How to spot accounting gimmickry: R&D Expensing
We all know how valuable an intangible asset to a company like patents, trademark, and copyrights so there must be some way to truthfully report them in the balance sheet. It would have been easy to do this if your company bought an intangible asset from another company wherein you can have solid and concrete numbers to start your basis in a balance sheet. Unfortunately as is often the case, the intangible asset is oftentimes developed internally instead of being purchased from another company.
The expenses that arose from the creation of these valuable intangibles like patents for a new drug are hard to ascertain because the expenses related to this have already been expensed and future benefits from this intangible asset are almost impossible to quantify. Because of this the recorded amount in the balance sheet for the value of the intangible asset is decidedly far below than its actual value.
The FASB has decided to expense all R&D even if this will cause an obvious distortion of the financial picture that the balance sheet will show. Their reason is firstly, future benefits from this R&D cost are very uncertain since it might turn out to be a flop after all. Second, there is no solid evidence in terms of hard numbers that there is a relationship between R&D expenses and future income. Lastly, if ever the research proves to create a valuable intangible asset, the amount of gain from this can not be measured in fixed numbers, or in any logical manner.
You might ask after all this background on why it can’t be recorded in predictable figures how to manipulate the earnings and other balance sheet ratios crucial for analysis. It is quite simple; the management would simply have to cut-back on their expenses in R&D and most possibly in advertising too thus creating an artificial rise in their earnings. While this may look good for the bottom line in a short term focus, this will undoubtedly be detrimental to the business in the long term because sooner or later competitors will come up with new and innovative products and steal your company’s market share. This might benefit the management who are simply concerned with their paychecks and bonuses which they don’t deserve but will ruin the poor investor who is unwary of the possible aggressive accounting gimmicks engaged by unscrupulous executives.
Therefore, even if you know that the real value of an intangible asset is not fully reflected in the balance sheet, you can appreciate the value that good management creates by continually pouring resources to create value that customers will seek and make the investor the happy sums he deserves.