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RESEARCH AND DEVELOPMENT AND FIRM PERFORMANCE

INVESTIGATING THE NEED FOR RESEARCH AND DEVELOPMENT

EXPENDITURE AS A FACTOR OF ENHANCING THE PERFORMANCE OF FIRMS

Author: Rufus Tekoh Ayam

Supervisor: Catherine Lions

Student

Umeå School of Business Umeå University-Sweden Spring Semester 2012

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ii

ABSTRACT

Despite the huge sum of money that is being spent on research and development (R & D) on yearly basis by firms, very few empirical studies exist to shed more lights about the effects of this practice on firm performance. However, the International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB) in their publication of International Accounting Standard (IAS) 38, require that expenditures incurred during R & D should either be expensed in the statement of comprehensive income or capitalized as an intangible asset in the statement of financial position provided certain criteria are fulfilled (IASB, 2012, p. 1045).Therefore, the main purpose of this study is to investigate the impact of expensed R & D and/or capitalized R & D on firm performance

METHOD: Data for the study was collected from the audited financial statements of firms listed at the London Stock Exchange as well as from the website of this stock market. Two sampling techniques were utilized in the study; namely stratified sampling and random sampling. Stratified sampling technique was used to stratify the companies into various industries while random sampling was used to randomly select firms that are engaged in R & D from each of these industries. The final sample consisting of 52 firms gave a total of 260 observations for a period of 5 years between December 31st, 2007 to December 31st, 2011.Expensed R & D and capitalized R & D were obtained by taking the averages of statement of comprehensive income R & D to Revenue and statement of financial position R & D to revenue respectively. Moreover, firm performance was measured using accounting-based indicators which were Return on Asset (ROA), Return on Capital Employed (ROCE), Dividend Yield (DY), Dividend Cover (DC), Earnings per Share (EPS), Price Earnings Ratio (PE) and Capital Gearing Ratio (CGR).

RESULTS: The results of the study show that expensed R & D has a significant positive impact on DC, a significant negative impact on EPS, positively correlated with CGR with no significant impact and negatively correlated with ROA, ROCE, DY and PE but had no significant impact. As concerns capitalized R & D, the results reveal that capitalized R & D has a significant negative impact on ROA, ROCE and EPS, positively correlated with CGR but have no significant impact and negatively correlated with DY, DC and PE as well though no significant impact was found.

KEY WORDS: Research and development, expensed R & D, capitalized R & D, firm performance, accounting-based indicators.

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iii

ACKNOWLEDGEMENTS

As summer has finally come to give a break to Umea´s prolonged and extraordinary winter weather, it is with much warmth and relief that I am penning these final words to express my gratitude to those who have stood by me during my ups and downs moments as a master student. I am highly indebted to my supervisor, Catherine Lions who has been very helpful to me throughout the research process. I deeply appreciate her enormous and valuable advices, her constant motivation as well as the pains she took in reading and correcting the manuscripts. Above all; I give thanks to God Almighty to whom this study has been dedicated to, for giving me the strength, good health and inspiration to accomplish this enormous task.

I want to also expressed my thankfulness to the following: all the professors at Umeå School of Business for the knowledge they have infused into me, my program coordinator; Rickard Lindberg, study adviser; Lennart Widmark, all the Liberians of Umeå University, Inger Granberg and Susanne Nilsson at the Umeå School of Business Student Administration office and to the Swedish Government for providing a conducive study environment for me to study. I cannot stop without expressing my sincere gratitude to my family for their financial, spiritual and moral supports. The last but not the least, my sincere gratitude is equally extended to all friends for their motivation and encouragement throughout my master’s studies.

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DEDICATION

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v TABLEOFCONTENTS

ABSTRACT ... ii

ACKNOWLEDGEMENTS... iii

DEDICATION... iv

LIST OF TABLES ... viii

LIST OF FIGURES ... ix

LIST OF ABBREVIATIONS ...x

CHAPTER ONE: INTRODUCTION ... 1

1.1 BACKGROUND... 1

1.2 RESEARCH QUESTION ... 3

1.3 PURPOSE... 3

1.4 SIGNIFICANCE OF THE STUDY... 3

1.6 DELIMITATION OF THE STUDY ... 3

1.7 DISPOSITION ... 4

CHAPTER TWO: METHODOLOGY ... 5

2.1 PRECONCEPTION ... 5

2.2 ONTOLOGICAL CONSIDERATION ... 5

2.3 EPISTEMOLOGICAL CONSIDERATION... 5

2.4 A POSITIVIST POSITION FOR THE STUDY ... 6

2.5 RESEARCH TECHNIQUE ... 6 2.6 RESEARCH APPROACH ... 7 2.7 LITERATURE SEARCH ... 8 2.8 VARIABLES ... 9 2.8.1 INDEPENDENT VARIABLES ... 9 2.8.2 DEPENDENT VARIABLES ... 10 2.9 DATA COLLECTION ... 10 2.10 SAMPLE SELECTION ... 11

2.11 SAMPLING TECHNIQUE AND SAMPLE SIZE ... 12

2.12 ASSESSMENT OF DATA ... 14

CHAPTER THREE: THEORETICAL FRAMEWORK ... 15

3.1 RESEARCH & DEVELOPMENT ... 15

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3.1.2 SOME STRATEGIES OF R & D INVESTMENTS ... 17

