Strategic Investment
GAAP rules require all spending to be expensed or capitalized depending on the activities giving rise to that spending or the assets being acquired. For example, spending on research and development is charged as an expense to current period income. Spending on laboratory equipment supporting R&D is capitalized and depreciated over the expected useful life of the equipment. Spending on construction of an R&D facility is capitalized during the period of construction (as construction-in-progress) and depreciation begun only after the facility has been completed and brought into service.
Acquisition spending may involve a spectrum of treatments ranging from certain integration costs that are charged to expense (sometimes before cash is even spent) to goodwill that is capitalized and amortized over forty years.
While it is a GAAP principle to match costs and revenues over reporting periods, a competing GAAP principle is conservatism. Conservatism creates a strong bias toward understating the assets in the business and, therefore, overstating current period costs in the belief that this will protect investors from fraudulent reports that overstate the value of an investment. Conservatism tends to overwhelm accounting considerations on the treatment of many investments.
Economics of Strategic Investments
Value is created whenever a dollar spent on a project yields more than a dollar of benefit. More formally, value creation occurs when the net present value (NPV) of a project net cash flow is positive.
While useful for capital budgeting, the "NPV" view is useless for managerial reporting purposes.
Reporting occurs period-to-period using historical data. In a period-to-period view of the business, value is created when project revenues exceed the "total cost" of the project in every period. "Total cost" is can be defined as comprising of three elements:
(a) cash operating costs,
(b) non-cash depreciation of wasting assets, and
(c) a capital charge on the undepreciated balance of net assets.
Revenue net of "total cost" for a project is the project's EP (or, more precisely, the project's contribution to business unit EP). The present value of EP (the same result as NPV of cash flow) provides a decisive indication of value creation.
Positive project EP from the first reporting period onward also provides a decisive indication of whether or not a project is creating value. In fact, even if EP is slightly negative in the project's earliest phase, one can still be confident that the project creates value if EP is positive thereafter.
EPs ability to indicate value creation becomes undermined when income significantly lags investment.
The lagging pattern of EP is typical of strategic investments such as new product development, new ventures, or acquisitions. These situations, where the present value of EP is positive, but EP itself is negative in early years, can create an unproductive bias toward disinvestment if they are not resolved.
Behavioral Impact
Since managers can only be objectively judged on results reported from prior periods, they may be reluctant to invest in value creating projects with negative early year results. Of course, value creation for projects with lagging returns may not be known by anyone until returns actually materialize. This would make a "wait and see" policy plausible for management as well as shareholders.
However, managers may also be reluctant to commit investments on projects where returns are remote only in time, not in likelihood. In such cases, the shareholders could very well see their returns "up front" in the form of rising share prices upon announcement of a value creating investment. Managers, meanwhile, would be stuck with negative EP in the early years and would have to wait around until EP goes positive before getting meaningful recognition for their investment.
We can overcome management's reluctance to invest in such projects by excluding the investment from all costs being reported. However, ignoring costs for reporting purposes will lead managers to care less about those costs, undermining accountability for strategic investments. This, of course, poses the opposite problem, i.e., an unhealthy bias toward over-investment.
Thus, the basic behavioral issue that confronts us with strategic investments is this: How can we encourage investment in value creating projects with lagging returns while maintaining accountability for that investment over the life of the project?
Alternative Treatments
From an EP perspective, the appropriate treatment for any investments depends on the pattern of income expected for that investment. If income is expected to materialize within a year of the spending, but the spending is being expensed in the current year, then it may be enough to just capitalize the expenditure and amortize it over the life of the project.
If an appropriately capitalized and amortized expenditure is still expected to result in negative early year EP and positive later year EP (with the present value of EP expected to be positive), then an additional adjustment may be necessary to encourage investment.
Before explaining this strategic investment adjustment, though, letÂ’s look more closely at treatments already discussed to see if there are any circumstances in which they may be appropriate.
Option 1 - Ignore early negative EP
Option 2 - Exclude project results from business unit results
Option 3 - Capitalize early year expenditures and their carrying cost
Option 3a - Capitalize all early year EP losses and their carrying cost
