Firm-Level Financial Measures of Innovation

FIRM-LEVEL FINANCIAL MEASURES OF INNOVATION

AN EXPLORATORY PROJECT TO DERIVE FINANCIAL MEASURES OF INNOVATION ACTIVITY FROM THE ACCOUNTING RECORDS OF MODEL AUSTRALIAN FIRMS

Innovation Division

Department of Industry, Innovation, Science,

Research and Tertiary Education

February 2012 This is a research report commissioned by the former Department of Innovation, Industry, Science and Research, now the Department of Industry, Innovation, Science, Research and Tertiary Education (DIISRTE). The views expressed in this report do not necessarily reflect the views of the Department or PricewaterhouseCoopers (PwC). Responsibility for the project’s Terms of Reference, as well as for errors, omissions and oversight rests with the project coordinator (HT).

Project Contributors

Ms Louise Talbot (DIISRTE)

Dr Hsien Toh (Project Coordinator, DIISRTE)

Mr Eugene Kalenjuk (PwC)

Mr Aaron Lal (PwC)

Mr Jae Seol (PwC)

Acknowledgement

The project coordinator thanks Mr Richard Snabel, General Manager, Industry Policy & Economic Analysis Branch (DIISRTE) and the Australian Bureau of Statistics for helpful critical comments and feedback on the report drafts.

ISBN 978 1 921916 27 4

This work is copyright. Apart from any use as permitted under the Copyright Act 1968, no part may be reproduced by any process without prior written permission from the Commonwealth. Requests and inquiries concerning reproduction and rights should be addressed to the Commonwealth Copyright Administration, Attorney General’s Department, Robert Garran Offices, National Circuit, Canberra, ACT, 2600 or at http://www.ag.gov.au/cca

Other requests are to be directed to the Department of Industry, Innovation, Science, Research and Tertiary Education, GPO Box 9839, Canberra, ACT, 2601.

2 CONTENTS

PROJECT BACKGROUND AND TERMS OF REFERENCE 5

1 EXECUTIVE SUMMARY 13

2 INTRODUCTION 14

2.1 Objectives 14 2.2 Innovation 14 2.3 Financial reporting 15 2.4 Relevant accounting standards 17 2.5 Chart of accounts across innovation activities 19 2.6 Chart of accounts across different business sizes 22 2.7 Definition of small, medium and large business 23

3 SMALL BUSINESSES 24

3.1 General characteristics 24 3.2 Accounting method 25 3.3 Case study 25 3.4 Technical Difficulties 33 3.5 Summary 34

4 MEDIUM BUSINESSES 35

4.1 General characteristics 35 4.2 Accounting method 36 4.3 Case Study 38 4.4 Technical difficulties 49 4.5 Summary 50

5 LARGE BUSINESSES 51

5.1 General characteristics 51 5.2 Accounting method 52 5.3 Large Business Case study (1) 54 5.4 Technical difficulties 71 5.5 Large Business Case study (2) 72 5.6 Technical difficulties 87 5.7 Summary 87

6 CONCLUSION 88

REFERENCES 89

TECHNICAL DISCUSSION AND LESSONS LEARNT 90

Introduction 90 The Business Accounting Process 90 Firm Structure and the Statistical Unit 93 Firm Innovation Expenditure 94

3 Implications for Policy 99 Lessons Learnt and Recommendations 103 Concluding Remarks 105 Bibliography 106

APPENDIX 107

4 PROJECT BACKGROUND AND TERMS OF REFERENCE

Firm-level innovation data have been collected by a number of OECD member countries using standardised innovation survey instruments since the mid-1990’s, providing more direct measures of innovation for research and analysis. The national surveys are designed to be representative of all industries within scope such that the results can be aggregated and comparisons made between industries.1 Therefore, the instrument has to accommodate a wide range of firms, ranging from micro-businesses to the largest and most complex firms, in both the goods and the services sectors, where in many cases the innovation activities are in practice not always easily distinguishable from normal production or other routine business activities. In the Australian case, the survey instrument design has to carefully balance the twin objectives of providing data that is fit-for-purpose while minimising respondent burden.

The Australian experience from undertaking business innovation surveys was that many firm respondents still experienced significant difficulties in providing quantitative measures of innovation, despite extensive form testing which trialled alternative versions of the questions on innovation expenditures and sales, resulting in low response rates and diminished data quality for these questions. Post-survey interviews with business respondents undertaken by the Australian Bureau of Statistics (ABS) following the 2003 and 2005 innovation surveys (ABS Catalogue No. 8158.0) identified the sophistication of a firm’s financial systems, the complexity of their operations, and the degree of specialisation within the firm as factors that affected a firms’ ability to provide reliable quantitative data, if at all.2 Imputation techniques were applied to deal with missing data but there were shortcomings with these techniques.

Brouwer and Kleinknecht (1995) similarly reported that when Dutch firms were asked to indicate the ease of estimating innovation expenditures in their Eurostat Community Innovation Survey (CIS) returns, only 24% of manufacturing firms and 20% of services firms indicated being able to provide reasonably accurate data, while the balance were either only able to provide rough estimates or were not able to provide any expenditure information at all, with manufacturers performing somewhat better than services firms.

Innovation expenditure data provide information on the underlying volumes of scarce resources allocated by firms to innovation-related activities. The absence of such data greatly restricts the ability of researchers and policy makers to assess objectively the economic impacts of innovation and innovation policies using analytical tools such as econometric methods (DIISR, 2009). The following discussion of the issues relating to businesses innovation expenditure data will serve to outline the basic framework for this project. categorising Innovation Activities

The respective definitions of R&D and innovation in the Frascati (OECD, 2002) and Oslo (OECD, 2005) Manuals are actually just a classification of institutional activities (within a reference period) to non- overlapping performance categories in order to distinguish activities with significant novelty objectives (i.e. developing new knowledge or new products, processes and methods) from other related activities. The further distinction between R&D and innovation recognises that innovations can be implemented without prior R&D: in the 2006-07 and 2008-09 ABS Business Characteristics Surveys, 15 % and 11 %, respectively, of innovation-active business respondents reported any R&D activity for the purpose of innovation. Table 1 provides a summary of the recommended categories of innovation activities from the Oslo Manual that will

1See also Oslo Manual (OECD, 2005), p. 21.

2See also Oslo Manual (OECD, 2005), p. 99

5 be applied in the project to identify firm transactions that relate to innovation.

Table 1. Innovation Activities (OECD, 2005) Innovation Activity Notes Research and All direct and indirect costs of intramural or in-house R&D; Experimental Extramural R&D cost is the total invoice amount of the external R&D service. Development (R&D) Acquisition of new This is the entire cost of purchase of capital goods for the purpose of machinery and implementing an innovation within the reference (also includes computer equipment and other software and the cost of major improvements, modifications and repairs). capital goods Capital items purchased for the purpose of R&D are allocated to R&D. Acquisition of other External knowledge in the form of patents, non-patented inventions, licences, external knowledge disclosures of know-how, trademarks, designs and patterns. Included are the cost of acquiring computer services and other scientific and technical services for product and process innovations. Design The cost of design for the implementation of product (including work on form and appearance) and of process innovations are to be included in Other Preparations for Product and Process Innovations. The costs of product design changes for marketing purposes with no significant improvement in functional characteristics or intended uses are included under Preparations for Marketing Innovations. Training Excludes the cost of training for routine upgrading of skills or training for new employees in existing methods or techniques. The cost of training for the purposes of R&D is included under R&D. Testing and evaluation Costs relating to routine testing activities must be excluded; Trial production, testing of prototypes and pilot plants are attributed to R&D if the trials lead to subsequent further design and engineering. Set-up and engineering Only include the costs relating to the implementation of an innovation. Set-up includes changes in procedures and software required for providing new services or the use of new delivery methods. Market preparations for The costs incurred for the market introduction of innovative good or service. product innovations Excludes the cost of routine advertisement post implementation. Development and use of Only related innovation (i.e. post-R&D) activities are included here. software R&D related activities are assigned to intramural or extramural R&D. Other preparations for Expenditures not assigned to the above categories. product or process innovations Preparations for Expenditures incurred to implement new methods in business practices, in organisational workplace organisation and in organisation of external relations. innovations Preparations for Includes only the cost incurred up to the point of implementation of new marketing innovations marketing methods in e.g. product design or packaging, pricing methods, product placement and product promotion,; Excludes expenditures for using these methods in daily business e.g. advertisement, event marketing and sponsorship.

The difficulty for firms is that there is no obvious correspondence between the economic categories of Table 1 and the cost incurred as part of normal business operations such as salaries, superannuation, payroll tax, materials, utilities and non-current asset. Furthermore, any activities such as the purchase of new capital equipment, training, testing and marketing costs are often also incurred as part of normal or existing business operations for a given reference period.

6 FIRM STRUCTURE AND ACTIVITY

The two preliminary steps for establishing some correspondence between firm operations and the economic measures of firm activity are to define what is meant by the firm and the basic units of inputs and outputs of the activities we trying to measure. Australian firms exist in a variety of distinct legal and organisational forms, ranging from non-employing micro-businesses to complex enterprise groups. At June 2009, 32.7% of Australian businesses were Companies, while 29.5% were Sole Proprietors, 20.2% were Trusts and 17.6% were Partnerships (ABS, 2009). Many of the larger firms comprise several distinct operations that may be associated with either a simple or complex legal structure. Criscuolo et al. (2003) cautioned that the quality of the analysis is critically dependent on the properties of the underlying data and described approaches to define the relevant analytical unit in a systematic way for British businesses.

The Oslo Manual recommends that the enterprise unit, defined to be the smallest organisational unit that is an independent economic entity with decision-making autonomy for their productive activities, be the primary statistical unit. The enterprise unit may either constitute a single legal unit or a group of legal units where the individual legal units cannot be considered as separate economic entities (OECD, 2005). This is consistent with the broad economic definition of firms as institutions that coordinate the transformation of inputs into outputs (Snyder and Nicholson, 2008). The approach adopted in this project for dealing with the relationship between the legal establishment and its economic functions is the Unit Model developed by the ABS (DIISR, 2009), which provides a consistent definition of the firm unit that is appropriate for productivity analysis.

The firm unit derived this way is also consistent with the Australian and New Zealand Standard Industrial Classification (ANZSIC) 2006 (ABS and SNZ, 2006) system that applies the supply-side approach to classify firms to an industry according to similarities in their ‘production functions’ i.e. the way factors of production are combined to transform intermediates to final products. Some industries are naturally more labour intensive while others are more capital intensive. While the lowest category (4-digit Class) would exhibit the greatest homogeneity on this basis, the ANZSIC classification of firms or production units is based on predominant activity.

Figure 1 summarises the key ideas from above and illustrates the statistical/analytical unit of the ‘firm’ using the representative production function and applying the Oslo Manual definitions, where the quantities of inputs and of outputs are expressed according to their respective innovation and non-innovation related components. The underlying quantities can be expressed in the more familiar form of revenues or expenses when multiplied by their respective unit market prices where the subscripts i and j refer, respectively, to the ith statistical (firm) unit and the jth output.

7 Figure 1. Firm production showing the innovation and non-innovation components3

Although not included in this discussion due to difficulties in obtaining robust measures, company or management culture, human capital, absorptive capacity and external relations are very important as determinants of business innovation and performance, but they are not directly measurable and there is no generally accepted valuation method. So, from the perspective of the survey, the quantitative measures available for analysis are restricted to the transactions that businesses can record in their financial accounts. firm ACCOUNTING data

The decompositions in Figure 1 provide an intermediate step to link the innovation activities listed in Table 1 to the transactions recorded in the firm’s accounting systems. Users must be aware that firm financial records have to support a range of functions such as taxation, reporting to stakeholders and internal management decision making. Therefore, a final step is to understand how the primary entries corresponding to each transaction are recorded and how they relate to the firm’s reporting obligations and the broader financial reporting framework. The accounting identity shown below in Figure 2 is the basic framework for preparing the financial statements that relates the items in the Balance Sheet (Financial Position) items to the items in the Profit and Loss (Income Statement) and the primary transaction accounts. The statement of cash flow provides additional information on the firm’s solvency.

The policy analyst intending to use firm accounting data must be cognisant of the following: (i) the accounting identity is an equality and it enables a firm to explain the changes to the opening balance between assets and liabilities (plus any owner’s equity) and the closing balance that result from the transactions undertaken during an accounting period, and (ii) each transaction entry is classified to the accounts sitting under each item in the accounting equation that it affects (i.e. increases or decreases); and a separate account is established for each significant category of asset, liability, revenue and expense (Hoggett and Edwards, 2000), resulting in the need to trace and manually aggregate information residing in several accounts in the general ledgers to the economic activities of interest e.g. R&D or innovation.

Figure 2. Overview of the Accrual Accounting Process

3The conventions of Snyder and Nicholson (2008) are adopted here where the lower case symbols for firm-level inputs and outputs and upper case when referring to an entire market; the production function can be truncated to q=f(k,l), ignoring intermediate inputs, where q will then have the interpretation of “value added”.

8 PROJECT OBJECTIVES AND SCOPE

The discussion above outlines a general procedure that will be applied in the project for mapping accounting data to the Oslo and Frascati Manual definitions of innovation activities. A priority is to develop strategies for improving the quality of the business innovation expenditure data (and the response rates) and to systematically identify the barriers faced by firms when providing the information requested in the surveys, with an initial focus on the reporting requirements of different types of firms and how they affect the content and level of detail of the data records maintained by firms.

PricewaterhouseCoopers (PwC) were engaged to undertake the exploratory study with the following Terms of Reference: i) The objective of this project is to systematically apply the OECD guidelines to source business accounts in order to: (a) estimate business expenditures and revenues associated with the implementation or introduction of an innovation (i.e. new goods/services, processes or methods) from first principles by systematically applying the Oslo Manual (OECD, 2005), definitions of innovation activities to the transactions recorded in source accounts, and (b) identify barriers or shortcomings of translating financial accounting information into economic measures from the mapping process in order to improve the reliability of financial data collected by surveys. ii) The report provides a preliminary discussion of the relevant current financial accounting concepts and methods with reference to firm size (i.e. large, medium and small firms) and firm type (e.g. publicly listed firms and private firms), as well as the application of relevant accounting standards (AASB Standards); iii) Illustrates the process for distinguishing resources devoted to implementing novel business activities from those devoted to maintain ongoing business activities for a given reference period, and classifying the innovation-related transactions identified in source accounts according to the recommendations of the Oslo and Frascati (OECD, 2002) Manuals, respectively, with the aid of model examples of real business accounts showing general journals, general ledgers, balance sheets and income statement corresponding to:

a) a small (0-19 employees) services firm;

b) a medium-size (20-199 employees) manufacturing firm with a single legal entity, and

c) two examples of large complex firms (200 or more employees) with multiple management/production

9 units, for example, where the units responsible for R&D or other innovation activities may be separate legal entities from the production units; iv) Applies the production unit approach of the ABS Units model for specifying the statistical or analytical unit. Such specification should enable business units to be classified consistently according to the Australian and New Zealand Standard Industrial Classification (ANZSIC) [ABS and SNZ, 2006]; v) The report will critically discuss the technical issues and potential limitations arising from the mappings undertaken in the project.

Figure 3 below provides an overview of the general methodology that is followed in the project.

Figure 3. A Summary Illustration of the Project Methodology

10 BIBLIOGRAPHY

AASB (2011) AASB Australian Accounting Standards. Australian Accounting Standards Board, Commonwealth of Australia, Melbourne.

ABS and SNZ (2006) Australian and New Zealand Standard Industrial Classification 2006. Australian Bureau of Statistics, Commonwealth of Australia, Canberra; Statistics New Zealand, New Zealand Government, Wellington.

ABS (2009) Counts of Australian Businesses, Including Entries and Exits – June 2007 to June 2009. Catalogue No. 8165.0. Australian Bureau of Statistics, Commonwealth of Australia, Canberra.

Brouwer, E. and A. Kleinknecht (1995) Measuring the unmeasurable: A country’s non-R&D expenditure on product and service innovation. Serie Research Memoranda. Vrije Universiteit, Amsterdam.

Criscuolo, C., J. Haskell and R. Martin (2003) Building the evidence base for productivity policy using business data linking. Economic Trends 600. Pp. 39-51. Office of National Statistics, United Kingdom Government, London.

DIISR (2009) Innovation Metrics Framework Consolidated Report. Department of Innovation, Industry, Science and Research, Commonwealth of Australia, Canberra.

Hoggett, J.R. and L. Edwards (2000) Financial Accounting in Australia. 4th Edition. John Wiley and Sons, Brisbane.

OECD (2002) Frascati Manual – Proposed Standard Practice for Surveys on Research and Experimental Development. Sixth edition. Organisational for Economic Cooperation and Development, Paris. ISBN 92-64- 19903-9.

OECD (2005) Oslo Manual – Guidelines for Collecting and Interpreting Innovation Data. Third edition – A joint publication of OECD and Eurostat. Organisational for Economic Cooperation and Development and Statistical Office of the European Communities, Paris. ISBN 92-64-01308-3.

Snyder, C. and W. Nicholson (2008) Microeconomic Theory. Basic Principles and Extensions. 10th edition. Thomson South-Western, Mason, USA.

11 DIISR INNOVATION FINANCIAL DATA PROJECT

A REPORT COMMISSIONED BY THE DEPARTMENT OF INDUSTRY, INNOVATION, SCIENCE, AND RESEARCH

30 JUNE 2011

12 1 EXECUTIVE SUMMARY

Innovation is a complex concept and one which is viewed through a theoretical lens from an economic perspective and practical lens from an accounting and business perspective. The economic and accounting perspectives of innovation have led to inconsistent behaviours between government (as policy makers) and businesses (as end users of policy).

The economic perspective of innovation adopted by Government has resulted in policy aimed at identifying and measuring the innovative activities that businesses undertake, through a strict adaptation/classification of the OECD Oslo Manual (2005) and Frascati Manual (2002).

In practice, organisations, whether small, medium or large do not classify business transactions by adopting the Oslo and Frascati Manuals, but rather are heavily influenced by the accounting concepts / standards and the practical needs of internal and third party users of financial reports.

There are some incentives for businesses to track innovation expenditure in their accounts, for example the application for government grants and tax concessions associated with research and development (R&D) activities. Where businesses engaging in R&D activities do keep track of R&D expenditure, the R&D expenditure recorded in the financial accounts is generally not per Oslo or Frascati Manuals but adopts the accounting standard definitions.

The rules applied to business and economic accounts differ due to the fact that the objectives of the two sets of accounts are different. The objective of business accounts include reporting to shareholders and regulators on the solvency and profitability of an individual enterprise, and determining taxes to be paid. The objective of economic accounts is to compile a set of accounts for the whole economy in order to provide information for economic analysis and the formulation of economic policy.

This report attempts to map or reconcile the Oslo Manual definition of innovation and innovation activities to the relevant financial accounting concepts and develop a set of guidelines for reliably estimating expenditures and revenues attributed to business innovations and innovation activities across small, medium and large business enterprises.

The four real world model examples outlined in this report illustrate that obtaining innovation data estimates from business accounts can be a difficult process. Whilst comfort can be gained from the fact that financial reporting allows the recording of all innovation expenditures and revenues in some way or the other, estimating, separating and sourcing innovation expenditure and revenue from various business financial accounts and sub-accounts is not straight forward.

13 2 INTRODUCTION

This report has been prepared on behalf of the Department of Innovation, Industry, Science and Research for general guidance only and does not constitute professional advice. The case studies contained in the report depicting business accounts, transactions and business names are hypothetical examples only. You should not act upon the information contained in this report without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this report, and, to the extent permitted by law, PricewaterhouseCoopers does not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this report or for any decision based on it.

This is an exploratory study to apply the OECD’s Oslo Manual and Frascati Manual guidelines to identify business innovation expenditures from first principles, which requires the translation of financial information collected in an accounting framework for analysis in an economic framework.

2.1 OBJECTIVES

The objective of this report is to produce a set of guidelines for reliably estimating expenditures and incomes related to business innovations and innovation activities.

This requires the ability to distinguish business innovation activities from routine business activities for a given reference period. Because the data source for firm-level economic analysis is the firms’ financial accounts, the high level objective of this project is to reconcile the OECD definitions of innovation activities with the relevant items recorded in business financial accounts and sub-accounts, with particular attention on the operations of the Australian Accounting standards issued by the AASB.

2.2 INNOVATION

This report has adopted the OECD definitions for innovation and innovation activities (Oslo Manual 3rd ed., OECD, 2005) and research and development (Frascati Manual, OECD, 2002) which are briefly defined as follows:

An innovation is the implementation of a new or significant improved product (goods or services), or process, a new marketing method, or a new organisational method in business practices, workplace organisation or external relations.

Innovation activities are all scientific, technological, organisational, financial and commercial steps which actually, or are intended to, lead to the implementation of innovations. Some innovation activities are themselves innovative, others are not novel activities but are necessary for the implementation of innovations. Innovation activities also include R&D that is not directly related to the development of a specific innovation.

R&D comprise creative work undertaken on a systematic basis in order to increase the stock of knowledge, including knowledge of man, culture and society, and the use of this stock of knowledge to devise new applications.

Innovation is a major policy priority for the government because its contributions to productivity growth and its implications for the sustainability of rising living standards or economic growth in the long-run. The issues of interest to government are firstly, the economic impact of the decisions by firms to allocate scarce resources with alternate uses to implement or support novel business activities as opposed to routine business activities and secondly, the effect of various public policies on the efficiency of those decisions. 14 For the purpose of business innovation, the measures of interest are the relative quantities of resources allocated between new and existing business activities that result from investment decisions, and their impact on output. This idea can be approximated by the concept of the production function, which defines and relates a set of inputs to outputs. While company or management culture, human capital and company relations are important inputs to business innovation, they are not directly measurable. So the quantitative measures are the transactions that businesses record in their financial accounts.

