Understanding the Nature of R&D Investments vs. Capital Investments

The Research and Development Spending is Not Equivalent to Innovating post examines R&D spending trends across the industry, but it’s important to note that the R&D number on the income statement does not represent the totality of a company’s investment in product development. Many of the equipment and material costs associated with R&D are capitalized. For technology companies, R&D expenses are largely comprised of engineering salaries. While that claim may seem straightforward, it’s worth spending a little more time discussing the accounting concepts that drive that statement.

This is about Accounting. Don’t panic.

tl;dr R&D costs land on the income statement as an expense and – for most technology firms – is largely comprised of engineering salaries.

The goal of R&D is to build the company’s future capabilities, but R&D is viewed differently from other types of investments from an accounting-treatment perspective. In what is sure to be the least-clicked link in the history of RedMonk, the Financial Accounting Standards Board (FASB) states that R&D costs “shall be charged to expense when incurred” largely because of the “high degree of uncertainty about the future benefits of individual research and development costs.”

So practically speaking, what does that mean?

The ‘matching principle’ is about reporting expenses in the same period as revenue, and it is one of the underlying tenets of Accounting. For example, if you pay a lot of money to build a data center, accountants consider that to be a capital expense (aka something that can be put on the balance sheet as a long-term asset instead of in the income statement as an expense.) Because 1) accountants like the timing of expenses to match revenue and 2) investing in a long-term asset helps drive revenue for the company over an extended period of time, the cost of building the data center is spread out over the useful life of the asset using depreciation. This process of capitalizing contrasts with expensing, or having all the expenses hit the income statement upfront when the costs are incurred.

What the FASB argues is that the nature of research and development is uncertain enough that we can’t reasonably predict whether the expenses incurred now are going to lead to long-term assets with useful lives. Failed R&D will have no future revenue to which an expense can be matched. Because there is no guarantee that R&D will lead to future economic benefit, instead of being capitalized as an investment it is treated as an expense in the current period.

So practically speaking, what does that mean? (we’re almost there, I promise!)

For the most part, companies have a strong preference towards capitalizing over expensing. An investment that has a reasonably defined future benefit or an “alternative future use” can be considered capital instead of R&D. Because of the nature of technology products and services, many of the materials/equipment (like servers, infrastructure, etc) that support research and development fit this criteria, and thus the company can justify putting them on their balance sheet. Therefore, R&D expenses for the technology industry tend to be largely comprised of salary expenses for engineers.

Soylent Green R&D is (Mostly) People

The point of understanding the accounting behind R&D is not to argue that R&D costs are more or less important than capex expenses, but rather to appreciate the fact that R&D is not a lever that can be pulled easily. When you realize that R&D costs are effectively people costs, it humanizes a company’s decision to increase or decrease R&D. There is a significant difference between buying a productive asset (like a piece of property) and building a productive team.

If we work from the assumption that R&D spending is significantly based upon engineering salaries, then what does this imply about organizations trying to increase R&D spend?

It likely means they are increasing the size of their team, either through internal growth or through merger/acquisition.¹ Effectively growing people and teams into a cohesive organization is one of the most notoriously difficult management challenges. Increasing R&D output means increasing human output, and with it comes all the challenges of trying to scale culture and organizational effectiveness in addition to the challenges that accompany the technological development.