3.1.3 MANAGING R & D PROJECTS ... 18

3.1.4 IFRS TREATMENT OF R & D ... 20

3.1.5 SPILLOVER EFFECTS OF R & D ... 21

3.2 MEASURING FIRM PERFORMANCE ... 22

3.3 CATEGORIES OF ACCOUNTING-BASED INDICATORS FOR MEASURING FIRM PERFORMANCE ... 23

3.3.1 PROFITABILITY ACCOUNTING-BASED INDICATORS ... 24

3.3.2 FINANCIAL PROFITABILITY ACCOUNTING-BASED INDICATORS ... 24

3.3.3 CAPITAL STRUCTURE ACCOUNTING-BASED INDICATORS ... 25

3.4 R & D AND FIRM PERFORMANCE ... 26

3.5 SELECTED ACCOUNTING –BASED INDICATORS ... 27

3.6 PRESENTING LONDON STOCK EXCHANGE... 27

3.7 MY RESEARCH MODEL... 28

CHAPTER FOUR: EMPIRICAL FINDINGS ... 30

4.1 BACKGROUND INFORMATION ... 30

4.2 PROFITABILITY ACCOUNTING-BASED INDICATORS FOR MEASURING FIRM PERFORMANCE ... 33

4.2.1 RETURN ON ASSET ... 33

4.2.2 RETURN ON CAPITAL EMPLOYED ... 35

4.3 FINANCIAL PROFITABILITY ACCOUNTING-BASED INDICATORS FOR MEASURING FIRM PERFORMANCE ... 38

4.3.1 DIVIDEND YIELD ... 38

4.3.2 DIVIDEND COVER ... 41

4.3.3 EARNINGS PER SHARE ... 43

4.3.4 PRICE EARNINGS RATIO ... 46

4.4 CAPITAL STRUCTURE ACCOUNTING-BASED INDICATOR FOR MEASURING FIRM PERFORMANCE ... 49

4.5 CAPITAL GEARING RATIO ... 49

4.6 LINEAR REGRESSION EQUATIONS ... 51

4.6.1 REGRESSION EQUATION FOR RETURN ON ASSET ... 51

4.6.2 REGRESSION EQUATION FOR RETURN ON CAPITAL EMPLOYED ... 53

4.6.3 REGRESSION EQUATION FOR DIVIDEND COVER ... 54

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4.7 SUMMARY PRESENTATION FOR FORMULATED EQUATIONS ... 58

4.8 SUMMARY PRESENTATION OF HYPOTHESES FINDINGS ... 59

CHAPTER FIVE: ANALYSIS OF EMPIRICAL FINDINGS ... 60

5.1 INTRODUCTION ... 60

5.2 ANALYZING THE IMPACT OF EXPENSED AND CAPITALIZED R & D ON RETURN ON ASSET ... 60

5.3 ANALYZING THE IMPACT OF EXPENSED AND CAPITALIZED R & D ON RETURN ON CAPITAL EMPLOYED ... 61

5.4 ANALYZING THE IMPACT OF EXPENSED AND CAPITALIZED R & D ON DIVIDEND YIELD ... 61

5.5 ANALYZING THE IMPACT OF EXPENSED AND CAPITALIZED R & D ON DIVIDEND COVER... 62

5.6 ANALYZING THE IMPACT OF EXPENSED AND CAPITALIZED R & D ON EARNINGS PER SHARE... 63

5.7 ANALYZING THE IMPACT OF EXPENSED AND CAPITALIZED R & D ON PRICE EARNINGS RATIO ... 64

5.8 ANALYZING THE IMPACT OF EXPENSED AND CAPITALIZED R & D ON CAPITAL GEARING RATIO ... 64

5.9 SUMMARY OF FINDINGS ... 65

CHAPTER SIX: CONCLUSIONS, THEORECTICAL AND PRACTICAL CONTRIBUTIONS, SUGGESTIONS FOR FURTHER RESEARCH AND LIMITATIONS ... 66

6.1 INTRODUCTION ... 66

6.2 CONCLUSIONS... 66

6.3 THEORETICAL AND PRACTICAL CONTRIBUTIONS ... 66

6.3.1 PROPOSED MODEL FOR R & D AND FIRM PERFORMANCE ... 66

6.3.2 PROPOSED MATHEMATICAL EQUATIONS ... 68

6.4 SUGGESTIONS FOR FURTHER RESEARCH ... 69

6.5 LIMITATIONS OF THE STUDY ... 70

CHAPTER SEVEN: QUALITY ISSUES IN QUANTITATIVE RESEARCH ... 71

7.1 INTRODUCTION ... 71 7.1 RELIABILITY ... 71 7.2 REPLICATION ... 71 7.3 VALIDITY ... 71 7.4 GENERALIZABILITY ... 72 APPENDIX ... 73

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APPENDIX 1: DERIVING A MATHEMATICAL EQUATION FOR EARNINGS BEFORE INTEREST

AND TAX ... 73

APPENDIX 2 : DERIVING A MATHEMATICAL EQUATION FOR NETWORTH ... 73

APPENDIX 3: DERIVING A MATHEMATICAL EQUATION FOR PROFIT/LOSS ATTRIBUTABLE TO ORDINARY SHAREHOLDERS ... 73

APPENDIX 4 : DERIVING A MATHEMATICAL EQUATION FOR NUMBER OF EQUITY SHARES ... 74

APPENDIX 5: DERIVING A MATHEMATICAL EQUATION FOR REVENUE ... 75

APPENDIX 6: STATISTICAL ASSUMPTIONS ... 75

REFERENCES ... 79

LIST

OF

TABLES

Table 1: Some Fundamental Differences between Quantitative and Qualitative Research Techniques………..…7

Table2: Summary Presentation of Selected Variables………..11

Table 3: List of all Firms Classified by Industries………13

Table 4: Some Examples of R & D and Non R & D Costs………..……15

Table 5: Accounting treatment of some examples of R & D Expenditure………...16

Table 6: Some examples of Research Activities and some Examples of Development Activities………...21

Table 7: Various Categories of Accounting-Based Indicators as Used by Different Groups of Stakeholders………..………..………….… 23

Table 8: Selected Profitability accounting-based indicators……….24

Table 9: Selected Financial Profitability Accounting-Based Indicators ………...…...24

Table 10: Selected Capital Structure Accounting-Based Indicators………...…...25

Table 11: Formulated Hypotheses………29

Table 12:Descriptive Statistics for ROA………..34

Table 13:Pearson Correlations Test for Expensed R & D in Relation to ROA………34

Table 14:Pearson Correlations Test for Capitalized R & D in Relation to ROA…...……..35

Table 15:Descriptive Statistics for ROCE………....36

Table 16:Pearson Correlations Test for Expensed R & D in Relation to ROCE…….…….37

Table 17:Pearson Correlations Test for Capitalized R & D in Relation to ROCE………...37

Table 18:Descriptive Statistics for DY……….39

Table 19:Pearson Correlations Test for Expensed R & D in Relation to DY………..40

Table 20:Pearson Correlations Test for Capitalized R & D in Relation to DY…………....40

Table 21:Descriptive Statistics for DC……….42

Table 22:Pearson Correlations Test for Expensed R & D in Relation to DC………...42

Table 23:Pearson Correlations Test for Capitalized R & D in Relation to DC………43

Table 24:Descriptive Statistics for EPS………44

Table 25:Pearson Correlations Test for Expensed R & D in Relation to EPS……….45

Table 26:Pearson Correlations Test for Capitalized R & D in Relation to EPS……….…..45

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Table 28:Pearson Correlations Test for Expensed R & D in Relation to PE………….…..48

Table 29:Pearson Correlations Test for Capitalized R & D in Relation to PE……….48

Table 30:Descriptive Statistics for CGR……….…..50

Table 31:Pearson Correlations Test for Expensed R & D in Relation to CGR…………....50

Table 32:Pearson Correlations Test for Capitalized R & D in Relation to CGR……….…51

Table 33:Constant and Coefficient for ROA Regression Equation………..…52

Table 34:Constant and Coefficient for ROCE Regression Equation………....53

Table 35:Constant and Coefficient for DC Regression Equation………....55

Table 36:Constant and Coefficient for EPS Regression Equation using Expensed R & D……...56

Table 37:Constant and Coefficient for EPS Regression Equation using Capitalized R & D………....57

Table 38: Summary Presentation of Formulated Equations………...……..………….….58

Table 39: Summary of Hypothesis for testing the impact of R & D on firm performance………..59

