When Does R&D Expense Distort Profitability Estimates?

Abstract:     
Financial analysts and researchers use accounting-based measures of profitability to assess the past performance of firms and as a starting point in forecasting future performance. Research and development costs can distort profitability measures because firms are required to expense R&D immediately, even if the investment creates future benefits. This article introduces a new model identifying two observable firm characteristics that must both be present for R&D costs to distort return on assets (ROA): large R&D expenditures and a sizable difference between ROA and the firm's growth rate. Because these conditions typically do not occur together, there is frequently little difference between unadjusted ROA and ROA estimates obtained by reversing, capitalizing, and depreciating historical R&D costs, and the two ROA measures produce similar rankings of firm profitability. Our approach identifies cases for which unadjusted ROA could be misleading, letting analysts and researchers target these firms for further analysis.

Number of Pages in PDF File: 17

JEL Classification: G31, M21, M41

Accepted Paper Series