#3 Investment Pill - R&D Expensing. Implications and Impact

Today’s newsletter delves into the potential shortcomings of how US Generally Accepted Accounting Principles (US GAAP) categorize research and development (R&D) expenses. Moreover, I am also explaining R&D capitalization adjustment, one adjustment you will usually see in my earnings reviews and investment thesis.

I find important to have in writing my thinking behind R&D capitalization and how and when do I use it because - as you might have already notice from my previous writings - my edge as an investor is in mainly in the pharma & biotech industry as well as industrial and chemical companies so you might expect to see this adjustment going forward.

Additionally, I am publishing a post with a link to the 10 years R&D capitalization tool I use only available to subscribers. It is easy to use and comes filled with Novo Nordisk’s R&D capitalization.

How are operating costs and CapEx defined?

Expenses are classified into three big groups: operating expenses, financial expenses and capital expenditures.

• Operating expenses: all expenses a business incurs in to carry regular operations, generating a revenue and benefit limited to the period where the expenses belong to.

• Financial expenses: expenses generated from the liabilities incurred for financing activities.

• Capital expeditures (CapEx): all expenses incurred which are expected to generate benefits for the company over multiple periods.

Then we need to think and understand what R&D activities are.

In October 1974, the Financial Accounting Standards Board (FASB) issued the Statement of Financial Accounting Standards No. 2 (SFAS 2) requiring uniformity in the accounting of R&D from January 1st of 1975.

In this statement the FASB defined R&D activities as follows:

So as per above definition, the FASB recognizes that R&D are activities which benefit will impact not only the current period when the expense is made but future periods will also be benefitted. Why is it that FASB established R&D to be an operating expense?

Expensing R&D vs. Capitalizing It

The given rationale in SFAS 2 by the FASB to force companies to expense R&D instead of capitalizing it was based on:

1. Uncertainty of future benefits: R&D activities outcome are uncertain and so are the benefits from the expending in those activities.

2. Lack of causal relationship between expenditures and benefits: If R&D activities outcome were certain or predictable it is not possible to quantify those benefits accurately over several future periods.

3. Lack of measurability for accounting purposes: R&D activities capitalization will lead to a R&D asset against which companies could borrow money. This was considered a risky scenario as that R&D asset is uncertain and not possible to be measured accurately.

Why Companies Engaged in R&D Should Consider Capitalization

The argument for capitalizing R&D holds relevance for any company with significant R&D spending. The current practice of expensing R&D can lead to several potential issues:

• An understatement of a company's true value (book value): By failing to recognize the intangible asset created through R&D, the company's balance sheet might significantly underestimate its actual worth.

  E.g. Patents generated by your own company will not show in the balance sheet and acquired patents will.

• Misleading measures of profitability: Expensing R&D upfront lowers operating income and net income, potentially leading to an overestimated returns (ROE, ROA, ROIC, ROCE). This can create a misleading picture as the company is investing for future returns, not experiencing a decline in profitability.

Capitalizing R&D: A More Accurate Picture

By capitalizing R&D, a "research asset" is created on the balance sheet, reflecting the intangible value generated. This asset is then amortized (expensed) over its estimated useful life, providing a more accurate picture.

To capitalize R&D the following procedure has to be followed:

1. Remove R&D expenses from the income statement.

2. Create an “CapEx in R&D asset” in the balance sheet - comparable to the “Purchased Plant and Equipment” category - applying the following formula:

   CapEx in R&D asset = Operating income * (1 - effective tax rate)

3. Create a R&D amortization category. R&D asset are amortized over the chosen Estimated Amortizable Life (EAL). A tricky part in this step is to estimate D&A from the start of the analyzed period. To do so it will be needed to accumulate and depreciate the R&D asset for a period of time equal to the established amortization schedule.

   E.g. To estimate current R&D D&A, we'll capitalize the company's past 10 years (chosen EAL) of R&D expenses, creating a 10-year depreciable R&D asset. Accumulated depreciation on this asset reflects R&D D&A in the present year.

4. Create an “R&D asset” category in the balance sheet. The R&D asset for any given period will be to the unamortized value of “CapEX in R&D asset” from the previous year within the established EAL for the asset.

Finally, R&D assets will be written off the balance under two circumstances: 1. The research or product is found not to be viable and research is abandoned; 2. Research succeeds and R&D assets become a physical asset.

Impact in accounting statements

Financial statements will be impacted when capitalizing R&D as an asset. Let’s have a look of it:

• Income statement

R&D expenses will be removed from the income statement while depreciation and amortization will increase. Its impact on the operating and net income will depend on the growth phase of the company.

A company under expansion cycle will show larger R&D expenses than D&A costs hence operating and net income will be boosted. On the other hand, a mature company will show larger D&A costs from former investments and the operating and net income will be reduced due to the proposed adjustment.

• Balance sheet

Creation of an R&D asset will increase assets and equity to the same extent. A larger asset/equity base will reduce company returns measured in that basis, specially when a company is scaling up and developing all its IP.

• Cash flow statement

R&D capitalization will have no impact on FCFF as you can see from the table below because the adjustment gets neutralized by itself.

Closing remarks

R&D capitalization allows us to arrive at more precise representation of real, underlying business conditions. R&D capitalization provides a cleaner picture of what is it actually earning on its assets and how much it is reinvesting into the business.

Furthermore, R&D capitalization rationale can be applied to any operating expense a company might incur and which benefits will impact not only the current period. E.g. Coca-Cola marketing expenses which enable the product positioning for years coming, impacting a whole generation of future customers.

Bibliography

1. Damodaran, Aswath. "Research and Development Expenses: Implications for Profitability Measurement and Valuation." Stern School of Business, New York University.

   Link: https://www.stern.nyu.edu/faculty/bio/aswath-damodaran.

2. Financial Accounting Standards Board. (1974, October). Statement of Financial Accounting Standards No. 2: Accounting for research and development costs (FASB Statement No. 2). Financial Accounting Foundation. Link:http://www.xavierpaper.com/documents/usgaap/n.Fas2.pdf 

This is the end of today’s newsletter. Hope you enjoyed it, a little out of the topics I usually cover. I believe understanding this adjustment will benefit future earnings reviews and investment thesis as the companies I look into usually have substantial R&D expenses which I then adjust.

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