1. Choose an amortization period.
2. Capitalize R&D expenses over the amortizable period.
3. Calculate amortization expense.
1. Amortization Period
According to general accounting standards, spending on research and development (R&D) is immediately expensed rather than capitalized and amortized over time. This means that the pro forma value of assets created by research is not reflected on the balance sheet. For firms that have significant R&D outlays, such as technology and pharmaceutical companies, failure to recognize these intangible assets can have a material impact on the capital and profitability ratios for the firm. Therefore, just as with operating leases, hidden assets should be capitalized to more accurately assess a company’s financial position.
The first step in capitalizing an expense like R&D is to choose a reasonable amortization period. This requires an analyst to make a subjective assessment about the average time it takes a company to develop a commercially-viable product after research begins. Amortizable lives are generally between 2 and 10 years, but should be informed by product and industry characteristics. Pharmaceutical companies, for example, will have longer amortization schedules whereas software firms will have shorter amortizable lives.
2. Capitalize R&D Expenses
After an amortization period is chosen, the next step is to capitalize R&D expenditures over the amortizable life of the research asset. After historical data on R&D expenses is collected, the implied value of the asset is calculated as the cumulative total of the unamortized R&D over the period. If the amortizable life is 3 years, the value of the research asset is equal to the sum of one-third of R&D expenses two years ago, two-thirds of R&D expenses one year ago, and the full amount of the current year’s R&D expense. This pro forma total is added to assets and equity on the balance sheet.
3. Calculate Amortization Expense
Once R&D expenses are re-categorized as capital expenditures, the amount of amortization expense in the current year can be calculated. This is computed as the cumulative total of each year’s R&D amortization amount over the life of the research asset. For example, if the amortization period is still assumed to be 3 years, the current amortization amount is equal to the sum of one-third of R&D expenses three years ago, one-third of R&D expenses two years ago, and one-third of R&D expenses one year ago.
If you decide to capitalize R&D, the value of the research asset must be added to the book value of assets and equity. In addition to financial ratios being affected by the revised asset and equity values, the increase in equity also affects the calculation of WACC. You must also eliminate the R&D expenditure from the income statement and include R&D amortization expense in its place. If you are interested in measuring the return on R&D investment alone, it can be calculated using the following equation.
Spending on R&D is capitalized on a pro forma basis because the benefits from the expense are believed to accrue over multiple periods. In light of this argument, a case can also be made for treating other types of spending, such as advertising, as a capital expense. This method should not, however, be applied too liberally. There should be considerable indication that the expense will provide benefits over a time horizon greater than one year.
Aswath Damodaran. Estimating Cash Flows. (Slides 12-15)