We Need Better Detailed Disclosures on Intangible R&D Assets

Not all intangible assets are equal, and their economic values change based on industry. This is why there needs to be better disclosures of when intangibles such as intellectual property and brand reputation are acquired in research and development—and more detailed disclosures on associated risks.

The issue has prompted the Financial Accounting Standard Board to invite comment through May 30 as it decides whether to add a project on intangibles to its technical agenda.

R&D disclosures inform investors and users about future potential earnings growth. More and better disclosures can help a company develop intangible assets to commercial success that support investors and users of financial statements.

Financial statements often include a variety of intangibles, including iconic brand names such as Disney, Band-Aid, Pepsi, Amazon or General Motors that appear frequently in commercials and are advertised widely.

From an accounting standpoint, most companies would consider these iconic brand names to be an indefinite lived asset (assumed it was acquired in a purchase) that wouldn’t be amortized into an income statement. Their value will continue to maintain it or grow as these intangibles are supported by sales, unless there is a significant change in the market for these names.

Other intangibles that don’t meet the indefinite lived criteria are accounted for as a definite lived intangible asset. This means those acquired through a business combination is fair valued and amortized over the expected life, based on future cash flows.

Expensing R&D

Future cash flows support the accounted value when the intangible appears on the balance sheet the day it’s acquired. Accounting tries to match the sales reported to the amortization of the definite lived intangible asset. A significant drop in sales prompts companies to assess for impairment of the intangible to properly match the remaining book value to expected future sales.

In the life sciences industry, under US generally accepted accounting principles and industry practice, there is no management discretion. Unapproved R&D is typically expensed regardless of whether it’s acquired or developed internally.

No intangible assets are being created from guidance the Securities and Exchange Commission issued more than 30 years ago, reflecting the inherent uncertainties of the regulatory approval process. This means a company can’t sell products until it gets Food and Drug Administration approval.

Accounting therefore becomes simple—any R&D costs incurred prior to FDA approval should be expensed to the income statement, as there is no economic value unless you receive the ability to sell in this industry.

An R&D asset acquired or internally developed can change based on the probability of commercial success. Companies must ensure solid risk assessment when developing an intangible asset for commercial use.

Once commercial success is probable (75% or higher), most companies will capitalize the costs incurred by creating these intangible assets.

Unique Industry

The life science industry is unique because, unlike other industries, there is a third-party independent regulator dictating when economic value is created. To capitalize R&D costs can differ greatly from one industry to another.

The high failure rates in life science R&D projects, particularly in drug development, are well known. These failures can occur at various stages, from preclinical research to clinical trials, due to a lack of efficacy, safety concerns, and poor drug-like properties.

Knowing these factors, the accounting rules still allows for capitalization, which is contradictory to other intangible assets that are capitalized based on probability of commercial success. Probability and commercial success occur at the same time in the life science industry, which is why expense accounting makes more sense.

To capitalize R&D costs before getting FDA approval to write them off later doesn’t serve investors or users well, since probable commercial success hasn’t been achieved.

An exception to the above principles is in life sciences: Accounting for an unapproved R&D intangible through business combinations requires this cost to be capitalized as an indefinite lived intangible asset.

Most companies call this in-process research and development, or IPR&D. What makes it somewhat confusing is that the expectation of capitalizing this cost doesn’t align with the probability of achieving FDA approval at the time of acquisition.

This indefinite lived R&D asset has to be monitored and tested every year based on fair value. How is this indefinite lived status applied when compared with the iconic brand names mentioned above?

In my view, they aren’t the same, knowing the likelihood of selling is low. Because of the accounting, this creates unnecessary volatility and costly fair value analyses to support balance sheet value for each reporting period based on science.

Test Triggers

Impairment testing of IPR&D assets is triggered when events or changes in circumstances indicate the asset’s carrying amount may not be recoverable, due to a decline in market price, changes in strategy, or shifts in customer purchasing behavior.

Indefinite-lived intangibles, like goodwill, require annual impairment testing. This work requires continuous monitoring as these factors can result in charges that sometimes aren’t even related to the science. Usually, impairments mean bad news in the life sciences industry, but higher interest rates could cause an impairment that has nothing to do with the status of the R&D project, creating bad news for investors unnecessarily.

Smaller life science public companies, with limited cash to monitor the current balance, often take cash away to support R&D innovation, rather than use cash to support costs incurred for accounting and financial reporting from third-party valuation firms and external auditors.

Capitalizing on acquired unapproved R&D assets should be accounted for when FDA approval is achieved. Anything less than this threshold should be expensed. It’s difficult to explain how an unapproved R&D asset can be accounted for as an indefinite lived intangible asset just because of how it was acquired.

If we continue practicing capitalization, we should at least consider changing IPR&D status as a definite lived asset. This would reduce the time, complexity, and cost of monitoring each reporting period by preparers.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Stephen Rivera is the former global technical accounting advisory services and policy vice president at Johnson & Johnson.

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