2.3 FINANCIAL REPORTING

Regulatory Framework

The Financial Reporting Council (FRC) is the statutory body responsible for the broad oversight of the Accounting and Auditing Standard-setting process in Australia by monitoring the operation of Accounting and Auditing Standards to assess their continued relevance and their effectiveness in achieving their objectives in respect of both the private and public sectors of the Australian economy.

It is also responsible for appointing members of the Australian Accounting Standards Board (AASB) and Auditing and Assurance Standards Board (AuASB) including giving AASB and AuASB directions, advice or feedback on matters of general policy and on the AASB’s and AuASB’s procedures.

The functions of the AASB

The functions of the AASB, as set out in the Australian Securities and Investments Commission (ASIC) Act, are:

• to develop a conceptual framework, not having the force of an Accounting Standard, for the purpose of evaluating proposed Accounting Standards and International Standards

• to make Accounting Standards as required under the Corporations Act 2001

• to formulate Accounting Standards for other purposes

• to participate in and contribute to the development of a single set of Accounting Standards for worldwide use

• to advance and promote the main objectives of the ASIC Act.

Australian Accounting Standards

Financial reporting in Australia is governed by the accounting standards issued by the AASB. The main objectives of the current Standard-setting arrangements, as set out in the Australian Securities and Investments Commission Act 2001 (ASIC Act), are: a to facilitate the development of accounting standards that require the provision of financial information that:

i allows users to make and evaluate decisions about allocating scarce resources

ii assists directors to discharge their obligations in relation to financial reporting

iii is relevant to assessing performance, financial position, financing and investment

iv is relevant and reliable

v facilitates comparability

15 vi is readily understandable b to facilitate the Australian economy by:

i reducing the cost of capital

ii enabling Australian entities to compete effectively overseas

iii having accounting and auditing standards that are clearly stated and easy to understand c to maintain investor confidence in the Australian economy (including its capital markets).

Accounting standards

Accounting standards govern the way in which financial statements are prepared, with the aim of achieving comparability between financial statements. Historically accounting standards have been drawn up on a national basis by individual countries but with the globalisation of business, there is now a need to make financial statements comparable across international boundaries. This was the driving force behind Australia adopting international accounting standards in 2005.

Application of Accounting Standards

Generally reporting entities and entities bound by the Corporations Act need to comply with the accounting standards as these entities are required to produce general purpose financial reports.

Reporting entities are all entities (including economic entities) in respect of which it is reasonable to expect the existence of users dependent on general purpose financial reports for information which will be useful to them for making and evaluating decisions about the allocation of scarce resources. (Statement of Accounting Concepts 1)

General purpose financial reports

General purpose financial reporting is not an end in itself, but is a means of communicating relevant and reliable information about a reporting entity to users.

Reporting entities control resources and influence members of the community through providing good and services, setting prices, levying charges, rates and taxes, and acquiring and investing resources. The community interest is best served if scarce resources controlled by reporting entities are allocated to those entities which will use them in the most efficient manner in providing goods and services. Efficient use of resources raises output, has desirable macroeconomic effects by enhancing employment and the standard of living, and enables social policy objectives to be achieved at the lowest cost. Efficient allocation of resources will be enhanced if those who make resource allocation decisions are provided with appropriate financial information on which to base their decisions. General purpose financial reporting aims to provide this information through rigid disclosure requirements.

Generally, medium to large businesses that have a number of users dependent on the financial information produce general purpose financial reports.

Special purpose financial reports

Non reporting entities generally prepare special purpose financial reports, however like general purpose financial reports, are subject to true and fair view requirements of the Corporations Act. Special purpose financial reports do not have to apply all the disclosure requirements contained in the Act.

Non reporting entities that are required to prepare financial statements must comply with AASB 101

16 Presentation of Financial Statements, AASB 107 Cash Flow Statements, AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors, AASB 1031 Materiality and AASB 1048 Interpretation and Application of Standards.

Generally small businesses prepare special purpose financial reports driven mostly by factors such as tax compliance and debt financing.

2.4 RELEVANT ACCOUNTING STANDARDS Accounting Explanation Relevance to Potential issues standard innovation AASB 8 An operating segment is a To assist with Operating segments are common Operating component of an entity that identifying the in large/complex type business Segments engages in business appropriate statistical structures with multiple activities for which it may or analytical unit as manufacturing or services divisions. earn revenue and recommended by the Potential issues could arise when incur expenses. Oslo Manual. allocating innovative expenditure across multiple operating segments for example corporate overhead costs. AASB 116 Property, plant and New capital Businesses especially small to Property Plant equipment are tangible investment medium sized entities find it difficult and Equipment items that are held for use in associated with the to separate routine acquisition of the production or supply of implementation or property plant and equipment goods and services, for introduction of new from acquisitions that are new to rental to others and are products, processes the business and their expected to be used more and organisational characteristics or intended use than one period. methods differ significantly from those previously used by the business.

Another potential issue could be the rate at which these assets are depreciated over their useful life. AASB 118 Revenue is defined in the Revenue from Separating revenues from multiple Revenue AASB as the gross inflow of innovation or existing outputs with passive and economic benefits during products. extraordinary incomes. the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants. AASB 119 This particular standard Labour costs Separating innovation related Employee requires proper disclosure associated with new labour costs from normal business benefits of all benefits provided to products, processes, labour costs employees in respect of organisational and their employment including marketing methods short-term employee and research and benefits, post-employment development. benefits, other long-term benefits and termination benefits.

17 AASB 123 This standard requires Borrowing costs that Separating borrowing costs that are Borrowing borrowing costs that are are directly directly attributed to the acquisition, costs directly attributable to the attributable to the construction or production of a acquisition, construction or acquisition, routine qualifying asset to a one production of a qualifying construction or that is new. asset form part of the cost production of a new of that asset. Other or significantly A qualifying asset is an asset borrowing costs are improved asset forms that necessarily takes a substantial recognised as an expense. part of the cost of that period of time to get ready for its asset. intended use or sale. AASB 127 This Standard applies to the To assist with Potential issues could arise when Consolidated preparation and identifying the allocating innovative revenue and and Separate presentation of consolidated appropriate statistical expenditure across entities in the Financial financial statements for a or analytical unit as consolidated group of entities. Statements group of entities under the recommended by the control of a parent entity. Oslo Manual. AASB 138 An intangible asset is an Primarily to R&D, Potential issues could arise where Intangible identifiable non-monetary copyright, trademarks an intangible asset does not meet Assets asset without related to new the criteria specified in the Physical substance. product, processes accounting standard; however for An intangible asset shall be and marketing innovative purposes it does, which recognised if, and only if: methods. could lead to off balance sheet a) it is probable that the intangible assets for innovative expected future economic purposes. benefits that are attributable to the asset will flow to the Accounting standards clearly state entity; and that internally generated brands, b) the cost of the asset can mastheads, publishing titles, be measured reliably. customer lists and items similar in An entity shall assess the substance shall not be recognised probability of expected as intangible assets. future economic benefits using reasonable and Furthermore, research and supportable assumptions development could be another area that represent with potential issues. The management’s best accounting standard broadly states estimate of the set of the expenditure during the research economic conditions that phase needs to be expensed where will exist over the useful as the expenditure during the life of the asset development phase needs to be capitalised (intangible asset recognised) provided certain specified conditions are met.

From an innovation perspective, the total innovation spend would be the total research and development expenditure. AASB 3 This Standard applies to a New products, Potential issues could arise where Business transaction or other event process, for example Ed’s Mowing acquiring Combinations that meets the definition of a organisational and Jim’s Fishing business. Whether (Goodwill) business combination. A marketing methods the assets acquired by Ed as part business combination is as it relates to the of the business combination would where the assets acquired assets of be considered new to his mowing and the liabilities assumed an acquisition. business, hence product innovation is a business. would depend on ultimate control The standard also requires and whether fishing activity is the acquirer to recognise offered as a new service by Ed’s and measure goodwill or a Mowing. By and large, Oslo Manual gain from bargain purchase. guidelines do not consider mergers and acquisitions to be innovations.

18 2.5 CHART OF ACCOUNTS ACROSS INNOVATION ACTIVITIES

The table below is a high level guide which shows accounts that could potentially identify innovative type transactions.

Types of innovation R&D Acquisition of Acquisition of Other Market Training Other Other other machinery preparation preparations preparations preparations external and other for products for product for for marketing knowledge or capital goods or process innovations organisation innovations intellectual innovations innovations property

Account

Current Assets Cash Most unlikely Most unlikely Most unlikely Most unlikely Most unlikely Most Most unlikely Most unlikely unlikely Accounts Receivable Most unlikely Most unlikely Most unlikely Most unlikely Most unlikely Most Most unlikely Most unlikely unlikely Inventory Neutral Neutral Neutral Neutral Neutral Neutral Neutral Neutral Prepayments Neutral Neutral Neutral Likely Likely Likely Likely Likely

Property, Plant and Equipment Land Neutral Most unlikely most likely Likely Likely Unlikely Unlikely Unlikely Buildings Neutral Most unlikely most likely Likely Likely Unlikely Unlikely Unlikely Equipment Neutral Most unlikely most likely Likely Likely Unlikely Unlikely Unlikely Vehicles Neutral Most unlikely most likely Likely Likely Unlikely Unlikely Unlikely

Intangible Assets Goodwill most likely most likely Neutral Likely Likely Likely Likely Likely Patent and Copyright most likely most likely Neutral Likely Likely Likely Likely Likely Trademarks most likely most likely Neutral Likely Likely Likely Likely Likely Current Liabilities Accounts Payable Most unlikely Most unlikely Most unlikely Most unlikely Most unlikely Most Most unlikely Most unlikely unlikely Unearned Revenue Most unlikely Most unlikely Most unlikely Most unlikely Most unlikely Most Most unlikely Most unlikely unlikely Loans Most unlikely Most unlikely Most unlikely Most unlikely Most unlikely Most Most unlikely Most unlikely unlikely

Non-current Liabilities Loans Most unlikely Most unlikely Most unlikely Most unlikely Most unlikely Most Most unlikely Most unlikely unlikely Bonds Most unlikely Most unlikely Most unlikely Most unlikely Most unlikely Most Most unlikely Most unlikely unlikely

Shareholders’ Equity Revaluation Reserve Most unlikely Most unlikely Most unlikely Most unlikely Most unlikely Most Most unlikely Most unlikely unlikely

Account Paid Up Capital Most unlikely Most unlikely Most unlikely Most unlikely Most unlikely Most Most unlikely Most unlikely unlikely Retained Earnings Most unlikely Most unlikely Most unlikely Most unlikely Most unlikely Most Most unlikely Most unlikely unlikely

Operating Revenue Sales most likely most likely most likely most likely most likely most most likely most likely likely Other Revenue Likely Likely Likely Likely Likely Likely Likely Likely

COGS Cost of Goods Sold most likely most likely most likely most likely Most unlikely Most Most unlikely Most unlikely unlikely

Overhead Expenses Advertising Likely Unlikely Unlikely most likely most likely Neutral most likely most likely Bank Charges Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely Cleaning Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely Computer Expenses Likely Likely Likely Likely Likely Likely Likely Likely Consulting Expenses most likely most likely Neutral most likely most likely most most likely most likely likely

20 Electricity most likely Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely Fees & Permits Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely General Expenses most likely Unlikely Unlikely Likely Likely Likely Likely Likely Insurance most likely Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely Marketing expenses Likely Unlikely Unlikely most likely most likely Neutral most likely most likely Motor Vehicle Expenses Likely Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely Printing, Postage, Stationery Likely Unlikely Unlikely Likely Likely Likely Likely Likely Rent and Outgoings most likely Unlikely Unlikely Likely Likely Unlikely Likely Likely Repairs and Maintenance Likely Neutral Likely Unlikely Unlikely Unlikely Unlikely Unlikely Salaries and Wages most likely most likely most likely most likely most likely most most likely most likely likely Staff Amenities and Training most likely Unlikely Unlikely most likely most likely most most likely most likely likely Subscriptions Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely Unlikely Superannuation most likely most likely most likely most likely most likely most most likely most likely likely Telephone and Internet Likely Neutral Neutral Likely Likely Neutral Likely Likely

21 2.6 CHART OF ACCOUNTS ACROSS DIFFERENT BUSINESS SIZES

The table below is a high level guide which shows accounts commonly associated with reporting by the small, medium and large sized businesses.

Account Small sized entity Medium sized entity Large sized entity

Current Assets Cash NO NO NO Accounts Receivable NO NO NO Inventory POSSIBLE POSSIBLE YES Prepayments NO POSSIBLE POSSIBLE

Property, Plant and Equipment Land NO POSSIBLE YES Buildings POSSIBLE POSSIBLE YES Equipment YES YES YES Vehicles YES YES YES

Intangible Assets Goodwill POSSIBLE YES YES Patent and Copyright NO POSSIBLE YES Trademarks NO POSSIBLE YES

Current Liabilities Accounts Payable NO NO NO Unearned Revenue NO POSSIBLE POSSIBLE Loans POSSIBLE POSSIBLE POSSIBLE

Non-current Liabilities Loans POSSIBLE POSSIBLE POSSIBLE Bonds POSSIBLE POSSIBLE POSSIBLE

Shareholders’ Equity Revaluation Reserve NO NO NO Paid Up Capital NO NO NO Retained Earnings NO NO NO

Operating Revenues Sales YES YES YES Other Revenues YES YES YES

COGS Cost of Goods Sold NO POSSIBLE YES

Overhead Expenses Advertising YES YES YES Bank Charges NO POSSIBLE YES Cleaning NO NO YES Computer Expenses POSSIBLE YES YES Consulting Expenses POSSIBLE YES YES Electricity POSSIBLE YES YES Fees & Permits NO NO YES General Expenses POSSIBLE POSSIBLE YES Insurance POSSIBLE POSSIBLE YES Marketing expenses YES YES YES Motor Vehicle Expenses POSSIBLE POSSIBLE YES Printing Postage Stationery NO NO YES Rent and Outgoings POSSIBLE POSSIBLE YES Repairs and Maintenance YES YES YES Salaries and Wages YES YES YES Staff Amenities and Training YES YES YES Subscription NO NO YES Superannuation POSSIBLE POSSIBLE YES Telephone and Internet NO NO YES

2.7 DEFINITION OF SMALL, MEDIUM AND LARGE BUSINESS

This report has adopted the Australia and New Zealand Standard Industry Classification (ANZSIC) which provides a standard framework under which business units carrying out similar productive activities are grouped together, with each resultant group referred to as an industry.

The report has also adopted the ABS convention which classifies businesses by number of employees for statistical purposes into the following categories:

• Small (less than 20 employees)

• Medium (20 or more but less than 200 employees)

• Large (200 or more employees).

The case studies that follow have adopted the above definitions for small, medium and large businesses.

In contrast to the above, the legal entity and their corresponding turnover and asset holdings are more relevant for financial reporting purposes.

For example, ASIC defines a company as a large proprietary company if two or more of the following criteria are met:

• The consolidated revenue for the financial year of the company and any entities it controls is $25 million or more.

• The value of the consolidated gross assets at the end of the financial year of the company and any entities it controls is $12.5 million or more.

• The company and any entities it controls have 50 or more employees at the end of the financial year.

The ASIC definition is critical for small businesses. Where a proprietary company meets two or more of the above criteria, the company is considered to be ‘large’ for financial reporting purposes. Large companies under the ASIC definition generally have to prepare general purpose financial report and the accounts must be audited.

There are various other definitions by size such as the definition of ‘small businesses for the purposes of unfair dismissal. Many businesses would however have the characteristics outlined below that fall under more than one size category – a small business may have some of the characteristics of medium or large businesses. Therefore classifying a business into one category by size and adopting that particular guideline would sometimes not be the most appropriate approach.

23 3 SMALL BUSINESSES

3.1 GENERAL CHARACTERISTICS

3.1.1 Entity type

There are various factors a small business owner takes into consideration when choosing the entity type and the business structure – asset protection, costs and benefits to start, operational convenience, regulatory requirements and taxation.

Generally a small business would be a single legal entity with one Australian Business Number (ABN) and would adopt one of the following structures:

• Sole trader

• Partnership

• Trust

• Company, or

• A combination of more than one entity.

Many small businesses commence as sole traders or partnerships and later transform to a trust or a company structure as their trading volume grows. The incentives to change the entity type vary depending on individual circumstances but are in many cases predominantly due to:

Asset protection purposes where the owners become aware of the business risks or were aware of such risks but did not previously want to operate under close regulatory requirements such as preparation of financial reports.

Taxation purposes through income splitting via a trust or taxed at a fixed rate with a company structure.

3.1.2 Operation

Small businesses often adopt informal processes in communication and business interactions. Employees are likely to be functionally driven with little or no clear division of labour.

Decision making process is relatively fast and informal and is often driven by the business owner’s personal preferences rather than through systematic decision making procedures.

Risk management and associated systems and processes are often very minimal and custodian of assets and accounts is held and controlled by one or a few personnel.

Many small businesses, particularly start-up businesses, often have minimal or no cash flow budget or cash flow management systems, compared to large businesses. It is also common for small businesses to have no strict policies around asset management and debtors and creditors control with no regular measurements or assessments of such transactions.

Small businesses tend to have a shorter life cycle compared to medium or large businesses

24 3.1.3 Industries

Many small businesses are in the industries where there is low or no entrance barriers – tough licensing requirements or economies of scale. The industries small businesses tend to operate in are primary production, construction, retail trade, real estate and professional services.

3.2 ACCOUNTING METHOD

3.2.1 Reporting requirements

As discussed in 3.1.1, many small businesses operate through entities other than companies. Generally small businesses are non-reporting entities; hence prepare special purpose financial reports. For instance, a sole trader may need to present financial reports that are required by the financial institutions for a finance application; or the partners in a partnership may need to provide some credential information to a potential buyer of the business.

Special purpose financial reports are unaudited and only provide low or no level of assurance with minimum disclosure requirements.

3.2.2 Bookkeeping

Many small businesses hire part-time accountants or use external accountants to prepare their financial accounts. A small business may however require a full finance team where the volume of transactions is large and/or the complexity require qualified or experienced full-time finance personnel.

Often small businesses use part-time accountants or contractors to carry out their monthly and quarterly tax compliance obligations.

3.2.3 Accounting software

Accounting software packages such as MYOB and QuickBooks are commonly used by small businesses. These software packages typically have limited functionalities .i.e. preparation of management reports and no other functionalities.

Large companies use software packages such as SAP and Oracle that provide multiple modules such as marketing, human resource and payroll functions.

The software packages most small businesses use are designed to only meet their taxation compliance and basic reporting requirements and are mostly not intended to carry out other operational assessments such as capturing innovative activities.

3.3 CASE STUDY

Ed’s Mowing Service

• Ed is a small business owner and runs ‘Ed’s Mowing Services’. Ed’s Mowing Services has over 130 regular customers and has been operating in Kingston and the surrounding suburbs in Canberra since 2003.

• The business trades through a proprietary company called, ‘ELQ Services Pty Limited’. Ed is the sole shareholder and the sole director of the company.

• The business has a large storage facility in Ed’s home backyard and uses it to store various mowing and gardening equipment. Ed uses one of the rooms at home as home office and keeps various office items

25 – office furniture, a computer, miscellaneous stationery and accounting records.

• The company has two part-time employees, Alex and Craig both working 3 days a week at $60 an hour. Ed is also employed by the company and works 5 days a week and occasionally on weekends at $90 an hour.

• The company has a standard 7 hours a day operating hours.

• The company uses MYOB accounting software package and has a bookkeeper Kate who is a contractor working 5 hours per week and charging $66 per hour including GST.

• The company has an accountant, CBR Tax Accountants, who prepares annual financial statement and income tax returns for Ed and the company using the MYOB management reports.

• The reference period is 2008/09.

Some notable transactions that occurred during the 2008/09 financial year are as follows:

1. On 10 July 2008, Ed decided to replace his current hand mowing machine with a slightly more powerful hand held machine, but with no change in the type of services offered. The new machine had cost Ed $18,000 which was paid by cash.

2. On 30 November 2008, Ed bought a ride-on mower which cost him $20,000 and enabled him to serve clients with larger properties much faster. Ed had spent $1,500 on specialist consultants to train Alex and Craig to use the new ride-on mower. The training was for half a day. Ed charges his clients $200 an hour for servicing clients with the new-ride on mower.

3. On 30 March 2009, Ed introduced new hedge trimming services investing $8,000 on equipment. Ed spent 50 working hours on research, planning and implementing the new hedge trimming business.

4. On 25 June 2009, Ed also spent around $5,000 on internet home page, radio and TV advertising (he normally used flyers). Ed spent 10 hours researching and assisting the web designers.

The above transactions would have been recorded in Ed’s accounts via the functionalities available in the MYOB software. A reconstruction of the above transactions based on the double-entry principle would record the entries as follows: Transaction Date Journal entries Debit Credit Type of innovation activity No 1 10 July 2008 Property, plant 18,000 Not an innovation activity equipment 1 Cash 18,000 1 (To record the purchase of hand held machine) 2 30 November Staff training costs 1,500 New product and 2008 associated training costs 2 Property, plant 20,000 equipment 2 Cash 21,500 2 (To record the purchase of ride-on mower and associated staff training costs) 3 30 March 2009 Property, plant 8,000 New product together with equipment associated market 3 Cash 8,000 preparation costs 3 (To record the purchase of equipment and staff training expenses) 4 25 June 2009 Advertising expenses 5,000 New marketing method

26 4 Cash 5,000 together with associated market preparation costs 4 (To record advertising expenses)

Ed’s profit and loss statement together with the balance sheet are shown below, and accounts affected by the four notable transactions above have been highlighted in grey. Most small businesses produce financial reports in a similar format.

