Research & Development Spend - Understanding the Software That Is Eating Us
Before we dive into the critical judgements of R&D spending, we need to understand the distinction between what is defined as ‘Research’ and what is defined as ‘Development’. In this article we explore Expensing Vs Capitalising, Development Spend Trajectory, Changes in Accounting Estimates for Development Spend as well as Valuation & Return Analysis.
In 2011 it was famously said by Marc Andreessen of famed venture capital firm Andreessen Horowitz that ‘software is eating the world’. There is no denying that we live in a world where every aspect is increasingly being underpinned by technology.
Arguably the best way to conceptualise what is underpinning technological advancements is through Moore’s Law; being the approximate doubling of computer chip power every two years. First predicted in 1965, this has largely held true since that time.
As Moore’s law continued over time, computer processing power has become exponentially more powerful, whilst the cost of computing becomes exponentially cheaper. The ramifications of this for use cases of technology means that it has never been easier for a software company to invest and innovate in a cost-effective manner.
Juxtaposing this is that with the rate of technological change so significant, software companies need to constantly reinvest, iterate, and improve to not only maintain a competitive advantage but perhaps more importantly, stave off obsolescence.
"A company shouldn't get addicted to being shiny, because shiny doesn't last." Jeff Bezos
How do software companies maintain their relevance in order to stay ahead? The answer can be partly attributed to continual spending on research and development (R&D). This is typically in the form of allocating capital to the software engineering teams within the organisation to achieve things such as (but not limited to):
• Undertake integrations with third party software;
• Release updated versions of existing software;
• Develop new products, tools and solutions;
• Improving their users’ experiences/customer interfaces;
• Fortifying data & cybersecurity;
• Investing to efficiently scale up operations; and
• Streamlining customer onboarding.
R&D spend is an important factor to consider when undertaking any fundamental analysis of a software company. While there are many aspects to analyse, we have outlined four of the common critical judgements (in addition to a Company determining how much capital it should allocate to this function).
Before we dive into the critical judgements of R&D spending, we need to understand the distinction between what is defined as ‘Research’ and what is defined as ‘Development’.
Research spending* is defined as:
“Original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.”
Development spending* is defined as:
“The application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use.”
There are two distinct accounting judgements for development spend in which a software company may apply in reflecting the capital allocated. They are expensing and capitalising.
• Expensing = the development spend will be recognised in the income statement as it is incurred.
• Capitalising = the development spend will be recognised as an intangible asset on the balance sheet and then amortised as a charge to the income statement evenly over the useful life of the asset.
Accounting standards preclude Research from being capitalised (i.e. it will always be expensed), whereas accounting standards do allow for Development spending to be capitalised.
For development spending to capitalised it must meet the abovementioned development spending definition in addition to meeting various other criteria primarily relating to a company’s ability to generate future economic benefits from this development spend.
Figure 1: Development Spend Treatment
Applying judgement across the internal decision a company makes in relation to expensing vs capitalising is critical to understand. In theory two companies with the same type and quantum of spend on development costs may in fact treat that spend very differently. We are not stating a viewpoint on the accounting treatment, however the illustration below of a theoretical comparison between Expense Co vs. Capitalise Co will highlight how differing classifications of development spending can impact the financial presentation of software companies.
Figure 2: Information on Expense Co. Vs. Capitalise Co.
For simplicity in the below table, we have assumed 100% of Development spend is either expensed or capitalised, however, in many cases businesses may recognise a proportion of Development spend which meets the recognition requirements (i.e. capitalised treatment), while the remaining spend is charged to the Income Statement immediately along with Research costs (i.e. expensed treatment).
Figure 3: Income Statement of Expense Co Vs. Capitalise Co in Year 1
What are the key observations from the above table?
Despite the same financials, Capitalise Co. appears to have a substantially higher EBITDA & EBIT than Expense Co. However, as the development spend for Capitalise Co. is (as the name suggests) capitalised, its Income Statement does not fully recognise a material component of its cost base.
To gauge a more comprehensive understanding of bottom-line performance and free cash flow generation we must also look at the cash flow statement. We have assumed both companies convert EBITDA to Group Operating Cash Flow at 100% and that all Capitalised Development Spend is then subtracted in order to calculate free cash flow. We can see below that the free cash generation is in fact the same for both companies despite the divergent accounting treatment.
