Research and development

Research and development (R & D) is clearly investment that is meant to generate cashflows. This means that the output of R & D meets the definition of an asset. In spite of this, research expenditure is treated as a cost rather than an investment; research expenditure is immediately deducted from operating profit rather than being capitalised. Development expenditure is capitalised and then amortised.

The reason for the distinction between research expenditure and development expenditure is that development costs create a particular identifiable new asset that can reasonably be expected to either be usable (it will generate cash) or sellable.

An example of development costs are the costs of designing a new product that a company plans to sell. An example of research costs are the large scale screenings of very large numbers of substances by pharmaceutical companies to try to identify those that may have useful properties.

The results of research expenditure are highly uncertain and therefore it is not possible to establish the value of the assets it creates (knowhow, patents etc.) with sufficient certainty to value them on the balance sheet. This can lead to a peculiar situation where assets that have been bought in (e.g. though the purchase of patents) are shown on the balance sheet (and their purchase price is amortised rather than being immediately shown as a cost) but very similar assets created in-house are not.

This also means that standard measures of returns on investment such as RoI ignore past investment in research and treat current research costs as expenditure. As the effectiveness of R & D is critical for many companies (especially in sectors such as pharmaceuticals and IT) this means that a key measure of efficiency is not being assessed.

One solution is to add back past research expenditure as an asset, adjusting the accounts to capitalise and amortise it. This is not overly difficult to do, although tedious as it would involve collating numbers from several past years.

An easier, and not any necessarily worse, alternative is a more informal look whether a company is generating the fruits of R & D. Does it have a healthy pipeline of new products? Is its technology advancing as fast as that of its competitors?

In many cases, particularly pharmaceuticals, investors can focus on the pipeline of products which are known to be under development, but which have not yet been launched as these are what will drive growth over the next few years. Important though pipelines in these sectors are, it is also important to consider how good a company is likely to be at replenishing it.

Finally, as this is a difficult issue to address from a purely financial viewpoint, getting to know industries and technologies can give an investor a much better idea of what result can be expected from a company's R & D efforts. issues that might help are:

• What reputation do the company's recent technologies enjoy in its industry?
• Is it a place in which people want to do R & D? Do they have a reputation that helps recruit researchers?
• Is its technology well placed to build whatever comes next? A company that is able to build on better versions of already successful products is more likely to be successful than one that has to develop something new and radically different.

None of this gives investors a quick fix as industry and technical knowledge is time consuming. Assessing R & D is difficult but important, especially for long term investors.