The requirements of IAS 38 in respect of Research and Development expenditure are

theoretically dubious and practically unnecessary. All such expenditure should be treated as

an expense in the Income Statement and its amount disclosed in notes to the accounts.

Prior to the introduction of the International Financial Reporting Standards (IFRS) in 2001,

all series of standards were a part of the International Accounting Standards (IAS). These are

a set of accounting standards that were published by the International Accounting Standard

Committee (IASC) between 1973 and 2001. They were then developed and supervised by the

UK based International Accounting Standards Board (IASB).

The rationale of IAS 38 is to display the appropriate accounting treatment for intangible

assets which are not attended specifically in the IFRS or any other Standard. An intangible

asset is thus defined as an identifiable non-monetary asset without physical substance (IASB,

2014). This Standard obliges an entity to acknowledge an intangible asset if, and only if,

rigorous criteria are met. The Standard then goes further by specifying how to assess the

carrying amount of intangible assets and requires specified disclosures about intangible assets

(IASB, 2014). Within IAS 38, internally generated intangible assets have their own criteria to

meet. Research and Development (R&D), which is at the heart of this essay, is included in

this category. The case of Research is straightforward: given the inherent uncertainty of its

outcome, IAS 38 requires that all Research is to be treated as expenditure. Conversely, the

cases of intangible assets arising from Development, however, are more subjective. As per

the Standard, these shall be recognised if, and only if, six specific requirements are fulfilled,

one including how the intangible asset will generate probable future economic benefits.

Those expenditures on development which fail to meet the six criteria are all written off as

expenses within the income statement (IASB, 2014). In contrast, under Americas accounting

standard, US GAAP, you would expense R&D costs when they are incurred, because the

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future benefit is not certain and if you can show that the company will receive specific future

benefit from the costs then some R&D costs can be capitalised.

This essay will discuss whether the requirements of IAS 38 in respect of Research and

Development expenditure are theoretically dubious and practically unnecessary and if, as a

result, all such expenditure should be treated as an expense in the Income Statement and its

amount disclosed in notes to the accounts. The essay will consider the affirmative and the

negative, laying out the case for each. It will then weigh the two sides, and come to a

comprehensive and constructive conclusion.

A prominent difficulty that occurs when exploring R&D expenditure is that the deficiencies

in disclosures demonstrably lead to adverse effects on capital markets, especially in relation

to knowledge-based organisations (Lev 2001). The argument put forth by Lev (2001) holds

that disclosure of expenditure is crucial upon adding value to the actual R&D. Lew (2001)

further went on to build an appropriate strategy which could uphold this disclosure, structured

such that it could initiate the revelation process. In his progress to form this strategy, Lev

(2001) utilises the findings of Boone and Raman (2001), who established that within

knowledge-based organisations, large amounts of intangibles consist of high cost capital. Due

to the large amount of intangibles, organisations create a higher bid-ask spread, which

inevitably results in a differentiation between economic worth and reality. This is because

their values consist mainly of intangibles. Nonetheless, R&D is not recognised as an asset in

an organisations balance sheet, leaving its value unheeded. Lev (2001) disputes that under

specified circumstances, if future economic benefits could be derived from R&D expenditure;

the practice of instant expensing within the Income Statement will inevitably lead to biased

performance reporting in respect to underlying earning from R&D capitalisation. The

consequences of biased reporting and misevaluations of valuing result in asymmetric

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information which furthers social damage. An example of this is related to cost of capital.

Under the affirmative case, there would be an impediment on investment and growth due to

the implication of an excessively high cost of capital. Hence, capitalisation is necessary.

In their book Corrado, Hulten & Sichel (2005) discuss the impact of R&D investment in

National Income and Product accounts (NIPA). They argue that by treating R&D as

expenditure, rather than an investment, NIPA underestimates R&Ds contribution to the GDP.

The suggestion from their updated article (2009), develops the following identity:

PQ(t)Q(t)=PC(t)C(t)+PI(t)I(t)+PN(t)N(t)=PL(t)L(t)+PK(t)K(t)+PR(t)R(t),

The current national accounts definition of GDP treats intangibles as an intermediate input to

the production of C and I. Here on the other hand, intangible expenditures are treated as

investment. The reasoning is that outlays on software, R&D, advertising, training,

organizational capital etc., are critical investments that sustain a firms market presence in

future years by reducing cost and raising profits beyond the current accounting period (van

Ark et al. 2009). Treating these items as an expense is thus a potentially vital understatement

of both investment (whose signals influence monetary policy decisions), and GDP growth as

a whole.

Furthermore, with increased levels of disclosure, the information asymmetry between the

firm and its vested shareholders and investors naturally subsides, which is directly related to

reducing the agency problem in limited companies. According to Lev (2001), there is little

difference between the balance sheet and the income statement, since the two tend to be

mutually impacting. Lev (2001) also suggests that, despite being important in its role of

informing investors, credible information diminishes as intangible assets become undervalued

3
within the financial statements. This argument is supported by the fact that shares of firms

with more R&D spending tend to perform best against firms with little or no investment into

R&D (Lev 2001). As a result of the current accounting practices, auditors systematically

undervalue intangibles.

