A significant shortcoming of accounting statements is the way in which research and development expenses are treated. Using the rationale that the products of research are too uncertain and difficult to quantify, accounting standards have evolved requiring all R&D expenses to be expensed in the period in which they occur. This has several consequences but one of the most profound is that the value of the assets created by research do not show up on the balance sheet as part of the total assets of the firm. This, in turn, creates ripple effects for the measurement of capital and profitability ratios for the firm.
We would argue that research expenses, notwithstanding the uncertainty about future benefits, should be capitalized. To capitalize and value research assets, we first need to make an assumption about the amortizable life of these assets. This life will vary across firms and reflect the commercial life of the products that emerge from the research. To illustrate, research and development expenses at a pharmaceutical company should have fairly long amortizable live, since the approval process is long and so is the patent protection granted for products that emerge from the research. In contrast, research and development expenses at a software firm, where products tend to emerge from research much more quickly and have shorter commercial lives, should be amortized over a shorter period.
Once the amortizable life of research and development expenses has been estimated, the next step is to collect data on R&D expenses over past years ranging back to the amortizable life of the research asset. Thus, if the research asset has an amortizable life of 5 years, the R&D expenses in each of the last five years has to be obtained. For simplicity, it can be assumed that the amortization is uniform over time, which leads us to the following estimate of the residual value of research asset today:
Thus, in the case of the research asset with a five-year life, we cumulate 1/5 of the R&D expenses from four years, 2/5 of the R & D expenses from three years, 3/5 of the R&D expenses from two years ago, 4/5 of the R&D expenses from last year and this years entire R&D expense to arrive at the cumulated research asset.