Wednesday, November 20, 2013

Making R&D Count

This summer we saw big news out from the Bureau of Economic Analysis: Corporate research and development accounts are henceforth to be counted toward "investment" in the calculation of the GDP, rather than as expenses. This has big implications for technology companies, and for innovation policy.

Innovation-driven companies like Apple, GE, Samsung, Space-X and First Solar depend on investments in research and development to stay cutting edge. If they aren't on the cutting edge, they won't stay in business long (case-in-point, look at the recent decline in Apple's market valuation, driven not by any tangible problems with its balance sheet, but rather by the fear that its innovative edge on major money making devices is starting slip relative to its competitors).

But despite the value of R&D and the product and process improvement is leads to for companies that deal in innovation, under the old GDP accounting rules R&D could not be counted as an "investment" in something of future value. Only as an "expense," money gone and never to return.

This is cognitively wrong, since it is clear that investments in new technology can be incredibly lucrative, if uncertain. The explanation for this has of course been the Financial Accounting Standards Board (FASB) is a notoriously conservative entity, and to allow companies to book "investments" in the uncertain future value of innovation would be too risky. Thus, they have always been counted as expenses, and where such expenses have resulted in a better product, the value is later booked as profit. Part of why Apple exploded into the place of most valuable company in the world in 2011 was because of years and decades of investments in R&D that led to better technology.

The advanced technology they developed for iPod, iPhone, and iPad (3 key pillars of Apple's success) were kept off the books, written down as "expenses," rather than being carried appropriately as intellectual assets.

While FASB's Generally Accepted Accounting Principles (GAAP) still have not changed, the Bureau of Economic Analysis's latest GDP estimate set a new precedent this week by treating past investments in R&D as they should be: as investments in intellectual assets—rather than as expenses. In Europe, such accounting is already commonplace, and fully legal under European accounting rules. But the restrictive US-dominated GAAP system has yet to accept the importance of R&D and intellectual property to value creation.

The BEA's move will have the immediate impact of increasing the US GDP this year, and every past year going back to 1929. And it makes complete sense.

Companies carry "intangible assets" on their balance sheets all the time. Coca-Cola company for example, carries a roughly $70 billion "goodwill" asset that simply represents the "goodwill" that global consumers have toward their brand.

If goodwill is allowed on balance sheets, shouldn't investments in intellectual property, innovation, and R&D be counted as assets? This week, the BEA showed that it thinks they should, and that's a great step. But while this will be great for macoeconomic innovation policy, there is much further to go. I have written a lot (see the innovation chapter in Progressive Growth) about how to accelerate innovation in the economy, but this accounting realization adds this potentially potent tool to the toolbelt:

If the FASB would revise GAAP to count R&D as investments in assets rather than as expenses, it would go a long way toward incentivizing companies to spend more on R&D, a net social positive. When companies have a bad year, short-sighted CEOs being evaluated on their stock price often look for the longest term spending to cut first. Because R&D is accounted for as spending, rather than investments in assets, it is often first to the chopping block, much to the detriment of our national innovation economy and national prosperity.

Changing the GAAP rules to be more permissible of accounting for R&D and intellectual property as assets could go a long way toward encouraging companies to invest in innovation. Even better: unlike the R&D tax credit, this change would be virtually free to the taxpayer, and would start yielding economic returns almost immediately.

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