Moving from Conservatism to Neutrality: Is this Reflected in Accounting for R&D Expenditures?

Transcription

1 Master Thesis Moving from Conservatism to Neutrality: Is this Reflected in Accounting for R&D Expenditures? The case of AkzoNobel and Royal DSM Student name: N.S. de Koning Student number: Date of submission: 24 th of June, 2013 Version being submitted: First Word count: 18,422 Qualification: MSc Accountancy & Control Specialization: Accountancy Name of the institution: Amsterdam Business School Faculty of Economics and Business, University of Amsterdam Name of UvA supervisor: Prof dr. D.M. Swagerman Name of Second UvA reader: dr. ir. S.P. van Triest Name of Deloitte supervisor: J.S. Visch MSc RA

2 Abstract Both the IASB as well as the FASB state that conservatism should no longer be part of the conceptual framework for financial reporting. The fundamental argument they provide for this change is that conservatism is believed to be inconsistent with the qualitative characteristic of neutrality. This move from conservatism to neutrality has led accounting standard setters to make changes to the current accounting standards to make them less conservative. One of the standards that have been revised is RJ210 (Dutch GAAP). This standard deals with the recognition of research and development (R&D) expenditures. Prior to the amendment of RJ210 in 2001 the standard prescribed to expense the R&D costs completely (in the income statement). The revised RJ210 standard states that the research expense component has to be expensed completely, while the development expenses must be capitalized when certain criteria have been met. According to IAS 38 (IFRS), which was established already in 1978, development cost must also be capitalized when certain criteria have been met. Conservatism refers to companies tending to disclose bad news (losses) earlier than good news (profits). Completely expensing R&D costs is a form of bad news, since the reported net income will be lower compared to a situation where some of these costs may be capitalized and expensed in later years instead. When this brake of expensing development costs is removed to let managers capitalize development costs and in this way show the investors what they are doing, one would expect that management will engage in more R&D, expense less and reflect more development costs in the balance sheet. This removal of the brake will be explored by examining two Dutch, R&D intensive chemical companies. This way, the impact of the revised standards concerning R&D expenditure is investigated. Has the revised IAS 38 standard and RJ210 led to increased neutrality in financial reporting? Keywords AkzoNobel, Conservatism, IAS 38, IFRS, Intangibles, Neutrality, R&D, RJ210, Royal DSM 2

3 Preface This report is my master thesis for the completion of my Master program Accountancy & Control at the University of Amsterdam. Moreover, it is also a completion of my internship at the Consumer Business, Core Audit department of Deloitte. I really appreciate the help I have received from many people while writing this thesis. I would first like to thank my supervisor from the University of Amsterdam, Prof dr. D.M. Swagerman. He gave me much guidance in how to structure the thesis. Moreover, brainstorming about the subject was very helpful to me. I would like to extend my gratitude to J.S. Visch MSc RA, my supervisor at Deloitte, Senior Manager at the Consumer Business, Core Audit department. He was very helpful in getting me into contact with some experts from the field. Last but not least, I would like to thank the experts from the field, who I have interviewed. The interviewees were Karim Safar and Ivar Smits from AkzoNobel; Peter Sampers and Jan van den Bossche from Royal DSM, as well as an expert of one of the big four accounting firms, who wished to remain anonymous. I am very grateful for the time and effort of all the mentioned people. The open interviews provided me with a good understanding of the issues regarding R&D accounting, which has been applied throughout this thesis. This thesis provides new insights in the accountancy science, especially regarding R&D accounting and the possible contribution of the standards regarding R&D accounting towards neutral accounting. Amsterdam, 20 th of June

4 Table of Contents 1. Introduction 6 2. Background and State of the Art of the Literature Trade-off between Relevance and Reliability Conservatism Explanations of Conservatism Contracting Explanation Income Tax Explanation Litigation Explanation Accounting Regulation Explanation Non-conservatism Explanations Criticism of Conservatism Move to Neutrality Criticism of Neutrality IAS 38 Intangible Assets: R&D Dutch GAAP: RJ Other Amendments Made to Move to Neutrality Managerial Problem of locating R&D costs Research Question Research Methodology Context Analysis AkzoNobel Royal DSM 29 6.Content Analysis AkzoNobel AkzoNobel and the R&D Accounting Standards Royal DSM Royal DSM and the R&D Accounting Standards Comparison AkzoNobel and Royal DSM Investors and R&D Conclusion Concluding Remarks Limitations and Future Research Final Conclusion 59 Literature References 61 Website References

5 List of Tables and Illustrations Figure 1 Book values of a fixed asset under conservative accounting 12 Figure 2 Reported net income under conservative accounting.. 12 Figure 3 Research Model: Step Figure 4 Research Model: Step 3 23 Figure 5 Research Methodology Model. 24 Figure 6 Research Methodology Model: Context Analysis 28 Figure 7 Research Methodology Model: Content Analysis 30 Figure 8 R&D Accounting Treatment AkzoNobel collected from DataStream. 32 Figure 9 R&D Accounting Treatment AkzoNobel hand collected from the annual financial statements Figure 10 Relationship R&D Expenses and Capitalized Development Costs AkzoNobel (DataStream) Figure 11 Relationship R&D Expenses and Capitalized Development Costs AkzoNobel (Hand collected).. 33 Figure 12 Extract from the Financial Economic Manual (FEM) of AkzoNobel.. 36 Figure 13 KPIs related to R&D of AkzoNobel: R&D Major Projects as % of R&D expenses Figure 14 R&D Accounting Treatment Royal DSM collected by DataStream. 42 Figure 15 R&D Accounting Treatment Royal DSM hand collected Figure 16 R&D Expenses and Capitalized Development Costs Royal DSM (DataStream). 43 Figure 17 PMP Process at Royal DSM. 45 Figure 18 KPI related to R&D of Royal DSM: Innovation Sales. 49 Figure 19 KPI related to R&D of Royal DSM: Total R&D Expenditure as % of Net Sales 49 Figure 20 Move from Tangible Assets to Intangible Assets 50 Figure 21 Comparison Capitalized Development Costs (in millions of Euros).. 53 Figure 22 EBITDA minus capitalized development cost on sales (Barco) 55 Figure 23 Research Methodology Model: Results. 57 Figure 24 Research Model: Final Conclusion

6 1. Introduction Despite criticism, conservatism in accounting has survived for many centuries (Watts, 2003, p.1.). Accountants traditionally express conservatism by the adage: anticipate no profit, but anticipate all losses (Bliss, 1924). Basu (1997, p.7) explains this adage by the tendency of accountants to require a higher degree of verification to recognize good news, such as gains, than the degree of verification required to recognize bad news, such as losses. Recently the International Accounting Standards Board (IASB) as well as the Financial Accounting Standards Board (FASB) argue that conservatism should no longer be part of the conceptual framework for financial reporting. The fundamental argument they provide for this is that conservatism is incongruent with the qualitative characteristic of neutrality, which encompasses freedom of bias (Conceptual Framework, 2008, pp.48-49). The IASB states that: Conservatism in financial reporting should no longer connote deliberate, consistent understatement of net assets and profits. The Board emphasizes that point because conservatism has long been identified with the idea that deliberate understatement is a virtue (Conceptual Framework, 2008, p.49). Some familiar terms like substance over form, reliability and prudence are therefore no longer mentioned in the framework. The move from conservatism to neutrality has led accounting standard setters to make changes to the current accounting standards to make them less conservative. This in turn would lead to a positive effect on value, which is relevant to the financial statement users. One of the standards that has been changed relates to the recognition and accounting for research and development (R&D) expenditures. In the Netherlands, the standard related to R&D is RJ210: Immateriële Vaste Activa (Intangible Assets) and the international standard related to R&D is IAS38: Intangible Assets. We will take a closer look at both standards since the sample, as explained later, consists of Dutch companies that complied with the Dutch GAAP till 2005, and have switched to applying International Financial Reporting Standards (IFRS) from that year on. However, from 2005 till 2012 they both applied Dutch GAAP as well, as far as applicable. RJ210 was amended in 1999, with effective date first of January According to this new accounting standard development costs are to be capitalized when certain criteria are met. Prior to this change, development costs were 6

7 expensed when incurred (RJ210, 1999, p.25-26). When considering a more global scope, for instance, take a look at IAS 9: Research and Development Costs which was established on the first of July IAS 38 superseded IAS 9 on the first of July, Under the now-superseded IAS 9, the research costs had to be expensed and the development costs had to be capitalized and expensed over the periods of expected benefit. IAS 38 regarding to R&D is similar to IAS 9; the research cost component should be expensed completely according to IAS 38 paragraph 54; and according to paragraph 57, the development expenses must be capitalized as an intangible asset when certain criteria have been met (IAS 38, 2012; History of IAS 38, 2013). As we can see, under IFRS capitalization of development costs was allowed many years before it was allowed in the Netherlands. The question that arises is whether this change in standards has indeed reduced conservatism and thereby increased neutrality in accounting. As such, the research question of this thesis is: Is the IFRS s move from conservatism to neutrality reflected in actual reporting of R&D? By examining two Dutch, R&D intensive chemical companies, the impact of the revised standard concerning R&D expenditure is investigated. By conducting case studies of the two sample firms, one can determine whether these two firms treat the IAS 38 and RJ210 standards concerning R&D in a similar way. It will become clear whether these companies indeed started to capitalize their R&D after the first of April 2001, which is the effective date of the amended RJ210 standard and whether they complied with IAS38 when they started to apply the IFRS standards back in 2005 (History of IAS 38, 2013; RJ210, 1999, p.25-26). In Chapter 4 Research Methodology, the choice for AkzoNobel and Royal DSM will be further explained. Since accounting exists, conservatism, also known as prudence, has been one of the most fundamental accounting principles. Therefore, the IASB and FASB s move away from conservatism, which became more explicit with the introduction of IFRS in 2005 and the 2008 Exposure Draft release from the common Conceptual Framework of the IASB/FASB, is of great interest. To my knowledge there is no prior research about whether the standards that the IASB has changed, aimed at decreasing conservatism, has indeed led to less conservatism. The motivation for this study is consequently derived from the literature gap of the effects of the change of the IAS 38 and RJ210 standards on financial reporting. Conservatism actually means that bad news (losses) will be disclosed earlier than good news (profits). Completely expensing R&D costs is a form of bad news, since the 7

8 reported net income will be lower than when some of these costs had been capitalized. When this brake of expensing development costs is removed, to let managers capitalize development costs and in this way show the investors what they are doing, one would expect that management will engage in more R&D, expense less and reflect more development costs in the balance sheet. This removal of the brake will be analysed by looking at two R&D intensive companies. The research result shows that both firms indeed started to capitalize development costs when it became allowed. AkzoNobel started capitalizing as early as 2001 and Royal DSM started capitalizing in 2009 due to applying the IFRS more strict than before and due to some difficulties they faced regarding the implementation of the new standard in their accounting systems and processes. However, both firms still take a conservative approach towards the new standard, which hampers the move towards neutrality. The firms both recognize a different explanation for conservatism; AkzoNobel recognizes the income tax explanation for conservatism and Royal DSM recognizes the contracting explanation for conservatism. Moreover, they both believe that the amendment did not have any, positive nor negative, effect on them. Other stakeholders do not seem to benefit from the amendment either; therefore the IASB and the FASB might reconsider accounting standards regarding R&D, as well as the move to neutrality itself. This thesis investigates the amended accounting standards concerning R&D expenditures since information related to the treatment of R&D expenditures is publicly available in the financial statements and therefore the information disclosure about R&D may have an effect on the decision-making process of investors. Investors are demanding market values to assist them in their decision making process. Financial reporting is trying to assist the investors; one of the objectives of financial reporting is to provide information that is decision-useful for current and future investors as well as other stakeholders (IFRS Conceptual Framework 2011). As such, this research can potentially be of great social relevance and offer a valuable contribution to the existent literature. This research will contribute to the controversial discussion about the accounting of R&D expenditures. Accounting policy makers, managers, the tax authorities as well as other stakeholders, all have different views of how one should treat R&D expenditures, whether they should be capitalized or be expensed. The main scientific contribution of this research is that it will become clear whether the amended RJ210 and IAS 38 regarding R&D has the desired effect, this effect being that accounting for R&D expenses has indeed become less conservative, as was intended. 8

