R&D Capitalization

According to financial legislation, intangible assets generated during the process of organic growth (including R&D) are not recorded on the balance sheet; instead, they are directly expensed, which distorts the true financial picture of the organization.

Expensing R&D in the initial growth stages shows negative results, while in later stages it shows very high ROIC, whereas the real economic figure is somewhere in between.

The graph below shows an example discussed in the book, illustrating how ROIC changes when R&D is capitalized instead of being directly expensed. As a result, the graph shows that ROIC is 10% instead of 33% (see also the Excel spreadsheet).

Capitalization means restoring historical figures and accruing R&D amortization instead of R&D expenses. This changes the restructured balance sheet and profit and loss items. Although historical cash flows will not differ, future forecasts may change. This is due to shifting from an approach where R&D expenses are tied to sales to one where net investment tied to sales is fixed.

Furthermore, when R&D is expensed, managers can show better results through short-term manipulations (by reducing R&D spending), whereas such opportunities disappear with capitalization.

One question that is somewhat difficult to answer relates to the amortization periods – over how many years should R&D be amortized? The answer to this question is specific, but as shown in the diagram below (Exhibit 24.6), the impact on ROIC from the range of error is not significant, so this issue is not a cause for concern.

Additionally, when R&D expenses are tied to revenues (e.g., 5% of revenues), the margin does not change if sales decrease, and the picture remains distorted, while with capitalization, R&D amortization expenses are not tied to sales.

Finally,

It is important to note that capitalizing all intangible assets is not always advisable for managerial reporting, as it can also create opportunities for manipulation. For example, costs that do not actually impact the future could be capitalized and then stretched out over time on the balance sheet to show better profitability.

The Excel file for the financial statements reorganization model due to R&D capitalization is here:

Source:

Valuation, Measuring and Managing the Value of Companies – by McK.&Co, T. Koller, M. Goedhart, D. Wessels