The loss of relevance inherent in the current accounting rules for R&D costs, against the backdrop of the revised definition of an asset in the Conceptual Framework, leads us to believe that it is appropriate to recognize costs to create intangible assets, such as R&D costs, as an asset that is periodically tested for impairment based on independent cash flows rather than as part of a larger cash-generating unit. This will, among other things, prevent the reporting disincentive that currently exists for internal R&D projects which stands in contrast to shareholders’ interests, and creates fertile ground for management manipulations. According to our proposal, that relates to the new important research project of the IFRS on intangible assets, the existing distinction between internally generated intangible assets and those acquired from third parties will be eliminated.
For understandable reasons that reflect the historical development of the global industry, traditional accounting has focused primarily on tangible assets and has remained relatively weak regarding intangible assets. The problem is that over the years, intangible assets have become a central part of the value of many companies, including the world’s largest companies. This can be seen clearly today in listed technology companies, where equity reflects a minimal and even negligible part of the market value of the companies’ shares. In fact, today, the statements of financial position of technology companies in general and startup companies and companies engaged in the development of new technologies in particular – are almost irrelevant to existing and potential investors. In his research studies and articles, Prof. Baruch Lev has been pointing out for decades the loss of relevance of accounting regarding intangible assets.
In this context, in April 2024, the IASB launched its important research project on intangible assets, considering, among other things, comments and recommendations from various parties. Those comments noted the lack of relevance of financial reporting regarding intangible assets and the gap between the recognition requirements for intangible assets acquired by a company from a third party and those developed internally.
Revision of the Definition of an Asset in the Conceptual Framework
In our opinion, a possible solution to this issue lies in the revision of the IFRS Conceptual Framework in 2018, in which one of the important and significant updates related to the definition of an asset. While previously an asset was defined based on expected economic benefits, the revised definition of an asset requires only the potential to produce economic benefits, without a minimum probability threshold. In other words, according to the revised Conceptual Framework, an asset can exist if the potential for cash flows can be determined economically, and there is no need for cash flows with a relatively high level of certainty (expected). One of the reasons for this change was that the former requirement for expected economic benefits excluded from the definition of an asset many items that clearly constitute an asset, such as an out-of-the-money option.
Despite this important conceptual change, the outdated accounting treatment of R&D costs and costs of other internally generated intangible assets, which is still essentially based on the concept of a single expected cash flow, has not yet been changed. Thus, according to IAS 38, costs in the research phase are recognised as an expense, while in order to capitalise costs in the development phase as an asset, six conditions must be met, which are intended to indicate a sufficient probability of cash flows. To illustrate, pharmaceutical companies, for example, record almost all of the costs of drug development as an expense when incurred, based on the belief that the strict conditions cannot be met before the FDA approval date, by which time most of the costs have already been incurred. It should be noted that under US GAAP the guidance is even more extreme, and except for software-related development costs, there is an explicit provision that all R&D costs for internally generated assets shall be recognized as an expense when incurred, without any probability threshold.
The Concept of Rational Management
According to the current accounting treatment under IAS 38, the acquisition of in-process R&D is recognized as an asset, while the subsequent costs incurred for the continuation of development will need to comply with the strict conditions to be recognized as an asset. The difference is that presumably there is additional evidence in a separate acquisition, as the price paid by the acquirer is usually a reliable measure of expectations about the probability of future economic benefits from the R&D process initiated by a third party. However, relying on this difference ignores the need for rational management to examine itself at any given moment during the stages of the R&D process. In other words, the costs already incurred are “sunk costs”, and similar to the exercise of an option, a rational business outlook should be forward-looking.
The problem is further exacerbated when it comes to business combinations, where an “in-process R&D” asset is recorded even though there is no evidence that a specific amount was paid for it. That is because the amount allocated to the in-process R&D asset is its fair value estimated as part of the purchase price allocation, rather than a contractual amount paid. Is such a distinction between internally generated assets and those acquired from third parties (whether separately or as part of a business combination) relevant to users of financial statements? Why should a user of financial statements be influenced by such a distinction?