9 However, a limitation of this thesis might be the small sample size as it consists of only two companies. Nevertheless, it can be argued that this will not be a problem since they both are R&D intensive and IFRS applicants. Therefore it can be assumed that focusing on different companies that are specialized for example in High Tech R&D or Automotive R&D will not lead to different conclusions, since the definition of R&D remains the same and they are all subject to the same R&D standards. Chapter 2 describes the background and the current state of the literature on this topic. The remainder of this paper is organized as follows: Chapter 3 contains the research question; Chapter 4 describes the research methodology chosen for this thesis; Chapter 5 contains the Context Analysis which provides a short introduction to AkzoNobel and Royal DSM; Chapter 6 consist of the Content Analysis, in this section the accounting treatment regarding R&D of the selected companies will be investigated and several interviews with employees with accounting and/or controlling expertise will provide insight in the problems related to R&D accounting; Chapter 7 contains the comparison of the results of the case studies; Chapter 8 describes to what extend investors are interested in capitalized development costs; and Chapter 9 provides the conclusion of the research. 9

10 2. Background and the State of the Art of the Literature 2.1. Trade-off between Relevance and Reliability Some accountants believe that historical cost accounting best predicts firm performance; others believe that current values will predict firm performance better. Historical cost will lead to more reliable financial statements and current values will lead to more relevant financial statements (Scott, 2012, pp.66-67). Two qualitative characteristics of financial accounting information are relevance and reliability. These qualitative characteristics are both critical for the quality of information, however an emphasis on one will hurt the other, and the other way around. When accounting information is provided in time it is relevant, however at early stages the information is uncertain and therefore not reliable. When we wait till the information gains reliability, the relevance is lost. Consequently, we have to make a trade-off between relevance and reliability (Accounting Explained, 2012). Whatever view taken, all accountants feel that financial statements should be useful (Scott, 2012, pp.66-67). According to the IFRS Conceptual Framework of 2011, as issued on January 2012 the general purpose of financial accounting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit. Many existing and potential investors, lenders and other creditors cannot require reporting entities to provide information directly to them and must rely on general purpose financial reports for much of the financial information they need. Consequently, they are the primary users to whom general purpose financial reports are directed (IFRS Conceptual Framework 2011, emphasis added). Concisely, the aim of financial accounting is to provide financial information that is decision useful for existing and potential stakeholders. There are two perspectives of decision usefulness; the information perspective and the measurement perspective. The information perspective states that information is useful if it leads investors to change their beliefs and actions. The degree of usefulness can be measured by the extent of volume or price change following the release of the information. It also acknowledges that investors are individually responsible for predicting future firm performance, instead of having accountants do it for them (Scott, 2012, Chapter 5). The 10

11 measurement perspective, on the other hand, states that accountants undertake a responsibility to incorporate fair values in financial statements to assist investors to predict fundamental firm value. The measurement approach to decision usefulness suggests a greater usage of current value in the financial statements to assist investors. This approach likewise acknowledges that investors are individually responsible for predicting future firm performance. However, this approach wants to enable better predictions by providing more useful information (Scott, 2012, Chapter 6). This last approach is fundamental in the discussion about the IASB s move away from conservatism to neutrality Conservatism As discussed in paragraph 2.1. the accounting standard setters have to choose between either making financial reporting more reliable or making financial reporting more relevant. It is not possible to make financial reporting both reliable and relevant. Only during the past decade the focus shifted to relevance as opposed to reliability which was previously prevalent in contemporary accounting practice. Reliability is mostly reflected by historical cost accounting. Conservatism comes into play when considering reliability. The concept conservatism is clearly depicted by the following quote: Assets are often, by reason of prudence, estimated and stated to be estimated, at less than their probable real value. The purpose of the balance sheet is primarily to show that the financial position of the company is at least as good as there stated, not to show that it is not or may not be better (Basu, 2009, p. 3). Basu (1997, p. 4) explains that conservatism is the concept that earnings are reflecting bad news more timely than good news, and therefore accounting information is biased towards negative events. Basu (1997, p.4-6) also states that bad news earnings is not only more timely but less persistent as well. This is known as conservatism bias, which is clearly depicted by Figure 1 and 2 below. Consider a company that receives news which forces the company to reconsider the remaining useful life of an asset. When the new estimate is longer, the depreciation charges that would have been taken in the current and future years are smoothed out over the new remaining useful life, which result in lower depreciation charges (Figure 1) and subsequently an increase in the reported net income (Figure 2). However, when the expected new remaining useful life is shorter, the company will have to impair the asset. Consequently there will be an increase in depreciation charges as the total depreciation will 11

12 have to be divided over a smaller number of years compared to before the change (Figure 1) and leads to a sharp reduction in the reported net income in the year of the impairment but will have no effect on future reported net income (Figure 2). The latter finding is clear evidence that the reporting of bad news is less persistent compared to the reporting of good news. Figure 1 Book values of a fixed asset under conservative accounting (Basu, 1997, p.5) Figure 2 Reported net income under conservative accounting (Basu, 1997, p.5) In the next paragraphs, possible explanations for accounting conservatism are given. 12

13 2.3. Explanations of Conservatism There are several explanations for conservatism. Watts (2003) claims that there are four conservative explanations, namely Contracting, Taxation, Litigation and Accounting Regulation, and two non-conservative explanations, namely Earnings Management and the Abandonment Option Effect, which will be described in the next paragraphs Contracting Explanation One explanation of conservatism is the contracting explanation. Due to moral hazard that arises because parties of the firm have asymmetric information, asymmetric payoffs, limited liability and limited horizons, various parties of the firm draft contracts to constrain managers to engage in activities that will harm the parties related to the firm. For example, a bank can draft a debt covenant contract before lending an amount of money to the company. When the company is in breach of a debt covenant, the bank has the legal right to withdraw the loan. As a result, the company should behave more conservative in order to retain the loan. In other words, conservatism mitigates the opportunistic behaviour exhibited by management. Another contract one can think of that leads to conservatism is the compensation contract. Due to the fact that the manager often has more information than other parties within the firm, a compensation contract can refrain the manager from exhibiting opportunistic behaviour. Moreover, the limited tenure and limited liability of the manager increases the need for contracting, to make sure the manager acts in the best interest of the shareholders. Phrased differently, contracting is simply another way of directing the manager s actions (Watts, 2003, p. 1-15) Income Tax Explanation Another explanation for conservatism is that of the income tax. The amount of tax that has to be paid by the company depends on its reported earnings. The higher the reported earnings, the higher the taxable income and consequently, the higher the tax to be paid. The link between reported earnings and taxable income creates an incentive for managers to defer or understate their income to reduce the amount of tax payable. Just like the contracting explanation, this incentive leads to the understatement of net assets and hence can be considered a form of conservatism (Watts, 2003, p. 20) Litigation Explanation Prior research finds that litigation risk under the Securities Act is more likely to materialise when a firm is overstating its assets than when a firm is understating its assets. Therefore 13

14 litigation risk is another explanation for a firm to engage in conservatism. Managers and auditors will be encouraged to understate assets in order to reduce the risk of litigation (Watts, 2003, p ) Accounting Regulation Explanation If firms overstate their assets, accounting standard setters and regulators are more likely to get negative criticism compared to when firms understate their assets. Therefore, accounting standard setters and regulators favour conservatism because this will lead to a reduction of the political costs that they will face in case of the discovery of an overstatement of assets (Watts, 2003, pp. 5, 21-22). An event that clearly depicts the extent to which the accounting regulators and standard-setters favour conservatism is shown by the fact that the Securities and Exchange Commission (SEC) during its first 30 years prohibited upward valuations of assets (Zeff, 1972, pp ). Another example of how conservatism is compelled is the enforced GAAP rules concerning revenue recognition. The revenue recognition rules require that there is a greater degree of verification needed to recognize revenues than for losses, which again is congruent with the core principle of conservatism (Watts, 2003, p. 22) Non-Conservatism Explanations Earnings management and the abandonment options are also explanations for conservatism; however they cannot be the fundamental explanation. Earnings management can be used by managers in a good way, to signal important information; however managers can also manage earnings in a bad way, to obtain personal gains. An example of bad earnings management is big bath accounting, which is when a manager understates earnings in one year in order to overstate earnings in future years. The understatement of earnings, as well as assets, is part of conservatism. However, the manager s intention is not based on prudence; the manager only understates earnings in an earlier year in order to overstate earnings in later years. The abandonment options is another conservatism explanation. Managers can abandon operations that are not profitable and this will lead to an understatement of assets. Again, the understatement of assets is part of conservatism. However, the manager s intention is not based on prudence (Watts, 2003, p. 6) Criticism of Conservatism There is a lot of criticism on conservatism in accounting. The main criticism is that conservatism is not very helpful for investors in their investment decision making since the conservatism depicts a lower firm value than the actual firm value. Conservatism therefore 14

15 leads to a gap between the firm value and the market value. By for example using historical cost accounting and by strict revenue recognition criteria, the firm s financial statements may cause the firm to be undervalued by investors Move to Neutrality Since accounting exists, conservatism, also known as prudence, has been one of the most fundamental accounting principles. Nowadays, the IASB as well as the FASB claim that conservatism should no longer be part of the conceptual framework for financial reporting. The fundamental argument they provide for this is that conservatism is inconsistent with the qualitative characteristic of neutrality. In their view more neutral accounting, hence moving to mark-to-market accounting, will lead to more useful information to investors. Fair value leads to an increase in relevance and a decrease in reliability. Relevance and reliability need to be treaded off. Nowadays, the accounting policy setters clearly try to move to more relevant financial information. Next to the views of opponents for moving away from conservatism described above, there are proponents as well. Some views of proponents are provided in the next paragraph Criticism of Neutrality Proponents for moving away from conservatism believe that moving to fair value accounting is risky because this form of accounting lacks verifiability. Moreover, it is argued that more neutral accounting will increase the opportunity for earnings management, since a lower degree of verification is asked for in contrast to historical cost accounting. Moving to neutral accounting may do more harm than good. For instance, Watts states that: successful elimination of conservatism will change managerial behaviour and impose significant costs on investors and the economy in general (2003, Synopsis). He argues that the FASB cannot afford more Enron scandals; the accounting standards setters should reconsider their move towards accounting neutrality (Watts, 2002, p. 31). Likewise, Commissioner Barnier commented on the proposals by the European Commission to reform the audit sector that the financial crisis was a reminder of how much reliable information is needed (Barnier, 2011). Conservatism has been an important principle in accounting for a long time. Therefore, one can question whether the move away from conservatism towards neutrality 15

