April employment

This morning’s employment report for April shows a relatively healthy economy. The unemployment rate fell by 0.4% to 6.3% and payrolls grew by 288,000. Economists had expected an unemployment rate of 6.6% and 218,000 new jobs.
However, the number of involuntary underemployed (part time for economic reasons) grew slightly in April. The good news is that the number of those who could only find part time work dropped. But number of workers part time because of slack work rose. The rise in slack work could signal a future slowdown. Involuntary underemployment remains well above pre-Great Recession levels.
Involuntary underemployed April 2014.png

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GDP, GAAP and R&D

As noted in past postings, the GDP data now treats R&D spending as an investment rather than an expense. The most recent Survey of Current Business includes a “BEA Briefing: Treatment of Research and Development in Economic Accounts and in Business Accounts.” As the title indicates, the briefing compares how R&D is treated in the System of National Accounts (which produces the GDP measure) and the generally accepted accounting principles (GAAP) for companies. Both are based on basic accounting principles, such as double entry bookkeeping. However, there is a big conceptual difference when it come to R&D. As the briefing points out:

Under U.S. GAAP, R&D is not recognized as capital formation because of the uncertainty of future economic benefits associated with R&D–that is, U.S. rule makers are traditionally conservative in the treatment of expenditures. Immediate expensing implies that R&D expenditures contribute to sales and the related profits in the current period with no contribution to sales and profits in future periods.

After careful consideration over a number of years, the economists in charge of the System of National Accounts can to a different conclusion. In the new GDP measurement (adopted in 2008 and implemented this year),

[R&D] Costs should be capitalized regardless of the actual commercial or technological success of an endeavor because all costs form part of a future successful endeavor. While some R&D may require many failures to reap one success, businesses are not presumed to incur costs related to R&D with an expectation of ultimate failure.

To me, it only makes sense that R&D is treated as an investment and not an expense. The easiest way to show that is through a simple thought experiment. Expenses are costs that are needed to keep an enterprise operating (which is why they are often referred to as “operating expenses”). Rent, salaries, electricity, and raw materials/supplies are all operating expenses. If they are not paid, the ongoing activities of the enterprise are in jeopardy (and may actually constitute technical bankruptcy). What happens if R&D stops? Nothing — at least immediately. Eliminate the R&D budget and the enterprise will generally continue to operate. Yes, long term, eliminating R&D will probably have an impact on the future functioning of the enterprise. But not in the short term (which is why R&D budgets are sometimes cut to make short term financials look better). Clearly, R&D is an investment (costs associated with long term benefits) not an operating expense (costs associated with immediate activity).
Accountant worry that the path from R&D costs to future benefits is not always clear. But is that any different from any other investment? Building a new building (which clearly is treated under GAAP as an investment) is fraught with uncertainty. Will the company be able to pay for the building? Are the goods and services made in the building right for the market? Will they sell? Is there enough demand? Are they priced right to produce a profit? Will the building last long enough to re-coop the investment? Treating R&D as an investment will simply put it on par with all other outlays that are rightfully considered investments.
There is another reason, as I’ve noted before, why R&D should be treated as an investment. Right now, there is a differential treatment of R&D expenses/technology between R&D undertaken in-house (an expense) and technology purchased from outside (an investment). Thus, 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 start-up companies. Start-ups are not well capitalized and are not in the position to acquire R&D from others. While start-ups 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 start-ups 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?