Can more transparency result in greater innovation?

To encourage greater investment in research and development to keep up with investments from U.S.-based competitors, China began regulating how publicly-traded, non-state-owned companies report R&D spending. Beginning in 2018, companies were required to explicitly state R&D expenditures in their financial statements. This approach differs from international and U.S. reporting standards, which allow R&D spending to be listed as an operating cost, a category that can also include expenses such as employee salaries, marketing or rent.

Since the change, R&D spending by Chinese companies has gone up considerably…at least on paper. But research by Partha Mohanram and Baohua Xin, professors of accounting at Rotman, suggests that at least some of this increase is an illusion. His research suggests it’s likely that some non-R&D spending is being passed off as research and development. What’s more, investors have taken notice since the stock prices of Chinese companies aren’t getting the kind of boost you’d expect from an increased investment in R&D.

“The rule change was well-intentioned, but it was not necessarily well thought out,” says Mohanram.  

In a paper published in the Review of Accounting Studies, Mohanram and his co-authors found that the relationship between R&D spending and patents in China has become weaker since the new reporting rule was implemented.

“When they implemented this rule, everybody’s R&D spending went up,” he says. “But the increase doesn’t necessarily mean that ‘real research’ increased. If R&D was genuinely increasing, we should see a proportional increase in patents and other R&D outputs. But we found that the relationship between spending and patents weakened after the rule was implemented, which means that some of the R&D spending companies reported was probably not actually R&D.”

Mohanram believes that Chinese firms are stretching the definition of R&D, and listing expenses like salaries or other operating expenses not related to R&D as R&D in their financial reports. However, he notes it’s impossible to rule out an alternative explanation: that Chinese companies were already at the optimal level of R&D and are now investing in low-quality R&D projects to meet investor expectations.

“Whenever you change a reporting rule, and that change is not verifiable, people will try to use the change for their own benefit,” Mohanram says. “And there is a lot of ambiguity in whether something is R&D or not. There is a fair amount of subjectivity involved, and it can be used for a manager’s personal benefit.”

Investors have taken notice. R&D expenditures are a measure of corporate innovation, and are one of many factors built in to a company’s stock price. If investors believe a company’s R&D will lead to future profits, those expectations will help drive up the value of that company’s stock. But that is not happening with Chinese stocks.

“Companies might overreport R&D with the intention of ‘fooling’ the markets,” says Mohanram. “But the markets are not actually being fooled.”

Mohanram compared the stock valuations of non-state-owned and state-owned public companies in China. Most Chinese state-owned public companies have a single dominant shareholder, and did not report a dramatic increase in spending after the R&D reporting rule was changed in 2018. Managers at these firms have less incentive to present inflated numbers because they rely on the government more and capital markets less for fundraising.

Their analysis looked at increases in a firm’s stock price at the time of its annual report and found that R&D spending by non-state-owned enterprises was discounted in comparison to R&D spending by state-owned ones. The announced R&D numbers didn’t boost the stock prices of non-state-owned companies to the same degree. This suggests that the markets probably suspect that some of the increase in R&D spending for these non-state-owned companies was not “real R&D”.

“This rule was intended to make R&D investments more transparent so that investors could value it more highly,” says Mohanram. “But the format change also incentivizes managers to be opportunistic or inefficient. Our analysis suggests that investors are aware that managers are being opportunistic in their reporting.”

When implementing new rules in capital markets, regulators need to be aware of the dynamic interactions of all parties involved, Mohanram argues. And in this case, a more flexible approach to financial reporting makes more sense.

“The model we use in Canada and the U.S. is much more organic. Some firms, like Pfizer, disclose R&D separately, but others, like Apple, do not,” he says. “Accounting should not necessarily be one size fits all. Giving people the flexibility to present information in the way that they want is not necessarily a bad thing.”