16 will be an appropriate basis for the framework of financial reporting. For example, the only accepted change regarding derivatives is to decrease the book value. However, when moving to neutrality, are accounting standard setters going to allow companies to increase the book value of derivatives as well? This issue will be dealt with further on in this thesis. Another criticism of neutrality might be that, since financial reporting will move towards relevance, this will reduce the reliability. Reliability is hampered due to the introduction of the extensive use of judgement and estimations. The last criticism one might think of is that neutrality may release competitor sensitive information, e.g. proprietary information of a company. This might be the case when companies capitalize intangible assets at market value, the competitor can then observe the company s view of what investments are profitable. This can lead to more entrants to the market (see Chapter 6.4.) IAS 38 Intangible Assets: R&D Since February 1977 accounting standards setters are establishing and constantly changing accounting standards concerning the treatment of intangible assets. The objective of the IAS 38 is to provide guidance for the accounting treatment for intangible assets that are not specifically discussed in other IFRS. When certain criteria are met, IAS 38 requires an entity to recognize an intangible asset. The two criteria which have to be met are the following: 1) it is probable that the future economic benefits that are attributable to the asset will flow to the entity and 2) the cost of the asset can be measured reliably (History of IAS 38, 2013). The requirement applies both to intangible assets obtained externally and to those generated internally. The IAS 38 prescribes additional recognition criteria for intangible assets that are generated internally: 1) The probability of future economic benefits must be based on reasonable and supportable assumptions about conditions that will exist over the life of the asset and 2) The probability recognition criterion is always considered to be satisfied for intangible assets that are acquired separately or in a business combination (History of IAS 38, 2013). When one or both criteria are not met the specific item must be expensed when incurred 16

17 (History of IAS 38, 2013). In this thesis the focus will be on the standards concerning the accounting treatment of R&D costs. One should start to look at IAS 9: Research and Development Costs which was established on the first of July IAS 38 superseded IAS 9 on the first of July, Under the now-superseded IAS 9, the research costs had to be expensed and the development costs had to be capitalized and expensed over the periods of expected benefit. IAS 38 regarding R&D is similar to IAS 9; the research cost component should be expensed completely according to IAS 38 paragraph 54; and according to paragraph 57, the development expenses must be capitalized as an intangible asset when certain criteria have been met (IAS 38, 2012; History of IAS 38, 2013). According to IAS 38 development costs are to be capitalized only after technical and commercial feasibility of the asset for sale or use have been established. This means that the entity must intent and be able to complete the intangible asset and either use it or sell it and be able to demonstrate how the asset will generate future economic benefits [IAS 38.57]. If an entity cannot distinguish the research phase of an initial project to create an intangible asset from the development phase, the entity treats the expenditure for that project as if it were incurred in the research phase only (History of IAS 38, 2013). Initial recognition of an on-going R&D project acquired through a business combination is treated as follows: a research and development project acquired in a business combination is recognized as an asset at cost, even if a component is research. Subsequent expenditure on that project is accounted for as any other research and development cost [IAS 38.34] (History of IAS 38, 2013) Dutch GAAP: RJ210 Following the appearance of IAS38 Intangible Assets, the existing RJ210 was thoroughly revised. The amendment closely relates to IAS38, only provisions that are inconsistent with Dutch law were not adopted. Some of these provisions, which are inconsistent with Dutch law, relate to the valuation of intangible assets at fair value and the amortization of all intangible assets based on the estimated economic life. According to the amendment of RJ210 in 2001; research costs may not be capitalized anymore but must be expensed when 17

18 incurred (RJ210, 1999, p ) However, development costs must be capitalized when all the following criteria have been met: (a) the technical feasibility of completing the intangible asset so that it will be available for use or sale; (b) its intention to complete the intangible asset and use or sell it; (c) its ability to use or sell the intangible asset; (d) how the intangible asset will generate probable future economic benefits. Among other things, the enterprise should demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset; (e) the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and (f) its ability to measure the expenditure attributable to the intangible asset during its development reliably (IAS 38, 2003, p. 22) These criteria of RJ210 are exactly the same criteria according to IAS38 (IAS 38, 2003, p.22.; RJ210, 1999, pp )(see Chapter 2.7.) Other Amendments Made to Move to Neutrality Some other accounting standards that have been amended in order to make financial reporting more neutral are IAS 38 relating to intangibles assets acquired from business combinations and useful life accounting; and IFRS 3, relating to business combinations (IAS 38, 2012). The most important change regarding IFRS 3, in accordance with IAS 38 Intangible Assets, is that intangible assets that are obtained from a business combination must be recorded separately from goodwill (IFRS 3, 2012; IAS 38, 2012). The amended standard states that in-process R&D that is acquired in a business combination is recognized as an asset at cost, even if a component of the project relates to research (History of IAS 38, 2013). This amendment makes accounting less conservative, since even research costs can be translated into assets, which IAS38 does not allow for internally generated intangible assets. Therefore a lower degree of verification is needed to record the assets, which makes accounting less conservative. The other change of IAS 38 next to the changes in internally generated R&D and externally acquired R&D from a business combination is that intangible assets are allowed to have an indefinite life and therefore should not be amortized; they 18

19 should undergo a yearly impairment test. The useful life has moved from maximum 20 years to indefinite (IAS 38, 2012). Previously under the old standard, a company would have to amortize its assets while the useful life in reality might be longer than 20 years, this in turn would lead to an undervaluation of assets. This clearly indicates conservative accounting. When one would give the assets an infinite useful life, one has to periodically perform impairment testing, which leads to a book value on the balance sheet that better reflects the underlying value of the asset. These two standards are effective for Business Combinations since the first of April Managerial problem of locating R&D costs Dukes et al. (1980, p.3) state that there is a connection between decisions related to R&D and the reporting of the associated costs. When R&D must be expensed completely, reported net income will be lower. If spending on R&D will lower a company s reported net income, managers may be inclined to reduce R&D expenditures. This reduction in reported net income will have an effect on the market valuation as well as on the compensation and tenure of managers. The agency theory explains why changes in reported net income may affect the decisions taken by managers. For example, it seems as if the bond and debt covenants are part of the compensation, both are tied to reported net income, which emphasizes the importance of the reported net income for management. These two components may lead to earnings manipulation in order to obtain the adequate level of reported net income. To confirm Dukes (1980) assertions, Baber, et al (1991, p.818) find that if spending jeopardizes the ability of reporting a positive net income figure, R&D expenditure is significantly less. When development costs, which meet the specific recognition criteria, can be identified as an asset instead of an expense, the manager will be less inclined to spend less on R&D, since it does not affect the reported net income directly. Another advantage of capitalizing development costs is that this will provide more inside information to stakeholders, regarding the success that is expected of a development project to stakeholders. However, the problem which remains is that the capitalization of development costs provides a greater opportunity for earnings management (Healy, et al., 2002, p.678). The financial crisis of 2008 has raised questions about the value of audits, the independence of auditors and the quality of audit work (Sika, 2009, p.2). The Autoriteit Financiële Markten (AFM), the supervisor of the Dutch financial markets regarding savings, insurance, loans and investments (AFM, 2013), has increased pressure on the Big Four accounting firms to improve the quality of their work (Druk AFM, 2012). 19

20 To provide insight in how auditors deal with complex judgmental issues regarding R&D accounting by a client, an expert who is working for one of the big four accounting firms and deals with consultations of auditors every day, has been interviewed. He wished to remain anonymous and therefore his name, and the audit firm he is working for, will not be mentioned throughout this thesis. The remainder of this chapter consists of the results of the interview. Audit quality is the license to operate of each big four accounting firm. There is a tendency observable of auditors who are searching for assurance when it comes to complex accounting issues and to achieve this they can consult the Consultation Desk (this is a fictitious name, to ensure the anonymity of the big four office). The interviewee observes an increase in the number of consultations submitted by professionals in recent years. This has not yet been investigated; however it may have to do with the firms ambition to become the standard of excellence. The Consultation Desk can be consulted by submitting an accounting position paper to the Consultation Portal of the Consultation Desk. The issue will be laid out by the auditor, and the view of the audit team as well as that of the client is described. Next, the Consultation Desk will give their advice, which is always signed off by two employees. Auditors can request guidance when they are dealing with complex, material auditing issues. One can think for example about the issue of determining at what specific moment it is allowed to start capitalizing development costs. Specific statistics were not available at the time of the interview, however in the last few years the Consultation Desk has not been consulted often when it comes to issues regarding capitalization of development costs. This may be due to the fact that this issue is possibly not considered as material to a company. Another reason might be that the financial reporting framework for this issue already exists for many years and therefore has become common practice which may reduce the need to consult the Consultation Desk. In the years 2001 to 2004 accounting for R&D was more a hot topic than it is today. As said before, it has become common practice. In the chemical and pharmaceutical industry R&D accounting is still of great interest. When pharmaceutical companies like Pfizer, Johnson & Johnson and Roche develop an improved recipe for an existing medicine, there are often different project phases spread over several years. Only from the moment when a company receives Food and Drug Administration (FDA) approval, the product can be brought on the market. However, since there often is a significant period of time between the start of the research phase and ultimate FDA approval, the question arises at what specific moment development costs meet the criteria to be capitalized. In this period of time a lot of 20

21 development will have been done, which will meet almost all of the criteria but may not be capitalized since it is not 100% clear whether the product will actually be sold or not. Due to this legislation, many development costs are assigned to the research component and expensed through the profit and loss statement. The current accounting standards regarding the treatment of development expenses, RJ210 and IAS38, state that when a company meets the recognition criteria to capitalize, they shall capitalize the expenses and when they do not meet all the recognition criteria they shall not capitalize the costs and expense these to the profit and loss statement. It is not only important not to capitalize when recognition criteria has been met, it is also important to capitalize development costs when a company does meet all of the recognition criteria. However, a cautious auditor might focus more on whether or not the account development costs may be on the balance sheet. The auditor should also consider the research costs in the profit and loss statement and determine if these costs meet the recognition criteria and whether these expenses should be recognized as development costs on the balance sheet instead. If an audit team detects a misstatement in the draft of the financial statements of a company, for example when development costs are capitalized when the costs do not meet all the recognition criteria, a qualitative and quantitative evaluation of the error will provide insight into the impact of the error on the balance sheet. When the misstatement is material, e.g. when it can influence the decision-making process of financial statement users, the misstatement must be corrected. If the misstatement occurred in prior year(s), it must be corrected retrospectively in equity when the misstatement is fundamental, i.e. when the misstatement substantially affects the decision-making process of financial statement users. However when the misstatement is material (but not fundamental) the error will be corrected prospectively in the profit and loss statement (RJ210, 1999). 21

22 3. Research Question The theory regarding R&D provided in the prior chapter reveals that it is not certain that the current accounting standards related to R&D will contribute to the move towards neutrality. It seems that from the current accounting standards diversified incentives might emerge, which places an increase in decision-usefulness to financial statement users on an unstable ground. Therefore, these incentives might hamper the move towards neutrality. This has been the trigger to investigate in practice how and why the accounting standards related to R&D are used; and finally conclude whether the move to neutrality is reflected in actual reporting of R&D. Figure 3 consists of the Research Model which will guide us through the different research steps taken throughout this thesis. In the prior chapter the theory was described via desk research, which represents the first step of the research model. In this chapter the second step will be discussed. The second step consists of formulating a research question. The research question is formulated as follows: R&D? Is the IFRS s move from conservatism to neutrality reflected in actual reporting of The research question will be answered by first obtaining an understanding of how and why firms report their R&D expenditures in a certain way. There are two research approaches possible; the deductive approach and the inductive approach. The deductive approach reasons from general to more specific. It is also called the top-down approach since it starts off with a theory and moves its way down to the confirmation. The inductive approach however, works the other way around. It is also called the bottom-up approach since it starts with an observation and works its way up to form a theory (Trochim, 2006). Clearly, the deductive approach is appropriate for this research since it starts off with a theory. Theory Research Question Research Methodology Results Figure 3 Research Model: Step 2 In the next chapter, the research methodology will be described more thoroughly. 22

