Last we discussed Accounts Payable and the role they play in cash flow efficiency. We learned that one company’s A/R is another company’s A/P. This week we’re analyzing one of the more complex accounting problems: capitalizing research & development (R&D) costs.
We’ll learn the difference between capitalizing vs. expensing, why it matters and how it changes margins, profits and returns.
Why We Should Capitalize R&D Costs
US GAAP accounting requires companies to treat R&D as expenses on the income statement (P&L). That biotech company spending $1M developing a new drug? Under GAAP that’s a $1M expense, not an asset.
This distorts profits, margins and ROA calculations for many tech/R&D heavy firms. That’s not ideal. Think about it. Companies that leverage R&D to generate revenue and cash have periods of massive R&D investment.
If you don’t adjust for R&D, the income statement looks like a bouncy ball on cocaine.
Investments in R&D support the long-term cash-flow generation of a company. They’re operating assets. As such, we should capitalize them on the balance sheet.
Capitalizing R&D is also a more conservative estimation of a company’s returns and profitability for two reasons:
- Capitalizing increases a company’s total assets (which could reduce ROA/ROE)
- Capitalizing keeps an amortization expense on the income statement
Let’s learn how to do that.
Capitalizing R&D Investments (Step-By-Step): Boeing, Inc. (BA)
We’re using Boeing (BA) as our example. Remember, we’re keeping things simple with this example. You can get more complex (see here), but that’s not our goal.
Step 1: Find Amortization Duration
The first step in capitalizing R&D is to determine the useful life of a company’s R&D assets. The longer the usefulness, the longer the amortization period (i.e., how many years we expense). High-tech companies in ever-changing industries have low amortization periods.
BA makes airplanes that have long lifespans. We’ll use ten years.
Step 2: Calculate Value of Amortized R&D Asset
We calculate the amortized value of the R&D asset by using the straight-line amortization method. This means we amortize 1/10th of the total sum of the last ten years’ R&D expense. If we chose 7 years, we’d amortize 1/7th of the total sum of the last seven years’ R&D expense.
Then we calculate the annual amortization expense by dividing that year’s R&D by 1/10th (0.1).
Here’s what that looks like:
Step 3: Recalculate Book Value of Equity
We need to add our capitalized R&D value to tangible book value to get a better picture of the company. This is simple. Take Tangible Book Value and add R&D value.
Here’s what that looks like in 2018:
$339M (BV) + $3.27B (R&D value) = $4.059B
Step 4: Recalculate EBIT
Next we adjust EBIT to reflect our capitalized R&D investments. To do this, we take our current year EBIT, add current year R&D expense and subtract total amortization of R&D.
Here’s what that looks for BA in 2018:
$11.6B (EBIT) + $3.27B (R&D) – $3.71B (Amortization) = $11.16B Adjusted EBIT
Why does EBIT drop after adjusting for R&D investment? BA’s decreasing R&D investment (see above).
To Be Continued …
I know, capitalizing R&D is confusing. But it’s important if we want to understand the true economics of an investment-heavy business.
We’ll review this concept in more detail next week, don’t worry.
If you have any questions feel free to reach out.
Student of value investing for over 13 years spending his time in small to micro-cap companies, spin-offs, SPACs and deep value liquidation situations.