R&D activities are first
mentioned in accounting literature in 1917 by the Federal Reserve Board in a Federal Reserve Bulletin. At
this time, the Federal Reserve Board declared that R&D should be
categorized as a deferred charged in published financial statements. This is
another way of saying R&D expenses should be capitalized and recorded on the
balance sheet. We follow this treatment of R&D in our intangible-adjusted financial statements. This capitalization view held for four decades and was
supported by a wide variety of financial institutions such as the National
Association of Cost Accountants, the Internal Revenue Service and again by the
Federal Reserve Board. In the mid-1950s, the IRS modified its stance and
allowed companies to, in effect, keep two sets of books. One book for internal
purposes, wherein most companies capitalized R&D, and another for tax
purposes, wherein most companies expensed R&D in order to lower their
taxable income. It is believed that the IRS took this approach in order to
spur investment after WW2. This “dual book” system lasted for two decades and
it wasn't until 1974 that the Financial Accounting Standards Board (FASB)
enacted Statement of Financial Accounting Standards (SFAS) No. 2 which stated
that a direct write-off of R&D expenses was mandated. At this point, companies
could no longer choose how they wanted to treat R&D and had to expense all
R&D expenses as they were incurred. The great irony here is this rule was
put into effect just a few years after the start of the greatest
technologically innovative period in the history of humankind. Corporations for
the past four decades have undertaken more R&D than in any other period in
human history, however, SFAS No. 2 completely obfuscated those corporate
innovative activities from investors. This is one of the primary reasons why
the Knowledge Effect exists.
Before changing the rule in the
1974, FASB actually considered four different methods of accounting for
R&D. They considered: 1) charging all costs when incurred 2) capitalizing
all costs when incurred 3) capitalizing some costs when incurred if those costs
met certain specified conditions, and 4) accumuling all costs in a special category
until the future benefits could be determined. In the end, FASB took the most
conservative approach and declared all R&D expenditures must be immediately
expensed. This is where our view, as well as leading academic views, of R&D
considerably differs from FASB. FASB took a very myopic view in determining
whether or not the future benefits of R&D could be determined, and
consequently, be capitalized as an asset on a company’s balance sheet. They
were concerned with the riskiness of individual R&D projects and worried
individual projects had a high rate of failure. However, they overlooked that a
portfolio of R&D projects can have a much lower aggregate level of risk
than an individual project has. On a collective basis, an individual R&D
project can offset a portion of another R&D project’s risk because of the
benefits of diversification and because knowledge creation creates many beneficial
spillover effects. As professionals in the investment community, our readers are well
versed on this interaction between risky endeavors as this is one of the bedrock
principles of modern portfolio theory. Diversification produces a lower level
of overall risk for a portfolio than individual assets can produce. This holds
as much for a portfolio of stocks as it does for a portfolio of R&D
projects. Also large, modern corporations indeed view R&D from a portfolio
perspective, not on an ad-hoc, individual basis. R&D for companies that
follow an innovation strategy, such as those that we define as Knowledge Leaders, is part of an organizational strategy. As such, companies do not put
all of their innovative eggs in one basket or one project. A portfolio
perspective on R&D, accompanied with the capitalization of innovative
investments, gives investors the clearest picture available of the unique
capital stock that drives future profits for a corporation.