The impact of the current accounting treatment of R&D costs is not limited only to the loss of relevance of the statement of financial position, but is much broader, relating to the distortion in the measurement of ongoing business results. In addition, as a result of treating R&D costs as an expense, their classification in the statement of cash flows is within operating activities rather than as investing activities as would be appropriate given their nature. The negative impact on cash flows from operating activities, in addition to the negative impact on operating profit, amplifies the disincentive among managers to invest in internal R&D projects that may be vital to a company’s future in the long term, in order to reflect better financial results in the short term.
It should be noted that the distortion in the measurement of results is twofold and is reflected in the case of successful R&D when generating ongoing revenues from the project. The reason for this is that the costs were recognized as an expense when incurred and therefore, when revenues are recognized, the amortization component in the cost of sales will not be recognized, and the resulting gross profit will be biased upwards.
Management Manipulations Under the Auspices of Accounting Standards
The current accounting treatment also creates fertile ground for “legal” manipulations in the measurement of results in the statement of profit or loss and damage to the economic activities of companies and consequently to their shareholders. Academic research shows opportunistic timing of costs by managers and deferral of R&D projects in order to meet earnings forecasts. This is in fact an acute example of the agency problem, where management compensation is based on current earnings, a situation that provides an incentive for managers to postpone internal R&D projects, in a way that harms shareholders twice – both in the long term in the absence of economic investment in R&D that has the potential to generate profits, and also in the biased and inappropriate payment of ongoing compensation to managers. In addition, the current accounting treatment creates a reporting incentive for companies that use EBITDA as a performance measure to acquire intangible assets rather than develop them internally. This is because the amortization component of acquired intangible assets is eliminated for the EBITDA calculation, while the expense recognized for internally generated intangible assets affects EBITDA immediately.
Proposed Accounting Model
In our opinion, the requirement for expected economic benefits should be removed when it comes to an intangible asset such as in-process R&D, acquisition of traffic to a website, etc., so the distinction between internally generated intangible assets and those acquired from third parties will be eliminated. As we understand and recognize that there is more skepticism towards intangible assets, we propose that these assets be tested for impairment directly, i.e. based on independent cash flow, because then the impairment test is more effective! In other words, the measurement of impairment will not be “absorbed” within a larger cash-generating unit (“cross-subsidization”), similar to the recoverability test of contract acquisition costs in accordance with IFRS 15.
At the same time, the sweeping draconian provision in IAS 38 not to capitalize costs for advertising and sales promotion as an asset should be amended, so that such capitalization be allowed in cases where potential customers resulting from the advertising can be identified. This is similar to the accounting treatment that exists under US GAAP for advertising costs that generate a direct response in certain cases.
It is important to emphasize that coherence between accounting standards on essentially similar issues and between them and the revised Conceptual Framework is critical. For example, the solution we propose can also help in the future to determine the accounting treatment of oil and gas exploration costs, which are similar in nature to R&D costs. In both cases, there are low probabilities on the one hand, but very high cash flows on the other hand, and therefore it is appropriate that the accounting treatment in both cases be similar. As of now, the relevant standard for these costs, IFRS 6, sets forth temporary provisions and allows more than one accounting policy.
In conclusion, the accounting model we propose will lead to an improvement in the usefulness of financial statements among investors and will eliminate the disincentive that currently exists for investing in internal R&D projects. This is only a partial solution to the broad problem of loss of relevance, but it is a first feasible and necessary step on the issue towards a broader discussion that we assume will take place in the future regarding the question of recognition of additional intangible assets in accordance with the IASB’s new broad research project.
(*) This paper was co-authored by Shlomi Shuv and Danny Vitan, Partner, Head of Department of Professional Practice, KPMG Israel