LIST

OF

FIGURES

Figure 1: Disposition of Study……….………...4

Figure 2: An Inductive Approach………...7

Figure 3: A Deductive Approach………..………..8

Figure 4:.Knowlege resources and frequency of R & D investments………...18

Figure 5: The R & D Strategic Cycle……….………...19

Figure 6: The Four Perspectives of the Balanced Scorecard………22

Figure 7: R & D and Firm´s Performance………26

Figure 8: My Research Model for R & D and Firm Performance………...28

Figure 9:Average Expensed R & D against Industries………...………..…30

Figure 10: Average Capitalized R & D against Industries………...…30

Figure 11: Graphical Representation of Mean Expensed and Mean Capitalized R & D across different Industries……….31

Figure 12: Average Expensed R & D against years………32

Figure 13: Average Capitalized R & D against years………..……….32

Figure 14: Average ROA against industries……….33

Figure 15: Average ROA against years………..…..33

Figure 16: Average ROCE against industries………...35

Figure 17: Average ROCE against years………..35

Figure 18: Average DY against industries………38

Figure 19: Average DY against years………...38

Figure 20: Average DC against industries………41

Figure 21: Average DC against years………...41

Figure 22: Average EPS against industries………...43

Figure 23: Average EPS against years………..43

Figure 24: Average PE against industries……….46

Figure 25: Average PE against years………46

Figure 26: Average CGR against industries……….49

Figure 27: Average CGR against years………49

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x

LIST

OF

ABBREVIATIONS

AD: Aerospace and Defense ATO: Asset Turn Over BOD: Board Of Directors BSC: Balanced Scorecard

CapR&Dit : Capitalized R & D for the firm i in the year t CGR: Capital Gearing Ratio

CR: Current Ratio DC: Dividend Cover

DPSG: Dividend Per Share Growth DY: Dividend Yield

EEE: Electronics and Electrical Equipments EPS: Earnings Per Share

EPSG: Earnings Per Share Growth

Exp R&Dit : Expensed R & D for the firm i in the year t GI: General Industrials

GM: General Manager

HCES:Health Care Equipments & Services H0: Null Hypothesis

H1: Alternative Hypothesis

IASB: International Accounting Standards Board IAS: International Accounting Standard

IE: Industrial Engineering

IFRS: International Financial Reporting Standards LTDit : Long-term debt for the firm i in the year t MT: Mobile Telecommunications

NAVPS: Net Asset Value Per Share

NDOSit :Net dividend on ordinary shares for the firm i in the year t NESit : Number of equity shares for the firm i in the year t

NOA :Net Operating Assets

NP/Lit : Net profit or loss attributable to ordinary shareholders for the firm i in the year t NPAT: Net profit after tax

NPM: Net Profit Margin OPM: Operating Profit Margin

NWit :Net worth for the firm i in the year t PATit : Profit after tax for the firm i in the year t PB: Pharmaceutical and Biotechnology

PE: Price Earnings Ratio

PEG: Price Earnings Ratio Growth QR: Quick Ratio

Rit :Revenue for firm i in the year t. ROA: Return On Assets

ROCE: Return On Capital Employed ROE: Return On Equity

RNOW: Return On Net Worth ROS: Return On Sales

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xi R & D: Research and Development

SCI R & Dit : Statement of comprehensive income R & D for firm i in the year t SFP R & Dit :Statement of financial position R & D for firm i in the year t TAit :Total Assets for the firm i in the year t

UK: United Kingdom α :Constant

β : Gradient (slope)

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1

CHAPTER

ONE:

INTRODUCTION

1.1

BACKGROUND

During the last few decades the intensity of corporate Research and Development (from this point R & D) has increased significantly (Pandit, Wasley, & Zach, 2011, p. 122).Companies have become more motivated to carry out R & D as a result of exposure to competition as well as the fact that most of the world`s economies have embarked policies reforms on market-oriented liberalization aimed at promoting economic performance (Salim & Bloch, 2009, p. 351).In theory,the International Accounting Standard(IAS) 38,paragraph 8,issued by the International Accounting Standards Board (IASB) defines research as an “original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding”. The standard also defines development as “the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use”(IASB, 2012, p. 1037).

As a result, R & D has been regarded as a significant factor in enhancing the specialization patterns of a company’s competitive advantage internationally, helps in the maintenance or improvement of existing products, creation of new products and innovation of the production processes of companies thereby improving firm´s performance (Salim & Bloch, 2009, p. 352).In addition, R & D is also aimed at polishing the professional know-how associated with the manufacturing and production processes of companies, covering issues such as basic research, product design, manufacturing processes and service procedures (Shu-Ching & Wenching, 2006, p. 139).Therefore, an increase in a company`s R & D will help modernize the production of tradable goods, rendering them appealing to catch the attention of domestic buyers away from imports as well as to catch the attention of foreign buyers, thus increasing exports (Salim & Bloch, 2009, p. 351).

Moreover, R & D is also known as innovation cost because it is the cost of discovering new knowledge concerning the manufacturing processes of a company, its products and its services. The knowledge discovered when applied is instrumental for the creation of new or improved products and services that are important in fulfilling the needs and wants of the market (Khazabi, 2008, p. 54).Therefore, R & D has a significant role to play on economic growth, economic welfare (Grabowski & Vernon, 2000, p. 214),firm´s performance as well as a major factor that is used in determining the competitiveness of firms and economies (Salim & Bloch, 2009, p. 351).Thus, both publicly supported and privately funded R & D will bring into being ideas and information about new products or components, new ways on how to arrange or utilize them as well as new ways on how to properly design new goods or services for producers to meet the potential wants and needs of consumers satisfactorily (Griliches, 1992, p. 30).

On the other hand, firm´s performance is generally measured using accounting-based indicators and these indicators have been regarded as the most important criterion for evaluating the performance of firms (Sher & Yang, 2005, p. 5).Among the relatively large number of accounting-based indicators that are used to measure firm´s performance are: Return On Common Equity (ROCE), Return On Assets (ROA), Interest Cover (IC), Asset Turn Over (ATO), Earnings Per Share (EPS), Price Earnings Ratio (PE), Dividend Cover (DC), Dividend Yield (DY), Capital Gearing Ratio (CGR) and so on (Wood & Sangster, 2002, pp. 378-379). Moreover, profit is generally used to form the foundation for measuring firm´s performance or the basis on which accounting-based indicators are measured (IASB, 2012, p. 44). In addition, several other prior researchers have used

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accounting-2

based indicators to measure firm´s performance such as Lev, Sarath, & Sougiannis (2005), Sher & Yang (2005) and Shu-Ching & Wenching (2006).

However,the benefits from R & D on firm´s performance cannot be realized in the year in which the investment took place (Blanes & Busom, 2004, p. 1462).Thus, any form of government support to business R & D is more likely to help improve firm´s performance if the support is programmed within a long-term framework thereby dropping to an extent some forms of uncertainty that firms might encounter (Guellec & Van Pottelsberghe de la Potterie, 2003, p. 238).Consequently, R & D has continued to increase progressively within industries and management considers it as an important factor to help improve firm`s performance thereby leading the firm towards profitability. Hence, the ultimate goal of R & D is the creation of future revenue and profits (Mank & Nystrom, 2001, p. 3).