Figure 1 Profit and Loss Statement for year ended 30 June 2009 2009 $ Ed’s Mowing Services – Profit and Loss Statement for the income year ended 30 June 2009

Revenue from ordinary activities

Income Sales 600,000 Total Revenue from Ordinary Activities 600,000 Less Expenses Accounting fees 7,000 Advertising 10,000 Book keeping fees 14,400 Cleaning 500 Computer expenses 2,500 Depreciation 20,000 Donations 100 Filing fees 212 Government taxes 6,893 Insurance 12,000 Interest paid 4,637 Lease expense 12,000 Licence fees 385 Marketing expenses 3000 Motor vehicle expenses 7,940 Postage 1,455 Printing & stationery 3,227 Repairs & maintenance 5,819 Salaries & wages – Directors 172,000 Salaries & wages – Employees 102,000 Staff training costs 8,000 Subscriptions 9,182 Superannuation 16,500 Telephone 2,000 Travel expenses 1,200 Total Expenses 422,950 Operating profit/(loss) before related income tax expense 177,050

27 Figure 2 Balance Sheet as at 30 June 2009 Ed’s Mowing Services – Balance Sheet as at 30 June 2009 2009 $

Current assets Cash 215,000 Debtors 55,000 Total current assets 270,000 Non-current assets Goodwill 75,000 Investments 110,000 Property, plant & equipment 150,000 Total non-current assets 335,000 Total assets 605,000

Current liabilities PAYG withholding tax 6,440 GST payable 2,000 Superannuation 1,000 PAYG Instalments (2,000) Total current liabilities 7,440 Non-current liabilities 100,530 Loan Total non-current liabilities 100,530 Total liabilities 107,970 Total net assets 497,030

Equity Contributed equity 100,000 Retained profits 397,030 Total Equity 497,030

Ed’s Mowing Service – Measuring innovation expenditure and related revenue

1. In 2011, Ed received a survey questionnaire from the National Statistical Agency asking him if he had introduced any new or significantly improved goods or services, implemented a new or significantly improved process, organisational process or marketing methods during the 2008-09 reference period, and if he did, to provide an estimate of:

i. the cost (ie the amount spent) of implementing the new product, process or method; and

ii. to provide an estimate of the revenues earned from the sale of new products during the reference period.

The National Statistical Agency has adopted the recommendations of the OECD’s Oslo Manual (2005) for measuring innovation and the Frascati Manual (2002) for defining and measuring R&D activities.

2. Activities undertaken by Ed and staff are as per case study in the report.

3. By applying the OECD Oslo Manual’s guidelines for measuring innovation, Ed notes the following:

i. that he had introduced a new (new to his firm) or significantly improved service through the introduction of a new hedge trimming service and the capacity to service larger properties through the purchase of a late model ride-on mower.

ii. as a result of expanding demand for his company’s services, Ed also introduced a new approach to

28 communicating his expanded services through the establishment of a business internet website that also allowed his clients to book services on-line – whereas this was previously done by manually distributing flyers and this corresponds to a new way of marketing his business.

4. In terms of identifying the relevant statistical unit, Ed’s business conforms to a single economic entity that has full control over its factors of production and uses a type of business model to deliver a set of closely related services. Therefore, Ed’s Mowing business as a unit can be classified to the ANZSIC Division N (Administrative and Support Services), Class 7313 (Gardening Services).

Ed’s Mowing Proprietary Limited is a single legal entity with one ABN. Based on this approach, Ed’s business with his three employees plus himself would be categorised as a micro-business (0-5 employees) for statistical purposes.

5. As a result, the information required to estimate Ed’s innovation expenditure in 2008-09 can be sourced from the single set of accounts maintained by Ed’s mowing.

6. The application of the Oslo Manual guidelines to accounting data for measuring innovation spend together with related revenues is illustrated in the table below.

29 Measuring innovation expenditure Type of Innovation Item Reference Source account Cost allocation Innovation Notes innovation activity period expenditure 01/07/2008- 2008-2009 30/06/2009 ($) Introduction of Acquisition of Latest model 30 Property, plant and Full working life of 10 years at 20,000 The purchase New Service machinery ride-on mower November equipment 3.5 hours per week for 50 fell within the (Product and 2008 weeks per year; estimated reference Innovation) equipment annual capital consumption: period. and other $20,000/(3.5x50x10) = capital goods $114.286/hour New Hedge 30 March Property, plant and 8,000 8,000 The purchase Trimming Cutter 2009 equipment fell within the reference period. Training Customised 30 Training expenses 1,500 1,500 Cost of hiring associated training by November trainers expenses for equipment supplier 2008 the Employee wages: 30 Salaries and wages $90/hr x 4 hr = $360; 840 Half day training introduction Ed at $90/hr; November – Directors; ($60/hr x 4 hr) x 2= $480 (4 hours at of new Alex at $60/hr; 2008 Salaries and present wage services Craig at $60/hr; Wages – rates) Employees. Other employee 30 Superannuation; $8.1 x 4 = $32.40; 75.60 Prorated compensation: November Government Taxes ($5.4 x 4) x 2 = $43.2 or superannuation Ed at $8.1/hr; 2008 (payroll tax). 840 * .09 = 75.60 expense Alex and Craig at $5.4/hr each. Market Overhead costs in 30 March Accounting fees Accounting fees – 5% of $7,000 2,531 Ed has used preparations respect of 2009 Bookkeeping fees Bookkeeping fees – 7% of estimated for product preliminary market Postage 14,400 percentages innovations research and tests Computer Postage – 2% of $1,455 before the expenses Computer expenses – 10% of introduction of the Printing and $2,500 new hedge Stationery Printing and Stationery – 15% of trimming service. Telephone $3,227 Motor vehicle Telephone – 8% of $2,000 expenses Motor vehicle expenses – 3% of Travel expenses $7,940 Travel expenses – 1% of $1,200

30 Employee wages: 30 March Salaries and wages $90/hr x 50 hr = $4,500; 4,500 50 hours spent Ed at $90/hr; 2009 – Directors; by Ed for Salaries and market Wages – preparation for Employees. the new hedge trimming business Other Employee 30 March Superannuation; $8.1 x50 = $405; or 405 Prorated compensation: 2009 Government Taxes 4,500 * .09 = 405 superannuation Ed at $8.1/hr; (payroll tax). expense Introduction of R&D N/A N/A N/A N/A 0 N/A New Service (Product Acquisition of N/A N/A N/A N/A 0 N/A Innovation) external knowledge or IP Implementation Preparations Advertising 25 June Advertising $5,000 5,000 $5,000 paid to of New for marketing 2009 web designers Marketing method Employee wages: 25 June Salaries and wages $90/hr x 10 hr = $900; 900 10 hours spent Method innovation Ed at $90/hr; 2009 – Directors; by Ed in (Marketing activities related Method to the Innovation) development and implementation of new marketing methods Other Employee 25 June Superannuation $8.1 x 10 = $81; or 81 Prorated compensation: 2009 900 * .09 = $81 superannuation Ed at $8.1/hr; expense Postage; 25 June Postage; Postage – 2% of $1,455 1,173 Ed has used Computer 2009 Computer Computer expenses – 10% of percentages by expenses; expenses; $2,500 the number of Printing and Printing and Printing and Stationery – 15% of hours spent and Stationery; Stationery; $3,227 from receipts. Telephone; Telephone; Telephone – 8% of $2,000 Motor vehicle Motor vehicle Motor vehicle expenses – 3% of expenses; expenses; $7,940 Travel expenses Travel expenses Travel expenses – 1% of $1,200

31 New Preparations N/A N/A N/A N/A 0 N/A Processes for process innovation New Preparation N/A N/A N/A N/A 0 N/A Organisational for methods organisational innovations

Innovation revenue from the services provided Type of Item Reference period Source Revenue Revenue from Notes innovation 01/07/2008 - Account Estimation Innovation 30/06/2009 Activities 2008-2009 ($) Introduction New service 30 November 2008 Sales Estimated annual 21,000 Ed charges clients $200 an hour for mowing of new with ride-on to revenue: services. service mower 30 June 2009 $200/hr x 3.5hrs/wk The ride-on mower was operated for 3.5 hours x 30 weeks = a week for 30 weeks during the reference $21,000 period. New hedge 30 March 2009 to Sales $50/hr x 12 hrs/wk x 7,800 Ed charges clients $50 an hour for hedge trimming 30 June 2009 13 weeks = 7,800 trimming services. service Ed’s records show that at an average 12 hours per week has been spent on hedge trimming business for 13 weeks during the reference period. Introduction New web 25 June 2009 to Sales See notes - It is difficult to estimate the revenue increment of new page 30 June 2009 due to the new advertising method as it was marketing implemented at the same time as the new method services during the reference period 2008/09. However, the following factors would have assisted Ed in estimating the revenue: • Number of customers via the website; • No of service hours in respect of the website customers; • Average charge rate per hour;

32 3.4 TECHNICAL DIFFICULTIES Trans Date Comments No 1 10 July 2008 • Ed replaced his current mowing machine with a slightly more powerful hand held machine. This is not innovation activity as there is no change in the type of services offered.

• The new mower is being capitalised to the property, plant and equipment in the balance sheet and basically increasing the balance by $18,000.

• The difficulty here would be when Ed is completing the survey form, he would not have readily available information which would enable him to differentiate routine purchases such as this one from a new purchase which is innovative (see transaction 2&3) as all asset additions have been coded to the property, plant and equipment account.

• It may be that Ed will need to look at the fixed asset register to identify and separate routine asset addition from “new” (from an innovation perspective) asset additions 2 30 Nov 2008 • Ed bought a latest ride-on mower which cost him $20,000 that enabled him to serve new clients with larger properties much faster. Ed had spent around $1,500 on training staff to use the new ride-on mower.

• The purchase of the ride–on mower has been capitalised to property, plant and equipment account in the balance sheet.

• The staff training costs of $1,500 have been expensed in the profit and loss statement.

• Financial reporting requires aggregation of data. It is not a practice to have individual assets on the face of the balance sheet. For a small business, the most readily available information would be the profit and loss and balance sheet and their fixed asset register.

• For example if Ed is asked the question whether he acquired any new machinery, equipment and capital goods, the first thing Ed would do is look at his balance sheet which shows property, plant and equipment balance of $150,000. He would then either provide an estimate or drill down to individual asset additions in the fixed asset register to determine which ones are new acquisitions. Whether Ed is able to differentiate routine acquisitions from “new” (for innovation purposes) is something to consider as well.

• Moreover, Ed has to estimate the marginal increase in revenue from the new ride- on mower and staff efficiency from the training provided.

33 3 30 March 2009 • Ed introduced a new hedge trimming business by investing $8,000 in a hedge trimming cutter.

• The equipment purchased of $8,000 has again been capitalised to property, plant and equipment.

• There are technical difficulties with both the input and output measures.

• Output measure as the new hedging sales income has not been recorded separately in the profit and loss statement as it is included in sales income of $600,000. One way to obtain all new hedge trimming sales income for the year would be to sum all individual hedging sales invoices for the year. Another easy way would be for bookkeeper to create a new chart of account “Sales – hedge trimming” and code all new hedge trimming sales to this account.

• Input measures as the equipment purchased of $8,000 has been capitalised in property, plant and equipment with all other routine asset acquisitions.

• Further Ed has spent considerable amount of time doing preliminary market research and tests before the introduction of the new hedge trimming service. The time spent by Ed, the wages associated and the overheads used would constitute innovation spend. However, the overheads and directors wages in respect of the market preparation work have not been recorded separately. This is probably one of the difficult areas for small business to monitor as there is no incentive for Ed to keep separate time records. 4 25 June 2009 • Ed also spent around $5,000 on internet home page, radio and TV advertising during the year (he normally used flyers). This would constitute innovation with the lowest levels of novelty.

• The difficulty here would be to separate normal business advertising from advertising which is new to the business. Generally small business would either code such expenses to adverting or marketing expenses.

• Ed again has to estimate the marginal increase in revenue from the new marketing method as it is difficult to identify new sales from this new marketing method.

3.5 SUMMARY

To conclude, most small businesses produce similar profit and loss statements and balance sheet as depicted above. Small businesses first point of reference to a survey would be their profit and loss statement and balance sheet.

Small businesses need to be aware of what is “new” or “significantly improved” from an innovation perspective as well as knowing the disaggregation of profit and loss and balance sheet items to identify such items. The above case study shows some of the difficulties small business face. Greater awareness of Oslo and Frascati definitions of innovation and R&D and incentives for small businesses to have proper reporting frameworks are some of the things which can be done to make the data gathering and estimation process easy and accurate.

34 4 MEDIUM BUSINESSES

4.1.1 Entity type

Like small businesses, a mid size business owner also takes into consideration a number of factors when choosing the entity type and the business structure.

Generally a medium size business would be a single legal entity with one ABN and would take one of the following forms:

• Sole trader

• Partnership

• Trust

• Company with a parent entity and a few subsidiaries

Many medium size businesses also commence from a sole trader or a partnership and later convert to a trust or a company structure as their trading volume grows. The incentives to change the entity type vary depending on individual circumstances but are in many cases due to:

• Business expanding with potential for increasing market share (business planning going national).

• Ability to raise finance.

• Tax considerations.

4.1.2 Business processes

Medium size businesses normally have more stakeholders involved who have invested their monies in the business, hence are interested in knowing how the business is performing. Medium size businesses have defined business goals, missions, and strategies and have formal communication and business interactions. Employees have clearly defined job descriptions.

Medium sized businesses can range from very formal to informal corporate governance structures, which mean they may have a Board of Directors and a Chief Executive Officer.

Decision making goes through a systematic process and normally requires Board approval for most major projects.

Risk management and associated systems and processes are rigid with proper reporting frameworks.

Most medium sized businesses would have succession plans in place.

4.1.3 Industries

Like small businesses, medium businesses generally are in the industries where there is low or no entrance barriers – tough licensing requirements or economies of scale. The industries medium businesses tend to operate in are primary production, construction, retail trade, information technology, real estate and

35 professional services.

Many medium businesses operate through companies. Generally medium entities range from reporting to non-reporting entities; hence would produce general purpose or special purpose financial reports respectively. Medium businesses that meet certain criteria are also required to comply with the reporting requirements stipulated in the Corporations Act.

4.2.2 Bookkeeping

Many medium businesses may employ a small finance team (Finance Manager with a few assistants) as the volume of transactions is sufficiently large and/or the complexity of the transactions require qualified or experienced full-time in-house finance personnel.

Small size non-reporting entities normally replace their external accountants (small boutique accounting firms) with large accounting firms as they grow. This is due to the fact that reporting entities have a rigid reporting and disclosure framework to adhere to.

Generally the external accountants are provided with year-end management accounts which they then transform it into general purpose financial reports.

36 4.2.3 Accounting software

Accounting software packages such as MYOB and QuickBooks are generally used by small to medium sized businesses. However, there is a second stage of reporting as MYOB and QuickBooks do not produce general purpose financial reports. The diagram below shows the processes involved.

37 4.3 CASE STUDY

XYZRacks Manufacturing Pty Limited (XYZRacks)

• XYZRacks is a medium size manufacturing business based in NSW with annual turnover of $20 million and employing approximately 60 staff.

• The company designs, develops and manufactures server racks, key cabinets, termination boxes and power rails for both Government and the Commercial sectors.

• The company are innovators and leaders in the development of server rack designs and have developed an endorsed server rack which significantly reduces energy consumption whilst allowing for over 10KW of heat to be dissipated from the endorsed server rack.

• XYZRacks prepares special purpose financial reports and generally applies for R&D tax concession rebate.

Some notable transactions that occurred during the 2008/09 financial year are as follows:

1. Between 1 July and 30 September 2008, XYZRacks spent $1,000,000 in designing and producing a new prototype server rack. The company had spent around $50,000 in setting up the factory for the production run.

2. On 30 October 2008, XYZRacks spent $20,000 in marketing and advertising of the new server racks.

3. Between 1 July and 20 June 2009, XYZRacks had paid $600,000 to a University research centre for research work in respect of termination boxes.

4. As at 30 June 2009, XYZRacks had $2,000,000 in cash sales of the newly designed server racks during the year. The company had manufactured 5,000 new server racks, all of which were sold during the reference period.

5. Between 1 July 2008 and 30 June 2009, XYZRacks had cash sales of $500,000 during the year of power rails which it had developed last year (2007/08).

The above transactions would have been recorded in XYZRacks’ accounts via the functionalities available in the MYOB software. A reconstruction of the above transactions based on the double-entry principle would record the entries as follows: Transaction Date Description Debit Credit Type of innovation activity

No 1 As at 30 Direct Materials 300,000 Research and September 2008 development expenditure 1 Salaries 350,000 in respect of the new 1 Consultants 150,000 server rack plus other preparation for product 1 Other R&D 200,000 innovation (repairs and expenses maintenance specific to Repair and 50,000 setting up the production maintenance run for the new server 1 Cash 1,050,000 rack). 1 (To record the research and design expense of the new server racks)

38 2 30 October 2008 Advertising 20,000 Market preparations for 2 Cash 20,000 product innovation 2 (To record the advertising and marketing expenses) 3 As at 20 June 2009 Consultants 600,000 Research and 3 Cash 600,000 development for new termination boxes 3 (To record sub-contracting of research work) 4 As at 30 June 2009 Cash 2,000,000 Revenue from sale of 4 Sales – 2,000,000 new server racks Server Racks 4 (To record sales of server racks) 5 As at 30 June 2009 Cash 500,000 Revenue from sale of 5 Sales – 500,000 power rails Power Rails 5 (To record sales of power rails)

XYZRacks’ profit and loss statement together with the balance sheet is shown below and potential accounts that could be affected by the above five notable transactions above have been highlighted in grey. Most medium businesses produce similar financial reports.

Figure 3 Profit and Loss Statement for year ended 30 June 2009 2009 $ XYZRacks Manufacturing Pty Limited – Profit and Loss Statement for the income year ended 30 June 2009

Income Accessory sales 400,000 Server racks 6,000,000 Service fees 2,000,000 Freight income 250,000 Miscellaneous income 300,000 Termination boxes 4,000,000 Key cabinets 4,000,000 Power rails 2,500,000 Total income 19,450,000

Cost of sales

Direct material costs Direct materials 4,000,000 Accessory 47,106 Painting and finishing 78,519 Fittings and fasteners 1,001,542 Consultants 978,562 Total direct material costs 6,105,729

Factory wages Salaries 4,000,000 Total factory wages 4,000,000

Other direct expenses Gas 66,895 Packaging 87,150 Manufacturing – repairs and maintenance 240,283 Replacement tools – manufacturing 43,437 Waste Management 5,278 Freight 265,434

39 Total – Other direct expenses 708,477

Rents & managements fees Rent – Plant & Equipment 2,200,000 Rent – Factory 140,400 Rent – Other 9,600 Management Fees 233,100 Lease factory 15,000 Total – Rents & managements fees 2,598,100 Total cost of sales 13,412,306 Gross Profit 6,037,694

Expenses Amortisation – intangibles 1,592 Advertising 193,883 Accounting fees 31,000 Legal & professional services 30,425 Car and truck expenses 31,170 Office expenses 84,213 Telephone 22,520 Insurance 7,301 Depreciation expenses 318,255 Sundry expenses 580 Total administrative expenses 720,939 Staff amenities 7,645 Superannuation 184,759 Bonus 135,920 Workers compensation 19,208 Training and seminars 12,915 Other employer expenses 4,536 Info tech costs 54,954 FBT 8,062 Payroll tax 92,288 R&D expenses 2,500,000 Total employment expenses 3,020,287

Other general expenses Electricity 79,303 Hire equipment 5,316 Total – Other general expenses 84,619 Overseas travelling 10,212 Meals and entertainment 1,581 Total travel, meals and entertainment 11,793 ATO general interest 946 Total Expenses 3,838,584 Operating profit 2,199,110

Other income Interest income 38,881 Gain on selling shares 808 Total – other income 39,689

Tax and dividends Income tax expense 620,662 Dividends paid 300,000 Total tax expenses 920,662 Net profit/(loss) 1,238,759

40 Figure 4 Balance Sheet as at 30 June 2009 XYZRacks Manufacturing Pty Limited – Balance Sheet as at 30 June 2009 2009 $

Assets

Current assets Cash on hand 200 General cheque account 50,000 Westpac account 700,000 Westpac Maxi 8,000 Petty cash 8,000 Total cash on hand 766,000 Trade debtors 1,500,000

Inventory Raw materials 200,000 Work in progress 250,000 Total inventory 450,000 Total current assets 2,716,000

Other assets Deposits paid 30,000 Registration of patent costs 20,000 Amortisation of patent costs (5,000) Loan 1,300,000 Total – Other assets 1,345,000

Non-current assets

Plant and equipment Manufacturing plant at cost 2,000,000 Accumulated amortisation (600,000) Manufacturing equipment cost 1,200,000 Manufacturing equipment accumulated depreciation (200,000) Total plant and equipment 2,400,000

Furniture and fixtures Furniture and fixtures at cost 500,000 Furniture and fixtures accumulated depreciation (220,000) Total furniture and fixtures 280,000 Office equipment 800,000 Office equipment at cost Office equipment accumulated depreciation (300,000) Other plant and equipment 200,000 Other plant and equipment accumulated depreciation (50,000) Total office equipment 650,000

Motor vehicles Motor vehicles at cost 125,000 Motor vehicles accumulated depreciation (60,000) Total motor vehicles 65,000 Total non-current assets 3,395,000 Total assets 7,456,200 Liabilities Current liabilities Trade creditors 2,250,000 Income tax instalment 220,000 GST collected on sales 300,000

Payroll liabilities

41 PAYG withholding 60,000 Superannuation payable 12,000 Workers compensation premiums payable 10,000 Payroll tax payable 25,000 FBT liability 25,000 Insurance payable 30,000 Total payroll liabilities 162,000 Other current liabilities 60,000 Total current liabilities 2,992,000

Long-term liabilities Loan 500,000 Total long-term liabilities 500,000 Provision for income tax 327,186 Total liabilities 3,819,186 Net assets 3,637,014

Equity Capital 1,345,400 Retained earnings 1,052,855 Current year earnings 1,238,759 Total equity 3,637,014

XYZRacks Manufacturing Pty Ltd (XYZRacks) – Measuring innovation expenditure and related revenue

1. In 2011, XYZRacks received a survey questionnaire from the National Statistical Agency, asking if XYZRacks had introduced any new or significantly improved goods or service, implemented a new or significantly improved process, organisational or marketing methods during the 2008-09 reference period, and if XYZRacks did, to provide an estimate of:

i. the cost (ie the amount spent) of implementing the new product, process or method ii. to provide an estimate of the revenues earned from the sale of new products during the reference period.

