To capitalise or not? James Faulkner on the profit impact of R&D

Research & Development (or R&D) is often a crucial factor in maintaining or improving a company’s competitive position. It usually entails the creation of new technologies or products that can help drive future profitability, and is therefore of high importance to investors looking to spot the next winner.

However, investors should also be careful to keep keen a lookout for the different accounting treatments of R&D spend and their overall impact on the picture presented of the current state of the company. The impact different accounting treatments can have on the accounts may vary considerably, even when R&D spend is roughly comparable between the companies in question. Later in this article I’ll be looking at a couple of examples in order to get a better picture of how R&D effects company accounts in practice, but first we need to know what the rules are as outlined by the regulatory bodies.

Accounting regulations specify that R&D costs should be split into their constituent parts – research costs and developments costs. Research activities by definition do not meet the criteria for recognition as an intangible asset, as it cannot be certain that future economic benefits will probably flow to the entity as a result of these undertakings. Research costs should therefore be written off as an expense as they are incurred, as there is simply too much uncertainty as to the likely success or otherwise of the project.

However, the treatment of development costs is more of a grey area. Development costs may qualify for recognition as an intangible asset provided that certain criteria can be demonstrated. These include the technical feasibility of completing the intangible asset and its intention to do so; the company’s ability to use the intangible asset or sell it; the company’s ability to demonstrate a market (or internal use) for the intangible asset; and the company’s ability to measure the expenditure attributable to the intangible asset’s development.

The accounting standards for the treatment of development costs are therefore much more open to interpretation. Some companies choose to simply run the majority or all of their R&D spend through the profit & loss (P&L) account, which has the immediate effect of suppressing reported profits, but can lead to greater future profits if R&D turns out to be successful. Others choose to capitalise their development spend whenever possible, with the associated costs showing up on the balance sheet as an intangible asset and then gradually amortised through the P&L. Both approaches have their pros and cons – the former is generally seen as the more prudent approach by analysts, but the latter better fits the accruals & matching principle, where costs are more closely offset against benefits derived therefrom.

To illustrate the effects of the different approaches to the treatment of R&D costs, I’ve selected two companies: Globo (GBO) and Publishing Technology (PTO). Both are technology driven companies, so R&D is critical to the success (or failure) of both businesses.

Globo – the capitaliser…

In the case of Globo (GBO), results for the year to 31st December 2013 show us that investment in product development during the year was €14.6 million, which was used to develop the firm’s GO!Enterprise offering by incorporating new features that include Mobile Device Management and Cloud deployment. There was a net €11.3 million increase in intangible assets during the period, which, after adding back amortisation of €8.6 million, suggests a large proportion of this was capitalised (with the rest presumably made up from acquired intangibles as a result of acquisitions). Therefore, although the company produced free cashflow of just €5.2 million during 2013, a pre-tax profit of €27.4 million was recorded, as the accounting treatment spreads the cost of product development over many years, despite the fact that the cash cost to the company is borne upfront.

Publishing Technology – the expenser…

Meanwhile, a different picture emerges at fellow techie Publishing Technology (PTO). In its results for the year ended 31st December 2013, it recorded revenues of £16.9 million and a pre-tax profit of just £0.7 million. However, this was struck after R&D costs of £2.8 million, which appears to be expensed as incurred – with goodwill & intangibles only forming a small part of the balance sheet (£3.7 million) and remaining flat over recent periods. This means that profitability has been suppressed in the short term with the flipside that it should be greater over the long term. Indeed, in the 2011 Annual Report, we are told that “The Group carries out research and development activities in connection with administration systems, web delivery, access control and linking technologies. All costs relating to these activities are written off to the Statement of Comprehensive Income as incurred. The charge to the Statement of Comprehensive Income was £2.5m (2010: £2.7m) in the year to 31 December 2011.” So if PTO were to stop all R&D expenditure tomorrow, it could presumably make a significant profit.

Things for investors to bear in mind…

The mismatch in cashflows created by R&D activities can have an impact on how the market perceives a particular company. If all R&D is expensed, it can have the effect of dragging down profitability, especially if it is carried out at an accelerated rate. This may hold back share price performance in the short-term, but can lead to long-term gains should the R&D prove successful and lead to long-term improvements in returns. If the investor has confidence in the firm’s ability to invest well, this may present an opportunity if the shares are being held back by the short-term impact on profitability. Conversely, if profitability is inflated vis-a-vis free cashflow in a firm that chooses to capitalise development expenditures, this could be setting the stock up for a fall, should the investment prove unsuccessful.