R&D disclosure in the annual report: empirical evidence from automotive and pharmaceutical companies

Intangibles are value-driving resources for many companies. They allow companies to achieve and maintain a competitive advantage (OECD, 2008) and prior research provides evidence of a positive association between intangible intensity and corporate performance (Chauvin and Hirschey, 1993; Andras and Srinivasan, 2003; Heiens et al., 2007; Ehie and Olibe, 2010; Boujelben and Fedhila, 2011). The relevance of intangibles has become more evident in the last decades when a shift from the traditional economy to the “new economy” occurred. The “new economy” mainly relies on innovation, digitalisation, and knowledge-based resources, thus leading to a new paradigm in which intellectual property, brands, technology, human capital, and customer relationships play a crucial role. The pandemic crisis has further emphasised this intangible-centric approach and prompted companies to make substantial efforts to create or increase the value of intangibles. The amount of intangibles varies across industries and companies, according to the specific features of the business model (BM),1 but there is near unanimous agreement that intangibles have experienced substantial growth in recent decades and that intangible assets have gained more prominence in estimating a company’s value compared to tangible assets (Zéghal, 2000; OECD, 2007; Zambon et al., 2020). In this context, a significant issue arises regarding how to recognise these resources in a company’s financial statements (Cañibano et al., 2000; Lev, 2001; Jenkins and Upton, 2001; Zéghal and Maaloul, 2011; Lev, 2019). The recognition of intangibles in the balance sheet is influenced by their origin. Companies, indeed, can either acquire intangible assets from third parties or internally develop such resources, resulting in internally generated intangibles. Both IAS/IFRS and US GAAP are still very restrictive in allowing the capitalisation of internally generated intangibles, which are therefore included as expenses in the income statement of the year in which they have incurred. The constraints to capitalisation of internally generated intangibles are due to three main reasons. The first is the questionable usefulness of these expenses, as in many cases the correlation with future revenues is not demonstrable. This issue is closely tied to the second reason, which is the discretionary nature of capitalisation. When capitalisation is allowed, certain conditions should be met, the assessment of which is to some extent subjective. This can lead to opportunistic behaviour. Third, many of these resources do not have legal protection, thereby negating the requirement of control for recognising them as assets. Due to the aforementioned restrictions, the current debate deals with the role of capitalisation and disclosure of internally generated intangibles as a valuable source of information for users of annual reports (Lev, 2019; Barker et al., 2022; Penman, 2023; Xie and Zhang, 2023). As internally generated intangibles provide uncertain returns, it could be difficult – especially for external users – to estimate in advance the quality of and the risks associated with innovative projects as well as their contribution to future performance, thereby increasing information asymmetries. Due to its relevant implications for financial reporting quality and usefulness, this issue has attracted the attention of standard-setters. In 2021, EFRAG issued a Discussion Paper, “Better Information on Intangibles – Which is the best way to go?” (EFRAG, 2021). One of the key issues in the Discussion Paper is how companies can provide users with a better presentation of internally generated intangibles, suggesting that the development of specific disclosure requirements is a feasible solution to be implemented in the short term without requiring changes to current accounting criteria. Companies could provide more meaningful information on internally generated intangibles by explaining how they contribute to a company’s competitive advantage. This disclosure is closely linked to the presentation of a company’s BM. If a company generates value through internally generated intangibles, then the presentation of how they relate to its BM would allow users to better understand its value-creation process. Another important information that companies could disclose refers to non-capitalised expenses that are related to projects that will ultimately bring future economic benefits, also defined in the EFRAG DP as future-oriented expenses (FoEx) (EFRAG, 2021). The disclosure of FoEx could overcome the lack of information on the association between certain expenses and future benefits when those expenses do not meet the capitalisation requirements. Based on these arguments, this chapter analyses the disclosure of internally generated intangibles. In particular, our study focuses on R&D expenses as a valuable example of internally generated intangibles. Notably, R&D investments play a crucial role in economic development. From 2008 to 2018, the total global R&D expenditure accounted for approximately 2.00% of GDP, with a prominence of US companies among the top R&D spenders (Xie and Zhang, 2023). We develop an empirical study that addresses the following questions: (i) how do companies currently disclose information on R&D?; (ii) is R&D disclosure connected with the presentation of the BM?; and (iii) do companies currently disclose information on FoEx in their annual report?. To this aim, we analyse the R&D disclosure practices of a sample of companies from two relevant industries: pharmaceutical and automotive. Pharmaceutical companies are selected because they traditionally have all the characteristics of knowledge-based firms where the research activity has a major impact on economic success. By contrast, automotive companies represent a more traditional sector that is currently facing the sustainability challenge, which requires efforts to introduce innovation into product development. This study contributes to the accounting literature on intangibles by emphasising the role of disclosure on internally generated intangible assets and FoEx in enriching the information environment. From a practical perspective, it also provides empirical evidence of interest to preparers and users of financial reports, by presenting the best current disclosure practices on R&D expenses and their relationship with the BM.