For these reasons we do not advise routinely creating

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For these reasons, we do not advise routinely creating pro forma net income and balance numbers by capitalizing and amortizing R&D expenses. (An exception might be for
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growth companies that have yet to reach a steady level of R&D outlays, for companies with product breakthroughs, and for companies that require financial comparisons to IFRS-com- pliant reports.) Further, for companies that spend about the same amount each year on R&D. the income statement adjustment would be small. To see this, recall our example above: if the company spends $100 on R&D each year, then after five years, the amortization of previously capitalized amounts will be $100 (5 X $20) which is exactly the same as the R&D expense itself. However, the balance sheet adjustment can be more substantial as the R&D asset i "missing" entirely from the GAAP balance sheet (in the same way that benefits from the pay- ment of wages or advertising are missing). Hence, when we compute ratios that involve income and assets (such as ROA or RNOA) or income and equity (such as ROE), the effects of expens- ing R&D are likely to overstate such ratios (from the absence of R&D assets in balance sheets). A similar conclusion is reached in a recent study (Danielson and Press, "When Does R&D Expense Distort Profitability Estimates?" Journal of Applied Finance, 2005): 5-15 Module 5 I RevenueRecognitionand OperatingIncome ... the accounting and finance literatures provide no guidance as to when potential distortion in accounting-based return measures makes an adjustment necessary. The expensing of R&D costs affects both the income statement and balance sheet, and therefore has an uncertain impact on a firm's accounting rate of return. It is possible for the income statement and balance sheet errors to cancel out-resulting in a small difference between adjusted and unadjusted accounting rates of return-even for a firm with high R&D costs. Thus, it is not obvious when complex and time-consuming adjustments for historical R&D costs are an essential step in a profitability analysis. The study concludes that: "unadjusted ROA and adjusted (for R&D costs) ROA typically rank firm profitability in a similar order. Thus, unadjusted ROA is a reasonable proxy for firms' under- lying economic profitability in many research applications, and complex adjustment procedures are often unnecessary." Consequently, what analysis and/or adjustment for R&D expenses should we implement'. Unfortunately, there is no simple computational adjustment. Instead, we begin our quantitative anal- ysis by comparing common-sized R&D expenditures over time and across companies in the same industry (see Business Insight below). Differences in R&D outlays and marked departures from industry benchmarks call for further analysis. For our qualitative analysis, we look to the MD& section of the lO-K, along with external sources of information, to gauge the effectiveness of the company's R&D efforts. Pharmaceutical companies typically disclose the drugs under developmenr ("pipeline") as well as newly patented drugs. Wecan also evaluate new product introductions result-
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