Furthermore, the relationship between current R & D and firm´s performance can only be solid if management implements and utilizes better control measures of R & D expenditures within the firm (Doyle & Navratil, 1981, p. 21). Therefore, the overall effect of R & D on firm´s performance will largely depend on top management ability in terms of putting in place effective and efficient control measures for managing the R & D expenses. Hence, the total profitability that a firm should earn from a successful R & D program should be greater than the total R & D expenditures, if not, then it would be better if the R & D program is closed off (Doyle & Navratil, 1981, p. 21) or reviewed. Nevertheless, from the standpoint of accounting theory, R & D expenditures that are incurred and are expected to benefit future accounting periods should not be written off against the revenues of the current accounting period (Bierman Jr & Dukes, 1975, p. 55).As a result, one school of thought argues that R & D should be treated as intangibles assets by capitalizing them before subsequent amortization in order to expense it across other accounting periods (Green, Stark, & Thomas, 1996, p. 191).

Moreover, the main incentive for immediate expensing of R&D occurs when reliable evidence of future economic benefits from current R&D activity is lacking (Kothari, Laguerre,& Leone,2002,p. 358).On the other hand, the main incentive for capitalizing R&D lies on the grounds that the benefits from R & D investments are not harvested in the year in which the expenditure took place (Flamm, 1990, p. 55).This therefore requires capitalizing before subsequent amortization in order to spread the cost across other accounting periods ((Roberts, 1965, p. 57).

Also, R & D when capitalized has been found to affect stock returns negatively and R & D when expensed was found to have a positive association with stock returns (Cazavan-Jeny & Jeanjean, 2006, p. 55).In addition, another study shows that announcement of large R & D investments has a significant positive association with abnormal stock returns (Doukas & Switzer, 1992, p. 97).On the other hand, a different study reveals that R & D expenditures appear to have no major effect on stock returns signifying that the stocks have been fairly priced (Anagnostopoulou, 2010; Doyle & Navratil, 1981; Nguyen, Nivoix, & Noma, 2010, p. 907).Moreover, Oswald & Zarowinargue (2007) also argue that capitalization of R & D might not result in more informative stock prices (Oswald & Zarowin, 2007, p. 705),thus creating some contradictions justifying more research.

Prior researches reviewed so far indicate that past empirical studies concerning R & D have focused largely on either the accounting treatment of R & D; for instance Green et al.,(1996);Bierman & Dukes (1975) or on investigating the effects of R & D on stock prices of the firm; for instance Cazavan-Jeny & Jeanjean (2006);Nguyen et al.,(2010 ).In addition, the only study that I could find about R & D and firm´s performance is a study carried out by Hanel & St-Pierre (2002) and this

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study focused only on investigating the effect of the knowledge spillover of R & D on profitability in which the result indicates that the net effect of knowledge spillovers produced from R & D activities do not contribute to firm`s profitability (Hanel & St-Pierre, 2002, p. 320).Hence, to the best of my knowledge very little or no prior empirical research has been done to investigate the need of R & D as a factor of enhancing the performance of firms, thus creating a research gap that needs to be fulfilled. The empirical ground is based on data drawn from London Stock Exchange market. The stock market offers a complete set of already computed accounting-based indicators pertaining to each listed firm.

1.2

RESEARCH

QUESTION

As pointed out in the previous section, one of the ways in which this study is different from prior empirical studies is that it focuses on investigating R & D as a factor of enhancing the performance of firms. As a result, the following research question has been put forth:

What is the impact of expensed R & D and/or capitalized R & D on the performance of firms?

1.3

PURPOSE

The main purpose of this study is to investigate the impact of expensed R & D and capitalized R & D on firm’s performance. As it will be detailed in chapter three, firm’s performance shall be measured in this study by using ROA, ROCE, DC, DY, EPS, PE and CGR.

1.4

SIGNIFICANCE

OF

THE

STUDY

A study of this nature with the title “research and development and firm performance: investigating the need for R & D as a factor of enhancing the performance of firms” aims to make significant contributions to existing literature in accounting and finance in the follows ways: First; as earlier mentioned, most prior researchers who studied R & D focused on either the accounting treatment of R & D or on investigating the effects of R & D on stock prices of the firm ,whereas this study focuses on investigating R & D as a factor of enhancing the performance of firms. Second, understanding the empirical relationship between R & D and firm´s performance is important for Board of Directors (BOD) and General Managers (GM) of firms as well as other policy makers when they have to make strategic economic policies and decisions about R & D investments.

1.6

DELIMITATION

OF

THE

STUDY

It is important to draw some boundaries for the study under consideration so that readers should be aware of the direction in which the study is focused. The first boundary arises from the fact that the phrase “firm`s performance” or “performance of firms” is most often used in business vocabulary to refer to the financial and non-financial performances of firms. However, the phrases as used in this study refer only to the financial performance and not to the non-financial performance. The second boundary arises from the fact that only United Kingdom (UK) firms listed at the London Stock Exchange Market have been utilized in this study. Therefore, it is important for readers to know that the word “firms” as used in this study refers only to UK firms.

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1.7

DISPOSITION

After presenting the introduction above, the rest of the study has been organized as follows: Figure 1: Disposition of the Study

This chapter provides an overview of philosophical considerations, adopted research technique, adopted research approach, how expensed R & D and capitalized R & D have been measured, accounting-based indicators that have been adopted for measuring firm performance as well as data used in the study.

This chapter presents relevant literature relating to R & D and firm performance.

Chapter four contains the following: graphs of expensed R & D and capitalized R & D plotted against different industries, against various years and against each accounting-based indicator, statistically tests to investigate the impact of expensed R & D and capitalized R & D on firm performance as well as some regression equations. The chapter ends with a summary presentation of all formulated regression equations as well as for all tested hypotheses.

This chapter presents analyses of empirical findings and ends by giving a summary of main findings that are relevant in answering the research question and to meet the purposes of the study.

This chapter presents concluding remarks, theoretical and practical contributions suggestions for further research as well as some limitations of the study

Chapter seven ends the entire study by presenting quality criteria for the evaluation of quantitative researches conducted in business studies.

Source: Author CHAPTER 2 CHAPTER 3 CHAPTER 4 CHAPTER 5 CHAPTER 6 CHAPTER 7

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5

CHAPTER

TWO:

METHODOLOGY

2.1

PRECONCEPTION

The author of this study has studied accounting and finance courses at the master´s level as well as at the Bachelor´s level, as a result has received the necessary theoretical knowledge relating to R & D and firm´s performance. In addition, the author has also worked as an accountant thereby possessing professional experience in the field of accounting. The theoretical as well as the professional knowledge that the author possesses have been the source of inspiration for the choice of the subject. However, the results and conclusions of this study cannot be affected negatively by the author’s preconceived ideas as the entire study relies on scientific measurements which are based solely on objective evidence. This is apparent from the fact that the study has adopted the quantitative research approach to investigate the impact of R & D on firm´s performance. Hence, the use of objective measurement through the formulation of hypotheses together with the statistical tests to be performed will determine objectively the impact of R & D on firm´s performance.

