Chinese Study highlights limitations on IAS 38, accounting for intangible assets

 A recent study from China highlighted the limitations of IAS 38—the International Accounting Standard that governs intangible assets—and its impact on innovation, particularly in high-tech industries. The research “How to improve IFRS for intangible assets? A milestone approach” was authored by Shefei Ma and Weiguo Zhang in 2023.

This study provides some key insights that are highly relevant to our discussions and podcasts at the CFO Club on how South Africa can improve its treatment of intangible assets to foster economic growth.

Context and Background

The study was conducted to address a critical challenge in the modern economy: the declining relevance of financial information related to intangible assets. In a knowledge-based economy, assets like research and development (R&D), software, patents, and technology are becoming more important than physical assets.

However, IAS 38, which governs how companies account for intangible assets, is seen as too restrictive. It prevents companies from capitalising their internally generated intangible assets unless very stringent criteria are met.

The study focuses specifically on how these limitations affect high-tech companies in China, particularly those in the medical device industry. The authors argue that the standard is not suitable for industries that rely on long-term innovation cycles, where R&D investment is essential.

Key Issues Highlighted in the Study

1.  Overly Strict Recognition Criteria: Under IAS 38, internally generated intangibles like R&D costs can only be capitalized in the development phase if specific conditions are met, such as proving the asset will generate future economic benefits. This is a significant problem because, in industries like medical devices, R&D cycles can take years or even decades to complete. As a result, much of the R&D investment is expensed upfront, which creates a mismatch between costs and the revenues they eventually generate.
2. Impact on Innovation: By not capitalising these assets, companies appear less profitable, which discourages further investment in R&D. This is particularly damaging for high-tech startups and innovative sectors where continuous investment is key. The study found that many firms in China’s emerging high-tech markets are forced to expense their R&D entirely, which can stunt their growth and distort financial reports.
3. Variation in R&D Capitalization Timing: The study explored different approaches companies use to determine when to capitalize R&D costs. It found that even within the medical device industry, there was no consistency—some companies began capitalizing R&D costs at early stages, while others waited until much later, such as during clinical trials. This inconsistency further clouds the financial reporting and makes it difficult for investors to assess the true value of companies.

Proposed Solutions

 The authors propose a milestone approach to IAS 38, which would align the recognition of intangible assets with key points in the R&D lifecycle. This would allow companies to start capitalizing costs earlier in the development process, increasing the relevance of their financial reports and providing a clearer picture of their financial health.

They also suggest that international accounting standards should be revisited to better reflect the needs of high-tech, innovation-driven sectors. The recognition criteria should be loosened, and more R&D-related assets should be capitalized to reflect their true value.

Relevance to South Africa

For South Africa, this study underscores a vital issue. Like China, our future economic growth depends heavily on innovation and technology-driven industries. However, IAS 38’s restrictive criteria prevent many of our companies from fully realising the value of their internally developed intellectual property.

If South Africa continues to apply IAS 38 in its current form, we risk stifling local innovation, underreporting the value of our intangible assets, and missing out on investment opportunities. The lessons from China highlight the need for South Africa to adapt international standards to better suit our local economic realities. By reforming how we recognize and report intangible assets, particularly those generated through R&D, we can better position ourselves for success in the global knowledge economy.

To compete globally, South Africa must rethink IAS 38 and advocate for a more flexible approach that recognizes the unique challenges of innovation-driven industries. The Chinese study gives us a blueprint for what can be done—adopting a milestone-based approach that allows us to capture the true value of our companies’ intellectual property and intangible assets.

This is not just about accounting—it’s about stimulating growth, attracting foreign investment, and driving the next wave of economic development in South Africa.

Relevance to CFOs

 This issue is particularly important for CFOs because intangible assets are increasingly driving value in today’s knowledge-based economy. However, under the current IAS 38 framework, CFOs are limited in how they can recognize and capitalize these assets, which leads to several key problems:

1. Underrepresentation of Value:

 IAS 38 makes it difficult to capitalize R&D and internally developed assets unless they meet stringent criteria. This results in significant underrepresentation of innovation-driven value on financial statements. For CFOs, this means their companies may appear financially weaker than they actually are, which can affect:

• Investment decisions: Investors and creditors might undervalue the company due to the absence of these intangible assets on the balance sheet.
• Share price: Without a clear reflection of R&D and innovation, the market capitalization could remain lower than it should be, especially for companies in technology, pharmaceuticals, and other high-growth sectors.

2. Missed Opportunities for Investment:

Companies that are unable to properly capitalize their intangible assets may struggle to secure funding or attract investors. CFOs are left with fewer resources to reinvest in innovation, creating a vicious cycle where limited capital constrains future growth and competitiveness.

3. Increased Pressure on Short-Term Financial Performance:

CFOs may face pressure to reduce R&D expenditures to improve short-term profitability because they cannot capitalize these costs. This can lead to lower long-term value creation, weakening the firm’s ability to compete globally.

How CIBA and the CFO Club Can Assist CFOs

1. Advocacy for Policy Change:

CIBA and the CFO Club can play a leading role in advocating for reform of IAS 38. By working together with CFOs to present a unified voice to regulatory bodies (such as the IRBA and FRSC in South Africa), we can push for the following:

1. • Flexible capitalisation rules: To reflect the economic reality of developing nations like South Africa, allowing internally developed intangible assets to be recognized earlier in the innovation process.
   • Better alignment with local economic goals: Standards that reflect the unique challenges and opportunities in developing economies can encourage investment and growth, especially in high-tech sectors.

2. Impact on Financial Statements:

With advocacy support and eventual reform, CFOs will be able to:

• • Recognize more value: Internally generated intangible assets, such as R&D, would be capitalized, improving the balance sheet and providing a more accurate representation of the company’s financial health.
  • Boost company valuation: Properly capitalizing intangible assets can increase equity, improve financial ratios, and raise the company’s overall market valuation.
  • Attract more investors: Transparent financial statements with clearly capitalized intangible assets will make companies more attractive to investors, as they can see the true potential of the company’s innovation.

3. Training and Guidance:

CIBA and the CFO Club can offer specialist training for CFOs on how to manage and report intangible assets more effectively, helping them navigate the complexities of existing standards while preparing for possible changes.

Long-Term Impact on the Economy

If we succeed in pushing for changes to IAS 38, the long-term benefits would be substantial. South African companies would:

• Encourage more innovation: Proper recognition of internally developed assets could spur more investment in R&D, fostering a culture of innovation.
• Improve global competitiveness: More accurate financial reporting will help local companies compete internationally, particularly in industries driven by intellectual property.
• Drive economic growth: By valuing intangible assets correctly, South African companies will be better positioned to contribute to broader economic growth and job creation.