Many organisations fail to disclose the amounts spent on research and development (R&D) in their financial statements while at the same time offering narrative description of their R&D activity elsewhere in their annual reports, according to a new report.
Conducted by ACCA in partnership with the Adam Smith Business School, Reporting of R&D: disclosure without recognition? looked at more than 18,000 organisations in 40 countries over a period of five years, and found that 53% did not report any R&D asset or expenditure in financial statements. These organisations are classified as ‘R&D inactive’.
The study concluded that many of these organisations may not be genuinely R&D inactive. It found that organisations that make no reference to R&D in their financials use R&D terminology extensively in their narrative reporting.
‘Organisations that do not report any R&D assets or expenses tend to have lower book-to-market ratios’
‘Reporting of R&D activity and the associated expenditure helps readers understand where the organisation is spending its money to build future value and how much money has been spent,’ explains Aaron Saw, senior subject manager – corporate reporting, at ACCA. ‘Readers want to know the value that R&D generates.’
The researchers identified 170 annual reports where organisations included no financial information about R&D in their financial statements while using R&D-related terms more than 100 times elsewhere in their annual reports. A further 496 reports had no financial reference but used R&D-related terms between 50 and 100 times.
Frequently used R&D terms include ‘innovation’, ‘innovative’, ‘development cost’, ‘research and development’, ‘patent’, ‘product development’ and ‘new technology’, among many others.
R&D-inactive organisations tend to be in countries where total R&D investment each year is less than 3% of GDP
Critical for stakeholders
Saw adds that disclosure of R&D amounts is critical for stakeholder decision-making. ‘Organisations that do not separately report any R&D assets or expenses tend to have lower book-to-market ratios than organisations that separately report R&D assets or expenses. This tells us that information about R&D expenditure does influence investors’ perception of an organisation’s growth potential, and it is reflected in an organisation’s market value.’
Other insights were also uncovered. For example, R&D-inactive organisations tend to be located in countries where total R&D investment each year is less than 3% of GDP and have a low level of intangible assets.
There is a mismatch between the definition of R&D in IAS 38 and the views of management
Meanwhile, there was evidence that organisations rarely switch from one category to another, with those that are R&D inactive rarely becoming active; only 2% were found to have made the switch. Meanwhile, only 1% had moved in the opposite direction, from active to inactive.
The report suggests that there are a number of underlying reasons for poor R&D reporting. These include ambiguity over what qualifies as R&D; a lack of incentives for separating R&D-related costs from other operating costs and disclosing the former separately in financial statements; and corporate cultures that may reduce the openness and extent of R&D reporting, which may be caused by commercial sensitivity.
There are also fundamental problems in the reporting of R&D. This includes a mismatch between the definition of R&D in IAS 38, Intangible Assets, and the views of management.
Ambiguous information in annual reports is confusing and falls short of being ‘decision useful’
This could indicate a disconnection between the work of professional accountants, as preparers of financial statements, and other functions or departments in the organisation.
The report says that narrative reporting of R&D without disclosing the relevant amounts in annual reports creates ambiguity. Such information is confusing and falls short of being ‘decision useful’.
A number of recommendations for accountants stem from the report’s findings. These include identifying activities that should be classified and accounted for as R&D. The report says: ‘This is particularly relevant for organisations that currently employ a high volume of R&D-related terms in the narratives but give no matching R&D expense or asset in the finance statements.’
Organisations should consider R&D disclosures’ attractiveness to investors, customers and talent
The report also suggests organisations encourage a change of mindset towards reporting of R&D across all departments; collect information on activities that could be classified as R&D; and explain how R&D is important to an organisation’s business model. Boilerplate disclosures should be avoided.
‘Better reporting of R&D should help users to understand the significance of R&D to the business and connect to any material finance, financial, social and/or environmental impact that is relevant to the organisation,’ Saw advises. ‘This will also have a profound impact on the quality of data in industry- or national-level statistics.’
He adds: ‘An organisation’s disclosure about R&D activity and associated expenditure will affect stakeholders’ perception of its future prospects. Organisations should consider its attractiveness to investors, customers and talent.’
The study is the fourth in a series of investigations looking at the capitalisation of R&D and intangible assets. Previous reports analysed the capitalisation of R&D, accounting for exploration and evaluation expenditure in extractive activities, and capitalisation of software development costs.