2.2

ONTOLOGICAL

CONSIDERATION

Ontology is a philosophical consideration concerned about the nature and existence of social phenomena (Gratton & Jones, 2010, p. 24).Investigating the impact of R & D on the performance of firms is a social phenomena. The degree of this impact can vary depending on whether R & D has been expensed or capitalized. Ontology also tries to answer the question relating to whether social entities can or should be considered as objective entities with reality external to social actors or whether social phenomenon can be or should be built from the perceptions and actions of social actors (Bryman & Bell, 2007, p. 22).Thus, the ontological consideration of this study is concerned about whether the engagement of firms into R & D are based on the perceptions and actions of those managing the firms or are based on the fact that R & D as a social phenomenon can have a positive impact on firm´s performance.

Objectivism is equally an ontological consideration that asserts that social phenomena as well as their meanings have an existence that confront social actors as external facts that are beyond their reach or influence (Bryman, 2008, p. 18).Firms can engage in R & D because the organizational rules and regulations stipulate that they should do so without knowing the impact that R & D will eventually exert on the firm’s performance. Thus, the ontological position of objectivism is inevitable when trying to understand the reality of the impact of R & D on the performance of firms. This study has adopted the ontological position of objectivism to better investigate the reality of the impact of expensed R & D and capitalized R & D on the performance of firms.

2.3

EPISTEMOLOGICAL

CONSIDERATION

Epistemology is a philosophical consideration that is concerned about how knowledge relating to social phenomena can be acquired and what is supposed to be counted as knowledge (Gratton & Jones, 2010, p. 24) .This study aims to acquire knowledge relating to R & D by conducting an empirical investigation to find out its impact on the performance of firms. Moreover, epistemology is also concerned with answering the question about what is considered as acceptable knowledge in a field of study and whether or not social science researchers should study social phenomenon by using the same principles and procedures that are often used by natural science researchers (Bryman & Bell, 2007, pp. 16-17)

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The main purpose of this study as previously mentioned is to investigate the impact of expensed R & D and capitalized R & D on the performance of firms. Thus, the impact of R & D on firm`s performance will be better known through the utilization of the principles and procedures of natural sciences. This will be achieved through the formulation of hypotheses as well as performing statistical tests in order to fully increase understanding about the impact of expensed R & D and capitalized R & D on the performance of firms. Thus, the application of the procedures and principles of natural sciences will clearly indicate the relationship between expensed and capitalized R & D on firm´s performance as well as how firm performance.

2.4

A

POSITIVIST

POSITION

FOR

THE

STUDY

Positivism is an epistemological consideration that asserts that social science researchers should study social reality by using the methods of natural sciences (Bryman, 2008, p. 13).However, when carrying out researches in social sciences, the social science researcher can either adopt the epistemological consideration of positivism thereby acting as an objectivist or the epistemological consideration of interpretivism thereby acting as a subjectivist. Thus, interpretivism is another epistemological consideration that advocates that the best way for social science researchers to obtain knowledge relating to social phenomena is to grasp the subjective meaning of social actions (Bryman, 2008, p. 16).However, the character of the study under consideration will be conducted with a positivist approach because the approach supports numerical measurement which is essential for the gathering of data relating to R &D and firm´s performance.

Moreover, the social entities of the study under consideration are firms. These firms have different numerical figures for R & D. The reality of the impact of these numerical figures on their performance will be better known through positivism. In addition, the positivist position is well suited when trying to comprehend the impact of expensed R & D and capitalized R & D on their performance. Furthermore, this position also supports the formulation of hypotheses that shall form the basis for performing statistical tests in order to better understand the impact of R & D on the performance of these firms.

2.5

RESEARCH

TECHNIQUE

Social science researchers usually use two main types of research techniques when conducting research about social science phenomena which are quantitative research technique and qualitative research technique. However, quantitative research technique involves the use of numerical measurement to measure variables which can then be statistically analyzed. In addition, quantitative research technique is closely aligned with positivism (Gratton & Jones, 2010, p. 29).On the other hand, qualitative research technique is aimed at capturing non-quantifiable meanings and features such as thoughts, experiences and feelings of respondents, just to mention a few (Gratton & Jones, 2010, p. 30). Some fundamental differences between quantitative and qualitative research techniques as pointed out by Bryman (2008, p. 22) are as illustrated in table 1 below.

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Table 1: Some Fundamental Differences between Quantitative and Qualitative Research Techniques

Quantitative Qualitative Principal orientation to the role

of theory in relation to research Deductive; testing of theory Inductive; generation of theory

Epistemological orientation Natural Science Model, in particular positivism

Interpretivism

Ontological Orientation Objectivism Constructionism

Source: (Bryman, 2008, p. 22)

Quantitative research technique has been adopted in this study because it allows the variables of the study to be numerically measured in order to enable statistical tests to be performed. The results of the statistical tests will permit the research question which as earlier stated is to investigate the impact of expensed R & D and/ or capitalized R & D on the performance of firms to be answered. In addition, the utilization of the quantitative research technique will enable the gathering of objective and tangible evidence about R & D and firm´s performance thereby forming the basis on which conclusions with regard to the research problem shall be made.

2.6

RESEARCH

APPROACH

The three types of research approaches that are available for researchers to use when conducting researches in social sciences are the inductive, deductive and the adductive research approaches (Saunders, Lewis, & Thornhill, 2012, p. 144). The inductive research approach requires the researcher to draw generalizable inferences based on observations and this implies moving from observations/findings to theory (Bryman & Bell, 2007, p. 14). This is as illustrated in the figure that follows:

Figure 2: An Inductive Approach

Source: (Bryman & Bell, 2007, p. 14)

On the other hand, the deductive research approach is the reverse of the inductive approach and it usually moves from theory to observations/findings (Bryman & Bell, 2007, p. 14). This is as illustrated in the figure that follows:

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Figure 3: A Deductive Approach

Source: (Bryman & Bell, 2007, p. 14)

The abductive research approach is a combination of the inductive and deductive research approaches and it refers to a situation whereby the researcher collects data to explore a phenomenon, identifies concepts, explains patterns to generate new theories or modify existing theories and these theories will subsequently be tested by the researcher through the collection of additional data (Saunders et al., 2012, p. 145). The abductive research approach has been adopted in this study. The study started by presenting theoretical data relating to R & D and firm performance. It was based on these theoretical data that concepts such as expensed R & D and capitalized R & D as well as concepts such as accounting-based indicators as measures of firm performance were identified.

The identified concepts shall be used to generate a research model to depict the research gap (research question) and hypotheses shall be formulated based on the research model to enable the research question to be answered. In addition, after formulating these hypotheses, empirical data relating to expensed R & D, capitalized R & D and firm performance shall be collected and empirical findings carried out in order to reject or accept the formulated hypotheses. The results from the empirical findings will form the basis for the modifications that have to be done on the research model. This is in accordance with the abductive research approach because it is a combination of induction and deduction implying that this study shall move from theory to observations/findings and then back again to theory.

