Capitalizing R&D

Expenses Research expenses, notwithstanding the uncertainty about future benefits, should be capitalized. To capitalize and value research assets, we have to make an assumption about how long it takes for research and development to be converted, on average, into commercial products. This is called the amortizable life of these assets. This life will vary across firms and reflect the barriers to converting research ideas into commercial products. To illustrate, research and development expenses at a pharmaceutical company should have fairly long amortizable lives, since the approval process for new drugs is long. In contrast, research and development expenses at a software firm, where products tend to emerge from research much more quickly should be amortized over a shorter period.

Once the amortizable life of research and development expenses has been estimated, the next step is to collect data on R&D expenses over past years ranging back to the amortizable life of the research asset. Thus, if the research asset has an amortizable life of 5 years, the R&D expenses in each of the five years prior to the current one have to be obtained. For simplicity, it can be assumed that the amortization is uniform over time, which leads 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, you cumulate 1/5 of the R&D expenses from four years ago, 2/5 of the R & D expenses from three years ago, 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 value of the research asset. This augments the value of the assets of the firm, and by extension, the book value of equity and capital.

The adjusted operating income will generally increase for firms that have R&D expenses that are growing over time. The net income will also be affected by this adjustment:

While we would normally consider only the after-tax portion of this amount, the fact that R&D is entirely tax deductible eliminates the need for this adjustment.12

12 If only amortization were tax deductible, the tax benefit from R&D expenses would be: Amortization * tax rate This extra tax benefit we get from the entire R&D being tax deductible is as follows: (R&D - Amortization) * tax rate If we subtract out (R&D - Amortization) (1- tax rate) and add the differential tax benefit which is computed above, (1- tax rate) drops out of the equation.

 

See Technical Indicators