratio = Net revenue/ Average fixed assets

Current R & D treatment,

Average fixed assets = (15216+15525)/2

= 15370.5

FATR= 17851/15370.5
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=1.16

Proposed R & D changes

Average fixed assets = (((15216-330) + (15525-273)))/2

= 15069

Fixed asset turnover ratio, FATR = 17851/15069

= 1.18

4. Return on Capital Employed

ROCE = EBIT/capital employed

Current R & D treatment

ROCE = 6271/ (9768+808)

= 0.59 or 59%

Proposed R & D changes

ROCE = ((6271-330)/ (9768+808)

= 0.56 or 56%

5. Gearing ratio

Gearing ratio= Total debt/ total equity

Current R & D treatment

Gearing ratio = 24902/808

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= 30.81

Proposed R & D changes

Gearing ratio = 24902/ (808-330)

= 52.10
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References

BT Group plc, (2015). Annual Report & Form 20-F 2015. Investing for the future building on a

history of innovation, pp. 80-183.

Cazavan, J & JeanJean T, (2006). The Negative Impact of R&D Capitalization: A Value

Relevance Approach, European Accounting Review Vol. 15, No. 1, 37–61,

Goodacre, A. & McGrath, J. (1997): An experimental study of analysts ‘reactions to corporate

R&D expenditure. British Accounting Review. Volume 29, Number 2, pp. 155-179(25)

Nixon, B., (1997). The Accounting Treatment of Research and Development Expenditure: Views

of U.K. Company Accountants. The European Accounting Review, 6: 265-277.

Oswald, D. & Zarowin, P. (2007). Capitalization of R&D and the informativeness of stock

Prices. European Accounting Review 16 (4): 703–726.

Tsoligkas, F. & Tsalavoutas, I. (2011). Value relevance of R&D in the UK after IFRS mandatory

implementation. Applied Financial Economics. Jul 2011, Vol. 21 Issue 13, p957-967.