FIRM INNOVATION AND RESEARCH & DEVELOPMENT COSTS UNDER IFRS

Abstract

This paper examines the relationship between research and development (R&D) expenditures under International Financial Reporting Standards (IFRS) and firms’ innovation, proxied by future patent counts and patent citations. Accounting for R&D is a major difference between IFRS and generally accepted accounting principles in the United States (US GAAP). The difference is that certain development costs can be treated as assets under IFRS, but all R&D expenditures are expensed under US GAAP. This difference in the accounting treatment is grounded in the conceptual question of whether R&D expenditures provide future benefits, consistent with the definition of an asset, or whether the benefits are so uncertain that they are treated as the consumption of resources, consistent with the definition of an expense. If R&D expenditures provide future benefits, they are expected to be associated with future patents and citations. Capitalized development costs should exhibit a stronger association as they meet the criteria to be assets, expecting to provide future benefits. Expensed R&D can also be associated with patents and patent citations as these expenditures may also lead to patents and patent citations. As expensed R&D relates to expenditures in the research stage or those development costs that do not meet the criteria to be capitalized, the association should be weaker. Therefore, this paper examines the association between R&D expenditures that are expensed and those that are capitalized under IFRS with patents and patent citations as future benefits.Using a hand-collected sample of high-tech firms in European Union from 2012 to 2018, this paper finds economically and statistically significant different associations between capitalized development costs and expensed R&D and a firms’ innovation, as proxied by future patents and patent citations. Using median effects, the association between one million euros investment in firms’ capitalized development costs and patent counts (citations) is 200% or more than the association between one million euro’s expensed R&D and patent counts (citations). This paper is one of the first to examine the relationship between R&D capitalization under IFRS and firms’ innovation, as measured by future patent counts and patent citations. This paper contributes to the literature on R&D capitalization by identifying the fundamental difference in the association between capitalized development costs and expensed R&D and innovation. Further, this paper contributes to our understanding of the accounting for R&D, and the different treatment between US GAAP and IFRS by finding that capitalized development costs display a different association from expensed R&D.