Figure 4: Cash Flow Statement of Expense Co Vs. Capitalise Co
We now turn our attention to the balance sheet to fully comprehend where this development spend has been allocated to. Given Capitalise Co. has not recognised the full allocation of Development costs within their Income Statement, it therefore must do so on their Balance Sheet through the creation of an intangible asset.
On the other hand, Expense Co. have done the opposite hence they do not recognise an intangible asset on their Balance Sheet. This in turn results in the total assets and total equity for Capitalise Co. being significantly higher than that of Expense Co. All other items are assumed to be equal.
Figure 5: Balance Sheet of Expense Co Vs. Capitalise Co in Year 1
2. Development Spend Trajectory
It is commonplace for software companies to continually increase their level of development spending over time. Reflecting on the ‘software eating the world’ analogy mentioned at the outset, and the resulting need for software companies to constantly invest and innovate to maintain relevance, this continual increase in spending is unsurprising.
We often see many software companies budget their level of R&D spend to represent a percentage of their revenues (e.g. development spend at 20% of revenue). As revenues increase, the dollar value of development spending should increase in lockstep with revenue growth.
Recall that in our theoretical example, both Expense Co. and Capitalise Co. expect to see their Development spend increasing by $50 a year over a 5-year period (see Figure 2). The below table summarises this.
Figure 6: Development Spending 5-Year Profile
Recall that when Development spend is capitalised it is recognised as an intangible asset and amortised over its expected useful life (assumed to be 5 years in this example). If we refer to the below (Figure 7), we can see how this increased Development spending flows through to the amount that is amortised as well as the value of the intangible asset created on balance sheet.
Figure 7: Development Spending 5-Year Profile
From the above, there is a substantial increase in expenses recognised (through amortisation) in the Income Statement of Capitalise Co. as can be seen in column (4) growing from $60 in year 1 to $400 in year 5. In addition, after 5-years we have a $900 intangible asset recognised on the balance sheet as can be seen in column (5).
For Capitalise Co. in Figure 8 above we see 1/5th of the current year spend and 1/5th of the spend incurred in prior years (for all years within a 5 year look back range). The increasing spend per year takes multiple years in Capitalise Co. to catch up to the actual level of spend occurring each year (assuming a continuous increase in spend beyond Year 5).
For Capitalise Co. in effect the current year amortisation charge is ‘benefitting’ from lower spend in previous years. This ‘drip feeding’ of amortisation through the income statement will still see Capitalise Co. income statement showing a higher EBIT margin than Expense Co. during periods of increased development spend than if the full impact of the current year’s Development spend is expensed. Conversely in periods of declining Development spend, it will take a period of time for the amortisation profile to run down in Capitalise Co., while Expense Co. will see an immediate benefit to bottom line performance.
Figure 9: Changes in Development Spending Summary
3. Changes in Accounting Estimates for Development Spend
From time to time, a Company may change their accounting policy or estimates in relation to development spend either because of:
• Internal factors – for example change in the estimated useful life or ceasing to commercialise a specific product; or
• External factors – for example a product doesn’t meet the needs of the market any longer.
The change in estimates or policy could include switching from expensing to capitalising of development spend, or vice versa.
Why do companies make such a change?
• When moving from expensing to capitalising it may typically be relevant if a company is building a new software platform, module or solution for which they believe will generate future economic benefits.
• When moving from capitalising to expensing, it may typically involve a Board or management team taking the view that there is uncertainty in obtaining future economic benefits from the software, or a software platform is considered to be sufficiently built out, and only incremental upgrades are occurring from now on which don’t meet the recognition criteria to capitalise.
Why is this change important from an investor standpoint? It adds further complexity in our analysis of the income statement. While we can’t cover off every variable, we will analyse the holistic impacts of each of these changes below:
• Moving from Expensing to Capitalisation of Development Spend
While development spend continues to be completely expensed as incurred there is no amortisation impact on the income statement. If in Year 1 expensing is switched to capitalising, development expenditure is removed from the income statement however only the impact of year 1’s amortisation is seen resulting in a level of amortisation artificially lower than the true economic cost.
