Do Accounting Rules Discourage Research & Development?

Businesses spend billions of dollars trying to develop new and better products, These outlays are referred to as research and development (R & D) costs. Accounting rule makers have struggled with how best to classify such expenditures. The classification of an outlay as an expense or an asset depends upon how long the firm will benefit from the outlay. If the benefit will be for more than one accounting period, it is classified as an asset. If the outlay provides economic benefit for less than a year it is generally classified as an expense. The five years of research and development outlays has lead to the development of an effective pill that they will market and patent under the trade name Mirakle Grow.

Since the R & D outlays have lead to the development of a pill that will generate significant revenue over several years you would expect that the outlays would be classified as assets rather than period expenses. There are two reasons why accounting rules treat R & D outlays as expenses.


A second problem in treating R & D costs as assets involves deciding their useful life. Assuming that successful R & D costs can be identified, over what period of time do we spread or amortize these costs? If the R & D costs lead to a patent we could simply use the life of a patent as our guide. But what really matters is the life cycle of a successful new product, not the period of patent enforceability. If accounting rules allowed the treatment of R & D costs as assets, management would be sorely tempted to record both unsuccessful and successful outlays as assets. This would lead to the overstatement of assets, the understatement of expenses and in turn the overstatement of income.

Unintended Consequences

Accounting rule maker's decision to not treat R & D costs as assets probably has undesirable consequences for firms and society as a whole. CEO's of large corporations are partially compensated and evaluated based upon their firm's stock price. Under current accounting rules a CEO interested in short-term earnings will avoid long term R & D commitments because they will depress current earnings and hence the stock price.

Society is probably also better off if companies increase their R & D outlays. The rules may prevent individual firms from overstating income and assets in the short run but reduce the income of the firms and the well being of society in the long run.

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