2.7

LITERATURE

SEARCH

The main source that has been used for the search of relevant literature for this study was the Umeå University Electronic Library. This was because the Umea University Electronic Library is made up of several Electronic Databases containing up to date scientific and peer-reviewed articles in the field of accounting, finance, management, and marketing as well as in other disciplines. Examples of some of the Electronic Databases that are found at the Umeå University Electronic Library in the field of Business Administration are; Business Source Premier (EBSCO), Business Searching Interface and Scopus. Thus, relevant literature was gathered from these Electronic Databases. However, the Electronic Database that was of frequent utilization when searching for scientific articles was Business Source Premier (EBSCO).This was mainly due to the fact that Business Source Premier is connected electronically to several other Electronic Databases such as EconLit (EBSCO),Academic Search Elite (EBSCO),Web of Science (ISI) and SCIRUS(Elsevier).

All of these Electronic Databases contain up to date scientific and peer-reviewed articles providing comprehensive information about the topic under consideration. Scientific peer-reviewed articles were obtained by using some key words and phrases. For instance, some of the key words and phrases that were used to search for relevant scientific articles from the Electronic Databases as well as the hits that were obtained are as follows: Research and Development Expenditures

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9

(2729 Hits), Expensed Research and Development (26 Hits), Capitalized Research and Development (9 Hits), Firms Performance (24718 Hits), R & D and firms Performance (902 Hits). However, some of the hits were many; as a result not all of the articles were read because of time constraint. Consequently, articles that were read were randomly selected.

Moreover, additional scientific peer-reviewed articles were also obtained by reading the title of articles found at the reference list of other peer-reviewed articles and consequently using the titles to search for more articles in the Electronic Databases that have been mentioned above. Thus, scientific peer-reviewed articles were not only obtained by using key words and phrases. Furthermore, more relevant literature was also obtained from some accounting and finance text books that are found at the Umeå University Electronic Library. Also, few other scientific articles were equally gathered from other databases such Social Science Citation Index (SSCI), Google Scholar and Social Science Research Network (SSRN). The scientific articles and books that have been used in this study are peer-reviewed and have been written by renowned authors. Thus, literature used in the study is assumed to be credible and reliable.

2.8

VARIABLES

The study under consideration is composed of independent and dependent variables. Therefore, it is necessary to give more information about these variables so that readers should be aware of their nature as well as their method of calculation. Hence, section 2.7.1 below explains the nature and the method in which the independent variables have been calculated and section 2.7.2 below also explains the nature and types of dependent variables that have been used in the study.

2.8.1

INDEPENDENT

VARIABLES

The independent variables for the study are expensed R & D and Capitalized R & D. The expensed R & D and capitalized R & D for each firm were computed by using the ratio; Statement of Comprehensive Income R & D to Revenue and the ratio of the Statement of Financial Position R & D to Revenue respectively. This same formula had been used also by prior researchers to compute figures for R & D. For instance, Nguyen et al., (2010), computed figures for R & D by calculating the ratio of R & D to sales (Nguyen et al., 2010, p. 905).In addition, Shu-Ching & Wenching (2006), also computed figures for R & D by calculating the ratio of R & D to revenue (Shu-Ching & Wenching, 2006, p. 140).Therefore, the ratio of average R &D to revenue has been adopted in this study to compute figures for Expensed R & D and Capitalized R & D in percentages for each firm and for each year as presented in the following formulae:

A) For Expensed R & D:

ExpR&Dit = (SCI R & Dit) ×100 Rit

Where,

ExpR&Dit=Expensed R & D for the firm i at the year t in percentage

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10 at the year t

Rit =Revenue figure for the firm i at the year t B) For Capitalized R & D:

CapR&Dit = (SFP R & Dit) ×100 Rit

Where,

Cap R&Dit=Capitalized R & D for the firm i at the year t in percentage

SFP R & Dit=Statement of Financial Position figure R & D for the firm i at the year t

Rit=Revenue figure for the firm i at the year t

2.8.2

DEPENDENT

VARIABLES

Firm performance is the dependent variable of this study and has been measured in other empirical studies by the use of accounting-based indicators. As mentioned earlier, these indicators have been considered as potential measures for firm performance, thus, are regarded as the most important criterion to be used to measure the performance of firms (Sher & Yang, 2005, p. 5).In addition, several other prior researchers have used these indicators to measure the performance of firms. For instance, Lev et al.,(2005),measured firm´s performance by using three accounting-based indicators which were; ROA, Return On Equity (ROE) and Earnings Growth (Lev, Sarath, & Sougiannis, 2005, p. 981). Also, Shu-Ching & Wenching (2006), measured firm´s performance by using four accounting-based indicators which were; ROA, EPS, Net Profit Margin (NPM) and ROE (Shu-Ching & Wenching, 2006, p. 140). Finally, Sher & Yang (2005), also used three accounting-based indicators which were; ROA, Return On Sales (ROS) and ROE to measure firm performance (Sher & Yang, 2005, p. 5).Similarly, in this study, the performance of firms have been measured by the use of accounting-based indicators that are in accordance with International Financial Reporting Standards (IFRS) recommendation and these indicators include some of the above mentioned indicators.Thus,the indicators that have been adopted in this study for measuring firm´s performance are as follows:ROA, ROCE, DY, DC, EPS, PE and CGR. However,further discussions about these accounting-based indicators have been given in the chapter that follows (chapter three).

2.9

DATA

COLLECTION

The source and period of data was taken into consideration when collecting data for this study. A recent period of time was used for data collection and it covers a time period of five years starting from January 1st, 2007 to December 31st, 2011 inclusive. Also, the data that has been used in this study was collected principally from two sources which are (1) from the London Stock Exchange Market Website and (2) from the audited financial statements of companies that are listed at the London Stock Exchange Market. Firms that are listed in this Stock Market also have available information for investors in their websites. Thus, the audited financial statements of the target firms

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11

were retrieved easily by using their websites to locate their annual reports. This was because figures for expensed R & D, capitalized R & D and revenue for each firm and for each year were to be extracted from the audited financial statements of these firms. The figures were recorded in Microsoft Office Excel to facilitate computation of the independent variables: Expensed R & D (ExpR&Dit) and Capitalized R & D (Cap R&Dit) .