2. The National Statistical Agency has adopted the recommendations of the OECD’s Oslo Manual (2005) for measuring innovation and the Frascati Manual (2002) for defining and measuring R&D activities.

3. Activities undertaken by XYZRacks and its staff are as per case study in the report.

4. By applying the OECD Oslo Manual’s guidelines for measuring innovation, XYZRacks notes the following:

i. that XYZRacks had introduced a new (new to this firm) or significantly improved product through the research and design of new server racks (experimental development as per Frascati Manual 2002).

ii. that XYZRacks also had undertook activities to acquire new knowledge .i.e. outsourcing research activities to a University in respect of building significantly improved termination boxes (research and development as per Frascati Manual 2002)

iii. that XYZRacks also undertook activities (market tests and launch advertising) aimed at market introduction of the new server racks.

5. In terms of identifying the relevant statistical unit, XYZRacks conforms to a single economic entity that has full control over its factors of production and uses a type of business model to deliver a set of closely related products. Therefore, XYZRacks as a unit can be classified to the ANZSIC Division C

42 (Manufacturing), Class 2421 (Computer and Electronic Equipment Manufacturing).

6. XYZRacks is a single legal entity with one ABN. Based on this approach, XYZRacks would be categorised as a medium size business (employing 20 or more but less than 200 employees) for statistical purposes.

7. As a result, the information required to estimate XYZRacks’ innovation expenditure in 2008-09 can be sourced from the single set of accounts maintained by XYZRacks.

8. The application of the Oslo Manual guidelines to accounting data for measuring innovation spend together with related revenues is illustrated in the table below.

43 Measuring innovation expenditure Type of Innovation Item Reference Source account Cost allocation Innovation Notes innovation activity period expenditure 01/07/2008- 2008-2009 30/06/2009 ($) Introduction Research, Direct Various Inventory – Average unit price per 300,000 Costs of direct of a new designing and Materials transactions up balance sheet input x quantity of inputs materials used in product production of to 30 September used in the R&D phase: the research, design (Product prototype 2008 $5 x 60,000 materials and production of Innovation) server rack; used = $300,000 the prototype R&D (in- Employee Various Factory wages – Average hourly rate per 350,000 Costs of direct house) wages: transactions up expense employee x total number labour in relation to to 30 September of hours spent by the research and 2008 employees in the research design of server and design phase of racks server racks: $70/hr x 5,000 hrs = $350,000 Other Various Superannuation – 350,000 * .09 = $31,500 31,500 Prorated Employee transactions up expense superannuation compensation: to 30 September expense 2008 Workers Various Workers compensation Workers compensation 1,681 Prorated workers compensation transactions up – expense expense x cost of direct compensation to 30 September labour/total factory wages: expense 2008 19,208 x 350,000/4,000,000 = $1,681 Payroll tax Various Payroll tax expense Payroll tax expense x cost 8,075 Prorated payroll transactions up of direct labour/total tax expense to 30 September factory wages: 2008 92,288 x 350,000/4,000,000 = $8,075

44 Fringe Various Fringe benefits Fringe benefits tax 705 Prorated payroll benefits tax transactions up tax expense expense x cost of direct tax expense expense to 30 September labour/total factory wages: 2008 8,062 x 350,000/4,000,000 = $705 Consultants Various Consultants – expense 150,000 150,000 Consultancy fees in transactions up respect of design of to 30 September the server racks 2008 R&D expense Various R&D expense 200,000 200,000 Trial and testing transactions up expenses to 30 September 2008 Introduction Research, Other Various Gas – 2% Estimated percentage of 150,000 Overhead costs in of a new designing and overheads transactions up Packaging – 5% the overhead costs estimated respect of the R&D product production of to 30 September Repairs and attributed to the research based on cost (Product prototype 2008 maintenance – 6% and design of the server drivers for each Innovation) server rack; Replacement tools – 3% racks x individual overhead expense. R&D (in- Waste management – overhead cost; house) 2% For example 2% of Gas Freight – 5% attributed to the R&D Rent – 7% phase: Office expenses – 8% 2% * $66,895 = $1,340 Accounting fees – 3% Legal fees – 2% Telephone – 6% Insurance – 6% Depreciation expense – 3% Sundry expense – 6% Training and seminars – 6% Electricity – 9% Hire equipments – 6% IT costs – 7%

45 Market Advertising Various Advertising expense XYZRacks notes that it 20,000 Market test and preparations transactions up spent $20,000 in market advertising for product to 30 October tests and advertising for expenses incurred innovations 2008 the new server units in the reference period. Note the benefit of this advertising can flow into future periods as well. Other Repairs and Various Manufacturing – repairs XYZRacks spent $50,000 50,000 plus Costs incurred in preparations maintenance; transactions up and maintenance; on repairs and a prorated setting up the for product Overheads; to 30 September Lease payments; maintenance amount of production run for innovations Lease 2008 Depreciation; Any applicable lease overhead the new server payments; Interest payments and payments, depreciation costs, lease, racks such as Depreciation; relevant and interest payments to depreciation painting, changing Interest overhead expenses be apportioned based on and interest fitting arrangements expenses new production quantity payments etc and costs in over total production attributed to respect of existing quantity on production in production production the reference period equipment equipment used to and produce new production products run set up. Introduction Acquisition of N/A N/A N/A N/A N/A The innovation of a new machinery, activity would have product equipment been relevant if (Product and other XYZRacks had Innovation) capital goods acquired advanced machinery for the manufacturing of the new server racks including the prototype.

46 Other Property, plant Various Depreciation expense Prorated used of PPE to Total Includes office preparations and transactions up produce prototype and depreciation equipment for product equipment to 30 September can include office expense of depreciation as innovations (capital 2008 equipment depreciation as $318,225 x appropriate consumption) appropriate % of machine hours attributed prototype production Training N/A N/A N/A N/A N/A N/A

Acquisition of N/A N/A N/A N/A N/A N/A external knowledge or IP Research and Consultants – Various Consultants $600,000 600,000 Amount paid to the development research sub- payments up to University research – acquired contracted to 20 June 2009 centre to acquire (Basic and University knowledge in applied respect of building research) better termination boxes New Preparations N/A N/A N/A N/A 0 N/A marketing for marketing methods innovations New Preparations N/A N/A N/A N/A 0 N/A organisational for methods organisational innovations New Preparations N/A N/A N/A N/A 0 N/A Processes for process innovations

47 Innovation revenue from the services provided Type of Item Reference period Source Revenue Revenue from Notes innovation 01/07/2008 - Account Estimation Innovation 30/06/2009 Activities 2008-2009 ($) Product New Server Sales up to Sales – server [No of new server racks 2,000,000 Sale of new server racks. innovation Racks 30 June 2009 racks sold] x [sale price per unit of server rack]. Assume 5,000 units manufactured during the reference period were all sold: 5,000 x $400/sale price per unit = 2,000,000 New Power rails Sales up to Sales – Power [No of new power rails 500,000 Sale of new power rails. Note 30 June 2009 rails sold] that XYZ would not have any x [sale price per unit of innovation spent corresponding power rail]. to the revenue as power rails Assume 1,000 units was developed and marketed in manufactured during the the 2007/2008 financial year. reference period were all sold: 1,000 x $500/sale price per unit = 500,000

48 4.4 TECHNICAL DIFFICULTIES Transaction Date Comments

No 1 30 September 2008 • XYZRacks spend $1,000,000 in designing and production of a new prototype server rack.

• The main difficulty is sourcing the innovation expenditure from a number of accounts as seen above 2 30 October 2008 • XYZRacks spend $200,000 in marketing and adverting of the launch of new server racks.

• This area especially problematic for a firm that develops and designs and launches new products every year.

• Marketing and advertising expenditure are all lumped in one account which could be made up of the following:

– Advertising and marketing for the initial launch of a new products

– Ongoing advertising and marketing of existing products 3 30 November 2008 • XZY had $2 million in cash sales of the newly designed server racks.

• The total sales of $2 million in respect of the newly designed server racks are a direct measure of the innovation revenue.

• XYZRacks manufactures different varieties of server racks (some old and some new).

• Although the sales have been allocated to “Sales – server racks”, this account is still made up of sales from old server racks and different varieties of new server racks.

• If XYZRacks is completing a survey form, it would have difficulties completing the form due to the above reasons. XYZRacks may need to drill down to general ledger accounts to arrive at estimates which can be a time consuming process. 4 31 January 2009 • XYZRacks had cash sales of $500,000 during the year of power rails which it had developed last year (2007/08).

• This example emphasises the point that it is possible for (input) research, design and development and production to take place in one reporting period while the (output) revenue inflow is in another financial reporting period.

• Accordingly it is possible for XYZRacks to report nil innovation spend in respect of power rails in the reference period, however it may have innovation related revenue as is the case in the above example.

49 5 20 June 2009 • XYZRacks had paid $600,000 in 2008/09 to a University for research work carried out by the University around building significantly improved termination boxes.

• As the research work has been sub-contracted to the University, XYZRacks is recording the payments as consultancy fees. Difficulty arises when separating normal business consulting fees from consulting fees paid to the University for research work. There is a high possibility that XYZRacks may not consider the payments made to the University for research work as innovation expenditure.

4.5 SUMMARY

To conclude, an accurate estimation of innovation requires the organisations’ basic understanding of the Oslo and Frascati Manual definitions of innovation and R&D.

The accounting standards for reporting entities stipulate that expenditure during the research phase needs to expensed and capitalised during the development phase if certain conditions are satisfied. The Frascati Manual 2002 does not specify accounting treatment but provides definitions of what constitutes basic and applied research and experimental development.

Medium entities that produce special purpose financial reports generally do not adopt AASB 138 Intangible Assets; hence they expense all the expenditure during R&D phase in the profit and loss statement (as in the above case study) which is also driven by tax incentives.

The case study above shows the difficulties that businesses potentially face and some of the key points that the case study highlights are as follows:

• Sourcing expenses from various accounts to calculate innovation expenditure.

• Research and development expenditure that falls into more than one accounting period.

• Accounting difficulties in tracing revenue to innovation related activities.

• Keeping separate records for activities relating to market introduction of new products for example advertising expenses.

50 5 LARGE BUSINESSES

5.1.1 Entity type

A large business can take the following forms:

• Partnership

• Trust

• Company with a parent entity and subsidiaries

There are over 1,300 economic groups and entities in the large business category, encompassing over 32,000 businesses (mainly companies). Approximately two-thirds of these businesses are public companies. About 1,100 of these groups have annual turnover greater than $250 million, the remainder are businesses that due to their unique characteristics are grouped within the large business category.

A large business can generally be:

• a single legal entity with one ABN and operating predominantly in one industry

• a single legal entity with one ABN and operating in multiple industries

• multiple entities with respective ABNs and operating in multiple industries.

5.1.2 Culture

Large businesses have a very formal culture in place. A large business will have the following in place:

• Organisational structure

• Corporate Governance and various Committees

• Board of Directors and Chief Executive Officer

• Internal Finance, HR, Payroll, IT, Corporate and Legal teams.

5.1.3 Industries

Large businesses generally are found in the following industries:

• Energy and resources sector including businesses in the natural resources, petroleum, utilities and services sector

• Financial sector including banking, financial services and insurance

• Technological sector

• Manufacturers including agriculture and food

51 • Retail and wholesale businesses.

Mostly large businesses are reporting entities. Hence, they prepare general purpose financial reports with comprehensive accounting disclosure requirements and other reporting requirements as stipulated in the accounting standards and the Corporations Act.

5.2.2 Bookkeeping

Large businesses have an internal finance team with approximately 15-80 staff. The finance team would generally consist of accounts payable, accounts receivable, audit, accounting, tax, facilities, regulatory affairs and pricing, treasury, group performance and advisory, and corporate services teams with strict access controls over the accounting software.

Apart from financial accounting systems, large businesses also have cost accounting systems (generally job costing or process costing systems). Job costing is common in industries that produce goods to meet customer specifications whereas process costing is common in industries that use a series of steps (processes) to make large quantities of similar products.

The chief financial officer is responsible for integrating all the modules/systems to produce a detailed set of management reports of the company.

5.2.3 Accounting software

Real time online accounting software packages such as SAP, Oracle, Microsoft Dynamics GP (Great Plains) and ERP are generally used by large businesses. However, like medium business there is a second stage of reporting as Oracle, SAP and ERP software do not produce general purpose financial reports.

The diagram on the following page shows the processes involved.

52 53 5.3 LARGE BUSINESS CASE STUDY (1)

BCD Australia Pty Limited (BCD)

• BCD is a large information technology company in Australia employing approximately 1,000 staff.

The company has three core businesses that are reportable operating segments as follows:

• IT Call Centre Operation (220 staff)

• Engineering and Consultancy (280 staff)

• IT Equipment Manufacturing (350 staff)

• Corporate headquarters (150 staff)

The reference period is the 2008/2009 financial year.

• BCD is a reporting entity and prepares general purpose financial reports. BCD is also a single legal entity with one ABN.

• BCD uses a combination of integrated software, such as Microsoft Dynamics GP, Payroll and Cost and time management systems. The diagram below shows how the automated integrated software works:

Some notable transactions that occurred during the 2008/09 financial year are listed below.

The above transactions would be recorded in BCD’s accounts as follows:

• BCD prepared and lodged a tender on 15 July 2008 with the Government to build a new defence system. The tender documentation process cost incurred by BCD was approximately $900,000. BCD was successful in its bid on 31 July 2008 for $100 million to build a new defence system by the end of 30 June 2009. The project involved the development of a complex system involving different pieces of equipment and different operating software. The development programme of the naval system and the major costs involved are shown below.

54 Task Description Costs $’000 Proposal Tender submission process 900 User’s operational What is expected of the new defence system in the field 5,000 requirements Detailed specification What the new defence system needs to do to achieve its role 5,000 Concept design /proof of The initial design to demonstrate the specifications can be 10,000 principle met Detail design Design subsystems, identify equipment/subcontractors best 30,000 suited to achieve specification, looking first to existing naval (includes $20 systems, then modifying existing systems and if necessary million designing a new one. subcontracting) Systems integration Assembling all subsystems and testing to ensure all 10,000 components function together as required Trials Carry out extensive trials and testing to demonstrate 5,000 achievements of specifications Re-design/modify Incorporate modifications identified as a result of the trials 5,000 User demonstration Government carries out own trials to ensure product meets 3,000 specifications to their satisfaction Acceptance of design Production Build Standard agreed, Technical Data Pack 2,000 prepared Production Production of a new defence system to agreed build standard 10,000 Post-design services Modification to production build standard after entry into 5,000 service. This involves design of modifications and production of modification naval system Total 90,900

Figure 5 Extracts from BCD’s general purpose financial reports are shown below with some significant accounting disclosures and policies

BCD Australia Pty Limited – Statement of comprehensive income for the year ended 30 June 2009 2009 $’000 Revenue 700,000 Cost of sales (560,000) Gross profit 140,000 Other income 3,000 Administrative expenses (50,000) Other expenses (40,000) Profit from continuing operations before income tax expense 53,000 Income tax expenses (15,900) Profit from continuing operations after income tax expense 37,100

Other comprehensive income Cash flow hedges (500) Other comprehensive income for the year, net of tax (500) Total comprehensive income for the year 36,600 Total comprehensive income for the year attributable to the members of BCD 36,600 Australia Pty Limited

55 Figure 6 Statement of financial position as at 30 June 2009

BCD Australia Pty Limited – Statement of financial position as at 30 June 2009 2009 $’000

Current assets Cash and cash equivalents 200,000 Receivables 30,000 Inventories 700 Other 25,000 Total current assets 255,700

Non-current assets Property, plant and equipment 25,000 Deferred tax assets 9,000 Intangible assets 30,000 – intellectual property, software, capitalised contracts and goodwill Retirement benefit obligations (surplus) 500 Other 5,000 Total non-current assets 69,500 Total assets 325,200

Current liabilities Payables 95,000 Current tax liabilities 4,000 Provisions 19,400 Total current liabilities 118,400

Non-current liabilities Deferred tax liabilities 5,000 Provisions 5,800 Total non-current liabilities 10,800 Total liabilities 129,200 Net assets 196,000

Equity Contributed equity 11,000 Reserves 15,000 Retained profits 170,000 Total equity 196,000

56 Figure 7 Statement of cash flows

BCD Australia Pty Limited – Statement of cash flows for the year ended 30 June 2009 2009 $’000

Cash flows from operating activities Receipts from customers (inclusive of goods and services tax) 500,000 Payment of suppliers and employees (inclusive of goods and services tax) (400,000) Interest received 3,000 Income taxes paid (15,000) Net cash flow operating activities 88,000

Cash flows from investing activities Payments for property, plant and equipment (2,000) Proceeds from sale of property, plant and equipment – Net cash (outflow) from investing activities (2,000) Net increase in cash held 86,000 Cash at the beginning of the financial year 114,000 Cash at the end of the financial year 200,000

NOTE 1 SUMMARY OF SOME OF THE SIGNIFICANT ACCOUNTING POLICIES

Revenue Revenue is measured at the fair value of the consideration received or receivable. Amounts disclosed as revenue are net of duties and taxes paid. Revenue is recognised for major business activities as follows:

(i) Contract revenue Contract revenue and expenses are recognised in accordance with the percentage of completion method unless the outcomes of the contract cannot be reliably estimated. The stage of completion is measured by reference to total cost incurred to date as a percentage of estimated total cost at completion for each contract. Where it is probable that a loss will arise from a construction contract, the excess of total costs over revenue is recognised as an expense immediately.

Where the outcome of a contract cannot be reliably estimated, contract costs are recognised as an expense as incurred, and where it is probable that the costs will be recovered, revenue is recognised to the extent of costs incurred.

(ii) Interest income Interest income is recognised in profit or loss as it accrues.

(iii) Government grants Grants from the government are recognised at their fair value where there is reasonable assurance that the grant will be received and the company will comply with all attached conditions. Government grants relating to costs are deferred and recognised in profit or loss over the period necessary to match with the costs that they are intended to compensate.

(iv) Other revenue Other revenue is recognised as invoices are raised and/or accrued as services are provided.

57 Property, plant and equipment Property, plant and equipment are stated as historical cost less depreciation. Historical cost includes expenditure that is directly attributable to the acquisition of the items.

Depreciation on other assets is calculated using the straight line method to allocate their cost or revalued amounts, net of their residual values, over their estimated useful life, as follows:

Leasehold improvements 5 – 10 years based on lease term Office furniture and equipment 4 – 10 years Computer equipment 3 – 5 years Aircraft 1 0 years with residual value Computer software 3 – 5 years

The assets’ residual values and useful lives are received, and adjusted if appropriate, at the end of each reporting period. An asset’s carrying amount is written down immediately to recoverable amount if the asset’s carrying amount is greater than its estimated recoverable amount. Gains and losses on disposals are determined by comparing proceeds with carrying amount. These are included in profit or loss.

Intangible assets

(i) Goodwill Goodwill represents the excess of the cost of an acquisition over the fair value of the company’s share of the net identifiable assets of the acquired subsidiary/associate at the date of acquisition. Goodwill acquired in business combinations is not amortised. Instead, goodwill is tested for impairment annually or more frequently if events or changes in circumstances indicate that it might be impaired, and is carried at cost less accumulated impairment losses.

Goodwill is allocated to cash generating units for the purposes of impairment testing.

(ii) Capitalised contracts Capitalised contracts are deemed to have a finite life and are carried all cost less accumulated amortisation and impaired losses. Amortisation is calculated using the straight line method to allocate the cost of the capitalised contracts over their useful lives, which is no greater than 20 years.

(iii) Intellectual property Intellectual property is deemed to have a finite life and is carried at cost less accumulated amortisation and impaired losses. Amortisation is calculated using the straight line method to allocate the cost of intellectual property over its useful life, which is no greater than 20 years.