On a related note, vital inside information in regards to the progress and succession of a

project is carried within capitalisation. Thus, Lev (2001) argues, a more lenient criterion upon

reliability and control of expenditure should be introduced. With respect to the issue of

recognising clear economic benefits, the auditor could revisit and capitalise past and further

expenditure on the respective project, (Lev, 2005). The introduction of such a criteria would

permit the distribution of credible and relevant information to stakeholders and investors,

reducing the information gap between the company and two parties. The purpose of an

auditor is to comment on whether a companys financial statements are a true and fair

representation (in their view). If more discretion were to be handed to managers in regards to

recognising such intangible assets, an auditors view can be grounded more firmly in facts

and less on professional judgment (Wyatt, 2008). Under IAS 38, R&D can be capitalised via

the accruals principle, where revenue and cost are corresponded. Once commercial

production commences, a stop and start cycle is practiced to amortise the product over its

useful life and subsequently depreciated by the straight-line method. This type of

capitalization will allow for a truer and fairer representation of the company, benefiting the

financial statements. In essence, the concept behind IAS 38 is not theoretically dubious.

On the other hand, the findings of Lev (2001) and Corrado, Hulten & Sichel (2005) fail to

associate their results to the deficiency in the disclosure of R&D expenditure, instead only

demonstrating how they economically diverge. As such, Skinner (2008) claims that these

4
companies with high bid-ask spreads inevitably co-exist with a higher risk. The implication is

thus that this is what is actually behind Lev (2001)s findings.

It is highly plausible that from conducting a project, initiated through research and

development, there will be no revenue stream due to the high level of uncertainty. What this

means is that R&D expenditures are more vulnerable to legal challenge by the relevant

stakeholders; in essence, their value is state driven (Basu and Waymire, 2008). The shadiness

associated with intangible valuation has been stressed by Basu and Waymire (2008), who

state that valuing accounting intangibles on a stand-alone basis requires heroic assumptions

about seperability, highly uncertain estimates of ambiguous future benefits, and arbitrary

allocations of jointly produced income (Basu and Waymire, 2008). This supports the claim

that R&D expenditure should be entirely expensed as it creates a risk for investors.

Organisations holding intangibles contain larger asymmetries which ultimately lead to a less

liquid market and a higher cost of capital. In the practical sense, there is no clear economic

benefit due to these uncertainties.

Moreover, in relation to Levs (2001) concern with the accounting ratios, Basu and Waymire

(2008) began accompanying the inconsistency of market to book ratios to the variation in the

value of non-accounting economic intangibles, which had been displayed through the

relationship analysis of improvements in the government function and the impacts of

deregulation. The appropriate follow-up question is then: where should valuation be derived

from? As per Graham and Meredith (1937), it is the earning power of these intangibles,

rather than their balance sheet valuation, that really counts. The suggestion is that disclosure

of R&D expenditure is unnecessary, since the treatment of R&D is not required for equity

valuation. In other words, contrary to the argument of Lev (2001), there is no need to

5
establish the value of R&D, meaning that, due to the concerns regarding measurability

mentioned previously, it is better to simply dispense with IAS 38.

Again, given that it remains uncertain as to whether these were, in fact, abnormal returns, and

whether there was indeed undervaluation, the rationale behind IAS 38 seems dubious. Indeed,

the market might have correctly reduced these firms expected cash flow, given the riskier

nature of R&D projects (Skinner, 2008). Dedman et al. (2009), contrary to Lev (2001),

concluded that there is little evidence of undervaluation within firms with higher R&D

expenditure. In support of this argument, he demonstrated that the ratio of R&D to market

value is positively associated with the cross-section of average returns (Dedman et al, 2009).

The value of R&D can be questionable at the time they are made, as those expenditures are

expenses rather than capitalized at that time.

This also raises concerns as to whether the auditor will be able operationalize the accrual

principle, since the beneficial cash flow from the R&D is unknown at the time of its

investment. For example, consider the many companies that undergo expensive development

of drugs. The subsequent product may, however, be entirely unsuccessful. Allowing

capitalization would allow auditors to go back and undo any accounting decisions. This

ability to change the accounting decisions ex post inevitably gives rise to unreliability and

incorrect manipulation. There also comes the question of management threats; the auditor in

this scenario is actually partially preparing accounts.

Furthermore, the level of aggregation to apply is very ambiguous. Some firms consider R&D

expenses to be individual products, whilst others look at R&D expenditure on aggregate to be

consisting of many projects. As such, applying prudence may give very different results,

leading to a lack of consistency and comparability across, potentially, firms in the same

6
industry. In this case, the implications in their financial statements would be dependent on

their decisions surrounding aggregation and disclosure of R&D, rather than actual substance.

In addition, numerous companies such as global Tech leader, Google, trade at a larger

premium to their indicated book value, which forms evidence to contradict the notion that

investors solely rely on accounting recognised assets when scrutinizing equity (Penman,

2007). Nixon conducted a survey, questioning organisations accountants and concluded that

accountants believed the expensing of R&D expenditure in the Income Statement had an

negligible impact on companies in terms of the valuation positioned on them, and neither

their ability to attract investors and raise finances (Nixon, 1997).

In conclusion, on the balance of the evidence presented above, it is clear that one must accept

that the requirements of IAS 38 in respect of Research and Development expenditure are

theoretically dubious and practically unnecessary. Whereas the rationales, as well as the

arguments put forth by its proponents, contain good justifications of the Standard, the nature

of R&D is far too uncertain to be applied consistent with prudence. The argument made by

authors such as Lev (2001) focus on the adverse impact that treatment of R&D expenditure as

an expense in the income statement upon managements decisions. However, the rebuttal

from Dedman et. al (2009), stating that the findings are associated more with risk than with

deficiency of procedure, is far more intuitive. The determination of clear economic benefit

is ultimately far too subjective and uncertain. It is compounded by the management threat

arising from auditors then having to correct accounting decisions on behalf of their clients

when capitalised R&D fails to materialise. For these reasons, this essay concludes that the

requirements of IAS 38 in respect of Research and Development expenditure are theoretically

dubious and practically unnecessary.

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WORD COUNT: 2,033

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