Thus, figures for SCI R & Dit (Statement of comprehensive income R & D) and Rit (Revenue) for each firm and for each year were manually extracted from the Statement of Comprehensive Income of each firm. The extracted values - SCI R & Dit and Rit were inserted into equation (1) to compute figures for ExpR&Dit. Also, figures for SFP R & Dit (Statement of financial position R & D) for each firm and for each year were manually extracted from the Statement of Financial Position section of each firm and inserted into equation (2) shown above to compute figures for CapR&Dit. Figures for ROCE, DY, DC,EPS,PE and CGR were already computed and were simply extracted from the stock market. Except of the fact that figures for profit before tax and figures for total assets for each firm and for each year were extracted from the London Stock Exchange to compute figures for ROA.A summary presentation of all variables is shown below:

Table 2: Summary Presentation of Selected variables

Variables Meaning

Independent variables:

ExpR&Dit Expensed R & D for firm i at the year t CapR&Dit). Capitalized R & D for firm i at the year t Dependent variables:

ROA Return on Asset

ROCE Return on Capital Employed

DY Dividend Yield

DC Dividend Cover

EPS Earnings per Share

PE Price Earning Ration

CGR Capital Gearing Ration

Source: Author

2.10

SAMPLE

SELECTION

As at December 311st, 2011, a total of 2,594 firms were listed at the London Stock Exchange Market. In order to facilitate sample selection, information about the firms was downloaded from the London Stock Exchange website into Micro-Soft Excel and the firms were already arranged by group codes, sector (industry), name, listed date and country of incorporation. The aim of downloading the information into Micro-Soft Excel was to facilitate sorting and screening in order to eliminate some of the firms. First, firms were sorted and eliminated according to the date in which they were listed at the London stock exchange market. Hence; firms that were introduced between January 311st, 2008 and December 311st, 2011 were eliminated from the population because their financial statements did not cover a time period of five years. This reduced the total number of firms from 2,594 to 2,049 firms.

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12

Second; firms were sorted and eliminated by industry. Thus, industries such as financial, insurance, leisure goods, real estate, gas, water and utilities were eliminated because such industries were assumed not to be R & D intensive. This eventually reduced the target population further from 2,049 to 664 firms. Third, firms were sorted and eliminated according to their country of incorporation. This was because some firms that are listed at the London stock exchange market have their financial statements published using the currency of their country of incorporation. Thus, all firms that are incorporated in countries other than the UK were eliminated to avoid inconsistency in data that can be caused as a result of currency differences. Finally, firms whose financial statements were not published consecutively for five years within the period December 31st 2007-December 31st 2011 were eliminated in order to reduce survivor bias. This further reduced the target population from 664 to 443 firms.

2.11

SAMPLING

TECHNIQUE

AND

SAMPLE

SIZE

The sample selection process as described above resulted to a population comprising of 443 firms. Two sampling techniques were adopted to further reduce the number of firms that have to be used in the study. The target sample comprising of 443 firms was further reduced through stratification and followed by random selection. This implies that the sampling techniques that have been used in this study are stratified sampling technique and random sampling technique in the following ways: First; stratified sampling technique was used to stratify the target population comprising of 443 firms into their various industries. This is in accordance to Gratton & Jones (2010, p. 112),as they point out that stratified sampling technique should be used in situations where the target population can be divided into sub-groups in order to ensure that the chosen sample will reflects all the appropriate sub-groups that are found within the population.

Second; random sampling was then applied to randomly select firms that are engaged in R & D from each of the industries. Random sampling is a sampling technique that gives each member of a population an equal chance of being selected (Gratton & Jones, 2010, p. 111).Hence, the aim of using random sampling was to ensure that each firm found in each industry should have equal opportunity of being included into the final sample. The final sample gave a total of 52 firms that were found to be engaged in R & D over a period of 5 years between the periods December 31st, 2007 to December 31st, 2011.A list of all firms used in the study is shown below:

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13

Table 3: List of all firms classified by industries

General Industrials Industrial Engineering Mobile Telecommunications Pharmaceutical & Biotechnology Aerospace & Defense Electronics & Electrical Equipments Health Care Equipments & Services

Rexam Plc Weir Group Plc Vodafone Group Plc Glaxosmithkline Senior Plc Volex Plc Smith & Nephew

Rpc Group Plc Fenner Plc Ergo Group Plc Btg Meggitt Morgan Crucible Co

Consort Medical Plc Cookson Group

Plc

Goodwin Plc Inmarsat Plc Dechra

Pharmaceuticals

Avon Rubber Halma Corin Group Smiths Group

Plc

Rotork Plc Messaging International

Summit Corp Plc Cobham Oxford Instruments

Vindon Healthcare Smith (Ds) Plc Tex Holdings Plc Mobile Tornado Group Abcam Umeco Renishaw Bioquell Smurfit Kappa

Group Plc

Corac Group Plc Zamano Plc Hikma

Pharmaceuticals

Qinetiq Group Domino Printing Sciences

Surgical Innovations Group Porvair Plc Tanfield Group Plc Solid State Plc Anpario Plc Cohort Spectris Mediwatch

TEG Group Plc DIALIGHT

XAAR Source: Author

As it can be seen in the diagram above, each industry had at least 7 firms carrying out R & D activities for a period of 5 years. Multiplying 7 by the number of data points for each firm which is 5 gives 35 implying that each industry had at least 35 data points. This makes the sample size for each industry to be valid from a statistical viewpoint considering the fact that a minimum sample size of 30 has been recommended for statistical analysis (Saunders et al., 2012, p. 219). Thus, 260 observations were obtained for all firms.

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14

2.12

ASSESSMENT

OF

DATA

Data is usually collected from two main sources which are primary and secondary sources, known as primary and secondary data respectively. Primary data refers to data that a researcher has collected by himself either through the use of his own questionnaires or interviews or observations and so on. On the other hand, secondary data refers to data that others have already collected and it can come from various sources such as research articles, annual reports, government publications, just to mention a few (Gratton & Jones, 2010, p. 73).In this study, secondary data has been used. This is because theoretical data relating to R & D and firm´s performance was collected from secondary sources. Empirical data relating to R & D and firm performance have also been collected from secondary sources such as the financial statements of public listed companies and from the London stock exchange website.

Moreover, when using secondary data to carrying out researches in social sciences, the researcher has to ensure that the data to be collected is reliable, valid, current as well as checking whether the data has been used in other researches by prior researchers (Gratton & Jones, 2010, p. 73).Likewise in this study, the empirical data that has been extracted from the financial statements of firms relating to R & D and firm´s performance is assumed to be reliable and valid because the financial statements have been audited and certified by professional auditors. The data that has been extracted from the London stock exchange market website is equally assumed to be valid and reliable because the data originates from the audited financial statements of public companies. Moreover, the London stock exchange market website is also assumed to be credible and reliable as it publishes information that is generally used by investors, students, researchers, stock brokers and so on. Finally, both the theoretical and empirical data relating to R & D and firm´s performance is current and not outdated. This is evident from the fact that recent articles were used to extract theoretical data and a recent period of time was used to extract empirical data starting from January 1st, 2007 to December 31st, 2011.

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15

CHAPTER

THREE:

THEORETICAL

FRAMEWORK

3.1

RESEARCH

&

DEVELOPMENT

R & D has been considered as very essential for the long-term success of a firm (Flamm, 1990, p. 55).Thus, investing in R & D implies generating an important asset for the firm though, this asset can easily disappear if not maintained continuously. For this reason, a firm needs an uninterrupted stream of investment in R & D. This will help maintain the assets thereby preventing them from becoming extinct overtime (Cuervo-Cazurra & Annique Un, 2010, p. 764).However, when companies do invest in R & D, they should be conscious of the fact that the benefits from R & D investments are not harvested in the year in which the investment took place. For instance, a firm that has invested in R & D should not expect its profits or sales to increase in the year in which the investment took place (Flamm, 1990, p. 55).Moreover, when a firm is making decisions on whether or not to invest in a given R & D program ,the firm should compute and compare the present value of the expected profit connected to the R & D investment with the expected present value of the profits that can be earned if the firm does not invest in the R & D project (Blanes & Busom, 2004, pp. 1462-1463).

