This week’s shoot-the-shit is on the 14th comprehensive revision of the national income and product accounts (a.k.a. GDP). GDP, as you all know, is a measure of the output of the economy. Last year, 2013, the Bureau of Economic Analysis, which is part of the U.S. Department of Commerce announced the 14th comprehensive revision to GDP. The revision expands the intellectual property account to include expenditures for research and development (R&D), entertainment, literary, and artistic originals under the assumption they provide long-lasting service to the businesses, nonprofit institutions, and government agencies that use them. Why is this important to know?

First it adds to GDP, and in part accounts for the larger GDP estimates in the 3rd and 4th quarters of 2013 and those throughout 2014. I don’t want to give you the impression that I oppose these changes but I am disappointed that it was not verbalized in the media. In fact, I don’t believe there was any discussion at all. I may be wrong on that, and if so I stand corrected, but, we, as consumers, businessmen and citizens need to understand the change and the corresponding increases in the GDP estimates. These changes will be less important going forward but for 2013 and 2014 they are relevant especially in understanding why we are seeing GDP estimates of 3 and 4 percent yet unemployment is still at 5.8%.

The second important point to get a handle on, because it’s one that impacts a large number of businesses is the treatment of R&D expenses going forward.

Business transactions have a financial treatment and a tax treatment. Currently, the financial accounting treatment of R&D expenses is to recognize 100% of R&D as period expenses. Let’s say that in 2014 you had $1,000,000 of gross income and incurred $350,000 of R&D expenses. Your net income for the accounting period is $650,000. This is the income that would be reflected on your profit and loss statement.

For tax purposes, you can take 100% of all R&D expenses in the current tax year, or you can depreciate R&D expenses over any period of time up to 60 years.

1. In the first example you have  gross income of $1,000,000 and R&D expenses of $350,000 so your taxable income is $650,000.
2. In the second example, you decide to amortize R&D over a 10 year period using a straight line method.  The yearly deduction you can take is $350,000 / 10 = $35,000. So, for the current tax year, your gross income is $1,000,000 and your R&D expense is $35,000, so your taxable income is $965,000.

Under the 14th comprehensive revision , a business would have to carry R&D as an asset that would then be depreciated using some formula. Your balance sheet would increase year over year by the amount of continued R&D investment net of current period depreciation. I’m not sure if the Financial Accounting Standards Board has a pronouncement to deal with the change, so I’ll need to research that. However, for tax purposes, it is quite likely that you will lose the ability to deduct 100% of R&D expenses in the tax year incurred. So plan on depreciating accumulated R&D expenses and the associated higher taxable income.

So, here’s the net effect of the change.

1. On your financial statements you’ll have an increase in assets and increase in income. On your statements of cash flows the only net change you’ll see is an increase in taxes. (this is all assuming FASB goes along with a corresponding change to financial statements to accommodate the BEA change)
2. On your tax returns you will report a larger taxable income and will therefore incur a larger tax liability all other things being equal.
3. Wall Street will love it because they’ll be able to bid up stocks prices.

Here is my question….

With this change, R&D expenses went from intermediate inputs to output. When companies incur R&D expenses, they do so to produce a product, service or technology that is sold or licensed at some point in time; those are the real outputs of a business. Those outputs are captured in  the GDP accounts when they occur. So, adding accumulated R&D balances to intellectual asset accounts in calculating GDP creates, at least in my mind, the potential for distorting income and balance sheet asset valuations. I honestly don’t see a compelling need for this change and quite frankly I’m still trying to digest entertainment and literary works. But, the 14th change is here, so sit down with your accountant, CFO and or comptroller and run it past them just to make sure you understand the implications for your business. It’ll be time well spent!

Send us your questions and or comments.

Have A Great Weekend Everybody!