When a company builds a plant or purchases equipment, the asset is capitalized on the balance sheet and depreciated over time. Conversely, when a company creates an intangible asset, such as a brand name, distribution network, or patent, accounting rules dictate that the entire outlay must be expensed immediately. For firms with significant intangible assets, such as technology companies and pharmaceutical firms, failure to recognize intangible assets can lead to significant underestimation of a company’s invested capital and, thus, overstatement of return on invested capital (ROIC). To illustrate why and how to capitalize expenses, in this chapter we focus on one category, research and development (R&D) expenses.
For the purposes of measuring a company’s economic performance, any expense with benefits lasting more than a year should be treated as an investment, since it has created a durable intangible asset. We recommend capitalizing R&D expenses for three reasons:
1. To represent historical investment more accurately: By expensing items with long-term benefits, the accounting statements will understate the company’s historical investment. This understatement of capital can artificially boost ROIC in later years, making a business appear more attractive than it really is. (In the example to follow, ROIC drops from 42 percent to 13 percent when R&D expenses are appropriately capitalized.)
2. To prevent manipulation of short-term earnings: When R&D is expensed, ...