Also, when making decisions about R & D, firms should be conscious of the fact that most R & D projects are conducted differently using different ways. For example, a firm in the electric utilities industry can conduct its R & D simply by using in house facilities or by collaborating with other firms (Jamasb & Pollitt, 2008, p. 998).Notwithstanding, R & D can be conducted for the benefits of the reporting firm itself or for the benefits of other firms under contractual agreements or it can simply be purchased from other firms (Graham, 2011, p. 115).Moreover, not all costs incurred during R & D are considered as R & D costs. Thus, examples of some costs that are considered as R & D costs as well as examples of some costs that are not considered as R & D costs are as illustrated in table 2 below:

Table 4: Some Examples of R & D and Non R & D Costs

Examples of Some R & D Costs Examples of Some Non R & D Costs

Laboratory research to discover new knowledge

Engineering during an early phase of commercial production

Formulation and design of products or processes such as (1) testing for products alternatives and (2) modification of products or processes

Quality control for commercial production

Production prototypes and models such as (1) tools, dies and so on for technology and (2) pilot plants not capable of commercial productions

Troubleshooting during a commercial production breakdown

Engineering activity performed until the product is ready for manufacture

Routine, ongoing efforts to improve products

Others include adaptation of existing capacity for a specific customer or requirements, Seasonal design changes to products, routine design of tools dies etc. Source :(Graham, 2011, pp. 115-116),tabulated by author.

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Furthermore, another cost considered as R & D cost is the cost that arises from In Process-R & D which is the cost acquired during merger and acquisition when the target firm is currently carrying out R & D. Thus, In Process-R & D has been defined as the value that is allocated to an unfinished R & D project during purchase acquisition by the acquirer (Dowdell, Lim, & Press, 2009, p. 531).This cost when acquired as part of a group of assets in a business combination is usually accounted for through the purchase method (Clem, Cowan, & Jeffrey, 2004, p. 408).In addition, empirical evidence concerning the accounting treatment of In Process-R & D shows that the acquiring firm write offs are usually consistent with the previous R & D write offs of the acquired firm (Dowdell et al., 2009, p. 549).Thus, In Process-R & D has been considered to be very useful when evaluating future cash flows and earnings quality of a firm. As a result, the accounting treatment of In Process-R & D has generated consistent debates over the decades (Clem et al., 2004, p. 425).

3.1.1

CAPITALIZING

AND

EXPENSING

OF

R

&

D

The decision with respect to whether a given expenditure should be capitalized and then amortized or should be expensed is dependent on whether the expenditure is expected to produce future economic benefits for the firm as well as on the degree of uncertainty that are involved for such benefits to be achieved (Ahmed & Falk, 2009, p. 46).Many R & D expenditures will be beneficial to the firm over a long period of time suggesting that such expenditures should be capitalized and then amortized so that they can be expensed across other benefiting periods (Roberts, 1965, p. 57).The accounting treatment of some of R & D expenditures according to Hunt,Kieso,Weygandt, & Warfied (2012, p.21) is shown in the table that follows:

Table 5: Accounting treatment of some examples of R & D Expenditure

Type of R & D Expenditure Accounting Treatment

Acquisition of R & D equipment for use on

current project only Expense immediately as R & D Construction of long-range research

facility for use in current and future projects (e.g. three story building)

Capitalize and depreciate as R & D expense Salaries of research staff designing new

laser bone scanner

Expense immediately as R & D Legal fees to obtain patent on new laser

scanner

Capitalize as patent and amortize to overhead as part of cost of goods manufactured

Acquisition of R & D equipment for use on

current project only Capitalize and depreciate as R & D expense Cost of successfully defending patent on

laser scanner

Capitalize as patent and amortize to overhead as part of cost of goods manufactured

Source: (Hunt et al., 2012, p.21), tabulated by author.

Notwithstanding, a considerable number of companies capitalizes and amortizes R & D under the assumption that they would eventually produce future economic benefits to the firm, thus, deferring expenses in this way, all else stays the same will cause the company to report higher current profits while at the same time the company will be able to boast of its R & D activities (Doyle & Navratil, 1981, p. 31). This implies, the association between expensed R & D on firm’s

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17

performance could be different from the association between capitalized R&D and firm’s performance. In addition, empirical evidence indicates that the advantage of capitalizing R & D expenditures is that it will help analyst forecasts to reduce the degree of uncertainty with regard to the quality of R & D investments thereby leading to increased accuracy in analytical forecasting (Anagnostopoulou, 2010, p. 80).On the other hand, the disadvantage of expensing R & D instead of capitalizing lies in the fact that corporate decision making might be distorted eventually leading to faulty measures of income as well as changes in income throughout the course of time (Bierman Jr & Dukes, 1975, p. 53).As a result, users of the company`s financial statements will not have the opportunity to access the information relating to the progress of R & D that can be conveyed when R & D expenditures are capitalized and then amortized over time (Anagnostopoulou, 2010, p. 66).

3.1.2

SOME

STRATEGIES

OF

R

&

D

INVESTMENTS

Some strategies have been suggested to be utilized by firms when making decisions about R & D investments. These strategies are more concerned about how often a firm should invest in R & D. Thus, in terms of the frequency of R & D investments, a firm can either choose any of the following strategies: (1) A firm can decide to always invest in R & D. (2) A firm can decide to never invest in R & D, though the bad thing about this strategy is that it disobeys R &D recommendations found in existing literature. (3) A firm can decide to sometimes invest in R & D. A firm that chooses the third strategy to sometimes invest in R & D can further adopt any of the following sub-strategies: (a) “start investing” and this strategy applies to firms that have never invested in R & D and demands that the firm should start investing in R & D on a continuous basis. (b) “Stop investing” this strategy calls for firms that have been investing in R & D on continuous basis to stop investing and (C) “vary investing” this sub-strategy requires that firms should invest in R & D in some years, and then skip some other years without making any investment, and yet again make R & D investments in other years (Cuervo-Cazurra & Annique Un, 2010, pp. 764-765).

Additionally, investment in R & D is regarded to be different from other business investments in terms of spending on wages and salaries. This is due to the fact that approximately fifty per cent or more of R & D spending originates from wages and salaries paid to highly educated scientists and engineers. Thus, such spending forms a knowledge base for the firm, thereby creating an intangible asset for the firm on which profits for future years shall be produced (Hall, 2002, p. 3).Hence, it has been asserted that firms that lack internal knowledge resources always have the tendency of limiting their frequency of R & D investment while firms that lack external knowledge resources always have the tendency of increasing their frequency of R & D investments (Cuervo-Cazurra & Annique Un, 2010, pp. 764-765).As a result, a model has been suggested to demonstrate the interaction between internal and external knowledge resources to be used by firms in determining whether they should never, always, or sometimes invest in R & D as illustrated in the figure below.

References

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