(iv) Software Costs incurred in developing products or systems and costs incurred in acquiring software and licences that will contribute to future period financial benefits through revenue generation and/or cost reduction are capitalised to software and systems. Costs capitalised include external direct costs of materials and service and direct payroll related costs of employee’s time spent on the project. Amortisation is calculated on a straight line basis over a period of 3 – 5 years.

(v) Research and development Research expenditure is recognised as an expense as incurred. Costs incurred on development projects are capitalised when it is probable that the projects will be a success considering its commercial and technical feasibility and its costs can be measured reliably. The development expenditure capitalised comprises all directly attributable costs, including costs of materials, services, direct labour as an expense as incurred.

58 NOTE 2 SEGMENT REPORT Segment information is presented in respect of the entity’s internal management structure as reported to the entity’s Chief Operating Decision Maker (CODM). The CODM for the entity has been assessed as the entity’s Managing Director.

The entity’s operations have been divided into three reportable segments comprising: Call Centre Operations, Engineering and Consultancy Services and IT Equipment Manufacturing.

The entity’s policy is to transfer products and services internally at negotiated commercial prices. Intersegment sales are eliminated when preparing BCD’s financial reports.

Operating segment disclosures for BCD Australia Pty Limited Call centre Engineering and IT equipment BCD (Total) consulting External revenue 100,000 400,000 200,000 700,000 Intersegment revenue 5,000 15,000 6,000 27,000 Interest expense 3,000 4,900 8,000 15,900 Depreciation 200 400 2,400 3,000 Reportable segment profit 10,000 20,000 10,000 40,000 Reportable segment assets 70,000 50,000 200,000 320,000 Reportable segment 20,000 80,000 25,000 125,000 liabilities

BCD Australia Pty Ltd (BCD) – Measuring innovation expenditure and related revenue

1 In 2011,BCD received a survey questionnaire from the National Statistical Agency asking if BCD had introduced any new or significantly improved goods or service, implemented a new or significantly improved process, organisational or marketing methods during the 2008-09 reference period, and if BCD did, to provide an estimate of:

(i) the cost (ie the amount spent) of implementing the new product, process or method and

(ii) to provide an estimate of the revenues earned from the sale of new products during the reference period.

The National Statistical Agency has adopted the recommendations of the OECD’s Oslo Manual (2005) for measuring innovation and the Frascati Manual (2002) for defining and measuring R&D activities.

2 Activities undertaken by BCD and its staff are as per case study in the report.

3 By applying the OECD’s Oslo and Frascati Manuals guidelines for measuring innovation and research and development activities respectively, BCD notes the following:

(i) That BCD’s Engineering and Consultancy division undertook activities related to the development and implementation of new process – reorganising and customising the tender submission process for the defence work tender (first major tender for the Government) as the Government tender requirements were different from other commercial tenders.

(ii) That BCD’s Engineering and Consultancy division in combination with the other two divisions developed new software for use in the Call Centre business. The software improves the response time by speeding reallocation of calls in queue. The software was sold to Call Centre Division on 30 March 2009 for $1 million dollars. The call centre’s 50 employees had a day’s training on 5 April 2009 on the new software by one of the developers from Engineering and Consulting division.

59 (iii) That all three BCD divisions undertook several innovative activities as part of the development of a naval system project which would provide BCD benefit for future projects. The project was predominantly carried out from the IT Equipment and Manufacturing Division.

4 In terms of identifying the relevant statistical unit, BCD has three main economic activities corresponding to 3 operating segments which can be classified under the following ANZSIC codes:

– IT Call Centre Operation Division N (Administrative and Support Services), Class 7294 (Call Centre Operation)

– Engineering and Consultancy Services Division M (Professional, Scientific and Technical Services), Class 7000 (Engineering Design and Engineering Consulting Services)

– IT Equipment Manufacturing Division C (Manufacturing), Class 2439 (Other Electronic Equipment Manufacturing)

BCD is a single legal and reporting entity with one ABN, however operating in multiple industries. Based on this approach, the above three BCD divisions would be categorised as a large business (employing more than 200 employees) for statistical purposes, however each division would be required to report their innovation expenditure and related revenue separately as they are operating in different ANZSIC industries.

5 As a result, the information required to estimate BCD’s innovation expenditure in 2008-09 cannot be sourced from the single set of accounts (general purpose financial reports shown above) maintained by BCD. BCD would rely on the internal management operating segment reports in order to determine the innovation expenditure and related revenue. BCD’s sophisticated accounting package allows for individual operating segment’s as well as consolidated financial reports to be maintained.

6 The application of the Oslo Manual guidelines to accounting data for measuring innovation spend together with related revenues is illustrated in the table below.

60 Measuring innovation expenditure for Engineering and Consulting Division Type of Item Reference Items in Source account – Cost allocation Notes innovation Innovation period general management activity 01/07/2008- purpose report 30/06/2009 financial report New process R&D, Materials Various Cost of sales Cost of sales – Unit price of BCD’s Engineering and training and transactions Engineering and material used x Consultancy division will have other within the Consultancy material used from internal charges for using preparations reference division all three segments materials from the Call Centre for process period and IT Equipment Manufacturing innovations divisions Employee Various Cost of sales Wages and Average hourly rate BCD’s Engineering and wages transactions Salaries – per employee x Consultancy division will have within the Engineering and total number of internal charges for using labour reference Consultancy hours spent by from the Call Centre and IT period division employees in Equipment Manufacturing tender submission divisions. This will be easy to process track if employees are using timesheets and putting their time under Engineering and Consultancy division for time spent on the new tender submission process. Other Various Cost of sales Superannuation – 9% of the Prorated superannuation Employee transactions Engineering and employees’ wages expense including internal compensation within the Consultancy expense attributed charges for superannuation reference division to tender expenses for employees who period submission worked on the tender submission process work in the process Engineering and Consultancy division

61 Workers Various Cost of sales Workers Total workers Prorated workers compensation compensation transactions compensation – compensation expense including internal within the Engineering and expense x charges attributed to employees reference Consultancy employee wages who worked on the new tender period division attributed to tender submission process submission process work/total BCD wages expense Payroll tax Various Cost of sales Payroll tax Total payroll tax Prorated payroll tax expense transactions -Engineering and expense x including internal charges within the Consultancy employee wages attributed to employees who reference division attributed to tender worked on the new tender period submission submission process process work/total BCD wages expense New R&D, Fringe Various Cost of sales Engineering and Total fringe Prorated fringe benefits tax processes training and benefits transactions Consultancy benefits tax expense including internal (new other tax expense within the expense x charges attributed to employees operational preparations reference employee fringe who are provided with fringe tender for process period from 1 benefits expense benefits and worked on the new submission innovations July 2008 to 15 attributed to tender submission process process) July 2008. proposal work/total fringe benefits expense Corporate Various Administration – Rent Corporate Corporate overheads costs in overheads transactions expenses – Admin and overhead expenses respect of tender submission within the Office expenses x % attributed to process reference – Telephone new tender period 1 July – Electricity submission 2008 to 15 July – IT costs process 2008. Engineering and Consultancy division Acquisition N/A N/A N/A N/A N/A N/A of external knowledge or IP

62 Acquisition N/A N/A N/A N/A N/A N/A of machinery and equipment and other capital goods Other N/A N/A N/A N/A N/A N/A preparations for product innovations New Preparations N/A N/A N/A N/A N/A N/A marketing for methods marketing innovations New Preparations N/A N/A N/A N/A N/A N/A organisational for methods organisation innovations

63 Measuring innovation expenditure for Call Centre Division Type of Innovation Item Reference Items in Source account – Cost allocation Notes innovation activity period general management 01/07/2008- purpose report 30/06/2009 financial report New Acquisition of Intangible 30 March 2009 Intangible Software – Call $1 million BCD’s Engineering and processes machinery, assets assets Centre (transferred at cost Consulting division would have (new equipment from Engineering incurred a number of costs in operational and other and Consulting to developing the software process) capital goods Call Centre) including the following:

Materials Employee wages Other Employee compensation Workers compensation Payroll tax Fringe benefits tax expense Corporate overheads

The cost at which it is being transferred to the Call Centre is the cost that is recorded in BCD’s balance sheet.

64 Measuring Training Training 5 April 2009 Cost of sales Call Centre 150 Call Centre As this is in-house training, BCD innovation – wages employees will not have a training expense expenditure – salaries wage rate per hour in their general purpose financial for – superannuation for call centre report, however it should have Call Centre – corporate employees x 8 internal reports on time spent by Division – office expenses working hours in a employees on training via the day x 150 plus pro- timesheet reporting software. rata of all other labour costs Software developers time wage rate per hour for the software developer x 8 working hours in a day x days plus pro-rata of all other labour costs Pro-rated corporate overheads, Printing and stationery, Rent, Utilities. New Other Overhead Various Cost of sales Various overhead Pro-rated amount All the costs associated in processes preparations costs transactions costs such as of overhead costs installing the software in the Call (new for process associated from 1 April to utilities, corporate based on the hours Centre Division. operational innovations with 30 June 2009 labour charges spent by corporate process) implementing etc employees the software coordinating the in the Call installation of the Centre software division R&D N/A N/A N/A N/A 0 The R&D activity to optimise performance of the software were carried out in the Engineering and Consulting division

65 Acquisition of N/A N/A N/A N/A 0 N/A other external knowledge or IP Other N/A N/A N/A N/A 0 N/A preparations for product innovations Market N/A N/A N/A N/A 0 N/A preparations for product innovations New Preparations N/A N/A N/A N/A 0 N/A organisational for method organisational innovations New Preparations N/A N/A N/A N/A 0 N/A marketing for marketing method innovations

66 Measuring innovation expenditure – IT Equipment Manufacturing Type of Innovation Item Reference Items in Source account – Cost allocation Notes innovation activity period general management 01/07/2008- purpose report 30/06/2009 financial report New Research and Intangible Various Intangible Software -IT Cost of developing BCD has to develop new Products development Asset transactions assets Equipment the software: software programmes which it within the Manufacturing – materials used or can use to develop the system. reference acquired The software can be used for period from 1 – labour costs future projects. July 2008 to (software BCD will have to rely on the 29 March developers) Engineering and Consulting and 2009. through timesheet IT Equipment Manufacturing records Division’s internal management – portion of corporate reports to ascertain the cost of overheads developing the software. Acquisition of Intangible Various Intangible Intellectual Cost of acquiring the BCD has to acquire IP to external Asset transactions assets property – IT intellectual property develop the system. IP can be knowledge or within the Equipment used for future projects. IP reference Manufacturing BCD will have to rely on the period from 1 Engineering and Consulting and July 2008 to IT Equipment Manufacturing 29 March Division’s internal management 2009. reports to ascertain the acquisition cost of acquiring the IP Acquisition of Advanced IT Various Property, Property, plant Cost of acquiring the BCD has to acquire IP to machinery equipment transactions plant and and Equipment advanced IT develop the system. The IP can and within the Equipment -IT Equipment equipment be used for future projects. equipment reference Manufacturing BCD will have to rely on IT and other period from 1 Equipment Manufacturing capital goods July 2008 to Division’s internal management 29 March reports to ascertain the cost of 2009. acquiring the advanced IT equipment.

67 Other New Various Cost of sales, Cost of sales, Cost of implementing BCD has to improve its preparations operational transactions Property, Property, Plant the new operational operational processes to enable for product process within the Plant and and Equipment – process them to develop the system. The innovations significantly reference Equipment Engineering and improved operational processes improving period from 1 consulting would provide benefits for the July 2008 to future projects. BCD will have to integration 29 March Cost of sales, rely on IT Equipment between the 2009. Property, Plant Manufacturing and Engineering two divisions and Equipment and Consulting Division’s -IT Equipment internal management reports to Manufacturing ascertain total spend on operational improvements. Market Marketing Various Cost of sales Marketing Cost of activities BCD will have to rely on IT preparations expense transactions expense – IT undertaken at market Equipment Manufacturing and for product within the Equipment introduction of the Engineering and Consulting innovations reference Manufacturing new defence system Division’s internal management period from 1 reports to ascertain the July 2008 to marketing expense on the 29 March introduction of the new system. 2009. New Products Training Training Various Cost of sales Training expenses Cost of training in BCD’s time management expense transactions – Engineering and respect software should provide the time within the Consulting and IT of the following: spent by employees on training. reference Equipment – advanced IT Other costs can be obtained period from 1 Manufacturing equipment from the divisional management July 2008 to – new IP reports. 29 March – new operational 2009. processes Costs would include: – cost of hiring any specialist trainers – labour costs during training – prorated overheads New Preparations N/A N/A N/A N/A 0 N/A Processes for process innovations

68 New Preparations N/A N/A N/A N/A 0 N/A organisational for innovations organisational innovations New Preparations N/A N/A N/A N/A 0 N/A marketing for marketing methods innovations

Innovation revenue – Call Centre Division Type of Item Reference period Items in general Source account – Revenue Notes innovation 01/07/2008- purpose financial management estimation 30/06/2009 report report 2008-2009 ($) Process New software for Various Revenue Call Centre Difficult to measure revenue and innovation call centre transactions Cost of goods Service fees cost savings from efficiencies operations within reference sold Cost savings achieved from the new software period from 30 being used in the Call Centre March 2009 to business 30 June 2009 Cost difference between previous period and period after implementation of new software

Innovation revenue – Engineering and Consulting Type of Item Reference period Items in general Source account – Revenue Notes innovation 01/07/2008- purpose financial management estimation 30/06/2009 report report 2008-2009 ($) Product New Software for 30 March 2009 Revenue Intersegment $1 million As the Engineering and Consulting innovation Call Centre revenue segment operating in a separate industry, it has to report the innovative revenue and expenses independently from the other divisions. Process New tender Various Revenue Intersegment $900,000 Costs incurred by Engineering and innovation submission transactions revenue Consulting in respect of the tender process within reference submission being recharged to IT period from 1 July Equipment and Manufacturing. 2008 to 15 July 2008

Innovation revenue – IT Equipment Manufacturing

69 Type of Item Reference period Items in general Source account – Revenue Notes innovation 01/07/2008- purpose financial management estimation 30/06/2009 report report 2008-2009 ($) Product New Defence Various Revenue Construction % of profit on the In developing the new defence innovation System transactions revenue defence contract system, BCD’s IT Equipment and within reference ($9.1 million) Manufacturing Division had to go period from 1 attributed to through multiple innovative August 2008 to various innovative activities. Allocating revenue to 30 June 2009 activities. these innovative activities is a difficult process as there is no direct relationship between the end product and innovative activities.

70 5.4 TECHNICAL DIFFICULTIES

Innovative activity Comments

Tender submission Whilst the cost systems capture the expenses in respect of the tender process submission process, they do not allow for the separate allocation of the total external revenue generated from such innovative activities as the external revenue (sale of the defence system to the Government) is generated by the IT Equipment Manufacturing Division. The intersegment revenue (internal) generated by the Engineering and Consulting Division due to recharging for costs incurred in the tender submission process must be eliminated when preparing the consolidated financial reports. Given that BCD is a single legal entity with one ABN and operating across three ANZSIC industries, Engineering and Consulting Division would record the tender preparation costs incurred and the recharged costs of $900,000 as innovative expenditure and intersegment revenue, respectively, when completing the survey form. It does not include innovation costs incurred in the 2007-2008 financial year.

Software for Call Centre As explained above, the software is being developed in the Engineering and Consulting Division for sale to Call Centre. Given BCD is a single legal entity, the development of the software by the Engineering and Consulting division can be classed as product innovation while the implementation of the software by the Call Centre can be classed as a process innovation. The reporting of innovation data gets very complicated with a single entity.

Defence System Whilst BCD is an innovation intensive entity, most of their innovation is specifically developed and produced for clients. If Government is assessed for innovation expenditure, they would report the $100 million on implementing the new defence system. It may be argued that entities which are R&D and innovative intensive and performing such activities for a fee, would have nominal innovation related expenditure and revenue.

The development of the defence system requires the use of a number of new and existing equipment, technologies and labour across the three industries. Given each segment would be required to report their innovation spend and revenue independently from other segments, the estimation process would require input of multiple persons/divisions – all of these issues impact on the quantity and /or availability of estimates and may result in data being collected of questionable quality.

71 5.5 LARGE BUSINESS CASE STUDY (2)

EFG Energy Pty Limited (EFG)

• EFG is a large energy company in Australia employing approximately 2,000 staff.

• The company produces and sells electricity, natural gas and liquefied petroleum gas (LPG).

• The company has three core businesses that are reportable operating segments as follows:

– Exploration and Production – Natural gas and oil exploration and production in Australia and South East Asia (700 staff)

– Power Generation – Natural gas-fired cogeneration and power generation in Australia (400 staff)

– Retail – Natural gas, electricity, LPG and energy related products and services in Australia and the Pacific (600 staff)

– Corporate headquarters (300 staff)

• EFG operates the Exploration and Production and Generation businesses through separate legal entities (EFGsubco1 and EGFsubco2 respectively). The retail business is operated through EFG.

• EFG in a reporting entity. It prepares consolidated general purpose financial reports.

• EFG uses SAP ERP software for Financials, Human Resources, Corporate Services and Operations Management

A few notable transactions that occurred during the 2008/09 financial year are as follows:

• EFG has been working for some years with a research centre for Sustainable Energy Systems, funding the development of a new way of manufacturing solar cell, which has the potential to reduce manufacturing costs for the solar power industry. The solar project was initially a research predominantly undertaken by a team from the research centre, with internal staff involved in project supervision. Progress with the research effort resulted in the project accountability being transferred to an operational division within the EFG to progress commercialisation of the technology. The firm hired specialist expertise to establish relevant in-house capacity, recognising that existing staff did not have the required skills. However, EFG retrained existing sales staff to enable them to work in new marketing channels.

• On 23 September 2008, EFG commenced commercial operations of its solar electricity installation business (as a pilot project) selling and installing solar electricity equipment as a package, currently purchasing most components from other manufacturers and assembling them in-house. Once the scale- up of its pilot technology is complete and the technology proved, it will be able to use its own retail market channels available to enter the market as both a component manufacturer and an electricity provider.

• EFG invested $50 million in new drilling equipment on 30 November 2008 which makes the drilling process in rocky terrain much faster.

• During the year ended 30 June 2009 (from 15 January 2009 up to 5 February 2009), EFG and controlled entities went through a major organisational restructure that saw the implementation of a new organisational model that gives the EGF group of companies employees greater autonomy in decision

72 making and encourages them to contribute their ideas.

Figure 8 Extracts from EFG’s general purpose financial reports are shown below with some significant accounting disclosures and policies

EFG Energy Pty Limited and Controlled Entities – Income Statement for the year ended 30 June 2009 2009 $’000 Revenue 8,500 Other income 60 Total expenses, excluding net financing costs (7,700) Share of results of equity accounted investees 150 Net financing costs (124) Profit before income tax 886 Income tax expenses (196) Profit for the period 690 Non-controlling interests (70) Profit attributable to members of the parent entity 620

Figure 9 Statement of financial position as at 30 June 2009

EFG Energy Pty Limited and Controlled Entities – Statement of financial position as at 30 June 2009 $’000

Current assets Cash and cash equivalents 830 Trade and other receivables 1,300 Inventories 150 Other financial assets, including derivatives 450 Tax assets 80 Other assets 160 Total current assets 2,970

Non-current assets Other financial assets, including derivatives 220 Investments accounted for using the equity method 5,400 Property, plant and equipment 9,200 Exploration and evaluation expenditure 1,200 Development expenditure 95 Intangible assets 2800 Tax assets 90 Other assets 50 Total non-current assets 19,055 Total assets 22,025

Current liabilities Trade and other payables 1,300 Interest-bearing liabilities 120 Other financial liabilities, including derivatives 420 Tax liabilities 8 Provisions 150 Total current liabilities 1,998

Non-current liabilities Trade and other payables 70 Interest-bearing liabilities 3,800

73 Other financial liabilities, including derivatives 3,400 Tax liabilities 950 Provisions 380 Total non-current liabilities 8,600 Total liabilities 10,598 Net assets 11,427

Equity Share capital 1,800 Reserves 327 Retained earnings 8,500 Total parent entity interest 10,627 Non-controlling interests 800 Total equity 11,427

Figure 10 Statement of cash flows

EFG Energy Pty Limited and Controlled Entities – Statement of financial position as at 30 June 2009 2009 $’000

Cash flows from operating activities Cash receipts from customers 9,000 Cash paid to suppliers (7,900) Cash generated from operations 1,150 Dividends/distribution received from equity accounted investees 15 Other dividends received 2 Income taxes paid (105) Net cash flow operating activities 2,162

Cash flows from investing activities Acquisition for property, plant and equipment, exploration and development (3,867) expenditure and other non-current assets Acquisition of businesses, net of cash acquired (9) Interest received 150 Net proceeds from sale of non-current assets 10 Net cash (used in) from investing activities (3,716)

Cash flows from financing activities Proceeds from borrowings 2,715 Repayment of borrowings (2,900) Interest paid (800) Dividends paid by the parent entity (380) Dividends paid to non-controlling interests (50) Net cash used in financing activities (1,415) Net (decrease)/increase in cash and cash equivalents (2,969) Cash and cash equivalents at the beginning of the year 3,800 Effect of exchange rate changes on cash (1) Cash and cash equivalents at the end of the year 830

74 NOTE 1 SUMMARY OF SOME OF THE SIGNIFICANT ACCOUNTING POLICIES

EFG is a company domiciled in Australia. The financial statements of the company for the year ended 30 June 2009 comprise the company and its subsidiaries (together referred to as the consolidated entity) and the consolidated entity’s interest in associates and jointly controlled entities.

