Governments, businesses, and other organizations often refer to “R&D expenditure” or “R&D spending” in reports and other communications. In this article we’ll explain why they shouldn’t do that! Instead, R&D expenditure (or spending) should be called R&D investment. Now, you might wonder, does it even matter? It certainly does, so let’s start with that.
R&D expenditure vs R&D investment, why does it matter?
When we consider research and development, especially from a government perspective, we consider nothing less than the future of humanity, and our potential to improve and progress. That’s right, our future, that’s pretty important stuff! And money spent on R&D is obviously an investment in that future. We are investing in R&D to improve the future. The problem with terms like R&D expenditure, R&D spending or similar is that it sounds like a potential waste of money. And that couldn’t be further from the truth! When approached properly, R&D is an investment, and it’s important to refer to it as such.
Words matter
As we all know, there are important psychological effects at play when our brains process words. When considering the word “expenditure”, it certainly sounds like we might be losing money. It closely relates to spending, expense, and so on. In everyday life we use such words when parting with our (hopefully) well-earned money. Let’s consider the phrase R&D expenditure in that light. Doesn’t it sound like we expect to spend R&D money without getting anything out of it? At the very least, it doesn’t imply us having high expectations for the potential returns. And that’s of course wrong!
Now, it’s true that in technical terms the word expenditure certainly can (and often does) refer to an investment. Investment is in fact a form of expenditure. However, the word expenditure simply doesn’t do right by our all-important R&D investments.
Faith in the outcome of R&D projects
How can we have faith in the outcome of R&D projects if we don’t sound convinced from the outset? Why imply that we might be wasting our money? How much better it would be to do away with the phrase R&D expenditure and refer to R&D investment instead! The word investment is much more positive. It actually sounds like we expect something out of it. And that’s how it should be!
Psychological biases, communication, and the willingness to invest in R&D
The idea that words differ in their psychological impact is of course not new. Marketers routinely take advantage of this, and there are plenty of resources listing “the right words”.[1][2] Moreover, scientists have shown how the use of certain words can affect and bias decisions.[3][4] The framing effect[5] is also of interest here. In relation to this effect, researchers have shown that people make different choices depending on how options are presented (phrased).[6] Furthermore, people’s opinions can differ depending on how certain background information is phrased.[7] Not surprisingly, such framing effects also occur when making financial (investment) decisions.[8][9][10]
The wider field of behavioral finance recognizes a large number of psychological biases that affect investor decisions.[11][12][13] For example, the mental accounting bias[14] may be of interest when considering the phrase “R&D expenditure” vs “R&D investment”. It’s not a huge leap to state that a similar bias is at work here. The willingness to invest in R&D can take a serious hit when we make it sound like we are “just spending” rather than investing our money. After all, don’t we usually prefer to spend our money on something useful rather than waste it? Using a word like expenditure simply doesn’t communicate much optimism or trust in the outcome of our R&D efforts!
Why are terms like R&D expenditure or R&D spending often used instead of R&D investment?
At this point, you might wonder why not everyone simply always uses the phrase R&D investment. Why bother speaking of R&D expenditure or R&D spending while there are such obvious reasons to stick with R&D investment? Let’s consider the following points:
- Difficulties around estimating the ROI of R&D investments
- Accounting standards and tax considerations
- Short-termism
We’ll discuss these in the sections ahead. Spoiler alert, at Beating Gravity, we don’t think any of these justify the poor choice of terminology!
Estimating the ROI of R&D investments is notoriously difficult
The nature of R&D expenditure makes it very difficult to determine an expected Return On Investment (ROI). This is especially true in case of basic research. Basic research is not specific to any particular product or application. Instead, the return primary comes in the form of accumulated knowledge, but how to put a price tag on that? Basic research may even result in a monumental breakthrough, but these things are impossible to predict. Applied research is more specific, and development even more so. However, even for these types of R&D, it’s still very hard to estimate the potential returns.
