Smoothen earnings through R&D spending

Cookie jar reserves are the accumulation of reserves during the profitable years and using them in the unprofitable years. This is a technique of income smoothening. Management may be tempted to record more expenses during the period when the business does well so that they can record less during the future periods.

They try to avoid volatility and stabilise earningsIf the expenses become high, then ‘cookies' can be taken out from the jar and thus expenses will not be as high as they should have been.

The management of a company is constantly under pressure to meet external expectations and internal targets. Companies with heavy research and development expenditure such as pharmaceutical and software companies have the possibility of creating cookie jar reserves by manipulating research and development expenditures.

Spending on research

IAS 38 on research and development expenditure clearly mentions in paragraph 54 and 55 that expenditure on research (or on the research phase of an internal project) shall be recognised as an expense when it is incurred. In the research phase of an internal project, an entity cannot demonstrate that an intangible asset exists that will generate future economic benefits.

Therefore, this expenditure is recognised as an expense when it is incurred. An intangible asset arising from development (or from the development phase of an internal project) shall be recognised if, and only if, an entity can demonstrate all of the following:

(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 future economic benefits, (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 reliably the expenditure attributable to the intangible asset during its development phase. Although the guidelines are mentioned about the useful life of the intangible asset, but when the capitalisation period is considered, it should be compared at an arm's length. The company may follow a conservative policy and can create a reserve by writing off research expenses higher than required and thus lower earnings before interest and tax.

A company may take advantage of the useful life of R&D expenses and thus show less expense by showing a longer useful life than required.

The company will have a higher asset base too as the remaining portion of the development expenditure will be capitalized. Researchers have provided evidence that the contribution of R&D to future volatility of earnings is higher than the contribution of capital expenditures (physical assets) to earnings volatilityIAS 38 is silent about the number of years in which R&D is to be capitalized and therefore it is subjective. Managers can thus play with the capitalized amount to report earnings figures that fit their purposes. If capitalization is increased, reported earnings will rise.

When R&D is fully expensed and managers wish to increase reported earnings, they can simply cut the actual R&D expenditure. This will affect the future growth of the company.

Cipla Ltd, from the pharmaceutical sector spent Rs 284.83 crore and Rs 262.68 crore in the financial year 2010-11 and 2009-10 respectively. Out of the total research and developmental expenses, the developmental expenses were 25.04 and 11.99 crore respectively, which was added in the fixed assets. Cipla's percentage of research and development expenses on its total income has decreased from 4.73 to 4.43 from 2009 till 2011.

Conservative policy

Is it a strategic decision to reduce research expenses or are companies not sure of their future earnings and thus are reducing expenses in R&D? Capitalising R&D expenses as developmental expenditure requires criteria to be fulfilled resulting in debiting huge amounts as research expenses.

It might be a ‘play safe' attitude of the companies to reduce these kinds of expensesAlthough IAS 38 or Ind As 38 does not make amortisation of R&D expenditure a cake walk, but even then there are ways of smoothening earnings by research expenses. IAS 38 has given flexibility to managers to choose the number of years of amortization as per their best estimates. Is there really a check on the amount of disclosure made by these companies as per AS/IAS?

(The author is Associate Professor, Accounting and Finance at IMT Ghaziabad)

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