Statement of compliance

The financial statements are general purpose financial statements that have been prepared in accordance with Australian Accounting Standards (including Australian Interpretations) adopted by the Australian Accounting Standards Board (AASB) and the Corporations Act 2001. The financial statements of the consolidated entity comply with International Financial Reporting Standards and interpretation adopted by the International Accounting Standards Board.

Principles of consolidation

Change in accounting policy

The consolidated entity has adopted revised AASB 3 Business Combinations (2008) and amended AASB 127 Consolidated and Separate Financial Statements (2008) for business combinations occurring on or after 1 July 2009. Transaction costs that the consolidated entity incurs in connection with a business combination, such as legal fees, due diligence fees and other professional and consulting fees, are expensed as incurred.

Accounting for acquisitions of non-controlling interests

The consolidated entity has applied AASB 127 Consolidated and Separate Financial Statements (2008) for the acquisitions of non-controlling interests that are accounted for as transactions with equity holders in their capacity as equity holders and therefore no goodwill is recognised. The change in accounting policy was applied prospectively.

Subsidiaries

The financial statements of the consolidated entity include the financial statements of EFG Energy Pty Limited and all entities in which it had a controlling interest. Control exists when the company has the power, directly or indirectly, to govern the financial and operating policies of an entity so as to obtain benefits from its activities. In assessing control, potential voting rights that are presently exercisable or convertible are taken into account. The effects of transactions between entities consolidated in the financial statements are eliminated. Non-controlling interests in the equity and results of entities that are under the control of EFG are shown as a separate item in the financial statements. Where control of entities commenced or ceased during the year, the profits or losses are included only from the date control commenced or up to the date control ceased.

Associates and joint ventures (equity accounted investees)

Associates are those entities over which the consolidated entity exercises significant influence, but not control, over the financial and operating policies and which are not intended for sale in the near future. Joint ventures are those entities over whose activities the consolidated entity has joint control, established by contractual agreement. In the financial statements, investments in associates and investments in jointly controlled entities, including partnerships, are accounted for using equity accounting principles.

The financial statements include the consolidated entity’s share of the income and expenses and equity movements of the entity accounted investees, after adjusting to align the accounting policies with those of the consolidated entity, from the date that significant influence or joint control commences until the date that

75 significant influence or joint control ceases. When the consolidated entity’s share of losses exceeds its interest in an equity accounted investee, the carrying amount of that interest (including any long-term investments) is reduced to nil and the recognition of further losses is discontinued except to the extent that the consolidated entity has an obligation or has made payments on behalf of the investee. The equity accounted results is disclosed in the income statements as “share of results of equity accounted investees”.

Jointly controlled operations and assets

The consolidated entity’s interests in unincorporated joint ventures are brought to account by including its proportionate share of the joint ventures’ assets and liabilities acquired at the carrying amounts recognised previously in the consolidated entity’s controlling shareholder’s consolidated financial statements. The components of equity of the acquired entities are added to the same components within the consolidated entity equity. Any cash paid for the acquisition is recognised directly in equity.

Segment reporting

As of 1 July 2008 the consolidated entity determines and presents operating segments based on the information that is internally provided to the Managing Director who is chief operating decision maker. The Managing Director regularly receives financial information on the underlying profit of each operating segment and the statutory profit. Reconciliation is also received to show the financial impact of the individual items that are excluded from statutory profit in the measurement of underlying profit. The underlying profit information is provided to the Managing Director to assess the performance of EFG’s ongoing business.

A segment is a distinguishable component of the consolidated entity that is engaged in providing products or services, which is subject to risks and rewards that are different from those of other segments.

Intangible assets

Goodwill

All business combinations are accounted for by applying the acquisition method. Goodwill represents the difference between the cost of the acquisition and the fair value of the net identifiable assets, liabilities and contingent liabilities acquired. Goodwill is stated at cost less any accumulated impairment losses. Goodwill is allocated to cash-generating units and is not included in the carrying amount of the investment in the equity accounted entity. Negative goodwill arising on an acquisition is recognised directly in the income statement.

Other intangible assets

Other intangible assets that are acquired are stated at cost less accumulated amortisation and impairment losses. Amortisation is recognised as an expense on a straight-line basis over the estimated useful lives of the assets.

Research and development

Expenditure on research activities, undertaken with prospect of gaining new scientific or technical knowledge and understanding, is recognised in the income statement as an expense as incurred. Expenditure on development activities, whereby research findings are applied to a plan or design for the production of new or substantially improved products and processes, is capitalised if the product or process is technically and commercially feasible and the consolidated entity has sufficient resources to complete development. The expenditure capitalised includes the cost of materials, direct labour and an appropriate proportion of overheads. Other development expenditure is recognised as an expense in the income statement as incurred, capitalised development expenditure is stated at cost less accumulated amortisation and impairment losses. Amortisation is recognised as an expense on a straight-line basis over the estimated useful lives of the assets.

76 Exploration and evaluation expenditure

Exploration and evaluation is accounted for in accordance with the area of interest method. The application of this method is based on a partial capitalisation model closely aligned to the ‘successful efforts’ approach. All exploration and evaluation costs, including directly attributable overheads, general permits activity, geological and geophysical costs are expensed as incurred except the cost of drilling exploration wells and the cost of acquiring new interest. The costs of drilling exploration wells are initially capitalised pending the determination of the success of the well. Costs are expensed where the well does not result in a successful discovery. Costs incurred before the consolidated entity had obtained the legal rights to explore an area are recognised in the income statement.

Exploration and evaluation expenditure is partially or fully capitalised where either (i) the expenditure is expected to be recouped through successful development and exploitation of the area of interest (or alternatively, by its sale) or (ii) exploration and evaluation activities in the area of interest have not at the reporting date reached a stage which permits a reasonable assessment of the existence or otherwise of economically recoverable reserves, and active and significant operations in, or in relation to, the area of interest are continuing, or where both conditions are met. Upon approval for the commercial development of a project, the accumulated expenditures is transferred to development assets.

Development assets

The costs of oil and gas assets in the development phase are separately accounted for and include costs transferred from exploration and evaluation once technical feasibility and commercial viability of an area of interest are demonstrable and all development drilling and other subsurface expenditure. When production commences, the accumulated costs are transferred to producing areas interest.

Land and building and surface plant and equipment associated with development assets are recorded in the other land and buildings and other plant and equipment categories respectively.

Property, plant and equipment

Items of property, plant and equipment are recorded at cost or deemed cost less accumulated depreciation and impairment losses.

Producing areas of interest

The costs of oil and gas assets in production are separately accounted for and include costs transferred from exploration and evaluation expenditure, transferred development costs and the ongoing costs of continuing to develop reserves for production. These costs are subject to depreciation and depletion in accordance with the policy outlined below.

Land and buildings and surface and equipment associated with producing areas of interest are recorded in the other land and buildings and other plant and equipment categories respectively.

Leased plant and equipment

Leases of plant and equipment which are classified as finance lease (where the consolidated entity assumes substantially all the risks and rewards of ownership of the assets) are capitalised and amortised over the period during which benefits are anticipated. Other leases are classified as operating leases and the lease costs are expensed on a straight-line basis over the term of the lease, except where an alternative basis is more representative of the pattern of benefits to be derived from the leased assets.

Self-constructed assets

These assets are carried at cost and tested for impairment. The cost of self-constructed assets includes the

77 cost of materials, direct labour, the initial estimate, where relevant, of the costs of dismantling and removing and restoring the site on which they are located, an appropriate proportion of production overheads and capitalised interest.

Depreciation and amortisation

With the exception of producing areas of interest and land, depreciation is charged to the income statement on a straight-line basis over the estimated useful lives of each part of an item of property, plant and equipment. The carrying values of producing areas of interest are amortised on a units of production basis using the proved and probable reserves to which they relate, together with estimated future development expenditure required to develop those reserves.

The range of depreciation rates for the current and comparative period for each class of assets are:

Generation property, plant and equipment 1% – 33% Other land and buildings 1% – 18% Other plant and equipment 1% – 50% Producing areas and interest 2% – 25%

Non-current assets held for sale

Non-current assets (or disposal groups comprising assets and liabilities) that are expected to be recovered primarily through sale rather than through continuing use are classified as held for sale. Immediately before classification as held for sale, the assets (or components of a disposal group) are remeasured in accordance with the consolidated entity’s accounting policies. Thereafter, generally the assets (or disposal group) are measured at the lower of their carrying amount and fair value less cost to sell. Any impairment loss on a disposal group is first allocated to goodwill, and then to remaining assets and liabilities on a pro-rata basis, except that no loss is allocated to financial assets, deferred tax liabilities, employee benefit assets and investment property which continue to be measured in accordance with the consolidated entity’s accounting policies. Impairment losses on initial classification as held for sale and subsequent gains or losses on re- measurement are recognised in profit or loss. Gains are not recognised in excess of any cumulative impairment loss.

Revenue recognition

Revenue

Revenue comprises revenue earned (net of returns, discounts and allowances) from the provision of products or services to entities outside the consolidated entity. Sales revenue is recognised in accordance with the contractual arrangements where applicable and only once the significant risks and rewards of ownership of the goods passes from the consolidated entity to the customer or when services have been rendered to the customer and collectability is reasonably assured. In practice, the above revenue recognition approach is applied to the consolidated entity’s business segments as follow:

Revenue from the sale of oil and gas in the Exploration and Production business segment is recognised when the commodities have been loaded for shipment and title passes to the customer.

Revenue from electricity and gas supplied by the Retail business segment is recognised once the electricity and gas has been delivered and is measured through a regular review of usage meters. Revenues from the sale of solar panels are recognised once installation is complete.

The generation business segment recognised revenues from the generation of electricity when the electricity has been supplied to customers. A tolling arrangement is in place at commercial rates between the Retail and Generation business segments in relation to the consolidated entity’s merchant power stations. The

78 external revenue generated by the merchant power stations is recognised in Retail’s revenue while Generation receives a tolling fee from Retail for capacity provided and costs incurred by these power stations.

Government grants

Government grants are recognised in the statement of financial position initially as deferred income when there is reasonable assurance that they will be received and that the consolidated entity will comply with the conditions attaching to them. Grants that compensate the consolidated entity for expenses incurred are recognised as revenue in the income statement on a systematic basis in the same periods in which the expenses are incurred. Grants that compensate the consolidated entity for the cost of an asset are deferred as unearned income until the asset is ready for use at which time they are recognised in the income statement as other income on a systematic basis over the useful life of the asset.

Dividends

The consolidated entity has applied amended AASB 127 Consolidated and Separate Financial Statements for the first time from 1 July 2009. Amended AASB 127 specifies that all dividends received from subsidiaries, jointly controlled entities and associates be recognised as income in the consolidated entity’s stand alone accounts when the right to receive the dividend is established. Previously, only post acquisition profits received were treated as income in the consolidated entity’s accounts. The change in accounting policy was applied prospectively in accordance with the transitional provision of the amended AASB 127.

Interest revenue

Interest revenue is recognised as it accrues.

79 NOTE 2 SEGMENT REPORT Underlying results Exploration Generation Retail Consolidated & 2009 $’000 2009 2009 $’000 Production $’000

Revenue Total Revenue 600 300 8,000 8,900 Intersegment sales elimination¹ (150) (250) 0 (400) Total segment revenue 450 50 8,000 8,500 Earnings before interest, tax, depreciation and 258 182 914 1,354 amortisation (EBITDA) Depreciation and amortisation expense (170) (44) (194) (408) (32) (07) (03) (42) Share of interest, tax, depreciation and amortisation of equity accounted investees Earnings before interest and tax (EBIT) 56 131 717 904 Net financing costs (13) Profit before income tax 891 Income tax expense (232) Profit for the period 659 Non-controlling interests in profit (66) Underlying profit attributable to members of the 593 parent entity Impact of items excluded from underlying profit 27 Profit attributable to members of the parent 620 entity

Assets Segment assets 8,180 3,200 4,295 15,675 Investments accounted for using the equity method 5,237 163 - 5,400 Total segment assets 13,417 3,363 4,295 21,075 Cash and interest rate derivatives and current and 950 deferred tax assets Total assets 22,025

Liabilities Segment liabilities (900) (80) (1,350) (2,330) Other financial liabilities, interest-bearing liabilities and related derivatives and current and deferred tax (8,268) liabilities Total liabilities 10,598

¹ Intersegment pricing is determined on an arm’s length basis. Intersegment sales are eliminated on consolidation.

The Exploration and Production segment sells gas and LPG to the Retail segment.

Australian corporate revenue and expenses are allocated across all business segments. Australian corporate assets and liabilities, excluding unallocated assets and liabilities, are allocated across all business segments.

Business segments Products and services

Exploration & Production Natural gas and oil exploration and production in Australia and South East Asia.

Generation Natural gas-fired cogeneration and power generation in Australia.

80 Retail Natural gas, electricity, LPG and energy related products and services in Australia and the Pacific.

2 Other materials non-cash expenses include exploration expense, bad debts expense, impairment and change in fair value of non-financing cost related financial instruments.

EFG Energy Pty Ltd (EFG) and controlled entities – Measuring innovation expenditure and related revenue

1 In 2011, EFG and controlled entities received a survey questionnaire from the National Statistical Agency asking if group had introduced any new or significantly improved goods or service, implemented a new or significantly improved process, organisational or marketing methods during the 2008-09 reference period, and if it did, to provide an estimate of:

(i) the cost (ie the amount spent) of implementing the new product, process or method and

(ii) to provide an estimate of the revenues earned from the sale of new products during the reference period.

The National Statistical Agency has adopted the recommendations of the OECD’s Oslo Manual (OECD 2005) for measuring innovation and the Frascati Manual (OECD 2002) for defining and measuring R&D activities.

2 Activities undertaken by EFG and controlled entities are as per case study in the report.

3 By applying the OECD’s Oslo and Frascati Manuals guidelines for measuring innovation and research and development activities respectively, EFG and controlled entities notes the following:

(i) that EFG established a new solar electricity installation business as a pilot project.

(ii) that EFGsubco1 (Exploration and Production) business purchased a new advanced drilling equipment; and

(iii) that EFG went through a major organisational restructure.

4 In terms of identifying the relevant statistical unit, EGF as the consolidated group has three economic entities which can be classified under the following ANZSIC codes:

– EFGSubco1 – Exploration and Production Division B (Mining), Class 1011 (Petroleum Exploration)

– EFGsubco2 –Power Generation Division D (Electricity, Gas, Water and Waste Services), Classes 2619 (Other Electricity Generation) and 2700 (Gas Supply)

– EFG – Retail Division D (Electricity, Gas, Water and Waste Services), Classes 2630 (Electricity Distribution) and 2700 (Gas Supply)

EFG and controlled entities comprise of three legal entities with their respective ABNs and operating in different ANZSIC industries. Based on this approach, the above three entities individually would be categorised as a large business (employing more than 200 employees) for statistical purposes, however each legal entity would be required to report their innovation expenditure and related revenue separately as they are operating in different ANZSIC industries.

5 As a result, the information required to estimate EFG and its controlled entities’ innovation expenditure in 2008-09 cannot be sourced from the consolidated set of accounts (general purpose financial reports 81 shown above) maintained by EFG. Each legal entity in EFG’s consolidated group would prepare their own financial statements and report their respective innovation expenditure and related revenue. EFG’s sophisticated accounting package allows for controlled entities to be consolidated.

6 The application of the Oslo Manual guidelines to accounting data for measuring innovation spend together with related revenues is illustrated in the table below.

82 Measuring innovation expenditure – EFG (Retail) Type of Innovation Item Reference Items in general Source account – Cost allocation Notes innovation activity period purpose financial Separate 01/07/2008- report financial 30/06/2009 statements New product R&D Research Various Total expenses & Research Amount expensed for Amount expensed for innovation (Intramural and expenses transactions Intangible asset payments to the research plus any research should (new solar acquired Intangible within the University; amount capitalised in include any funding installation extramural) assets reference In-house the balance sheet as provided to the business) period research intangible asset in research centre. expenses: respect of the new As EFG was eligible for • materials solar technology; R&D tax concession, it • wages and Portion of employee would keep a track of salaries and compensation in all the R&D associated other employee respect of employees expenditures compensation carrying/supervising • corporate the research; overheads Portion of corporate overheads; Portion of materials uses in research phase Acquisition of Property, plant Various Property, plant and • property, plant Cost of all new assets Costs involved in machinery, and equipment transactions equipment and bought during the setting up the solar equipment and within the • equipment reference period for installation business, other capital reference • materials use in the new solar for example, opening a goods period from 1 • wages and business; new retail outlet for July 2008 to 23 salaries and Portion of employee solar business, new September other employee compensation in plant, equipment, 2008. compensation respect of employees fixture and fittings etc • corporate setting up the new overheads solar installation business; Portion of corporate overheads; Portion of materials uses; setting up the business

83 Market Advertising Various Total expenses Advertising and Costs involved in The solar installation preparations and marketing transactions marketing marketing and business is a new for product within the expenses advertising the new product in the retail innovations reference solar equipment business. The retail period from 1 business should easily July 2008 to 23 track through proper September cost accounting, in 2008. respect advertising and marketing of the new solar installation business New product Training Training Various Total expenses Staff training Costs involved in For innovation innovation transactions expenses retraining existing purposes, EFG has to (new solar within the Overhead costs employees to market source the innovation installation reference new solar equipments spend in respect of business) period from 1 Portion of employee training from the July 2008 to 23 compensation training expenses September attributed to training in account as well as the 2008. respect of the new wages and salaries solar business account. New Preparation for Organisational Various Total expenses Consultancy fees Portion of the EFG paid for all the organisation organisation restructure transactions Capitalised expenses attributed to organisational al methods innovation within the restructure costs organisation restructure expenses reference Wages and restructure. for the consolidated period from 15 salaries group however it would January 2009 to Directors fees recharge the 5 February Superannuation subsidiaries for their 2009. Payroll tax share of the Fringe benefits organisational expense restructure expenses. Corporate overhead costs

84 Measuring innovation expenditure – EFGSubco1 (Exploration and Production) Type of Innovation Item Reference Items in general Source account – Cost allocation Notes innovation activity period purpose financial Separate 01/07/2008- report financial 30/06/2009 statements New processes Acquisition of New Drilling 30 November Property, plant Exploration and Cost of purchase – The innovation spend (new drilling machinery, equipment 2008 and equipment Production $50 million should not only include plant) equipment cost of acquisition, but and other cost of delivery and capital goods installation as well. Training Training 30 November Total expenses Exploration and Employee As this is internal 2008 Production compensation training, EFG will not attributed to the time have a training expense spent by employees in their general purpose on training constitutes financial reports. an innovation spend However for innovation purposes, the employee compensation attributed to the time spent by employees on training constitutes an innovation spend.

85 Innovation revenue – EFG and controlled entities Type of Item Reference period Items in general Source account – Revenue Notes innovation 01/07/2008- purpose financial Separate financial estimation 30/06/2009 report statements 2008-2009 ($) New Product New solar Various Revenue Solar installation See notes EFG’s accounting software would installation transactions service charges – allow for sales revenue from solar business within the EFG installation business to be recorded reference period separately. from 23 September 2008 to 30 June 2009. New Organisational Various Cost savings See notes See notes There is no direct revenue measure Organisational restructure transactions for organisational innovation except methods within the for efficiencies achieved in the reference period overall group. from 6 February 2009 to 30 June 2009. New Processes New drilling Various Revenue or cost Intersegment See note This requires an in depth analysis to equipment transactions savings sales to Retail estimate the revenue generated within the through the new drilling equipment. reference period The exploration and production from 1 December managers would look at the 2008 to 30 June marginal increase in production 2009 efficiencies from the new drilling equipment to estimate the revenue. The Exploration and Production segment sells gas and LPG to the Retail segment. Intersegment pricing is determined on an arm’s length basis.

86 5.6 Technical difficulties Innovative activity Comments New solar installation business Keeping innovative data for projects spanning a number of years for a large consolidated group can be a difficult process especially when the survey form itself is requesting old data. EFG has been working for some years with a research centre for Sustainable Energy Systems, funding the development of a new way of manufacturing solar cell. However where research is outsourced, it may be easy to separate innovative expenses from normal business expenses, as payment to the research centre would be easy to identify.

It would have been problematic if the research phase was done by one company and the commercialisation by another company in the consolidated group. Organisational restructure EFG and the controlled entities went through the organisational restructure. EFG paid for the restructuring costs however recharged some of the costs to the subsidiaries.

Each of the subsidiaries in the group would complete their survey forms individually as they operate in separate ANZSIC industries. Care should be taken to ensure that the innovation spend is not double counted. New drilling equipment Whilst it is easy to measure the innovation expenditure in respect of the new drilling equipment, measuring revenue generated from such innovative activity is practically impossible.

Furthermore, it should be noted that the exploration and production segment undertook the innovative activity; it also generated intersegment revenue by selling gas and LPG to retail segment at arm’s length prices. Whether EFG should use intersegment revenue or the external revenue generated by the retail segment when reporting revenue generated from innovative activity needs to be explored further.

5.7 SUMMARY

Large businesses have sophisticated accounting systems which allows for better tracking of innovation related expenditure and revenue. However difficulties arise, particularly for firms with complex structures, to achieve consistent statistical and analytical units, in particular, where the firm unit corresponds to the management unit or the production unit rather than the complete legal entity of complex firms.

The large case study examples show the complex entity structure differences in terms of a single legal entity with one ABN and a consolidated group with multiple separate legal entities with respective ABNs.

