Capitalizing R&D Expenses

Learn how and when to capitalize research and development costs

Capitalizing R&D Expenses

Under the GAAP, firms are required to expense research and development (R&D) in the year they are spent. For many firms, it leads to extensive volatility in profit and return calculations, and to an inadequate measure of assets or invested capital. The practice doubly impacts return on asset calculations, and not consistently so, thereby creating wildly different calculations of economic profit. In this guide, we analyze the practice of capitalizing R&D expenses, versus not.

 

Capitalizing R&D Expenses

 

Some would argue that the IFRS’s treatment is superior. In IFRS, all research spending is expensed each year. However, development costs are capitalized once the “asset” being developed meets the requirements of technical and commercial feasibility to signal that the intangible investment is likely to either be brought to market or sold. It offers the benefit that “successful” R&D is capitalized on the balance sheet as opposed to expensed. However, the fact is, because IFRS provides more opportunity for the application of judgment, it only adds to the risk of distortion of financial statements as management teams attempt to apply uncertain assumptions to the implied certainty of the financial statements.

 

Expensing R&D Leads to Volatility

R&D is very often not stable from year to year, creating material and directionally different changes in profit measures. Many companies in the technology and healthcare sectors succumb to the same problem. In the Consumer Discretionary sector, R&D expenses increased by more than 8% a year over the past 10 years, but with a 25% standard deviation in growth rates. While technology firms see R&D grow at 10% a year in the past decade, we measure a 7% standard deviation among growth rates. The matter is material in many other industries such as in the Healthcare, Industrials, Consumer Discretionary, and Energy sectors.

Without capitalizing R&D, a firm’s earnings can be materially understated because the traditional calculation of net income does not recognize the firm’s material investments in R&D as part of its operating investments. It violates one of the core principles of accounting, where expenses should be recognized in the period when the related revenue is incurred. R&D investment is an investment in the long-term cash flow generation of the company, and as such, it should be capitalized, not expensed. Moreover, the incorrect deduction of R&D investments as expenses makes it nearly impossible to objectively compare the firm to its peers and even to its own historical performance.

The solution is to consistently capitalize R&D over a fixed period of years across an industry group and include that in the asset base. The capitalized R&D would be amortized over the same set of years, effectively smoothing the R&D expense into adjusted earnings. Finally, the capitalized R&D would be carried net of accumulated amortization of R&D, allowing for far better Adjusted Return on Assets (ROA) measures of profitability.

 

The Process of Capitalizing R&D Expenses

We would argue that research expenses, notwithstanding the uncertainty about future benefits, should be capitalized. To capitalize and value research assets, we first need to make an assumption about the amortizable life of these assets.

The amortizable life will vary across firms and reflect the commercial life of the products that emerge from the research initiatives. To illustrate, R&D expenses in a pharmaceutical company should have fairly long amortizable lives, since the approval process is long and so is the patent protection granted for products that emerge from the research. In contrast, R&D expenses in a software firm, where products tend to emerge from research much more quickly and have shorter commercial lives, should be amortized over a shorter period.

After estimating the amortizable life of R&D expenses, the next step is to collect data on the expenses over past years ranging back to the amortizable life of the research asset. Thus, if the research asset is given an amortizable life of five years, the R&D expenses in each of the last five years must be obtained. For simplicity, it can be assumed that the amortization is uniform over time, which leads us to the following estimate of the residual value of research asset today.

Thus, in the case of the research asset with a five-year life, we cumulate 1/5 of the R&D expenses from four years, 2/5 of the R&D expenses from three years, 3/5 of the R&D expenses from two years ago, 4/5 of the R&D expenses from last year and this year’s entire R&D expense to arrive at the cumulated research asset.

 

Related Resources

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