On continuation of the 5-year amortisation schedule used above, then from year 2-5, the total amount of amortisation will grow. On the change to capitalising, it will take 5 years to ‘wash through’, that is, for the P&L to recognise the cumulative amount of amortisation that matches the economic cost. EBITDA will be positively impacted through the capitalisation whilst EBIT and NPAT will be higher than they would otherwise be if development spend had always been capitalised (for the previous 5 years).
• Moving from Capitalisation to Expensing of Development Spend
When adopting this change, the reverse of the above is true. The decision to expense previously capitalised development spend will take time for the amortisation amount associated with the previous years of capitalised development spend to ‘wash though’ resulting in a level of amortisation artificially higher than the true economic cost.
EBITDA will be negatively impacted as the previously capitalised development is now being recognised as an operating expense whilst EBIT and NPAT will also appear lower than they would have otherwise been if development spend had always been expensed (for the previous 5 years).
It is also worth pointing out here that, in some cases, a Company may have capitalised development spend that no longer meets the recognition criteria either to be capitalised. In such case, the Company is required to not only expense that development spend on a go forward basis, but also expense previously recognised development costs immediately. While this can have a material impact in the year of change, the ultimate benefit is that the Company removes the need to continue to amortise the spend over future years.
4. Valuation & Return Analysis
In the above analysis we have laid out the different impacts upon the income statement, cash flow statement & balance sheet that the accounting treatment of development spend can have, not only today but over time. Given these three statements are fundamental to analysing any company, it is therefore logical to assume that how we interpret a software company’s financials will be impacted by this accounting decision.
If we undertook the exercise of valuing our theoretical software companies using an EBITDA multiple of 10x then we can see how different they can appear. Is Capitalise Co. really worth 2x that of Expense Co. simply based on its accounting policy choice? Of course, it should not be. In a perfect world, they would likely be valued the same.
Figure 10: EBITDA Valuation of Expense Co vs. Capitalise Co.
In addition to valuation metrics, return metrics are also an important measure of a Company’s financial strength. If large intangible assets are created on balance sheets through capitalisation of development spend, this will impact how profitable a company appears and thus also significantly affect the return on equity (ROE) and return on assets (ROA) metrics. Free cash flow generated will provide the greatest level of transparency as this captures all development spending regardless of accounting policy choice.
Figure 11: Return Analysis of Expense Co vs. Capitalise Co.
The below summary table highlights the differences when comparing Expense Co Vs. Capitalise Co. when Expense Co. expenses 100% of its Development spending, whilst Capitalise Co. capitalises 100% of its Development spending (as highlighted in Figure 2)
Figure 12: ‘Cheat Sheet’ Summary of Expense Co vs. Capitalise Co.
The examples used in this article are simplistic by design. Often companies will adopt a hybrid approach when it comes to capitalising and expensing because the ability to capitalise is assessed on an individual asset basis and there are varying amortisation periods for their development assets given different estimated useful lives.
Expensing and capitalising are two very distinct accounting policies for development spend set out within accounting standards. The application of these definitions requires an element of judgement. These judgement calls fall to management, the Board and the Company auditors and include the following:
• How to we determine what is treated as ‘Research’ Vs. what is ‘Development’?
• Does our Development spend meet the recognition criteria in the first instance?
• Will the Development spending deliver future economic benefits to the Company in the future?
• How many years will we deem the ‘useful life’ of this intangible asset and therefore its amortisation profile?
Despite being perfectly acceptable under accounting standards, we would argue the ramifications of capitalisation of development spend creates complexity for investors when it comes to comparing apples with apples. If all companies treated development spend in the exact same methodology, then we would be able to compare, however it is simply not the case. We would argue that expensing all R&D spend creates a ‘cleaner’ picture of a Company’s operating performance as well as its cash generation and financial position.
There are many aspects required to consider when looking at a company. R&D spending is just one of the many ways we at NAOS analyse a company and by no means provides a complete understanding of company. With software now ever-present in our lives and it continuing to ‘eat the world’, understanding the above factors will continue to be an important part of our investing toolkit for many years to come.
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