87 6 CONCLUSION

The Australian Accounting Standards are framed with the goal of achieving many objectives some of which incorporate economic concepts. For example, allowing users to make and evaluate decisions about allocating scarce resources and recognising inflows and outflows of economic benefits to define revenues, expenses, assets and liabilities. This degree of compatibility supports the objective of this project in its attempt to map accounting concepts and measures to their corresponding economic measures.

However, many of the objectives of the Australian Accounting Standards do not incorporate economic concepts and are heavily focused on the user of the financial statements. For example, financial statements sought demonstrate relevance and reliability, facilitate comparability and be readily understandable.

Whilst comfort can be gained from the fact that financial reporting allows the recording of all innovation expenditures and revenues in some way or the other, estimating, separating, disaggregating and sourcing innovation expenditure and revenue from various business financial accounts and sub-accounts is the difficult part.

The non-economic and user functionality associated with the Australian Accounting Standards support a framework within which organisations may classify innovation in a more general and flexible manner than that defined by the Oslo/Frascati definitions. The non-economic and user objectives may result in deviations from the strict application of Oslo/Frascati innovation definition when an organisation records transactions of an innovative nature in the books of their accounts. More simply put, the accounting framework does not necessarily require the strict application of Oslo/Frascati definition of innovation when recording transactions of an innovative nature.

This deviation results in an organisation having to reconstruct/dissect its financial data in order to provide meaningful responses to questions raised in National Statistical questionnaires. The reconstruction of financial data often involves engaging methods that estimate rather than accurately define the amount of innovation on inputs and outputs. The estimation in turn results in a reduced reliability of the data provided by organisations when performing an economic analysis.

The degree of reliability may be higher in large organisations with sophisticated accounting systems, however, the degree of reliability may be offset by the degree of complexity of the organisation, for instance, where organisations operate across multiple industries, multiple jurisdictions and multiple entities. Irrespective of the business size and the reporting structure (special or general purpose financial reports), translating business financial data into data corresponding to economic concepts is theory dependent and allocation of business activities between innovation types involves some degree of subjectivity.

If it is assumed that the accounting standards are unlikely to shift the objectives in favour of a greater economic conceptual flavour in the immediate future, consideration might be given to reframing the questions raised in National Statistical questionnaires to improve the compatibility between economic data sought and manner in which accounting data is recorded in an organisation’s accounts.

88 REFERENCES

ABS (2010) Innovation in Australian Business (Catalogue No. 8158.0). Australian Bureau of Statistics, Commonwealth of Australia, Canberra.

AASB (2010) Australian Accounting Standards Board (AASB) Accounting Standards. Australian Accounting Standards Board, Commonwealth of Australia, Melbourne.

DIISR (2010) DIISR Key Facts. Department of Innovation, Industry, Science and Research, Commonwealth of Australia, Canberra.

DIISR (2009) Innovation Metrics Framework – Consolidated Report. ISBN 978 0 642 72621 6. Department of Innovation, Industry, Science and Research, Commonwealth of Australia, Canberra.

Office of Legislative Drafting and Publishing (2010) Australian Securities and Investment Commission (ASIC) Act 2001. Attorney General’s Department, Commonwealth of Australia, Canberra.

Office of Legislative Drafting and Publishing (2010) Corporations Act 2001. Attorney General’s Department, Commonwealth of Australia, Canberra.

OECD (2002) Frascati Manual. Proposed standard practice for surveys on research and experimental development. ISBN 92 64 19903 9. Organisation for Economic Co-operation and Development, Paris.

OECD (2005) Oslo Manual. Guidelines for collecting and interpreting innovation data. Third edition. ISBN 92 64 01308 3. Organisation for Economic Co-operation and Development, Paris, and Statistical Office of the European Communities, European Commission, Luxembourg.

89 TECHNICAL DISCUSSION AND LESSONS LEARNT

INTRODUCTION

The exploratory project that PricewaterhouseCoopers (The Consultant) was engaged to undertake is the final output of an integrated series of work initiated under the Innovation Metrics Framework Project (DIISR, 2009). The study applied the OECD’s innovation measurement frameworks to a real business setting, with emphasis on understanding how the different frameworks interacted in this context and therefore, how financial accounting data could be exploited as a source of economic information on the innovation activities of the firm. Implicit in the project’s objectives was recognition of the compliance burden faced by firms when responding to requests from government agencies for economic data. Since the primary objective of a firm’s accounting system is to support its managerial and reporting obligations, therefore a system to adapt primary accounting data for secondary purposes has the potential to ease provider burden.

This project also relates more generally to the use and the fitness-for-purpose of secondary data for economic research and analysis. A substantial body of work on the use of secondary data for making economic inferences exists (OECD, 2005; Griliches, 1998) and the paper of Criscuolo et al. (2003), in particular, had emphasised the importance of understanding the basis behind a firm’s accounting data and the relationship between the statistical unit and the firm’s legal structure prior to using such data in econometric analyses. The consultant’s use of model financial statements showing the typical transactions of real firms as instructive tools was essential for illustrating the particular technical barriers faced by Australian business survey respondents when providing information about their innovation expenditures. The study discussed some general principles for identifying innovation-related expenditures from source accounts and the potential sources of translation errors.

The consultant’s final report has been divided into six chapters. Chapter 2 outlined the regulatory environment in which Australian firms operate to provide a context for the methodology developed in later chapters, with particular attention to the purpose of financial reports, the variations in the format of financial statements due to a firm’s operations and structure, and how firm variations are accommodated within the confines of the reporting framework governing Australian businesses. Chapters 3 and 4 focused on the practical application of the OECD innovation measurement frameworks while taking into consideration the business reporting obligations in the context of a small services firm and a medium manufacturing firm. The interactions between the relevant economic and accounting concepts were illustrated with the aid of detailed worked examples. Chapter 5 presented two examples of large complex firms that produced general purpose financial reports, with an emphasis on the accounting issues and particular reporting obligations that are common to firms with complex structures. The lessons and policy implications are discussed below. The Business Accounting Process

Two important aspects of the Australian business regulatory system outlined in Chapter 2 were essential for the assumption of comparability across the derived statistical or economic units to make sense: (i) under Chapter 2M of the Corporations Act 2001 (the Act), Australian firms must present a true and fair view of their financial position and performance (ASIC, 2005), and (ii) the Act stipulates that the financial information must satisfy the minimum recognition and measurement requirement in all applicable Australian Accounting Standards Board (AASB) standards (ASIC, 2005), which in turn require the application of the accrual basis of accounting in accordance with AASB101 (AASB, 2009). The AASB standards govern the comparability of financial statements across reporting units by providing a framework within which a consistent meaning of ‘financial position’ and ‘profit and loss’ in financial reporting across entities can be determined (ASIC, 2005). Three general accounting issues from the case studies deserve attention:

90 Cost allocation method: AASB 101 – Presentation of Financial Statements (AASB, 2011) recommends presenting financial information according to the ‘nature of expense’ method or the ‘function of expense/cost of sales’4 method. The Cost of Sales approach conveys the costs of direct resources used up to bring products to market (inventoriable costs) and is readily understood by firms. A limitation is that not all overhead costs are included and some cost allocations at the margins may be arbitrary. Therefore, the project adopted a more suitable approach following a similar principle by identifying the full Product Cost i.e. costs associated with all areas of the value chain, including pro rata all relevant indirect costs i.e. overheads [Horngren et al., 2001], accompanied by the application of the novelty criteria in the Oslo/Frascati manuals to distinguish the innovation component.

A note on the impact of new capital purchases (for innovation purposes) on the accounting entries

The Oslo and Frascati manuals recommend attributing the full the cost of new capital purchases for innovation (according to) to the reference period in which the purchases occurred. However, the consequence is that the balance between the asset entries and the liability and owner’s equity (revenue and expense) entries in the accounting identity may not be preserved because the purchase of new capital impacts on the entries of several accounts. Therefore, profit measures derived this way must be used with care as they would be inconsistent with the accounting standards.

The implications of the normal accrual entries for capital purchases are as follows:

Transaction Debit (Dr) Credit (Cr) Effect on Account

Dr Land/Buildings $ xxxx Increases Asset account

Dr Plant and Equipment $ xxxx Increases Asset account

Cr Cash $ xxxx Decreases Asset account Cr Accounts Payable $ xxxx Increases Liability account Cr Loan/Mortgage $ xxxx Increases Liability Payable etc. account ΣDr entries = ΣCr entries

Transaction De

Accumulated depreciation is normally recorded in a contra asset account. However, accounting for the use of existing capital equipment for the purpose of innovation may present some difficulties because depreciation expense is currently excluded in the Oslo manual guidelines when determining the cost of innovation.

The boundaries between innovation and ongoing business activities: The main difficulty at the margins is to determine when R&D stops and innovation implementation begins, or when innovation implementation ends and revenue generating activities or routine operations begin. For smaller firms without detailed project accounts, the information in time-sheets, invoices and receipts may often be the only available references for determining the start and end points of an innovation activity, the respective innovation and non-innovation shares of labour and machine time, and whether the transactions fell within the reference period, as was illustrated by the worked examples in the report.

Intra-organisation transactions: Material intersegment income resulting from arms-length, intra-organisational transactions are recognised as revenues in the accounts of the reporting segments, but which are

4 AASB 101: Presentation of Financial Statements – Materiality and Aggregation, paragraphs 101-105, (AASB, 2011). 91 subsequently eliminated from the consolidated group financial statement. An example was the purchase of R&D services at ‘market price’ from a centralised R&D department and the internal payment was recorded as ‘revenue’ by the R&D department. These material intra-organisational transactions for a given statistical unit must be identified and treated consistently for all firms within scope in order to avoid the double counting of operating income.

92 FIRM STRUCTURE AND THE STATISTICAL UNIT

Firm size and the statistical unit

We noted in Chapter 2 that Australian regulatory agencies used a combination of consolidated revenue, the value of consolidated assets and a cut-off of 50 employees as measures of firm size in order to determine a firm’s financial reporting and auditing obligations. This definition of firm size was not suitable for economic analysis because of the loss of information on the relationship between the factors of production, the state of firm technology and output implied in the production function. Thus, the statistical units were no longer defined consistently, making it impossible to make meaningful inferences about firm productivity such as total factor productivity using the standard production function.5 More importantly the assumptions of homogeneity in the statistical units making up the ANZSIC category cannot be sustained, and the estimates of other variables such as revenue, labour costs, overhead cost shares, capital depreciation shares and input price deflators will be incorrect. The method adopted in the project for large businesses was to derive the statistical units from the Operating Segments of complex legal entities and matching them to the appropriate ANZSIC category. This was a preliminary attempt to adapt the more rigorous units model of the ABS6 to the real business environment by utilising existing and familiar accounting methods for segmenting complex firms, while preserving not only the consistency in the way the underlying ‘production function’ properties are determined across firm units, but also the equality of the accounting equation.

Operating Segments (AASB 8)

The concept of operating segments (AASB 8 – Operating Segments) had two properties that were suitable as an initial approximation of the Type of Activity Unit (TAU) concept developed by the ABS 6 and was applied in the study to identify statistical units within large and complex legal entities 7: (i) they are components of a (for-profit) entity that can engage in business activities for which it may earn revenues and incur expenses in its own right 8, and (ii) that operating segments that are aggregated into a single operating segment must have similar economic characteristics, such as similarity in the nature of the products and services or in the nature of the production processes. An extract of the relevant paragraph of AASB 8 is provided in the Appendix, Table A1.

The operating segments of the complex large business in Chapter 5, designated on the basis of operational specialisation, were mapped to the appropriate ANZSIC classes (ABS, 2006). The classification of firms on the basis of the parent-group entity similarly leads to the loss of homogeneity in terms of the production functions of the statistical units grouped to particular ANZSIC categories. An advantage of associating the statistical unit with an operating segment is that the legal entity comprising the enterprise group could be recovered, particularly when the sub-entities are themselves established as separate legal entities issued with their own Australian Business Number (ABN). When estimating the full cost of innovation, it is important

5 For completeness, it is noted that there is a long-standing dispute about the use of the aggregate production function but it is not the objective to deal with the debate here. In this study, we have retained the neoclassical form of the production function.

6 The ABS Units Model is described in detail in Project 4 of the Innovation Metrics Framework (DIISR, 2009).

7 See the large business example of BCD Australia Pty. Ltd. in Chapter 5.

8 Other aspects are that its operating results are regularly reviewed by the entity’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance; and for which discrete financial information is available.

93 that the contributions from sub-units that do not constitute a proper production unit, such as corporate services provided by the head-office, in-house workshop and maintenance services etc. are allocated pro rata together with the direct cost of implementation.

The concordance between the statistical unit defined by the operating segment and the ABS Units Model will have to be assessed on a case-by-case basis for very complex firms because the enterprise unit in the ABS Units Model can be related to TAU in one of four ways: one-to-one in the simplest case, many-to-one, one- to-many and many-to many (DIISR, 2009)9.

Responsibility Centres

For larger firms that are also organised along lines of responsibility – profit centres, cost centres, revenue centres and investment centres (Horngren et al., 2000), the profit centres may provide useful information for identifying functions grouped along a value chain. This additional information can be helpful for understanding how the various subunits contribute or relate to the value chain. However, further work in this area is required to determine whether a convenient concordance between the accounting entity and the economic entity can be developed for different types of firms.

FIRM INNOVATION EXPENDITURE

Table 1 below shows the distribution of innovation-related expenditures for the small firm and medium firm classified by type of innovation as defined in the Oslo Manual. From background information provided in the case studies, the small firm purchased new capital equipment in order to introduce the new services. The technology for supporting the mowing and hedge-trimming services was embodied in the new capital and no R&D was required for firm to introduce the new services. Whereas the manufacture of the new server racks and termination boxes by the medium manufacturing firm required additional inputs from R&D and design activities, which placed a greater demand on the combined labour and human capital services (Table 1). Thus, in this case, the products were innovative because they embodied new characteristics resulting from design and R&D.

Revenue from the innovative products during the reference period represented a relatively small proportion of the total sales revenue for both the small and medium firm of 4.8% and 12.9%, respectively. While it is not possible to infer anything about the difference in the revenue shares between the two firms without further information on their respective markets, the shares reflect the dynamic nature of the business environment where the new products are introduced alongside the firms’ current product offerings.

Table 1. Expenditure by type of innovation for the small and medium model firms Innovation/Innovation Activity in 2008-09 Small Firm Medium Firm ($) ($) R&D – Intramural 0 510,327.0 a R&D – Extramural 0 600,000.0 Preparations for new goods and services (New products) 37,851.6 b 978,128.0 a Preparations for new operational process 0 0 Preparations for new organisational method 0 0 Preparations for new marketing method 7,154.0 0 Sub-total innovation expenses in the reference period 45,006 2,088,455.0 Innovation-related depreciation expense - 18,298.0 Total innovation expenses + depreciation expense 45,006 2,106,753.0 Total operating expenses 422,950.0 17,250,890.0 Innovation share of total operating expenditure 10.6 % b 12.2 % Sales revenue from innovative good and service 28,800.0 2,500,000.0

9 ABS – Project 4: Complex Business Structures and Business Financial Data (DIISR, 2009).

94 Total sales revenue 600,000.0 19,450,000.0 Innovation revenues as a percentage of total operating income 4.8 % 12.9 %

Notes: a. Medium firm: To obtain a rough estimate of the depreciation expenses share attributed to in-house R&D and product innovation activities, the relative ‘volume’ of activity attributed to new product development is calculated by expressing the innovation related wages as a ratio of the total factory wages: $350,000/$4,000,000 = 0.0875. The estimated share of depreciation due to R&D is as given in costings data at 0.03 (or 3%), which gives an approximate split between R&D and post-R&D activities of one-third and two- thirds, respectively (i.e. 0.03/0.0875 and 0.0575/0.0875). This ratio was applied to the intramural innovation expenditures to obtain the dollar estimates in the table. The innovation share of factory rent/lease expenses is estimated to be: 0.875 x [Rents – plant, equipment and factory + Management fees + Factory lease = $2,588,500] ~~ $226,494. Post-R&D innovation share of depreciation is 0.0575 x $318,255 = $18,298. b. This cost allocation follows the recommendations of the Oslo Manual (OECD, 2005) where the entire cost of the new capital is attributed to the reference period in which the purchase occurred. The new capital purchase of $18,000 on 10 July 2008 (Chapter 3) was excluded because it was for replacing existing capital.

The innovation shares of total operating expenses in 2008-09 for the small service and medium manufacturing firms were about 11 % and 12 %, respectively. This compares with 5.6% for Australian Manufacturing or an average across all industries10 of 3.7% reported by the ABS for their 2004-05 business innovation survey (ABS, 2005). A possible difference between the shares calculated here and that reported by the ABS is that the shares calculated here are for the full cost of implementation i.e. they include both the direct and indirect costs attributed to innovation whereas the shares published by the ABS reflect estimates provided by business respondents11. The case studies showed the sources of difficulties in linking the innovative outputs to the activities that gave rise to them, especially if several outputs required similar inputs or if the activities occurred across reference periods.

The share of sales revenues attributed to innovative products in Table 1 for the mowing firm (4.8%) and for the manufacturing firm (12.9%) compare with the survey estimates published by the ABS of 4.5% on average across 12 industries or 5.1% for Manufacturing in 2004-05 (ABS, 2005).

The comparisons above give some reassurance that our model firms are a reasonable characterisation of the types of Australian businesses encountered in the ABS surveys and that the systematic application of the Oslo and Frascati frameworks to the primary accounting data has the potential to improve the reliability of the derived financial measures of business innovation.

10 For the 2004-05 innovation survey, the scope covered all businesses in 12 ANZSIC Divisions [see ABS (2005) for details of industry coverage]. Our small mowing firm belongs to Division Q – Personal and Other Services, which was not within the scope of the 2004-05 survey and therefore, no survey data is available for firms in this industry.

11 See ABS Catalogue Number 8158.0 (2005), paragraph 4 of the Technical Note.

95 Labour costs

The labour costs (i.e. salary/wages, superannuation, training costs, wage cost of training, bonuses, workers compensation, insurance, payroll tax) attributed to R&D and innovation activities in the small and medium firm examples in Chapters 3 and 4 are presented below as a percentage of total innovation expenditure and total labour cost. This exercise is not intended for benchmarking but rather to understand the labour requirements of the different firm types and the implications for innovation.

Table 2. Analysis of the innovation-related labour costs in the model small and medium firms Type of Expenditure (2008-09 Reference Period) Small Firm Medium Firm Labour costs attributed to innovation activities a $8,302 $391,961 Total innovation expenditure b $45,006 $2,027,803 Innovation labour cost share of total innovation expenditure 18.4 % b 19.3 % b Total labour cost $312,900 $7,020,287 Proportion of total labour cost attributed to innovation 2.7 % 5.6 % Labour cost as a proportion of total operating expenses c 74 % 41 %

Notes: a. Labour costs = [salaries/wages + superannuation + fringe benefits tax expense + workers compensation expense + training expense + bonus + other compensation + payroll tax expense]. For the small firm, the in- house bookkeeper’s cost is also included. b. For the small firm, the entire cost of the new equipment purchased for implementing the product innovation in the reference period was $28,000 = $20,000 + $8,000. For the medium-sized firm, the innovation expenditure included the cost of external expertise (consultants and outsourced R&D) of [$150,000 + $600,000] = $750,000. c. The total expenses of the small firm in 2008-09 was $422,950; Medium firm total expenses (cost of sales + total other expenses) in 2008-09 was [$13,412,306 + $3,838,584] = $17,250,890.

The analysis of the labour cost distributions in Table 2 provides some information about the relative demand for labour inputs. Labour costs accounted for about 74 % of the small services firm’s total operating expenses and about 41 % for the medium manufacturing firm. The proportion of total labour hours attributed to innovation was 2.7 % and 5.6 % in the small and medium firms, respectively. So the relative demand by innovation activities for labour services, stemming from the need to redirect labour from other activities, does not appear to be large in relative terms for both firms.

The Oslo innovation-related labour costs represented about 20 % of the total innovation expenditure for both firms. However, if the full cost of new capital acquisition in the small mowing firm were replaced instead by the estimated rate of capital use for implementing the innovations ($475 for 4 hours of training on the new equipment plus 4 hours trial-run and optimisation)12 in the reference period, the labour related share of innovation expenditure rises to about 47 % for the small firm. For the medium-sized firm, the other major labour/human capital related expense was the purchase of external consultancy and R&D services, and may be considered a substitute for retaining such labour and human capital services in-house by the firm. Adding the externally sourced human capital services to the innovation related labour costs for this reason brings the labour/human capital related costs to about 56 % of the innovation expenditure.

12 Given: (i) Both the new ride-on mower and hedge trimmer have a working life of 10 years with an average weekly use of 3.5 hours for 50 weeks/year, giving a cost of capital consumption of $114.3/hour for the mower and $4.6/hour for the hedge trimmer; (ii) two hours of training on each of the new equipment plus another 2 hours each for trial-run and optimisation. Therefore, the cost of capital consumption associated with the introduction of the new services for the small firm was: [$114.3 + $4.6]/hour x 4 hours  $475. 96 The relative cost shares of the different inputs in the worked examples above are critically dependent on the method applied. The Oslo approach avoids comparability problems due to the different capital depreciation policies adopted across firms, but introduces a different problem in that the cost of newly purchased capital and existing capital used in innovation are treated differently.

Capital depreciation expense

It was recognised early in the project that for the method of estimating the cost of capital services (for capital purchased outside the reference period) to be more readily applied by firms, then the data should come from either the capital depreciation expense account or the accumulated depreciation account in the first instance in order to maintain the integrity of the accounting balances i.e. the equality between credit and debit entries. The economic method of estimating capital services is preferable but it will be an onerous process for firms to determine the rate of capital consumption for each class of capital involved in the production process.

