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Accounting Rules Stifle Innovation

by Everyday Junglist 2 months ago in finance
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R&D as Cost Center Hurts R&D Scientists the Most But Everyone Pays a Steep Price

Image by ar130405 from Pixabay

The system today

"According to the Financial Accounting Standards Board, or FASB, generally accepted accounting principles, or GAAP, require that most research and development costs be expensed in the current period." For as long as their have been accounting rules the idea that R&D activities must be entered on the costs side of the ledger has held sway. To my knowledge none or only a very few have ever dared question the wisdom of this approach. After all, it seems obvious, R&D (in its most basic form) costs money, it does not make money, not directly at least. If it does make money it is only indirectly through the products and services that eventually come to market as a result of the money spent on R&D. Much like a building or other capital expense, R&D is viewed as a tool that can be used to make money, but not as a money making enterprise in an of itself. A building, however, is built, and maybe modified some over time, but it does not really do anything. Not anything active at least. It just exists, and is used by a business which occupies it to conduct business, to facilitate the doing of business. In the end it just sits there and does nothing but "exist as a building" On the other hand, R&D, some activities of which can be capitalized like a building (see linked article above for the gory details) is a very active thing (hence the reason we call it an activity or a process). It does much more than just "exist as R&D" waiting for some business to occupy it and use it to make money. Their are alternative R&D models of course that do exist, some of which set up R&D as a profit making enterprise with its own P&L, but these are few and far between and are typically highly risk averse, short term project focused, and significantly limited in scope. Nothing wrong with that model and it can be useful, but it is far from the norm and if all R&D were set up in this manner it is hard to see how real "move the needle" type innovation could actually happen.

Consequences

The real world consequences of this view of R&D as a cost center is highly destructive to both innovation and the people at the heart of that innovation, the R&D scientists actually doing those activities called R&D. Because R&D is a cost, its existence must always be justified, and when the economy or a particular business has a downturn it is one of the first to the chopping block. Business say we must "cut costs" to regain profitability or whatever financial metric they find most important. R&D is not only a cost, it is one of the biggest costs or sometimes the single biggest cost any modern business may incur. This makes it an obvious and attractive target for cuts. C-suite executives love to boast about taking the long view and the "importance of innovation" but when the rubber hits the road, and wall street comes knocking looking for heads, innovation suddenly becomes a lot less important, and the long view gets ever shorter. R&D scientists have not helped the situation. They tacitly accept the status quo every time they acknowledge R&D as a cost center and/or try to justify their existence by using arguments which proceed from a premise which accepts this view. And this happens constantly. It happens every time an R&D scientist puts together arguments for the importance of R&D which attempt to show how their work has actually created revenue for the business. You see, it's not really a cost, it's revenue generating, its profit making. The business people in the room smile politely and nod in agreement, but are really wondering to themselves, why am I paying these people so much money? How can I get the same for lower cost? Why do I need R&D? Some, maybe even a majority, may actually agree with that R&D scientists view, but it does not matter how much they agree, their accounting department absolutely disagrees, it has to, generally accepted accounting principles require it. And, in the end, it is the financial metrics, which the accountants control, that will determine the fate of any given businessperson, their personal beliefs not withstanding. And so, R&D always loses in the end, it simply cannot win, the system has been set up in such a way that makes it impossible. As long as R&D is officially accounted for as a cost in business it will always be viewed as expendable. It will always be vulnerable to cutbacks and reductions in the never ending quest for business profitability.

Is there another way?

What's the alternative you may be asking yourself. If I no longer call R&D an expense, what do I call it? If not expense, where does it go on the accounting ledger? Surely I can't be suggesting we call R&D activities income? While I am generally a radical contrarian even I would not go so far as to suggest that. But I do believe there must exist an alternative "third way" if you will that accepts that R&D costs money, but does not by default equate R&D expenses with, for example, building expenses, or consumables costs. Our tax code has been setup in theory to do just that, with sizable tax credits available for R&D. This is great, and they definitely help, but these credits also serve to reinforce the view that R&D is an expense, a cost. It may be a special kind of expense but it is an expense nonetheless. With that view come all of the consequences I described above. What if instead of expense or income we invented a third category for our ledger, a neutral category, we can call it whatever we want, for want of anything better lets call it excome. It is neither expense/cost nor income/revenue it is neutral, neither costing money nor making money. It just sits there on the ledger as its own thing. A number that can be looked at and used by Wall Street to make judgements about the seriousness of a business when it comes to innovation, but cannot be used to penalize it when the all important profit making calculations are made. Neither can it be used by a business to enhance revenue or profitability calculations. It can't be used for anything, not anything "real" at least. The important point here is that the number will no longer be looked at as the first place to cut when times are bad. Yes, this is a selfish view. It protects R&D scientists like myself, but it actually helps everyone. It keeps the innovation engine running at a time when that is most needed. If business people actually believe the words coming out of their mouths when they hype up the importance of innovation to the health of our economy than they cannot at the same time argue that such a thing does not deserve special protections.

Is this guy nuts?

At this point you may be questioning my sanity. What I am suggesting sounds like a totally made up, completely fake, meaningless number or set of numbers on a spreadsheet somewhere. In truth, it could be looked at that way, but in truth many accounting numbers are "made up." Taking the 30,000 foot view all of accounting is made up, we decide what the numbers mean in the end and we can decide to change those meanings if we have the will, and can muster enough logical arguments to articulate why such a change would be for the greater good of the system as a whole. Generally accepted accounting principles are just that, generally accepted, they are not universally accepted nor universally required. They can change and in this instance they should change. I can only imagine the groans of "This guy can't be serious" "He doesn't understand the complications that such a thing would entail" or "Does this guy even know how capitalism works" or "Someone needs to go back to business 101" or any of a thousand other less charitable attacks. I will be the first to admit I am no accountant, and I do not pretend to be. I am a research scientist and a citizen of the United States that has seen the damage first hand that the current system of generally accepted accounting principles has wrought on innovation in this country and on fellow research scientists like myself. My proposed alternative may not be practical or at all implementable, but there are many, many people out there, much smarter than myself that must have some ideas. Let's hear them. let's debate them, but let's do something. The current system has failed us, it is time to try something different.

finance

About the author

Everyday Junglist

Practicing mage of the natural sciences (Ph.D. micro/molecular biology), Thought middle manager, Everyday Junglist, Selecta (Ret.), Boulderer, Cat lover, No tie shoelace user, Humorist, Argan oil aficionado.

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