23 4. Research Methodology In the prior chapter s the first and second step of the Research Model has been described. We now arrive at the third step which consists of the research methodology, see Figure 4 below. Theory Research Question Research Methodology Results Figure 4 Research Model: Step 3 The question that arises is what method to choose for the analysis in practice. Case study research has been chosen as method over other methods, since the case study method is preferred when (a) how or why questions are being imposed, (b) the investigators has little control over events, and (c) the focus is on a contemporary phenomenon within a real-life context (Yin, 2009, p.2) Accordingly, the research does meet all the criteria for case study research. The research question will be answered by first finding out how and why managers report their R&D expenditures in a certain way. Next, the investigator has no control over the event of the reporting of the R&D numbers and lastly, it focuses on a contemporary phenomenon within a real-life context. The use of case studies helps to understand real-life events like small group behaviour and managerial processes (Yin, 2009, p.4). Figure 5 illustrates the details of the research methodology, which is the third step of Figure 4.The research methodology will consist of two case studies; AkzoNobel and Royal DSM. Case studies will be helpful in understanding a particular issue or situation in great detail and depth (Patton, 1987, p.19). Since this area has not been investigated before, case studies, e.g. qualitative research methods, will help in obtaining a deeper and more detailed understanding of the issues than only consulting qualitative research methods. The case study consists of two parts; a context analysis as well as a content analysis. The context analysis which is provided in the next chapter is in fact an introduction to the sample firms. The content analysis however, consists of two parts. First, financial statement data regarding R&D of the 23

24 sample firms will be analysed. Second, some experts from the field were interviewed to obtain a deeper understanding of the results of the financial data analysis. Figure 5 Research Methodology Model As mentioned before, to investigate the treatment of the Dutch and International standards regarding R&D two cases have been chosen. When deciding on what sample to take in order to analyze the hypotheses, it is useful to consider looking at two quite similar companies, within the same R&D intensive industry. This is because in this way almost all of the irregularities between the two companies should be filtered out; hence any differences in the treatment of IAS 38 and RJ210 should become clear. When searching for two quite similar companies that both are R&D intensive, listed and are both subject to reporting under IFRS on a mandatory basis, it seemed like a logical step to consider European companies, due to the fact that since 2005 all European listed companies must apply the IAS/IFRS standards (European Union, 2013). Consequently, the two Dutch companies Royal DSM and AkzoNobel were the first two companies that were found who met the selection criteria, and for this reason these two were chosen to be used as the sample. The sample of this research therefore consists of these two Dutch chemical companies. Since January 2005, all European listed companies must apply the IAS/IFRS standards (European Union, 2013), therefore the Netherlands is an appropriate country for investigating the effects of the amended standards of IAS 38. The selection process of the sample will be described next. A list of the top 30 R&D intensive companies of 2012 in the Netherlands, which consists of some worldwide known companies such as Phillips and Unilever and some companies which are less known such as RijkZwaan and Vanderlande Industries, was consulted in order to identify two quite similar companies (Top 30, 2012). The list consists of companies from a wide range of differing industries; from a tire manufacturer to a blood bank organization. The type of industry in which the companies operated did not play a role in determining what companies to include in the sample, as long as they operated in the same 24

25 industry. The main consideration was the extent to which they were alike as well as being globally well-known companies. The chemical companies disclosed in the top 30 R&D intensive Dutch companies are Shell (number two), Royal DSM (number four) and AkzoNobel (number eleven). Of these three companies Royal DSM and AkzoNobel are most alike since they are most similar in size; the total assets of these companies in the year 2011 are 11,157 million Euros and 19,869 million Euros respectively (Annual Report AkzoNobel, 2011; Annual Report Royal DSM, 2011, p.3). In contrast, Shell had total assets in 2012 of 345,257 million dollars, which was about 264,666 million Euros at 31 st of December 2011 (Annual Report Shell, 2011; Wisselkoersen, 2013), which places Shell on a total different level. By comparing two quite similar R&D intensive companies, one could find out whether these two companies treat the amended RJ210 and IAS 38 standards concerning R&D in a similar way. The consulted sources are as follows. The context analysis is done by consulting the website homepage of each firm, which is in fact desk research. The content analysis however, does not consist of only one consulted source. The first step of the content analysis consists of desk research as well; analysing financial data of the sample firms. The consulted sources for doing this are the database DataStream. DataStream has been chosen to collect the data from since this database has extensive financial information about European companies and the financial statements of AkzoNobel and Royal DSM for the years 2000 till RJ210 amended in 2001 and therefore, by looking at the years 2000 till 2012, one can see what the change has been since then till present time. The data has been hand collected via the websites of AkzoNobel and Royal DSM. Eventually, it should become clear whether these companies indeed started to capitalize development costs (more) after the first of July 2001, which is the effective date of the amended RJ210 standard (RJ210, 1999, p.25-26), and whether they, next to the RJ210 standard, applied the IAS 38 standard correct from the moment they started applying IFRS. The second step of the content analysis consists of interviewing experts from the field. Therefore, the last methodological approach of this thesis is the data collection from in- depth, open-ended interviews. There are three approaches of in-depth, open-ended interviews; (1) the informal conversational interview; (2) the general interview guide, and (3) the standardized open-interview (Patton, 1987, p.109). The second approach has been chosen for this research. An interview guide consists of a list of questions that are to be investigated in the interview, and it will help to make sure the same topics are covered in all the interviews. This approach has been chosen since the same topics are covered and at the same time, permits individual perspectives and experiences to evolve 25

26 (Patton, 1987, p.111). This seems appropriate because the topic has not been investigated before and therefore a thorough and detailed understanding is desired. After providing initial contact via or phone with the managers and controllers and explaining them the aim of the interviews, the actual open interviews were conducted. All interviews lasted for approximately one hour and minutes were handwritten. The interviews were then written down and sent back to the interviewees for their comments and suggestions, in order to confirm the interpretation and content of the interviews. After receiving feedback from the interviewees, any required changes were made and sent back for final approval of the interviewees. An expert in the field on consultations of complex issues who is working for one of the big four accounting firms and deals with consultations of auditors every day, has been interviewed at the 26 th of April, He wished to remain anonymous and therefore his name, and the audit firm he is working for, will not be mentioned throughout this thesis. The issues discussed were the policy of consultation, issues consulted most, judgment issues concerning R&D accounting and the rules regarding R&D itself. The knowledge gained by this interview has been implemented in Chapter 2.8. Moreover, two accounting and/or controlling experts of the two sample firms have been interviewed; Karim Safar, controller Research Development and Innovation (RD&I) Projects of AkzoNobel has been interviewed on the 13 th of May, 2013; and Peter Sampers, Senior Accounting Officer at Royal DSM has been interviewed on the 15 th of May, Some issues discussed with Karim Safar and Peter Sampers were the rules applied regarding R&D, any experiences with difficulties regarding allocating costs to research and development and whether management consults with the controller before deciding to invest in R&D projects. The knowledge gained by the latter two interviews has been embedded in Chapter 6 Content Analysis by providing quotes of the interviewees. All of the interview minutes are in hands of the author and available upon request. To strengthen the generalisation of the results from the Content Analysis, additional information was obtained from the two sample firms. The additional information was obtained to determine the extent to which investors and analysts are interested in the amount of capitalized development costs. This analysis is laid out in Chapter 8 Investors and R&D, in which the Investor Relations departments of AkzoNobel as well as of Royal DSM have been contacted. The contacted persons, Jan van den Bossche (Royal DSM) and Ivar Smits (AkzoNobel), were approached by on the 13 th and 6 th of June 2013 respectively. By comparing the AkzoNobel case with the Royal DSM case and a good comparison 26

27 can be made, one could assume that the results can be generalised. This is due to the fact that both companies apply to IFRS and are R&D intensive. Therefore it can be assumed that focusing on different companies that are specialized for example in High Tech R&D or Automotive R&D will not lead to different conclusions since the definition of R&D remains the same and they are all subject to the same R&D standards. Eventually, by consulting these different sources, it should become clear whether the sample companies indeed started to capitalize development costs (more) after the first of July 2001, which is the effective date of the amended RJ210 standard (RJ210, 1999, p.25-26), and whether they, next to the RJ210 standard, applied the IAS 38 standard correct. It will be unravelled further on in this thesis whether managers and controllers who were interviewed believe the amendment has added value to financial accounting and whether it has made financial accounting more neutral. 27

28 5. Context Analysis As you can see in Figure 6 the context analysis will be provided in this chapter. This chapter will introduce AkzoNobel and Royal DSM briefly. These companies are operating globally and are known worldwide. They are two of the main players in the chemical industry and are both very innovative. Figure 6 Research Methodology Model: Context Analysis 5.1. AkzoNobel The roots of AkzoNobel can be traced back to as early as After many years of mergers and acquisitions, in 1994, Akzo and Nobel Industries merged together to form AkzoNobel (History of AkzoNobel, 2013). AkzoNobel is one of the leading industrial companies in the world. The organization is divided into three branches; Decorative Paints, Performance Coatings and Specialty Chemicals. Decorative Paints are used in and on homes, buildings and infrastructure. Performance Coatings are coatings for, for example, cars, airplanes, boats, buildings, infrastructure, window frames, laptops, wood, pipelines and cosmetic packaging. Specialty Chemicals are crucial ingredients in everything from ice cream to asphalt, plastic to paper, and so on (Organization of AkzoNobel, 2013). The headquarter office is located in Amsterdam, the Netherlands, with 55,000 employees all over the world and it has operations in more than 80 countries. Furthermore, according to their website, they are one of the world leaders in sustainability. Some well-known brands that AkzoNobel created throughout the years are Dulux, Sikkens, Eka and International (About AkzoNobel, 2013). For more information, take a look at their website; 28

29 5.2. Royal DSM In 1902 Royal DSM started as a small coal mining company in the Netherlands. Since then, they started setting up new businesses in different areas and in 1973 the last coal mine was closed. Throughout the years, the company acquired many companies worldwide to expand its business. Royal DSM is a Dutch chemical company which is active in three branches; Health, Nutrition and Materials. Products that Royal DSM develops are for example vitamins, antibiotics, pharmaceuticals, food, dietary supplements, personal care, medical devices, food security (anti-infective solutions), automotive, paints, renewable energy, fiber optic coatings and bio-based materials. Just as AkzoNobel, the core value of DSM is sustainability. The headquarter office is located in Heerlen, the Netherlands with 23,500 employees all over the world and has operations in almost 200 countries. Most of the brands that Royal DSM created throughout the years are not well-known since most brands represent ingredients. Some examples are Arnite, CakeZyme, EcoPaXX and KhepriCoat (DSM, 2013). For further information, take a look at their website; At this point both firms have been introduced shortly. The next step is the content analysis, which will be laid out in the following chapter. 29