Some examples
- Large government-funded R&D projects that primary serve scientific goals such as the International Space Station,[15] the Large Hadron Collider,[16] the National Ignition Facility,[17] and many more.[18]
- Basic research done by universities.
- Military R&D projects.
- Companies doing R&D may research countless different ideas, and develop many different products (most of which will fail).
- New drug development, funded either by the government or pharmaceutical companies.
Commercial viability, spin-off technologies, and the social return of R&D
It’s often impossible to know upfront whether anything commercially viable or useful will come out of an R&D project. And the potential future revenue or value is even more difficult to predict. In some cases, the ROI may even come in the form of completely unexpected spin-off technologies or products. The internet is probably the most famous spin-off technology, but there are many other examples.[19][20] Especially with large government-funded R&D projects, it’s in many cases impossible to quantify the total benefits to society upfront. Models for measuring the social return to R&D investments do exist[21][22] but these may be more suitable to apply to whole industries or economies.
These challenges with determining the expected ROI of R&D are probably among the reasons why many tend to think of R&D investments in terms of “R&D spending” instead. And that feeling might be amplified by certain accounting principles, which brings us to the next section.
Accounting standards and tax considerations
R&D is often treated as an expense in accounting. And that is another factor in the R&D expenditure vs R&D investment terminology discussion. Consider the following 2 basic options:
- A company may expense all R&D instead of capitalizing any of it. Such a company can deduct all R&D costs from its profit before calculating tax.
- Alternatively, a company may capitalize an R&D investment. In that case, the company needs to amortize the total R&D cost over multiple years. For tax purposes, that means the company can only deduct a portion of the R&D costs from its profit in the year that the costs occur.
In many cases, businesses prefer option 1, to expense the full amount of an R&D investment. That way, they pay less taxes and improve their cash position. However, there may be situations where a business prefers to capitalize an R&D investment (option 2). When capitalizing, the profit comes out higher in the year that the costs occur. And a company might prefer that higher profit in order to impress potential investors or buyers. Another reason for capitalizing can be to show intangible R&D assets on the balance sheet. These would otherwise remain invisible (when fully expensed).[23]
Accounting and tax rules
So, can businesses always freely decide if they want to capitalize or expense an R&D investment? Not completely, because there are accounting rules, and also tax rules. The applicable rules differ wildly across situations, and depend for example on:[24]
- The country where a business is based.
- If the company is publicly listed or not.
- The applicable accounting standard, such as US GAAP or IFRS.
- Whether the investment concerns research or development.
- If intangible R&D assets were developed in-house or acquired.
Interestingly, the accounting standard a company follows need not always be the same as what the tax rules require. A relevant difference here can be the amortization method applied to the R&D expenditure (investment). For example, a company’s accounting standard may allow amortizing an R&D investment in 3 years while the applicable tax rules require amortizing it in 5 years.
What percentage of R&D expenditure (investment) is capitalized in practice?
Again, there are huge differences between countries but we did some R&D figure digging. Funnily enough, one of the world’s largest R&D spenders (Amazon) often doesn’t mention R&D in financial reports. They use the phrase “technology and content” instead.[25] Fun facts aside, it can be difficult to find exact R&D capitalization percentages as companies often don’t report such percentages specifically. Nevertheless, we found some relatively recent figures:
- Computer Weekly[26] reported in 2019 regarding the United States: many of the biggest R&D investors were software companies, and they tended to expend almost all R&D costs. Companies like Amazon, Alphabet and Meta (Facebook) capitalized less than 1% of their R&D.
- The findings differed for the United Kingdom: the top R&D spenders capitalized roughly around 40% of their R&D expenditure.
- In a different 2019 report,[27] ACCA found that the percentage of firms that capitalized R&D varied from just over 10% (India) to over 80% (Spain). Most of the countries in their study remained below 50%, with China sitting around the 25% mark. Notably, they didn’t include the US in this study as it focused on countries using IFRS.
