What are research and development expenses

Research and development expenses are generally considered to be operating expenses by accountants. Based upon our categorization of capital and operating expenses, would you consider research and development expenses to be a. operating expenses b. capital expenses c. could be operating or capital expenses, depending upon the type of research being done.


2. Non-Cash Charges

The distinction that accountants draw between operating and capital expenses leads to a number of accounting expenses, such as depreciation and amortization, which are not cash expenses. These non-cash expenses, while depressing accounting income, do not reduce cash flows. In fact, they can have a significant positive impact on cash flows, if they affect the tax liability of the firm. Some non-cash charges reduce the taxable income and the taxes paid by a business. The most important of such charges is depreciation, which, while reducing taxable and net income, does not cause a cash outflow. Consequently, depreciation is added back to net income to arrive at the cash flows on a project.

For projects that generate large depreciation charges, a significant portion of the cash flows can be attributed to the tax benefits of depreciation, which can be written as follows

Tax Benefit of Depreciation = Depreciation * Marginal Tax Rate While depreciation is similar to other tax deductible expenses in terms of the tax benefit it generates, its impact is more positive because it does not generate a concurrent cash outflow.

Amortization is also a non-cash charge, but the tax effects of amortization can vary depending upon the nature of the amortization. Some amortization, such as the amortization of the price paid for a patent or a trade mark, are tax deductible and reduce both accounting income and taxes. Thus, they provide tax benefits similar to depreciation. Other amortization, such as the amortization of the premium paid on an acquisition (called goodwill), reduces accounting income but not taxable income. This amortization does not provide a tax benefit.

While there are a number of different depreciation methods used by firms, they can be classified broadly into two groups. The first is straight line depreciation, whereby equal amounts of depreciation are claimed each period for the life of the project. The second group includes accelerated depreciation methods such as double-declining balance depreciation, which result in more depreciation early in the project life and less in the later years.

3. Accrual versus Cash Revenues and Expenses

The accrual system of accounting leads to revenues being recognized when the sale is made, rather than when the customer pays for the good or service. Consequently, accrual revenues may be very different from cash revenues for three reasons. First, some customers, who bought their goods and services in prior periods, may pay in this period; second, some customers who buy their goods and services in this period (and are therefore shown as part of revenues in this period) may defer payment until future periods. Finally, some customers who buy goods and services may never pay (bad debts). In some cases, customers may even pay in advance for products or services that will not be delivered until future periods.

A similar argument can be made on the expense side. Accrual expenses, relating to payments to third parties, will be different from cash expenses, because of payments made for material and services acquired in prior periods and because some materials and services acquired in current periods will not be paid for until future periods. Accrual taxes will be different from cash taxes for exactly the same reasons.

When material is used to produce a product or deliver a service, there is an added consideration. Some of the material that is used may have been acquired in previous periods and was brought in as inventory into this period, and some of the material that is acquired in this period may be taken into the next period as inventory.

Accountants define net working capital as the difference between current assets (such as inventory and accounts receivable) and current liabilities (such as accounts payable and taxes payable). Differences between accrual earnings and cash earnings, in the absence of non-cash charges, can be captured by changes in the net working capital.

In Practice: The Payoff to Managing Working Capital Firms that are more efficient in managing their working capital will see a direct payoff in terms of cash flows. Efficiency in working capital management implies that the firm has reduced its net working capital needs without adversely affecting its expected growth in revenues and earnings. Broadly defined, there are four ways in which net working capital can be reduced:

1. While firms need to maintain an inventory to both produce goods and meet customer demand, minimizing this inventory while meeting these objectives can produce a lower net working capital. In fact, recent advances in technology which allow for just-in-time production have helped U.S. firms reduce their inventory needs significantly.

2. Firms that sell goods and services on credit can reduce their net working capital needs by inducing customers to pay their bills faster, and by improving their collection procedures.

3. Firms can also look for suppliers who offer more generous credit terms since accounts payable can be used to finance inventory and accounts receivable.

4. Firms that need cash for operational reasons can reduce their net working capital by keeping this cash balance to its minimum.

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Lessons From The Intelligent Investor

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