Paragraphs 60-62 of AASB 116 recommend that the depreciation method reflect the expected rate of consumption of the future benefits embodied in the capital (AASB, 2011). But in practice a firm’s depreciation policy of applying straight-line depreciation, diminishing balance method or the units of production method over the asset’s useful life may not consistently reflect the economic pattern of consumption of capital services. Thus, the accrual accounting method also has inherent consistency problems across firm units and the proxy derived from the depreciation schedule applied by the firms can only be loosely be interpreted as the average level of capital consumption. For the reasons discussed above, the following example of depreciation expense allocation is only a partial solution:

Using the capital depreciation expense to allocate the cost of a rival input (physical capital)

The methodology described here is a departure from the Oslo Manual recommendation (see Appendix Table A1, item 4). The medium-size firm recorded accumulated physical capital depreciation expenses of $318,225 in 2008-09 (see Chapter 4). The innovation activities for the reference period took place between 01 July 2008 and 30 September 2008. During this time, other ongoing production activities continued and, therefore, machine time was shared between innovation activities and production of existing line of goods. Over the same period 5,000 hours of direct employee time was spent on R&D, prototype production and testing. At an average wage rate of $70/hr, the share of employee time spent on innovation activities relative to other activities is:

[$350,000/$4,000,000]  0.0875.

In the absence of other data, we assume that the machines are operating continuously while the workers are in the factory and the capital services consumed for innovation is proportional to the direct employee time spent on innovation. Therefore, the estimated dollar share of the depreciation attributed to innovation activities is distributed between R&D (3 % – from Chapter 4) and post-R&D prototype production and testing:

[0.0875 – 0.03] = 0.0575.

The consumption of the rival good by innovative and ongoing activities is given by:

1. Depreciation attributed to R&D: [$318,225 x 0.03]  $9,547;

2. Depreciation attributed to preparations for product innovations: [$318,225 x 0.0575]  $18,298;

3. Depreciation attributed to innovation activities: [$9,547 + $18,298]  $27,845;

4. Depreciation attributed to ongoing production activities: [$318,225 – $27,845]  $290,380.

97 Implications for firm resource allocation

The decomposition of innovation and R&D costs into their respective labour cost, cost of capital services, the cost of materials and purchased external R&D services or expertise is essential for understanding the economic impact of innovation activities because firstly, the physical inputs such as labour and capital are rival [Barro and Sala-i-Martin, 2004; Robertson, in DIISR (2009)] and secondly, the cost allocations reflect the idea of opportunity cost arising from decisions to allocate scarce resources. In this project, the derivation of the full cost of innovation and R&D from their constituent parts located in the accounting records of firms provided an insight into how the classification of firm transactions could potentially affect the way firms view and manage their scarce resources, particularly if the expenditure categories do not readily reveal the role of the transactions in the value-chain. The classification of transactions either by nature of the expense e.g. Wages and salary, Superannuation, Workers compensation, Administrative expenses, Materials and Property, plant and equipment and/or by function of the expense e.g. as part of cost of sales can obscure the purpose or objective of the expenditure such as the generation of new knowledge (R&D) or the implementation of new products, processes and methods (innovation) when the expenditures are reviewed retrospectively.

Furthermore, the activities defined as R&D in the Frascati Manual (OECD, 2002) correspond to the activities listed in paragraph 56 of AASB 138 and must be expensed, while the ‘R&D’ activities satisfying the recognition test for intangible assets under paragraph 59 of AASB 138 – Intangible Assets (June, 2009) actually relate to production activities that are no longer considered R&D according to the Frascati and Oslo guidelines. Therefore, expenditures falling under paragraph 56 of AASB 138 are also not recognised in the Cost of Sales (inventoriable costs). Their implications for the levels of R&D and innovation being undertaken by Australian firms, especially the smaller firms, must be incorporated into policy deliberations.

98 IMPLICATIONS FOR POLICY

Although innovation is essential for sustaining long-run economic growth, Robertson (2009)13 cautioned that the relationship was far more complex because innovation and R&D are themselves the product of investments in rival inputs14 that are subject to diminishing marginal productivity (Barro and Sala-i-Martin, 2004).15 The net impact of encouraging the flow of resources to innovation (versus the status quo) depends on the extent to which future benefits are offset by opportunity costs and diminishing returns. The cost decompositions in the project implicitly recognised and preserved these effects in the innovation activity measures derived from firm accounts.

Figure 1 summarises how the findings in this project relate to the integrated framework outlined previously in the Innovation Metrics Framework (DIISR, 2009) in a policy context. The innovation expenditure decompositions in the central panel relates the accounting (right) and economic (left) concepts as a means of understanding how economic objectives translate into a real business setting via a common set of variables. Certain resource allocations such as basic and applied R&D only generate costs from an accounting perspective because the associated inflow of benefits cannot be measured reliably, while others such as product innovation and ongoing production activities, on the other hand, generate both costs and benefits. The accounting definition of profit only reflects the difference between the benefits and costs that satisfy the recognition and measurement criteria.

The economic perspective emphasises that, given alternatives, the net economic impact of innovation is dependent on the relative contributions of all the offsetting costs and benefits arising from the resource allocation decisions though not all can be reliably measured. Figure 1 suggests that the R&D outputs may be embodied in some tangible innovative output, 16 be used to resolve technical problems, be embodied as human capital, or become obsolete, but makes no assumptions about its relationship to productivity. Many innovators do not undertake R&D to implement their innovation (DIISR, 200917; ABS, 2010) and this was illustrated in the example of the small mowing firm.

Sunk costs

Innovation expenditure can also give rise to sunk cost, for example through investments in intangible assets. Sunk costs are costs that are incurred by a firm in order to enter an industry or to reposition itself within the industry but that have little or no residual value upon exit (OECD, 2005). The medium firm incurred expenses for external design expertise ($150,000), trial and testing ($200,000) and research services for

13Peter Robertson – Project 2: Productivity, Innovation and Economic Growth (DIISR, 2009).

14In a neoclassical constant returns-to-scale production function is that the scale effect only relates to the rival inputs (labour and capital): F(K,L,T) =·F(K,L,T) for all >0 and  having an exponent equal to 1 (Barro and Sala-i-Martin, 2004). Here, T refers more generally to the state of technology.

15Positive and diminishing returns to the rival inputs (Barro and Sala-i-Martin, 2004):

16This idea is reflected somewhat in paragraphs 48-49 of AASB 116 – Property, Plant and Equipment, and paragraph 99 of AASB 138 – Intangible Assets, which state that if the tangible or intangible capital item is consumed for the production of other assets or is embodied in inventories, then they are to be added to the carrying amount of the other assets or inventories (AASB 102 – Inventories).

17Anthony Arundel and Kieran O’Brien – Project 1: Innovation metrics for Australia (DIISR, 2009).

99 basic research ($600,000), giving an investment in intangibles of $950,000 in the reference period, while the small firm expended $7,416 on intangibles comprising the cost of innovation-related training including staff time (compensation) of [$1,500 + $840 + $75.60  $2,416] and web-design services of $5,000. These outlays not only represent resources that could have been allocated to other business activities but also costs that cannot be recovered when the business is sold. On the other hand, these investments have the potential to generate a future stream of income from the new goods/services and to set standards that other new entrants must meet if they wish to compete in the industry.

Spillovers from R&D, training, design, aspects of organisational innovation and investments in other intangibles may manifest themselves as enhanced high-level problem solving skills and as greater firm-level absorptive capacity which can then enhance the way labour and capital are combined to produce outputs. The transactions that are seen to generate only costs and whose role in the value-chain are not clearly identified are particularly relevant to small firms, many services firms and firms with few formal structures, where staff and capital goods are often reassigned between business activities at relatively short notice depending on current business needs. Because such firms may not have the resources to absorb the short- run costs, it may result in less resources being allocated to R&D and innovation activities if the associated transactions are interpreted as discretionary expenses.

The absence of reliable measures of certain costs and benefits limits the information available to firms for objectively evaluating alternative resource allocation decisions and to manage such investments, such as the contribution of R&D to the long run survival of a small budget-constrained firm. Better guidance on what constitutes R&D activity in small firms will not only help these firms to better appreciate the consequences of their investment decisions for their future performance, but will contribute to better policy design through a better understanding of the barriers faced by firms. The Frascati Manual has recognised these difficulties.

Implications for using the derived measures in analysis and research

The retention of the measurement and recognition requirement of the relevant accounting standards should ensure that irrespective of the subsequent regrouping of transactions by operational units and the separation innovative activities from ongoing business activities in a given reference period, the variations between firms units can be assumed to reflect changes in the levels of activity.18 The result is that when such data are used in economic analyses, we can only make the weaker assumption that variations in the values of the innovation-related transactions covary with (or proxy) the variations in the underlying volume of economic activity attributed to innovation. However, in a statistical context, covariance can still be a strong assumption and further work will have to be done to test the robustness of this property.

The project actually deals with a specific class of translation errors i.e. errors arising from the use of accounting data to derive economic indicators for use in economic analysis, which in turn affect the quality of the analytical outputs. The particular solutions suggested for minimising translation errors relate specifically to the use of accounting data in economic analysis and should not be generalised to other situations. Data quality improvement is an ongoing iterative process whereby new firm-level indicators that incorporate the lessons learnt from this exploratory project are reanalysed using existing econometric tools to see what further refinements to our understanding of measuring innovation at the firm-level are required.

An important message as summarised in Figure 1 is that the outcomes of innovation can only evaluated by considering all offsetting effects (positive and negative). This is best approached through the appropriate decomposition of innovation related expenditure into the basic components of the production function such

18 [(Revenues from innovative products) + (Revenues from existing products)] – [(Total innovation-related expenditures) + (Total expenditures for other operational activities)] = Profits before Tax per Income Statement. Asset and Liability entries are as per the Statement of Financial Position.

100 as labour and capital inputs so that their implications for the key policy drivers of government can be systematically examined within existing economic frameworks.

101 Figure 1. Relationship between innovation expenditures, accounting and economic indicators

102 LESSONS LEARNT AND RECOMMENDATIONS

Lessons and recommendations arising from the exploratory study

1. The indicators of firm-level resource allocation to innovation can be derived from the business accounting data by a 3-step process where: (i) The statistical unit of the firm reflects the relationship between the factors of production as implied by the standard production function; (ii) The Oslo and Frascati guidelines are applied to the general ledger accounts to determine the expenditure shares attributed to R&D, innovation and routine firm activities, respectively; and (iii) The underlying recognition and measurement requirement of the relevant AASB standards and the equality of the accounting identity are preserved in the derived indicators. These measures are essential for the assumptions of comparability across statistical units.

2. The accounting concepts of Operating Segments (AASB 8) and, to a lesser extent, the responsibility centres, can be used in the first instance to complement the supply-side approach to determine the boundaries of the statistical unit in a consistent way. While its equivalence with ABS production-unit concept of TAU is not perfect, it provides a sufficient approximation that still preserves the underlying accounting principles governing the source data.

3. The OECD’s Frascati Manual allows the reliable derivation of R&D expenditure by distinguishing these activities from other post-R&D innovation activities and the guidelines can be applied to the relevant accounting entries. The capitalisable ‘R&D’ activities allowable under AASB 138 – Intangible Capital should not be confused with the Frascati definition. When applied in concert, the OECD’s Oslo and Frascati manuals provide non-overlapping definitions of innovation activities while recognition and measurement requirements of the AASB standards allow the assumptions of comparability and consistency across statistical units from different industries to be meaningful.

4. The cost of innovation and R&D activities must include all reliably measured direct and indirect costs, which in turn comprise (and can be decomposed back into) the sum of: labour compensation and taxes, cost of capital services, cost of intermediate inputs and supporting indirect costs (overheads) prorated by an appropriate activity-related factor. This reflects the full commitment of scarce resources to implement innovations. The total expenses and revenues reported in the income statement must be recoverable from the sum of the expenses and revenues comprising the respective shares of innovation and routine activities estimated by this method.

5. Where the firm engages in multiple activities with multiple products (goods and services), the Product Cost concept should be a starting point for estimating the full cost incurred to bring a good or service to market because it allows all costs associated with the value chain to be identified and the OECD manuals are used to identify the innovation components. The Cost of Sales can also be used provided the related overheads are also included.

6. The treatment of capital consumption here is a balance between the ease of implementation and reflecting the cost of usage. On the one hand, firm application the depreciation methods allowed by the accounting standard may not reflect the rate of consumption and will affect comparability across statistical units; the capital asset accounts may not allow individual assets to be easily identified. On the other hand, inclusion of the entire value of new capital purchased for innovation in the reference period also creates comparability problems in that new and existing capital are treated differently. It skews the calculated labour and capital component of innovation expenditure, and the accounting equation will not be in balance.

7. When deriving financial measures of innovation in large complex firms, the technical disclosures in general purpose financial statements must be used in conjunction with the primary accounting data

103 because they provide more detailed information on the on the application of particular accounting standards. This is particularly important for the treatment of internally generated revenue to avoid double counting.

8. The use of the input-based approach to industry classification is consistent with the ANZSIC 2006 classification framework, and renders the firm data comparable with other business economic statistics published by the ABS. The supply-side classification allows comparable productivity measures – total factor productivity (TFP) or multifactor productivity (MFP) – to be determined using, for example, the Cobb-Douglas production function by ensuring a level of homogeneity of the statistical units classified to an industry.

9. It may be difficult or not practicable at present for all firms to establish an ‘innovation account’ as part of their reporting activities in a dynamic business environment because of costs and because some innovation activities can only be identified retrospectively. But all firms should be encouraged to better label and organise their primary financial records such that innovation related expenditures are more easily identified within the existing accounting structure. This can minimise the time required to respond to survey questions.

10. Further work should be undertaken to identify ways of simplifying the process for extracting innovation-related financial indicators from primary accounting records. This includes developing a generalisable method to map the accounting concept of the operating segment to the production unit, as well as reliable methods for factoring in the differing objectives of the financial reporting and economic frameworks to avoid serious errors resulting from mistranslation.

104 CONCLUDING REMARKS

The economic and accounting perspectives of firm operation represent two sides of the same coin in that they provide insights into the same processes while serving different objectives. The current work represents a first step in systematically investigating the application of economic measurement frameworks to a real business setting, taking into account the operational and reporting obligations relevant to Australian firms. As recognised in the Oslo Manual, innovation in firms is a continuous process and measuring a dynamic process is much more difficult because of the greater number of technical issues that must be considered. The next steps would be to refine the approaches further by targeted case studies of existing firms and to apply the findings to innovation survey design.

The deliberate distinction between R&D and innovation in this project is because we seek to understand the role of R&D and non-R&D related inputs in the innovation process and how knowledge output from R&D in turn serves as input to innovation (OECD, 2005). However, ultimately, the objective is to obtain indicators that can be linked to the basic policy drivers of government so that the role of innovation can be rigorously evaluated as part of the national economic system. The approach was to decompose the R&D and innovation inputs further into their respective labour, capital and intermediate input components, which are elements of the production function.

The consultant’s use of case studies to emphasise the key aspects in the bookkeeping and accounting cycle, from the input of primary transaction data into the computer based accounting systems and the disclosure notes in the financial statements, illustrated the barriers faced by small, medium and large firms when adapting accounting data to the economic objectives of the survey, and particularly the ability of standardised statistical frameworks to accommodate the dynamic nature of the business environment. The model financial statements and transaction flows suggested ways of managing two sources of measurement errors: the firms’ structure and their reporting obligations under the Corporations Act 2001.

The project identified some preliminary principles for systematically mapping accounting data to the economic variables that are in theory expected to covary strongly with (or proxy) the underlying innovation activities of interest. The present study is unable to determine the covariance properties of the derived measures and targeted case studies of real firms will have to be undertaken to test the methodologies suggested here. However, this study represents just the first step in an ongoing series of work that is required to improve the way innovation data are collected from and reported by firms and must be followed by further theoretical considerations as well as methodological refinements. Nevertheless, one finding that cannot be disputed is that both the economic and accounting dimensions of the problem must be addressed together in the development of any methodology to extract economic information from firm accounting data.

105 BIBLIOGRAPHY

AASB (2011) Pronouncements – Accounting Standards. Australian Accounting Standards Board, Commonwealth of Australia, Melbourne.

ABS (2005) Innovation in Australian Business, 2005. Catalogue Number 8158.0. Australian Bureau of Statistics, Commonwealth of Australia, Canberra.

ABS (2006) Australian and New Zealand Standard Industrial Classification 2006. Australian Bureau of Statistics, Commonwealth of Australia, Canberra; Statistics New Zealand, Wellington. ISBN 0 642 17241 2.

ASIC (2005) Regulatory Guide 85: Reporting requirements for non-reporting entities. Australian Securities and Investments Commission, Commonwealth of Australia, Melbourne.

Barro, R.J. and X. Sala-i-Martin (2004) Economic Growth. 2nd edition. The MIT Press, Cambridge, Massachusetts. ISBN 0 262 02553 1.

Cricsuolo, C., J. Haskell, and R. Martin (2003) Building the evidence base for productivity policy using business data linking. Economic Trends 600. Pp. 39 – 51. Office of National Statistics, United Kingdom Government, London.

DIISR (2009) Innovation Metrics Framework – Consolidated Report. Department of Innovation, Industry, Science and Research, Commonwealth of Australia, Canberra.

Griliches, Z. (1998) R&D and Productivity – The Econometric Evidence. The University of Chicago Press, Chicago.

Horngren, C.T., G. Foster and S.M. Datar (2000) Cost Accounting – A Managerial Emphasis. 10th edition. Prentice Hall International Inc., New Jersey. ISBN 0 13 085177 9.

OECD (2002) Frascati Manual. Proposed standard practice for surveys on research and experimental development. Organisation for Economic Cooperation and Development, Paris. ISBN 92 64 19903 9.

OECD (2005) Oslo Manual. Guidelines for collecting and interpreting innovation data. Third edition. Organisation for Economic Cooperation and Development, Paris; and the Statistical Office of the European Communities, European Commission, Luxembourg. ISBN 92 64 01308 3.

106 APPENDIX

Table A1. Application of Relevant Concepts – A Summary Information Type Process to Extract Information

1. Transaction histories • For identifying the beginning and end points of an activity for the purposes of measurement subject to a reference period;

• Standard recognition and measurement requirements of AASB standards apply except for R&D which follows the Frascati Manual (OECD, 2002) as per 2(a).

2(a). Cost allocations for innovation Oslo Manual (2005), paragraph 320 – Prototype: “Construction and activities – distinguishing between testing of a prototype is classified as R&D if the primary objective is to R&D and innovation make further improvements. This is often the most important phase of the experimental development of an innovation. A prototype is an original model (or test situation) that includes all the technical characteristics and performances of the new product or process. The acceptance of a prototype often means that the experimental development phase ends and the next phase of the innovation process begin”.

This applies particularly to the cost of design, trial and testing and pilot plants which can have characteristics of R&D and innovation.

2(b). Cost allocations for innovation • The costs associated with implementing an innovation ends when versus ordinary activity the activity generates operational revenue (invoice or accounts receivable date);

• The costs associated either with the commencement of revenue inflow or entries into the “Inventory” sub-account would be part of Cost of Sales.

3. Cost allocation of any overheads • Electricity, gas, water, fuel, motor vehicle use, other general or corporate services should be prorated either by innovation share of total labour hours in the period (between the start and end date) or the hours of capital services, or output share, whichever best approximates the volumes consumed.

• Other general or corporate services must be prorated based on relative hours of support provided during the period of implementation.

4. Purchase of new capital items for Oslo Manual (OECD, 2005), paragraph 363: “Concerning capital innovation purchases, expenditures for the category acquisition of machinery, equipment and other capital goods, should exclude purchases of capital goods that are already included in intramural R&D. Purchases of capital goods should be included in full for the period in which they took place. All depreciation provisions for building, plant and equipment, whether real or imputed, should be excluded from the measurement of intramural expenditure.”

107 5. Labour Costs Oslo Manual (OECD, 2005), paragraph 369: “Labour costs comprise annual wages and salaries and all associated costs of fringe benefits such as bonus payments, holiday pay, contributions to pension funds and other social security payments and payroll taxes. The labour costs of persons not involved in innovation activities such as security personnel and maintenance staff should be excluded here and included under other current costs.”

6. Total innovation-related The costs are allocated according to the two step approach of expenditure identifying the statistical unit followed by assigning the journal/ledger entries to the relevant Oslo/Frascati category of activity. The balance in the accounting identity must be preserved.

7. Revenue determination • Total Sales Revenue = Revenue(innovative products) + Revenue(existing

products)

• Start and end dates are obtained from invoices or revenue receivable accounts corresponding to the inventory entries.

• While pilot plants or small scale trial production runs may generate some sales revenue, the revenue inflow after the production technology has been finalised or fixed is the innovative sales revenue of interest.

8. Operating Segments – AASB 8, paragraph 12 (AASB, 2010): Operating segments often Aggregation criteria exhibit similar long-term financial performance if they have similar economic characteristics. For example, similar long-term average gross margins for two operating segments would be expected if their economic characteristics were similar. Two or more operating segments may be aggregated into a single operating segment if aggregation is consistent with the core principle of this Standard, the segments have similar economic characteristics, and the segments are similar in each of the following respects: (i) the nature of the products and services; (ii) the nature of the production processes; (iii) the type or class of customer for their products and services; (iv) the methods used to distribute their products or provide their services; and (v) if applicable, the nature of the regulatory environment, for example, banking, insurance or public utilities.