The impact of R&D programme success on the decision to capitalise development expenditures in European firms

ABSTRACT

The financial reporting treatment of R&D expenditures can have important implications for firms’ strategic investment in R&D. Yet, financial reporting issues have been largely neglected in the R&D management literature. In this study, we first hypothesise that firms’ capitalisation of development expenditures subsequent to the mandatory adoption of IAS 38 (International Accounting Standard 38: Intangible Assets) is positively and significantly impacted by a measure of R&D programme success. Our empirical findings – based on a pan-European sample of firms – reveal strong support for this prediction. Our findings also offer support for our second hypothesis which predicts that capitalisation of development expenditures in conjunction with an evaluation of R&D programme success has a positive and significant impact on growth in shareholder value. Consequently, our work suggests that an important challenge for R&D professionals within firms is to develop improved measures of R&D success and to communicate this information to senior executives.

KEYWORDS:

• R&D investment
• financial reporting
• capitalisation
• income statement
• statement of financial position

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes on contributors

Professor Vincent O’Connell is full Professor of Accounting at the Gulf University for Science and Technology, Kuwait and at the Amsterdam Business School, University of Amsterdam, Netherlands. His PhD is from the London School of Economics and he holds a number of professional accounting qualifications (ACA, ACMA, CGMA). Previously, he held faculty posts at Smurfit Business School (University College Dublin, Ireland), Korea University Business School (Seoul, Korea) and Cork University (Faculty of Commerce, University College Cork). His work has been published in leading academic journals including Accounting, Organisations and Society, Strategic Management Journal, MIT Sloan Management Review, European Accounting Review, Accounting Horizons, Critical Perspective on Accounting, International Journal of Research in Marketing, Journal of the Academy of Marketing Science, British Accounting Review and European Management Journal.

Dr Naser AbuGhazaleh is an Associate Professor of Accounting and Head of the Department of Accounting & MIS at the Gulf University for Science and Technology, Kuwait. He graduated with a PhD in Accounting from the University of Aberdeen. He has previously held faculty posts at the University of Aberdeen in the UK and at a number of prestigious universities in the GCC and Jordan. His work has been published in a number of important journals such as the Journal of International Financial Management and Accounting, the International Journal of Accounting and Finance and Advances in Accounting.

Mr Abdelmounaim Kintou graduated with a Master’s Degree in Accountancy & Control from the Amsterdam Business School, University of Amsterdam, Netherlands. After graduation, he began working as an auditor at Pricewaterhouse Coopers (PwC). He is now a Senior Associate at PwC specialising in assurance practice where he primarily focusses on listed companies. Currently, he is finalising his post master study at the Amsterdam Business School to become a ‘Register Accountant’ (which is the Dutch equivalent of the CPA/ACA qualifications).

Notes

1. Kieso, Weygandt, and Warfield (2014, 570) define development activities (which may give rise to development expenditures) as ‘application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use’.

2. The specific criteria outlined in IAS 38 are as follows: (1) the project is technically feasible; (2) the intention to complete the asset with the ability to sell (or use) it; (3) the availability of resources, technical or financial, to complete it; (4) the ability to reliably measure the expenditure; (5) and the ability to justify that the asset will generate future economic benefits (IASB 2004). Development expenditures not meeting these criteria and all research expenditures must be expensed as incurred under IAS 38. In subsequent years, capitalized development expenditures will be amortized (i.e. written off to the income statement) over the useful life of the development project.

3. The new accounting rules came into operation in 2005. As some of our firms had their fiscal year-end in 2006, we undertake tests of our hypothesis using data from 2006 to 2011. However, the earnings variance metric is a time-series-based measure for which we use a longer time-series of data. This is why we use data from before 2005 for calculating the earnings variance measure.

4. The capitalization of software development costs is the only exception to the usual expensing requirement with respect to research and development under US GAAP (Aboody and Lev 1998).

5. The median and mode respectively of the two dummy variables are: CAPITAL_DUM (0,0) and EARNINGS_SIGN (1,1).

6. The significance statistics for Hypothesis 1 are based on one-tail tests as the hypothesis predicts a positive relationships. The significance statistics for the other variables are based on two-tail tests.

7. Because of the various scaling and transformation procedures, the magnitude of the reported coefficients are not directly comparable with one another (Williams 2010). However, the results do reveal that that RD_SUCCESS has a greater statistical impact than any of the other individual predictors with the exception of BETA and AGE.

8. We combine the Consumer Goods and Healthcare sectors in order to achieve a reasonable sample size. In the main analysis (Table 3) we include separate Sector dummies for each of Consumer Goods and Healthcare.

9. We note that fixed effects estimation is not possible here as the EARNINGS_QUALITY measure (discussed later in Section 5.1), which is time-invariant, cannot be included in fixed effects estimation.

10. We are grateful to two anonymous reviewers for their helpful suggestions with respect to the work presented here.