One obvious observation is that R&D capitalization in the US is much lower than in most other countries. This is mainly due to the US GAAP vs IFRS rule differences. However, new US tax rules affect this. US businesses should capitalize R&D for the financial year 2022 and onwards (even though there is discussion to postpone or repeal this change).[28]
Expensing R&D has benefits but also results in a bad habit
For our purposes, the main observation from the previous paragraphs is that it’s an almost global phenomenon that more R&D is expensed than capitalized. And even if that seems to be changing in some countries, it certainly has been the habit for many years to treat R&D expenditure as expense for accounting (and tax) purposes. Treating it as such for tax purposes may incentivize companies to invest (more) in R&D. However, there is an important downside to expensing all R&D costs. It gets us in the habit of thinking about R&D in terms of expense rather than investment!
Obviously, (most) managers are not silly and understand that R&D is still an investment even if a company expenses its R&D costs. However, it’s not difficult to see that it still feels much more “real” when R&D costs are capitalized and amortized. Seeing those intangible R&D assets on a balance sheet makes it much more obvious that we invest in the future. Moreover, fully treating R&D as an investment by capitalizing it, constantly reminds us of the future-focused aspect of it.
In our view, the habit of expensing R&D costs very likely influences how people think about R&D. This applies to managers, politicians and the general public alike. It’s one of the reasons why many tend to think of R&D as an expense rather than an investment in the future. And the latter is of course exactly what it is! However, it’s difficult to maintain that attitude in a world where we focus so much on short-term results.
Short-termism and R&D expenditure (investment)
We live in a world where short-term goals are often the main focus. This “short-termism” is prevalent in business as well as politics. In business, the pressure for fast financial returns seems one obvious cause for short-termism. And while many argue that corporate short-termism hurts the economy,[29] there are those with a more nuanced view.[30] Also, some say that the short-termism problem is bigger in politics.[31] Politicians focusing too much on the short-term, it somehow sounds familiar!
What causes short-termism?
MacKenzie[32] discusses some main causes for short-termism in politics:
- Voters have a bias towards the short term and influence politicians accordingly. This argument simply assumes that we all have a cognitive bias towards the short term. Sounds familiar?
- Politicians have strong incentives to focus on the short term. For example, by focusing on relatively short-term projects, politicians can show voters concrete results.
- Wealthy individuals or businesses may put pressure on politicians to focus on certain short-term interests.
- Future generations don’t have a say in what we decide today, even though they will feel the effects of what we decide. This results in a bias towards the short term.
And while these points concern a political context, it’s not hard to see how most of these translate to a business context. Furthermore, the first point probably translates to almost any context. After all, even in daily live, isn’t it always tempting to focus on short-term pleasures rather than long-term results? In our view, we are all prone to short-termism and we must work hard to avoid it!
But what does short-termism have to do with R&D?
It’s no surprise that short-termism also affects R&D decisions. In fact, this point has been made by many.[33][34][35][36] It’s understandably tempting to cut R&D expenditure (investment) as one of the first things when there is a need to reduce costs. Also, and in line with the points made above, managers and politicians may often favor short-term R&D projects with lower but more certain returns.
For the various reasons explained above, we have a strong bias towards what happens now. Therefore, the present costs of R&D feel very real while the future benefits may feel remote or downright hazy. Hence, it’s not difficult to see how short-termism contributes to thinking of R&D in terms of costs/expense/spending rather than investing. It’s difficult to properly see R&D as an investment if you are mainly concerned with the period of time that ends well before you can see the returns!
So let’s stick with “R&D investment”, seriously!
You’ll now likely agree that a term like “R&D expenditure” doesn’t do right by our all-important R&D investments. So, we’ll wrap up with a few simple requests. Dear governments, businesses and other organizations, please:
- Don’t let the challenges around R&D ROI estimates discourage you.
- Don’t let accounting standards or tax rules confuse you.
- Don’t fall victim to short-termism.
- Don’t use terms like “R&D expenditure” or “R&D spending” so much.
Instead, please:
- Communicate trust in the outcome of R&D investments and refer to them as such.
- Stick with the term “R&D investment”!
And in the unlikely case that you still don’t agree, please read the first section of this article again.