30 6. Content Analysis In Figure 7 one can see that we have arrived at the second analysis of the case studies, the content analysis. This chapter contains of the analysis of financial data with regard to how Royal DSM and AkzoNobel are applying the RJ210 and IAS38 standards from the years 2000 till Moreover, the open interviews with experts from the field with a controlling and/or accounting function and who work for Royal DSM and AkzoNobel will be intertwined throughout this chapter. By examining these results, a conclusion can be drawn about whether the amended RJ210 and IAS38 standards have made the accounting of these two companies less conservative. Figure 7 Research Methodology Research: Content Analysis 6.1. AkzoNobel Figure 8 below consists of the treatment of AkzoNobel s R&D costs in the years 2000 till 2012 (Annual Report AkzoNobel, ) as collected from DataStream. The three accounts investigated in are R&D Expenses, which is an item on the income statement, Capitalized Research Costs and Capitalized Development Costs. The latter are both items on the balance sheet. Capitalized research costs and capitalized development costs are both part of intangible assets of a company. By looking at these three accounts one can find out how AkzoNobel treated research and development costs throughout the years. Since the account Capitalized Development Costs is of great importance for this research, the large amount of Not Applicable (NA) for this account in Figure 8 was the trigger to hand collect the data from the annual reports as well. The hand collected data is provided in Figure 9. When amounts differed between the hand collected and database data, they are displayed in bold. When hand collecting data from AkzoNobel, an interesting account was found on the balance sheet; Preparation and Start-up Expenses, as mentioned before. Since this account might possibly be capitalized research, it is included in Figure 9. This account, however, was not available in DataStream. 30

31 When looking at Figure 9, which contains the hand collected data, you can see that AkzoNobel started capitalizing development costs in 2001 and it kept increasing from then till present day, this treatment is consistent with the revised RJ210 of On the contrary, when collecting data via DataStream, AkzoNobel capitalized in the years 2004, 2005 and Other years are not applicable (NA). This makes the data from DataStream less useful than the hand collected data. In Figures 10 and 11 the research and development costs (income statement) and the development costs (balance sheet) are depicted in a graph. Figure 10 shows the graph for the data collected from DataStream, and Figure 11 shows the data which was hand collected from AkzoNobel. In both graphs one can see an immense decline of the R&D expenses (income statement) from 2006 to There was a decline of 610 million Euros according to the DataStream data and a decline of 603 million Euros according to the hand collected data. What was the reason for this decline? We shall take a closer look at (the notes to) the financial statements to get a deeper understanding of the decline as well as to explain other changes in the three accounts. Before we analyse these large variations in the selected accounts, we derived from the financial statements what AkzoNobel stated to use as accounting policy regarding R&D and in what years they comply with Dutch GAAP and/or IFRS. This might help us to get a base understanding of the variations observed in Figure From 2000 to 2004 it is stated in the notes to the financial statements of AkzoNobel that As the financial data of AkzoNobel N.V. are included in the consolidated financial statements, the statement of income of AkzoNobel N.V. is condensed in conformity with section 402 of Book 2 of the Netherlands Civil Code (Annual Report AkzoNobel, ), therefore AkzoNobel conformed to Dutch GAAP. In the financial statements from AkzoNobel from 2005 onwards it is stated that the consolidated financial statements have been prepared in accordance with IFRS (Annual Report AkzoNobel, ),which is in accordance with the mandatory adoption of IFRS by the European Union in 2005, as well as in accordance to Dutch GAAP as far as applicable. From 2005 to 2012 it is stated in the 31

32 In millions of Euros Year R&D expenses Capitalized Research Costs Capitalized Development Costs NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA IFRS Compliance Figure 8 R&D Accounting Treatment AkzoNobel collected from DataStream In millions of Euros Year R&D expenses Capitalized Research Costs Preparation and start-up expenses Capitalized Development Costs NA NA NA NA NA NA NA NA NA NA NA NA NA IFRS Compliance Figure 9 R&D Accounting Treatment AkzoNobel hand collected from the annual financial statements financial statements as follows: the consolidated financial statements have been prepared in accordance with IFRS as adopted by the European Union, and also comply with the financial reporting requirements 32

33 included in section 9 of Book 2 of the Netherlands Civil Code, as far as applicable (Annual Report AkzoNobel, , emphasis added). RESEARCH RESEARCH & & RESEARCH & RESEARCH & RESEARCH DEVELOPME DEVELOPME & DEVELOPME RESEARCH RESEARCH & & DEVELOPME DEVELOPMENT; 2002; NT; DEVELOPME DEVELOPME 2003; NT; 2006; NT; 2001; NT; 2000; NT; 2004; NT; 2005; RESEARCH & DEVELOPMENT RESEARCH RESEARCH RESEARCH & & DEVELOPME DEVELOPME DEVELOPMENT NT; 2008; NT; 2007; NT; NT; ; 2010; 2011; 2012; COSTS - NET DEVELOPME DEVELOPME DEVELOPME DEVELOPME DEVELOPME DEVELOPME DEVELOPME DEVELOPME DEVELOPME NT COSTS NT COSTS - NT COSTS - NT COSTS - NT COSTS - NT COSTS - NT COSTS - NT COSTS - NT NT COSTS NET; 2000; NET; 2001; NET; ; NET; ; NET; ; NET; ; NET; ; NET; ; 5 NET; 2008; 02009; 2010; 2011; 2012; 0 0 Figure 10 Relationship R&D Expenses and Capitalized Development Costs AkzoNobel (DataStream) RESEARCH RESEARCH & & RESEARCH & RESEARCH DEVELOPME & RESEARCH DEVELOPME & DEVELOPME RESEARCH RESEARCH DEVELOPME & & NT; 2002; DEVELOPME NT; DEVELOPME 2003; DEVELOPME NT; 2006; NT; 2001; 912 NT; 2000; 887 NT; 2004; NT; 2005; RESEARCH & DEVELOPMENT RESEARCH & DEVELOPMENT RESEARCH & DEVELOPME RESEARCH COSTS DEVELOPME & NT; - NET 2012; DEVELOPME NT; NT; 2008; 2009; 2010; 2011; 387 NT; 2007; DEVELOPME DEVELOPME DEVELOPME DEVELOPME DEVELOPME 282 DEVELOPME NT NT COSTS COSTS - DEVELOPME DEVELOPME DEVELOPME DEVELOPME DEVELOPME NT COSTS NT COSTS - NT COSTS - NT COSTS NT NET; NET; - COSTS 2011; 2012; - - NT COSTS NT COSTS - NT COSTS - NT COSTS - NT COSTS - NET; - NET; 2005; NET; 2006; NET; 2007; NET; 2008; ; 2010; NET; NET; 2000; NET; 2001; 0 NET; 2002; 6 NET; 2003; ; Figure 11 Relationship R&D Expenses and Capitalized Development Costs AkzoNobel (Hand collected) In the summary of significant accounting policies of the financial statements of 2001 of AkzoNobel it is stated that The Company used to expense development costs as incurred. In accordance with the new accounting standard development costs are to be capitalized, starting in 2001, if certain conditions are met. These conditions relate to the (technical) ability and intention to complete and use the intangible asset, and the probability of future economic benefits generated by this 33

34 asset (Annual Report AkzoNobel, 2001, p. 64). This explains why AkzoNobel started capitalizing R&D expenses from 2001 on in the hand collected data. The new accounting standard they refer to must be the revised RJ210; therefore the accounting treatment of R&D has been implemented correctly. However, it would have been more complete if all the criteria had been described, since AkzoNobel does not mention all of them; for instance, the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset and its ability to measure the expenditure attributable to the intangible asset during its development reliably (RJ210, 1999, p ), none of them are mentioned. Moreover, from 2001 till 2005 it is declared that development costs are capitalized if it is probable that sufficient future economic benefits will be generated by the intangible asset arising from development, and amortized on a straight-line basis over the estimated useful life, which in the majority of cases is 5 years (Annual Report AkzoNobel, , emphasis added), which is in accordance with the revised RJ210. Again, not all the criteria are laid out by AkzoNobel in the financial statements, only the criteria of future economic benefits is mentioned. In 2006 the notes related to development costs were expanded into the following text: Development costs are capitalized if costs can be measured reliably, the product or process is technically and commercially feasible and sufficient future economic benefits will be generated, and the company has sufficient resources to complete the development. Capitalized development costs are amortized on a straight-line basis over the estimated useful life, which in the majority of cases is 5 years (Annual report AkzoNobel, 2006, emphasis added). In this year, AkzoNobel mentions four out of six criteria as required by RJ210. In 2007 the text is the same as in 2006 and was expanded with what development expenditures exist of 34

35 The expenditures capitalized include the cost of materials, direct labour, and overhead cost that are directly attributable to preparing the asset for its intended use (Annual report AkzoNobel, 2007). This text stays the same till In 2011 however, the text is expanded again: Development and software costs are capitalized if the costs can be measured reliably, the related product or process is technically and commercially feasible, sufficient future economic benefits will be generated and sufficient resources are available to complete the development. The expenditures capitalized include the cost of materials, consultancy, licenses, direct labour and overhead costs that are directly attributable to preparing the asset for its intended use. Capitalized development and software costs are amortized on a straightline basis over the estimated useful life of related assets, which generally is up to five years (Annual Report AkzoNobel, 2011, emphasis added). This text is also the same text as in implemented in the notes of the annual report of 2012 (Annual Report AkzoNobel, 2012). One could wonder whether AkzoNobel did not consider the two criteria that they did not mention. According to Karim Safar, controller Research, Development & Innovation (RD&I) Projects of AkzoNobel, the company uses an internal accounting standard manual; the Financial Economic Manual (FEM). This manual is based on IFRS and the usage of this manual is mandatory in AkzoNobel worldwide. Figure 12 is an extract from the FEM about the recognition of R&D, provided by Karim Safar by on the 15 th of May Clearly, it seems that AkzoNobel does apply the correct criteria as in RJ210 and IAS38, as described in Chapter 2.6. and 2.7., even though not all the criteria are mentioned in the annual report (Annual Report AkzoNobel, 2001, p.64). Karim Safar is responsible for the reporting of the R&D costs. AkzoNobel consist of a matrix organization with nine business units which all report R&D financials to Karim Safar, who consolidates all accounting numbers. Reasonableness checks are performed by him on the provided information and he stays in contact with the business units controllers, which makes it easier to know what is going on. However, Karim Safar states that he does not pay much attention when it comes to the capitalization of development costs. He trusts the controllers of the business units to know what they are doing, since they are professionals and 35

