Is R&D funding distorted by accounting rules?

Research and development (R&D) activities by companies is vital part of the American innovation ecosystem. Company R&D funding is the vital link between basic research (often government funded) and product commercialization. Economic policy promotes company R&D funding in a number of ways, such as through a tax credit and through direct funding using public/private partnerships. But U.S. accounting rules may be creating a barrier to and distorting company R&D activities.
At first blush, the issue may seem straightforward. Under U.S. Generally Accepted Accounting Practices (GAAP), company research and development expenditures are considered expenses. They are treated as day to day operating costs, similar to workers’ wages or the electricity bill. As such, when it comes time to calculate the company’s profit, these expenses are subtracted directly from the bottom line. The higher the spending on R&D, the lower the profit.
However, there is an alternative way of looking at R&D spending. Rather than a day to day operating expense, R&D is an investment. This view sees R&D as similar to a new piece of machinery or a building which have long term payouts for the company. Under GAAP, these investments in tangibles (equipment and buildings) are depreciated over time. Their costs are allocated not as an expense the year they are purchased, but apportioned over a number of years. Known as capitalization as it treats the spending as a form of capital improvement rather than an immediate cost. As a result, the immediate expense is lower and profits are recorded as higher.
Current accounting rules for companies do not allow for R&D spending to be capitalized. However, our accounting rules for the national economy shortly will. Beginning in 2013, our System of National Accounts will start incorporating R&D as a capitalized investment in the GDP statistics (see earlier posting and the BEA article “Toward Better Measurement of Innovation and Intangibles“).
To complicate matters, internal R&D spending is treated differently than R&D acquired from outside. If a company spends $1 million to develop a new technology, that is counted as an immediate expense. If a company spends $1 million to buy another company to acquire that technology, it is counted as an investment and must be capitalized. From an accounting point of view, this process may make sense because an internal expense is different from an acquisition. However, from an operating perspective, this difference between R&D expensing and R&D capitalization can be profound.
There are two possible problems: a decrease in R&D spending (a “lock up” effect) and a distortion of R&D spending toward acquisition versus internal R&D (the “balance” issue). The lock-up effect occurs when a company is hesitant to spend funds on R&D for fear of lowering reported profit — and thereby having a negative impact on shareholder value. The case of the stock market’s reaction to the divergent paths of Pfizer and Merck is a illustration of how increased R&D can be viewed by investors as a negative. This effect may be more pronounced for the small to medium sized (mid-capitalized) companies where stock analysts may not have the time to dig far beyond the profit and loss statements.
The balance issue affects where R&D takes place and who is making the research decisions. If acquired R&D is treated more favorable from a shareholder’s perceptive, there may be incentives created for existing companies to acquire technology from outside the company rather than development the technology in-house. Because of that incentive, the decision (consciously or unconsciously) regarding to what research is undertaken may not be made on the nature of the research but rather by who does it. For example, a company may decide not to pursue a certain line of research because it would have to be done in-house. Instead the company may wait to see what is developed externally and then seek to acquire that technology.
The balance issue may also impact the financial situation of startup companies. Startups are not well capitalized and are not in the position to acquire R&D from others. While startups may have access to R&D from universities and other public-private platforms funded by R&D activities flowing from the government or corporations, it is typical that a new, small business is creating their own R&D internally. As a result of the accounting rules, the smaller company which is reliant on internal R&D may be disadvantaged in the capital markets because of an appearance of lower profitability.
All of this has serious implications for the interaction between startups and existing companies — and the dynamics of the innovation process. Ideally, research decisions should not be biased one way or the other; the rules should be balanced or neutral between internal and external R&D. If a bias is to exist, there should be a solid public policy reason for that externally imposed bias. There may be good policy reasons to encourage the start-up/acquisition model of R&D over the in-house R&D model. But the possible existing bias toward acquisition due to the account rules exists because of historical circumstances, not a deliberate policy choice.
It is time to look more carefully at this issue to see whether the way in which account rules treat R&D (and intangibles in general) have become an impediment to innovation. And we need to ask a fundamental question: if we can treat research as an investment in our national accounts, why can’t we do the same in our company accounts?

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