Effect
on Returns
Since
the capitalization of R&D expenses affects
both the operating income and the book value
of equity, it will inevitably also affect
the measured returns on both capital and equity.
The direction and magnitude of the effect
will depend upon:
a.
The amortizable life of R&D: Since the value
of the research asset is computed based upon
the amortizable life, it will increase as
the life increases. Thus, the effect of R&D
on the invested capital will be greater in
sectors like pharmaceuticals, where the amortizable
life is longer, than in software, where the
life is much shorter.13
b.
Growth in R&D over time: The effect of R&D
on operating income is a function of the difference
between the current year's expense and the
cumulated amortization of prior year expenses.
This difference will be largest (most positive)
for firms where R&D expenses have grown substantially
over time, will decrease as the growth rate
decreases, becoming zero for mature firms
with level R&D expenses over time. It is even
possible for it to become negative, if R&D
expenses are decreasing over time.
Bringing
these two factors together, capitalizing R&D
expenses is most likely to increase the computed
return on capital (equity) for high growth
firms in sectors where it takes time for research
to be commercialized and to decrease return
on capital (equity) for mature firms in the
same sectors. The effect of capitalization
will be smaller for firms in businesses where
research tends to pay off quickly in the form
of commercial products. The effect of capitalizing
R&D on returns will also depend upon the level
of preadjusted returns. Firms that report
high returns on a pre-adjustment basis are
more likely to see their returns go down,
post-adjustment. The direction of the effect
can be captured by comparing the pre-adjustment
return on capital (equity) to the ratio of
the R&D adjustment to earnings and the R&D
effect on invested capital.
13
It is not atypical for a pharmaceutical firm
to have to wait 10-12 years for research to
pay off.
Return to document index