36 adhere to the FEM. Karim Safar is on the controlling side; he analyses and subsequently generates information. The persons who report information to him are more on the accounting side; they are more skilled in testing the accounting standards. Recognition of R&D Assets For internally generated intangibles only development cost can be capitalized. It is therefore important to distinguish between expenditures incurred during the research phase and expenditures incurred during the development phase. If it is not possible to distinguish the research phase from the development phase of a project, all the costs are expensed as incurred. Internally generated brands, publishing titles, customer lists and other similar items are not capitalized and not recognized as an intangible asset. Research Research is defined as (planned) investigation undertaken to gain new scientific or technical knowledge and understanding. Normally in the research phase it cannot be demonstrated that an intangible asset exists that will generate future economic benefits. For this reason expenditure in the research phase cannot be capitalized and is expensed as incurred. Development Development is the application of research findings or other knowledge in order to produce new or substantially improved materials, devices, products, processes, systems or services. The target of these expenditures is to come to commercial production or use. Capitalization criteria Expenditures in the development phase should be capitalized as an intangible asset if all the following additional criteria are met: 1) it is technically feasible to complete the asset so that it will be available for (internal) use or sale; 2) The intention is to complete the intangible asset for (internal) use or sale; 3) The entity is able to use or sell the intangible asset; 4) The entity can demonstrate how the intangible asset will generate future economic benefits (e.g. existence of a market); 5) Adequate technical, financial and other resources are available to complete the project and to use or sell the intangible asset; and 6) The expenditure attributable to the development of the intangible asset can be measured reliably. Expenditures related to intangible assets that were previously expensed may not subsequently be recognized as part of the intangible asset. Figure 12 Extract from the Financial Economic Manual (FEM) of AkzoNobel Another thing that is of interest is what one can derive from the annual report of The company capitalized preparation and start-up expenses. Unfortunately this data is not available in DataStream; however it is available when hand collecting it (see Figure 9). In the annual report of 2001 and onwards we do not see this account anymore on the balance sheet. 36

37 This change is explained in the 2001 annual report: The company used to capitalize preparation and start-up expenses of large investment projects and amortize these on a straight-line basis over the estimated useful lives of the facilities, after they had been put into service. In line with the new standard, preparation and start-up expenses are charged to income as incurred. Application of the new standard to 2000 resulted in operating income and net income being, respectively, EUR 7 million and EUR 5 million lower, compared with the amounts reported previously (Annual Report AkzoNobel, 2001). Are these capitalized preparation and start-up expenses actually capitalized research expenses? If this is the case, AkzoNobel is referring to the amended RJ210 in 2001, which states that research costs may not be capitalized anymore but must be expensed when incurred (RJ210, 1999, p.25-26), and subsequently treats this amendment correct. As one can see, this amendment has had a huge impact on the operating income and net income. Karim Safar explains that in the time that preparation and start-up expenses were recognized on the balance sheet, he was not working for AkzoNobel yet. He expects that this account was recognized by the Pharma business (Organon) which was sold to Shering-Plough in This sale of the Pharma business resulted in the fact that the largest part of the employees (including Finance employees) of the Pharma business were also taken over by Shering- Plough. To find out whether the preparation and start-up expenses were indeed capitalized research costs is difficult due to the fact that the Pharma business was taken over in 2007 and has been taken over again. Next, let us have a look at what the large drop caused in the development costs account from 2006 to The text on the front page of the financial statements of 2007 may be related to this drop; Year of Transformation is written on the front page. AkzoNobel states that they are bigger, stronger, and more focused : We are now not only the largest global industrial coatings manufacturer, but also the number one in decorative paints, as well as being a major worldwide supplier of specialty chemicals (Annual Report AkzoNobel, 2007). Karim Safar explains that the reason for this large drop is that the Pharma Business was sold in that time. Before 2006 AkzoNobel consisted of three divisions; Coatings, Chemicals and 37

38 Pharma. Decorative Paints in that time was so small that it was not recognized as a business on its own. After Pharma was sold, which was one third of all businesses, AkzoNobel s businesses consisted as it is today; Performance Coatings, Specialty Chemicals and Decorative Paints. Decorative Paints became a business on its own because ICI, which was a major competitor in Paints of AkzoNobel, was bought at that time. Figures 9 and 11 show that AkzoNobel started to capitalize development costs in From 2001 till 2012 the capitalized development costs rose from 6 million Euros to 166 million Euros. One could wonder whether the rise in capitalized development costs was attributable to the amendment in 2001 of RJ210. However, Karim Safar explains that these capitalized development costs mainly consist of software costs as well as of REACH proceedings. REACH is the process of identifying and categorizing the properties of chemicals. This identifying and categorizing is done by R&D employees on account of their technical knowledge, however this process is not really part of the core R&D (R&D for new or improved products and processes). The explanation for the rise in development costs is probably caused by the implementation of the operational excellence program Dynamo in the year 2011; many business units and corporate functions started to automate their processes better, which caused the rise of expenditure for software development and implementation time. AkzoNobel is striving for stability in the R&D expenses. According to Karim Safar, 99 percent of all the R&D costs are expensed. R&D is a normal on-going process and is a core activity of AkzoNobel and therefore any possible tax advantages that one will get by capitalizing development costs is not the primary objective for AkzoNobel. Of course it is something to take into consideration; however it is not something to steer on. Capitalizing development costs is partly based on judgment and therefore AkzoNobel is conservative when it comes to capitalizing development costs. Most of the time development costs are expensed rather than being capitalized. Nowadays AkzoNobel s goal related to R&D expenditure is to allocate 2.5 percent of the turnover to R&D projects. As explained in Chapter 2.8. there is a lot of complexity and judgment present in determining what part of R&D has to be allocated to research and what part to development when for instance, FDA approval has to be obtained, which is especially common practice in the pharmaceutical area. Is this also the case for AkzoNobel? For some business units of Performance Coatings a similar kind of formal approval is needed. Especially for the automotive and aerospace business units, which are specialized in refinish, approval is needed. However, this is quite different compared to the (FDA) approval process for 38

39 medicines since the approval for Performance Coatings will not take as many years as is the case with pharmaceuticals. At AkzoNobel, some sorts of ISO-Audits are performed at the Performance Coating area. In this ISO-Audit the production process is considered. This approval process does not lead to any experienced difficulties with locating research and development to the correct account, since the approval process is relatively short and 99% of all the R&D costs are expensed anyway. Problems might have surfaced in the Pharma area of AkzoNobel which was sold in 2007; however Karim Safar was not working for AkzoNobel at that time, consequently this information is unfortunately not available AkzoNobel and the R&D Accounting Standards There are some guidelines throughout AkzoNobel worldwide, which are really embedded in the DNA of AkzoNobel. One of these guidelines is that every investment and every financial decision which has effect on the outside world must be signed by two people, who are generally the responsible manager and his controller. This is internally referred to as the Dual Signature Rule. Therefore, the controller is involved in the decision-making process for investments in R&D projects. Controllers often describe their role differently, but at AkzoNobel, the controller is often seen as business partner of the management team, as the financial expert who helps to decide what good investment decisions are. Nevertheless, according to Karim Safar, management is not guided by accounting rules. Tax benefits can be taken into consideration during the planning of R&D investments (e.g. where do we want to open a new lab), but this is often only one of the many aspects to be considered, in addition to proximity of business units, access to talent, access to universities, etcetera. For each R&D project the most decisive items that are considered are the utility for the current product/process portfolio and the fit with AkzoNobel s strategy. Accounting rules will have no effect on the decision-making process for R&D investments; no more or less money will be spent on R&D because of the possibility to capitalize development costs. According to Karim Safar, the amendment of RJ210 did not have an effect on AkzoNobel s attitude towards R&D. The amendment will not have any positive nor negative effects. This is the case because R&D and Innovation is a normal on-going business for AkzoNobel, it is a core activity. He does agree that when something is attractive to invest in due to tax advantages, companies may want to take this advantage. However, AkzoNobel does not focus on tax advantages when deciding on R&D investments. Moreover, the amendment is not expected to have any effect on the share price of 39

40 AkzoNobel. Investors are more interested in Key Performance Indicators (KPI s) regarding the input and output of R&D than in capitalized R&D costs. Capitalized costs will only lead to short-term benefits which is not that interesting for the investor. Investors would be more interested in what the balance of R&D investments is, divided in short-term and long-term. One example of a KPI that is of interest for the investors is the ratio Research and Development Major Projects as a percentage of R&D Expenses. As one can see in the Annual Report of AkzoNobel of 2012, on the second page there is a summary page called Summary at Glance, which shows some important ratio s. One of these ratio s is the ratio just mentioned, which shows that in percent of all R&D expenses were allocated to major R&D projects (see Figure 13), which is exactly the target of AkzoNobel according to Karim Safar (Annual Report AkzoNobel, 2012, p. 2). Clearly, AkzoNobel has been very effective in achieving its targets regarding R&D in Figure 13 was obtained from the Annual Report 2012 of AkzoNobel. Figure 13 KPIs related to R&D of AkzoNobel: R&D Major Projects as % of R&D expenses In the remainder of this chapter the accounting treatment regarding R&D of Royal DSM will be examined. 40

41 6.3. Royal DSM Figure 14 below contains data on Royal DSM s R&D costs for the years 2000 till 2012 (Annual Report Royal DSM, ) as collected from DataStream. The three accounts investigated are R&D Expenses, which is an item on the income statement, Capitalized Research Costs and Capitalized Development Costs. The latter two are both items on the balance sheet. Capitalized research costs and capitalized development costs are both part of the intangible assets of a company. By examining these three accounts one can find out how Royal DSM treated research and development costs throughout the years. Since the account Capitalized Research Costs is of importance for this research, the large amount of Not Applicable (NA) for this account in Figure 14 was the trigger to also hand collect the data from the annual reports. The hand collected data is provided in Figure 15. When amounts differed between the hand collected and database data, they are displayed in bold. When hand collecting data from Royal DSM, an interesting account was found on the balance sheet; Preparation and Start-up Expenses. Since this account might possibly be capitalized research, it is included in Figure 15. This account, however, was not available in DataStream. When examining Figure 14 which contains the data collected from DataStream, one can see that DSM started capitalizing development costs in 2009 and kept capitalizing from then till present day. This treatment is consistent with the revised RJ210 of In Figure 16 the research and development costs (income statement) and the development costs (balance sheet) are depicted in a graph as collected by DataStream, since the data derived by hand were not so clear. In this graph one can see a drop of the R&D expenses (income statement) from 2009 to There was a decline of 79 million Euros according to the DataStream data (see Figure 14) and a decline of 69 million Euros according to the hand collected data (see Figure 15). What was the reason for this decline? We shall take a closer look at (the notes to) the financial statements to get a deeper understanding of the recognised decline as well as to explain other changes in the three accounts. Before we analysed these differences in the selected accounts, we derived from the financial statements what Royal DSM stated to use as accounting policy regarding R&D and in what years they complied with Dutch GAAP and/or IFRS,. This could help to get a basic understanding of the differences observed in Figure From 2000 till 2012 Royal DSM applied Dutch GAAP as is stated in the financial statements as follows: 41

42 In millions of Euros Year R&D expenses Capitalized NA NA NA NA NA NA NA NA NA NA NA NA NA Research costs Development Costs (DataStream) IFRS compliance Figure 14 R&D Accounting Treatment Royal DSM collected by DataStream In millions of Euros Year R&D expenses Capitalized NA NA NA NA NA NA NA NA NA NA NA NA NA Research costs Pre-operating and start-up expenses Development Projects IFRS compliance Figure 15 R&D Accounting Treatment Royal DSM hand collected In conformity with Book 2 of the Dutch Civil Code, article 402, a condensed statement of income is included in the Royal DSM N.V. accounts (Annual Report Royal DSM, ). 42

