How to explain a cost ahead of its time

Firms could list innovations over a five-year period ...

Innovation is increasingly seen as vital to industry. But if a company increases its R&D spending, how should the money be accounted for?

The RB-211 jet engine, now seen as an important contributor to the development of aviation, did not have a smooth development path.

In fact, so difficult was this period for Rolls Royce that - in 1968 - it had to make a write-down of more than pounds 10m of capitalised development costs, more than double the company's after-tax profits. And when, three years later, having written off another pounds 35m of anticipated losses, the company went into receivership, the affair focused attention on the problems of accounting for what can be significant investment in future products.

Of course, the engine went on to bring considerable income to the restructured company. But in the period leading up to the collapse, reported profits had been inflated because the costs of the project had been deferred, and a lack of published information on cash flow had helped to conceal the scale of the company's difficulties.

As a result, says a booklet recently published by the Institute of Chartered Accountants of Scotland, the episode became one factor in the development of an accounting standard in the area.

The other factor had been an investigation by the then Accounting Standards Committee into the accounting treatment of research and development costs, as part of a concerted effort to overcome Britain's declining expenditure in this field. (Sounds familiar?) The investigation apparently found that a number of different and inconsistent methods of accounting for R&D costs were in use.

The standard - SSAP13 Accounting for research and development - was issued in December 1977 and revised in early 1989. But, now that concern about business growth has once more brought the issue into focus, standard- setters are once more looking at the issue. The ICAS booklet is a report by a working party set up by the institute with the aim of influencing opinion in this area.

One of the issues is the fact that, at a time when business - especially in such research-and-development-intensive industries as pharmaceuticals and engineering - is becoming global, there are a number of different approaches.

In the United States, there is a requirement to write off all costs immediately to the profit and loss account in the period in which they are incurred. Canada, Australia and the international accounting standards take the approach of capitalising the costs and then amortising them in periods when the company will reap the benefit of the expenditure. The UK and Japan offer companies the choice of either of these two methods.

The recommendations made in the Scots' report, "Innovating Research and Development Accounting", when it slipped out in the dog days of early August, include a call for any future standard to focus on accounting for innovation, rather than simply research and development. The definitions used in the existing standard are regarded as being "too science-based" and are judged not to take sufficient account of innovation, described by the Department of Trade and Industry as "the successful exploitation of new ideas".

This is in keeping with the growing awareness in Britain of the importance of creativity of all kinds. The working party included Isobel Sharp, a partner in Arthur Andersen, Professor Niall Lothian, of Heriot-Watt University, and Charles Monaghan, of Unilever. They also point out that some might take the view that - given the low level of R&D spending by the majority of UK companies indicated by successive DTI R&D scoreboards - it is hardly worthwhile producing a separate standard.

Moreover, research indicates that few companies make much mention, in the Operating and Financial Review, of activities that may affect future performance, despite the Accounting Standards Board's preference for such a move.

However, it also stresses that in certain businesses R&D investment can be substantial and it is important that there be a consistency of reporting. Accordingly, the group made detailed proposals for improving the standard from a financial reporting point of view.

For instance, it called for capitalising innovation and development costs from the point at which an asset may be recognised, on the grounds that this provides information to accounts users on an entity's assets, is consistent with the ASB's draft statement of principles, satisfies the "matching" concept, and may achieve increased international harmonisation.

It also said that all costs incurred up to the point of the creation of an asset should be treated as expenses, and that capitalised innovation costs should be amortised systematically over the periods that benefit.

Finally, though the report rejected making disclosure requirements mandatory in the Operating and Financial Review, it said companies should state which amortisation methods are used and explain any significant differences in costs written off and capitalised between accounting periods.

As the document's conclusion says, "Companies could give details of their track record in innovation, by noting the number of new products introduced in recent years, say for a five-year period, and discuss how successful these have been, in terms of both the market and its competitors."

And, in an attempt to allay worries about revealing confidential material, it adds: "Investors would be able to judge the effectiveness of a company's research, development and innovation function, without the company having to divulge detailed and confidential information on its future developments, which may be prejudicial to its operations."

Of course, this may mean that, while the likes of Glaxo Wellcome and SmithKline Beecham have embraced this approach, and devoted pages to information of this kind, many other organisations will not nearly have so much to shout about, and may therefore be embarrassed by their shortcomings. But that is surely part of the point.