Accounting rules for R&D result in companies and nations under investing in research and development. Since increases in real per capita income are the result of increases in our level of technology, this accounting error actually results in all of us being poorer. The point of R&D is to create inventions, whether products or processes, that are useful. R&D that does not result in inventions may be interesting intellectually, but does not increase our wealth- so the rest of the post will discuss investments in inventions as opposed to the more nebulous concept of R&D.
Creating an invention without obtaining legal title to the invention is like building an office building without obtaining title to the land and building. Without legal title to the office building, you cannot finance the building, sell the building, or lease the building. In other words, without legal title to the office building its economic value is significantly reduced. The same is true of inventions. Inventing something without obtaining legal title to the invention means that you cannot license (lease) the invention, cannot sell the invention, and cannot finance the invention.
There are couple of ways to obtain title to an invention. You can either obtain a patent on the invention or you can keep the invention a trade secret. Many inventions are not amenable to trade secret protection. As a society, it is better if people obtain patents instead of keeping their inventions a trade secret, since a patent allows other people access to the knowledge associated with the patent, allowing them to use this knowledge to build other inventions.
The present accounting rules for the costs in creating an invention and obtaining title to the invention result in an immediate expensing of these costs. While this may be helpful from a tax point of view, it causes these costs to appear superfluous. Note that the rest of this post is concerned with accounting as an accurate measurement tool for the operations of a business and is not concerned with tax law, which has caused so many perversions to accounting and business generally. Our present accounting systems never show internally funded inventions produce any value.
For example, assume a new cellular telephone that was the result of millions of dollars of investment in numerous inventions, only shows a return on the assets associated with the manufacturing process. Nowhere do our present accounting systems show a return for the R&D expenses. However, without the R&D expenses to produce the inventions on which the new cellular telephone was built, there would not be the new cellular telephone. Note there is one exception to this scenario above, which is if the inventions were licensed or purchased from an external entity. In the case of externally purchased or licensed inventions, there is a cost associated with each cellular telephone produced. However, our accounting systems do not show if there is a return associated with the purchase (license) of these inventions since our present accounting systems do not have a way to show what the value of the product is without the inventions or compared to the costs of internally developing the alternative inventions.
Externally funded inventions look expensive since there is a cost for each product produced with the invention, but no way of determining a return for that expense. These errors in our accounting systems result in a number of problems. The most glaring problem is that expenses associated with creating inventions appear to have no return and therefore there is significant under-investment in inventions. As Nathan Myhrvold puts it, inventing is funded under a charity model. Governments and CEOs spend money on the hope that it will provide a return, but since they have no standard accounting mechanism of determining a return on this investment, it is just charity. This also causes companies to over value their manufacturing processes. Companies have no idea what their real return is on their manufacturing processes since they treat the cost of the inventions as if they were free. As a result, these companies cannot make an intelligent decision on whether to manufacture a product using the inventions or whether they should license their technology to another entity.
Another problem these accounting errors contribute to is the “Not-Invented-Here” (NIH) problem. Since internally funded inventions appear to be free, externally purchased or licensed inventions look expensive in comparison. This causes reluctance on the part of many companies to license other entities’ technologies. Another problem that results from our flawed accounting systems, is that brilliant engineers and scientists (inventors) are forced into management in order to obtain pay raises. Since our accounting systems show no value being derived from brilliant inventors, they are significantly underpaid and forced to move into management to obtain raises. This is bad for the company, since these brilliant inventors provide more value being inventors than managers. To some short sided CEO’s the whole invention and patent process appears to just be a tax necessary to enter a market without providing any real value. While they are clearly mistaken, if they rely on their accounting systems to explain what is happening in their business then this would appear to be an accurate picture.
So, how do we fix our accounting systems so they accurately reflect the value of investments in inventions? Since I am not an accountant, I am not going to pretend I have the whole answer. The basis of any solution should be to require a licensing fee from the manufacturing operation to the R&D operation of any company. This licensing fee should only be associated with inventions that have legal protection, since there is no justification for paying a fee for technology that is freely available. The fee must be paid for all inventions that the product uses and for any inventions the manufacturing operation wants to reserve for follow-on products. In addition, the manufacturing operation should pay a license fee for any other intellectual property it uses, such as trademarks and copyrights. When the value of these licenses is calculated on a discounted cash flow basis it should be compared to the company’s intangible assets value (as determined by the market value of the company) to provide a sanity check on these valuations. Most companies today have around 75% of their value in intangible assets. (see Why Investors Should Pay Attention to the Bilski Decision) These assets do not show up on a company’s balance sheet. That we accept an accounting system not accounting for over half of companies’ value is gross negligence.
Modifying our accounting systems to track the value of inventions and other intellectual property would show the value of these assets, result in them not being wasted, and increase investment in R&D. This would also provide a rational basis for a company to decide whether to use their inventions to manufacture a product or license the inventions to another entity or purchase another entity’s technology. This would help eliminate the NIH (Not-Invented-Here) syndrome. It would also encourage active trading of inventions, resulting in brilliant inventors not being forced into management in order to obtain meaningful pay raises. It would also make clear to CEOs that investing in inventing is not charity, but key to their business success. But, most importantly we would all be wealthier, since it would reduce under investment in inventions.
If you want to read more, the book The Invisible Edge: Taking Your Strategy to the Next Level Using Intellectual Property takes on this issue. Also, see the post Do Accounting Rules Discourage Research & Development? By Michael Sack Elmaleh.
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