43 RESEARCH RESEARCH & RESEARCH & RESEARCH & DEVELOPMENT; DEVELOPMENT; DEVELOPMENT; RESEARCH & 2008; 2009; RESEARCH & 2007; 372 RESEARCH 2011; 2012; & RESEARCH RESEARCH & DEVELOPMENT; & RESEARCH DEVELOPMENT; & RESEARCH RESEARCH & DEVELOPMENT; & DEVELOPMENT; DEVELOPMENT; 2006; 327 DEVELOPMENT; 2001; DEVELOPMENT; 2010; DEVELOPMENT; 2004; ; 289 RESEARCH & 2000; ; ; 268 DEVELOPMENT DEVELOPMENT COSTS - NET DEVELOPMENT DEVELOPMENT DEVELOPMENT DEVELOPMENT DEVELOPMENT DEVELOPMENT DEVELOPMENT DEVELOPMENT DEVELOPMENT DEVELOPMENT COSTS - NET; COSTS COSTS - NET; COSTS - NET; COSTS - NET; COSTS - NET; COSTS - NET; COSTS - NET; COSTS - NET; COSTS - NET; - NET; 2009; ; 2011; 2012; ; 02001; 02002; 02003; 02004; 02005; 02006; 02007; 02008; 0 Figure 16 R&D Expenses and Capitalized Development Costs Royal DSM (DataStream) In Royal DSM s financial statements from 2005 till present day it is stated that the consolidated financial statements have been prepared in accordance with IFRS (Annual Report Royal DSM, ), which is in accordance with the mandatory adoption of IFRS by the European Union in 2005 (European Union, 2013). From 2005 to 2012 it is stated in the financial statements as follows: DSM s consolidated financial statements have been prepared in accordance with International Financial Reporting Standards (IFRS) as adopted by the European Union (Annual Report Royal DSM, ). Accordingly, it can be assumed that DSM has applied IFRS as well as Dutch GAAP from 2005 till In the accounting policies of the financial statements of 2000 and 2001 of Royal DSM it is stated that Research and development expenses are charged to the operating profit in the period in which they are incurred (Annual Report Royal DSM, ). In 2002 till 2003 it is stated that Research expenditure is charged to income in the period in which it is incurred. Internal development expenditure is charged to income in the period in which it is incurred unless it meets the recognition criteria of IAS 38 Intangible Assets (Annual Report Royal DSM, ). 43

44 In 2004 the following text had been added related to the accounting treatment of R&D: Where the recognition criteria are met, development expenditure is capitalized and amortized over its useful life from the moment the product is launched commercially (Annual Report Royal DSM, 2004). In 2011 the text related to the accounting treatment of R&D is extended again: Development expenditure is capitalized if the recognition criteria are met and if it is demonstrated that it is technically feasible to complete the asset, that the entity intends to complete the asset, that the entity is able to sell the asset, that the asset is capable of generating future economic benefits, that adequate resources are available to complete the asset and that the expenditure attributable to the asset can be reliably measured (Annual Report Royal DSM, 2011, emphasis added). One can draw the following conclusions from these disclosed accounting treatments. Firstly, in 2000 Royal DSM was allowed to capitalize its research costs according to Dutch GAAP (RJ210, 1999), however they did not do this. Secondly, from 2001 on, RJ210 restricted to capitalize research costs and allowed to capitalize development costs when certain criteria had been met. Royal DSM disclosed this treatment from 2002 till present; however they only started to capitalize development costs since The question that arises is why they started to capitalize development costs in 2009 when they were already allowed to capitalize as early as Thirdly, Royal DSM started to disclose the recognition criteria which have to be met if development costs are to be capitalized in The recognition criteria mentioned in the financial statements are complete and in accordance with the revised RJ210 and therefore, also with IAS 38. By interviewing an expert from the field the incentives behind the R&D treatment of Royal DSM will become clear. First, the reason for the delayed capitalizing of development costs will be investigated. Peter Sampers, Senior Accounting Officer of Royal DSM in Heerlen has been interviewed on the 15 th of April He is responsible for all accounting policies and external financial reporting of Royal DSM N.V. Moreover, he is a professor in Financial Accounting at the University of Maastricht and he gives advice to accounting standard setters. The reason for Royal DSM starting to capitalize development costs in 2007 instead of 2001 appears to be that Royal DSM started to strengthen its policy regarding 44

45 accounting rules with the introduction of IFRS in From 2005 to 2007 they have struggled with one of the recognition criteria; its ability to measure the expenditure attributable to the intangible asset during its development reliably for capitalizing development costs (see Chapter 2.8.). They had to figure out how to reliably measure the costs and how to integrate the recognition criteria in the accounting systems and processes. The R&D process of Royal DSM is classified into different stages. In Figure 17 the process Royal DSM uses when determining at which phase an R&D project is at the moment, is depicted. This process is called the Project Management Process (PMP), which is divided into five phases. Figure 17 PMP Process at Royal DSM The phases are the following: Idea Evaluation Phase, Business Feasibility Phase, Development Phase, Scale-up and Validation Phase and lastly the Implementation and Transfer to Running Business Phase. The PMP consists of five decision points as well; Initial Screening, Decision to Develop, Decision to Scale-up, Decision to Launch and lastly Final Review. Only from Decision to Develop (from phase two to three) till Decision to Launch (from phase four to five) development costs can be capitalized, provided that all the recognition criteria have been met. The PMP is not an entirely unique process. Philips, where Peter Sampers had been employed previously, applied similar phases to differentiate between research and development. Currently, Royal DSM has a portfolio of about 150 projects. Only if a project is identified as material, that is the project costs amount to five million Euros or more, the controllers will use the PMP to differentiate between research and development. Finally, after 45

46 determining whether the development part meets the recognition criteria, development costs can be capitalized. However, when a project is not material, both research and development costs are simply expensed when incurred. Since the company has so many projects, looking at every project individually will be an extremely timely process. Therefore, some joint projects are considered together to differentiate between research and development. Every capitalization needs its own approval of group controlling. According to Peter Sampers, Royal DSM is quite conservative when it comes to capitalization of development costs because of impairment risk. When management is considering investing in R&D, the policy at Royal DSM is as follows: when examining the PMP in Figure 17, every orange diamond represents a decision point in which management, together with the controllers, make a decision. In other words, PMP is actually a decision-making and communication process as well. The PMP defines the different phases well and therefore Peter Sampers has not really experienced difficulties determining what part should be allocated to research and what part should be allocated to development. Most R&D was attributable to the Nutrition business of Royal DSM in However, in all four businesses one can find plenty of R&D. There is also a fifth business; Innovation Center. This business focuses on new areas where Royal DSM is not active yet. One can think of new markets, new products and new regions. This is why this business has got more R&D expenses than profit. Another thing that is of interest is what one can derive from the annual report of The company capitalized pre-operating and start-up expenses. Unfortunately this data is not available in DataStream; however it is available when hand collecting it. In the annual report of 2001 and onwards we do not see this account reflected on the balance sheet anymore. This change is explained in the 2001 annual report: Pre-operating and start-up expenses relating to major investment projects, which used to be capitalized and amortized over a period of six years, are now immediately charged to the operating profit, except when they relate to the construction and start-up of new plant, in which case they are capitalized as part of the cost of the plant concerned (Annual Report Royal DSM, 2001, p.51). Are these capitalized preparation and start-up expenses actually capitalized research expenses? If this is the case, Royal DSM is referring to the amended RJ210 in 2001, which states that research costs may not be capitalized anymore but must be expensed when 46

47 incurred (RJ210, 1999, p.25-26), and they subsequently treat this amendment incorrect. According to Peter Sampers, these costs are not capitalized research costs. The account contains costs related to the initial costs made in the start-up phase of new factories. Next, let us have a look at what caused the drop in the development costs account from 2009 to 2010 (see Figure 14 and 15). The reason for this large decline is that part of the business was sold in 2009, according to Peter Sampers. When examining the financial statements of 2009 the statement of Peter Sampers is confirmed. However, it might as well be related to the financial crisis: A substantial part of our business was heavily impacted by the economic downturn that swept across the world... In the second half of 2009 we completed the disposal of our area licensing and energy businesses (Annual Report Royal DSM, 2009, Letter from the Chairman). In 2010 AkzoNobel adopted a new strategy to focus more on R&D, which caused the R&D expenses to increase again (see Figure 16). The new strategy is named Driving Focused Growth (Annual Report Royal DSM, 2010, p.2), which aims to utilize innovation as growth driver. As explained in Chapter 2.8. there is a lot of complexity and judgment present in determining what part of R&D has to be allocated to research and what part to development when for instance, FDA approval has to be obtained, which is especially common practice in the pharmaceutical area. Is this also the case for Royal DSM? For pharmaceuticals and dietary supplements, approval is definitely necessary. In the United States Royal DSM has to obtain FDA approval. However, Peter Sampers explains that Royal DSM is not a developer of new pharmaceuticals; therefore they do not have to wait very long for approval. This makes it possible to determine with some certainty, already prior to the approval, that a product may be sold in the market. This allows Royal DSM to put some development costs on the balance sheet even before approval is received Royal DSM and the R&D Accounting Standards According to Peter Sampers, Royal DSM determines the amount of R&D expenditure based on their strategy and the opportunities they see in the markets. Accounting does not play a decisive role in this and any changes in accounting standards have never changed their decisions made. However, he also states that he believes that managers decisions will be affected by accounting standards. Management will have bonus incentives tied to the amount of Earnings Before Interest Tax Depreciation and Amortization (EBITDA) reported. The controlling department tries not to give management incentives by taking a conservative approach 47

48 towards capitalizing development costs. Once the controlling department will capitalize a lot of development costs, this can give management the incentive to spend more on R&D. The higher proportion capitalized development costs will lead to a higher EBITDA and therefore the company will look better on paper than it actually is. The amendment of RJ210 has been relatively unimportant for Royal DSM. There are no observable significant effects on the company. Peter Sampers believes that it is more important to explain to investors how much is spent on R&D in total and how much profit it generated through R&D investments. Therefore, investors will be more interested in the core KPI s of Royal DSM; total R&D as percentage of Net Sales and Innovation Sales (Annual Report Royal DSM, 2012, p.21). Figure 18 shows the KPI Innovation Sales as percentage of Continuing Sales. Eighteen percent of continuing sales contained Innovation Sales in Figure 19 depicts the other core KPI; total R&D as percentage of Net Sales. R&D expenditures amounted to 5.4 percent of net sales in Figures 18 and 19 are obtained from the Annual Report 2012 of Royal DSM. Moreover, investors have never asked Peter Sampers about the amount of capitalized development costs. The fact that investors appear not to be that interested in capitalized development costs, leads to the believe that the amendment will not have any effect on the share price of Royal DSM. Investors will be interested in the total R&D expenditure, Innovation Sales, and the eventual increase of cash flows due to R&D activities. When asking Peter Sampers whether he believes the amendment of RJ210 has indeed made financial reporting more neutral (less conservative), an interesting conversation took off. In practice, the adaption of the standard did not lead to an increase in comparability. The amendment does not lead to more neutral accounting due to the fact that it relies to a large extent on management judgment. It might be better to expense all R&D costs and make no distinction between research costs and development costs. This would give a better insight in the cash flows. Furthermore, when capitalizing development costs, these costs will be represented as intangible assets. However, these intangible assets represent the costs and not the market value of the underlying asset. Over the years, more and more intangible assets are visible on the balance sheets of companies, due to the move from a manufacturing-based to service-based world (see Figure 20, as obtained from Peter Sampers via ). 48

49 Figure 18 KPI related to R&D of Royal DSM: Innovation Sales Figure 19 KPI related to R&D of Royal DSM: Total R&D Expenditure as % of Net Sales It is therefore understandable that the accounting standard setters are allowing to capitalize more and more intangible assets. However, what would make it even better is when the market value instead of the costs of the intangible assets is capitalized. Only, the problem with this is that this information will be competition sensitive. The competitor can then observe your view of what investments are profitable. This can lead to more entrants to the market. Another disadvantage of using market values is that when capitalizing intangible assets at the market value, this is still subject to estimations and judgment. The result is that accounting will move towards relevance and away from reliability. The trade-off between reliability and relevance within accountancy appears to be a persistent problem. 49

