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September 5, 2023

R&D – valuable activity, valueless measurement?

Few figures in financial statements attract as much unmerited attention as R&D, but few areas of business activity deserve more attention.

Investors are fascinated by how much companies spend, or perhaps ‘invest’, in research and development. And analysts and other commentators are often tempted to create dramatic stories over how much, or how little, a company spends.

Investing in research and development of one kind or another is crucial to the long-term profitability of almost every business. Just as at one end of the scale a semiconductor manufacturing business cannot ignore the progress in materials and manufacturing technology, so at the other a restaurant chain cannot hope to prosper in the long term without evolving its menu.

How to measure R&D

The problem is that the numbers in the accounts for R&D are in many cases meaningless and do not provide the insight that some claim.

There is no international accounting standard covering the definition of research and development in the income statement. Where there are standards that deal with what can, should or must be capitalised in the balance sheet, they are not consistent and are subject to considerable scope for interpretation and, almost certainly, for manipulation.

This means that in many sectors it is difficult to draw comparison with any confidence between companies that compete with each other locally, and it is nigh on impossible to make comparisons globally.  Even if two companies say they are spending 6% of revenue on R&D, it doesn’t mean they are spending it or accounting for it in the same way.

The US accounting standard (ASC 730) defines R&D as follows:

Research is planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service (referred to as product) or a new process or technique (referred to as process) or in bringing about a significant improvement to an existing product or process.

Development is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use. It includes the conceptual formulation, design, and testing of product alternatives, construction of prototypes, and operation of pilot plants.

Accounting treatments inconsistent and unconvincing

The idea that we should capitalise development spend and charge the cost of development against the revenue arising from the associated products or services as they are delivered or consumed makes perfect sense from an accounting perspective. However, in examining this issue, the world has split as to the appropriate path to take.

International accounting standards have followed the path that if certain criteria are met then the spend should be capitalised, and that once you are following that application of the standard it is, or rather should be, difficult to change.

US GAAP has taken the path that says that in almost all circumstances there is to be no capitalisation of development spend.

This divergence, and the fact it is US GAAP that has taken the path of non-capitalisation, may appear odd to those who assume that US accountants might be better placed to judge on such issues.  It is, however, consistent with the differing balance between the rules-based (US) and interpretative (international) natures of the two accounting regimes.

We find the IFRS policy odd and possibly somewhat naïve. The level of knowledge and understanding required of the auditor and the challenge of audit testing for consistency and completeness appear unrealistically high.

That said, in practice the effective optionality International Standards provide over capitalisation has tended to mean that it is a path taken by far from all for whom it is an option.  However, this can mean that those who choose to follow the capitalisation path under International Standards may be treated with more scepticism than those who choose to directly expense.

r and table us and uk listed companies

It is somewhat incongruous that in the UK we can find smaller listed companies, like Bango, with far from certain products and profitability capitalising product development at a rate of around 30% or more of annual revenues (FY22), while the consistently profitable Sage expenses it all, citing uncertainty. Neither of the companies would appear to be doing wrong in this regard. However, it is an accounting difference that someone coming from the US to the UK might easily feel uncomfortable with, even though it is a relatively trivial matter to adjust for. I can’t help but think that anything that leaves US Gaap-centric investors asking questions, or with a simple excuse to move on to the next stock, is not a good thing.

The approach of many investors is just to see if the investment is broadly in line with the amortisation charge and then move on, comfortable; just as they would with capex and depreciation.  However, for anyone looking at EV/EBITDA, there is an issue.

Problem of delineation – where to draw the line

Just as there might be seen to be a blurring of lines between research and development, so there is a blurring of lines between development, production, marketing, sales and customer support.

Evidently the delineation between the nature of research and development spend is easier in some industries than others.  While identifying the R&D spend at a major pharma company is going to be a relatively simple task, drawing the line between development and marketing might prove more challenging at a software house, particularly one with a high-service business model. One software company’s development may be another’s cost of goods sold or customer service expense. We wonder how a junior auditor (let alone a senior one) is supposed to judge that line.

Can we find R&D another way?

Here we do have a clear answer, but unfortunately it’s a no. For small, simple companies in certain countries and tax regimes, some further glimpse through might be obtained by reversing out the tax credits in the tax notes to the accounts, but such cases are rare and such analyses butt up against other tax issues – timing, rates et cetera. Likewise, details in the report and accounts regarding staff numbers in R&D can give glimpses of insight and possible reference points, but rarely much of applicable value.

More information does not mean more insight, just more questions

Even if we were to get the correct figure, it is too simplistic to look at R&D as a correct percentage of revenues.

For many industries, there is a minimum that must be spent to develop a new product; a minimum that is unrelated to actual volume or value of sales made. It would be just as difficult to identify what the correct absolute level of spend would be, as that requires attribution of areas/projects and most companies are loath to disclose what they have in development in all but the broadest terms.

Perhaps the trite conclusion is that the only way to judge R&D is by its results, and sales of new products and services – the same as it is for marketing. But then we find ourselves asking how to define what a ‘new’ product is.

R&D – inherently unreliable

This blog should not be taken as a plea for some kind of revised standard to be set, nor should it be seen as a dismissal of the R&D figure completely.  It is more a word of caution lest anyone seek to rely on the figure as a basis for an investment decision or take seriously any broker research based on its ‘interpretation’.

That said, given the inconsistencies across UK companies, it would be good if something could be done to reverse UK small-caps out of their development capitalisation cul-de-sac; something that might also make them more appealing (or at least easier to analyse) for international investors.

 

Ian Robertson

irobertson@progressive-research.com

 

 

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