50 Figure 20 Move from Tangible Assets to Intangible Assets The next chapter will provide a comparison of the two cases. 50

51 7. Comparison AkzoNobel and Royal DSM When comparing the AkzoNobel case with the Royal DSM case one can find many similarities, as well as some differences, in the treatment of R&D accounting. The similarities will be discussed first. Both firms apply IAS38 as well as RJ210 correctly in the selected years. Neither experienced any significant difficulties when determining what part of R&D expenses should be allocated to research and what part should be allocated to development, as well as with determining whether development costs meet all the recognition criteria, in order to be allowed to be capitalized. Only Royal DSM indicated that they experienced some difficulties implementing one of the recognition criteria (see Chapter 2.7 and 2.8.) to capitalize development costs correctly in their accounting systems and processes. Another similarity is that both firms financial statements before the first of July 2001 include less capitalized development costs than the financial statements after the first 2001, which is the effective date of the change in RJ210. In other words, both firms utilize the amendment, since they both started to capitalize development costs. However, they both acknowledge that they are conservative when it comes to capitalizing development costs. The reason that AkzoNobel provides for this is that development costs are partly based on judgment and they are striving for stability in the R&D expenses. They acknowledge that firms may be tempted to capitalize development costs due to favourable income tax effects. AkzoNobel takes these tax effects into consideration, but indicates that it is not something they base decisions on. The reason Royal DSM provides is that managers decisions will be influenced by accounting standards. Management will have bonus incentives tied to the amount of EBITDA reported. The controlling department tries not to give management incentives by taking a conservative approach towards capitalizing development costs. Once the controlling department will capitalize a lot of development costs, this could give management the incentive to spend more on R&D. The higher capitalized development costs will lead to a higher EBITDA and therefore the company will look better on paper than it actually is. The third similarity is that both interviewees of the firms believe that the amendment of RJ210 did not affect the firm. The reason for this is that investors are more interested in R&D KPI s than in capitalized development costs. Another reason for why the amendment did not affect the firm that was provided by AkzoNobel was the following; they are keeping their R&D expenses stable, and therefore this amendment will not be the trigger to capitalize more development costs. Consequently, from both case studies one can draw the conclusion that the amendment had no effect on the share price of the two sample firms. 51

52 Next, let us take a look at the differences observed. Clearly, as stated above, there is a difference between the observed conservative explanations of AkzoNobel and Royal DSM. AkzoNobel recognized the income tax explanation (see Chapter ) and Royal DSM recognized the contracting explanation (see Chapter ). When it comes to conservatism, one might wonder whether AkzoNobel and Royal DSM are aware of the fact that it is not only important not to capitalize when recognition criteria have been met, it is also important to capitalize development costs when a company does meet all of the recognition criteria. This because the current accounting standards regarding the treatment of development expenses, RJ210 and IAS38, state that when a company meets the recognition criteria to capitalize, they shall capitalize the expenses and when they do not meet all the recognition criteria they shall not capitalize the costs and expense these through the profit and loss statement (see Chapter 2.9.). Royal DSM for instance, only distinguishes between research and development costs when a project is material (five million Euros or more). After determining whether the development part meets the recognition criteria, development costs can be capitalized. However, when a project is not material, both research and development costs are simply expensed when incurred. It is understandable that due to the fact that Royal DSM has so many projects, looking at every project individually will be an extremely timely process. However, they should be aware of the fact that a company must capitalize development costs when the recognition criteria have been met. The third difference observed is that AkzoNobel appears to capitalize much more and a lot earlier in the selected year s development costs than Royal DSM does. This difference is depicted in Figure 21. However, it must be mentioned that most of AkzoNobels capitalized development costs consists of software costs, which cannot be recognized as a core R&D activity. Data of this figure was obtained from Figure 9 and the Figures 15, which contains the hand collected data from both firms. 52

53 Akzo Nobel Royal DSM Figure 21 Comparison Capitalized Development Costs (in millions of Euros) After comparing the sample firms with each other, one might draw the conclusion that both companies seem to believe that analysts and investors are not that interested in the amount of capitalized development costs. In the next chapter, the views of analysts and investors will be laid out by gaining information from the Investor Relations department of AkzoNobel as well as Royal DSM. 53

54 8. Investors and R&D As mentioned by both AkzoNobel as well as Royal DSM, investors might not be so interested in the amount of development costs that are being capitalized by a company. Investors would be more interested in R&D related KPI s. To find out whether this is really the case, the Investor Relations departments of AkzoNobel as well as of Royal DSM have been contacted via on the 13 th and 6 th of June 2013 respectively. The contact person of Royal DSM, Jan van den Bossche, Manager Investor Relations, confirmed the feeling that investors and analysts are hardly interested in capitalized development costs compared to other measures. However, he expects that when capitalized development costs become a significant part of intangible assets on the balance sheet, investors and analysts will eventually ask questions about it. A high amount of capitalized development costs leads to a higher reported operating profit, compared to the situation where these costs are expensed immediately. However, at Royal DSM, this balance sheet item is very small and Jan van den Bossche has not had any analyst or investor so far who has asked him about capitalized development costs. When it comes to intangible assets analysts usually ask about goodwill and other intangibles. Questions related to R&D to Sales ratio and how R&D is being managed (priorities, cut-offs to progress to next phase) are frequently asked questions by investors and analysts. Another question that has been asked concerns future expected sales and the margin Royal DSM expects to obtain from the innovations. Investors (shareholders) want to know of course how (eventually their) money is being managed. Moreover, Jan van den Bossche provided some research reports of some banks of Royal DSM that confirm that analysts are not that interested in capitalized development costs. The question that arises is whether AkzoNobel s contact person will have different answers since capitalized development costs of AkzoNobel are a greater part of the total intangible assets. In comparison to Royal DSM, AkzoNobel s capitalized development costs consisted up to 3.73 (166/4,454) percent of total intangible assets (Annual Report AkzoNobel, 2012) and for Royal DSM this was 0.63 (24/3,811) percent in 2012 (Annual Report Royal DSM, 2013). The current manager at AkzoNobel has just started working for the firm and is therefore not yet in the position to answer questions regarding investors and R&D. Therefore, the former manager of the Investor Relations department, Ivar Smits, has been contacted by Karim Safar by phone, the information he obtained was provided by . The former manager of Investor Relations at AkzoNobel has only had few questions specifically about innovation and R&D. The questions being asked about innovation 54

55 especially concerned the output of R&D, and therefore what turnover R&D generates. In other words, investors and analysts did not seem to be interested in the R&D costs, but only in how much value R&D generates. However, investors are always interested in what AkzoNobel can do to increase the reported net profit. One might therefore conclude that capitalizing R&D may be of great interest to investors since it can reduce the overhead costs in the short term, which results in a higher net profit. Surprisingly, no investor has asked questions about this, according to the former manager of Investor Relations of AkzoNobel. Both Investor Relations departments do not believe that investors and analysts are interested in the capitalized R&D costs; only profit generated by R&D seems to be of interest. Interestingly, Barco, a global technology company from Belgium (Barco, 2013), happens to be a company in which analysts are actually interested in the amount of capitalized development costs, according to Jan van den Bossche. This is because Barco misused this account to reach the desired amount of EBITA; an activity that the Senior Accounting Officer of Royal DSM, Peter Sampers, tries to reduce to take a conservative approach regarding capitalizing development costs (see Chapter 6.4.). In Figure 22, one can see a press release of the financial results of Barco in which a large difference between EBITDA on sales and EBITDA minus capitalized development costs on sales is observable in 2012 (Barco Press Release, 2013). In 2012 the EBITDA on sales was 13.8 percent, of which 4.9 percent consisted of capitalized development costs. This example depicts the fact capitalized development costs can be used for contracting reasons or to meet or beat earnings targets. Therefore, accounting standard setters might reconsider the amended RJ210, since it provides an incentive for bad earnings management. Figure 22 EBITDA minus capitalized development cost on sales (Barco) This chapter clearly shows that analysts and investors have limited interest in capitalized R&D costs and thereby strengthens the generalisation of the results. 55

56 9. Conclusion Both the IASB as well as the FASB state that conservatism should no longer be part of the conceptual framework for financial reporting. This move from conservatism to neutrality has led the accounting standard setters to make changes to the current accounting standards to make them less conservative. One of the standards that has been revised is RJ210 (Dutch GAAP). This standard deals with the recognition of research and development (R&D) expenditures. Prior to the amendment of RJ210 in 2001 the standard prescribed to expense R&D costs completely (in the income statement). The revised RJ210 standard states that the research expense component has to be expensed, while the development expenses must be capitalized when certain criteria have been met. According to IAS 38 (IFRS), which was established already in 1978, development cost must also be capitalized when certain criteria have been met. IAS 38 as well as RJ210 have exactly the same recognition criteria for capitalizing development costs. When this brake of expensing development costs is removed to let managers capitalize development costs and in this way show the investors what they are doing, one would expect that management will engage in more R&D, expense less and reflect more development costs in the balance sheet. This removal of the brake was explored in this research by examining two Dutch, R&D intensive chemical companies. This way, the impact of the revised standards concerning R&D expenditure is investigated. Has the revised RJ210 and IAS38 standards led to increased neutrality in financial reporting? One can see that we have arrived at the last step of the Research Methodology Model (see Figure 23); the conclusion, which leads to discussing the results, of the Research Model (see Figure 24). In prior chapters the Dutch and international accounting standards regarding R&D, RJ210 and IAS38 respectively, have been examined. Next, the accounting treatment regarding R&D of two Dutch chemical companies, which are both R&D intensive as well as IFRS applicant, have been analysed to discover any differences and difficulties experienced with applying the standards. The analysis of Royal DSM and AkzoNobel regarding RJ210 and IAS38 has led to the concluding remarks provided in the next paragraph. 56

57 Figure 23 Research Methodology Model: Conclusion Theory Research Question Research Methodology Results Figure 24 Research Model: Results 9.1. Concluding Remarks The first concluding remark is that no stakeholder seems to benefit from the current standards related to R&D, which allow a company to capitalize development costs when certain criteria have been met. The stakeholders examined in this thesis, of which none seem to benefit from capitalizing development costs, are the managers, the shareholders, the controllers, the investors (and analysts) of the sample firms and the accounting standard setters. Managers are given an incentive to spend more on R&D to increase EBITDA, which will increase the information asymmetry. Due to the increased information asymmetry, shareholders will be off worse. Next, controllers will have to spend time and effort on determining what part of R&D belongs to research and what part to development as well as to determine whether the development costs shall or shall not be capitalized. Lastly, investors (and analysts) generally are not interested in the account capitalized development costs, unless the account amounts to a substantial part of total intangible assets of the company or when investors are aware of prior earnings management activities with capitalized development costs to achieve the desired EBITDA. Investors are generally more interested in KPI s related to R&D. This remark makes one wonder why accounting standards setters allow the capitalization of development costs in the first place, since it appears that no one seems to benefit from it. Giving firms the flexibility to best convey information about what they are doing by capitalizing development costs, instead of expensing it, seemed beneficial for firms as well as for investor, analysts and shareholders. This holds for the latter three since the information provided by capitalizing development costs might help stakeholders to 57