Why Most Organizations Aren't Funding Innovation

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Why Most Organizations Aren't Funding Innovation

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Summary

Twelve official definitions for R&D. Zero agreement. The US government publishes at least a dozen distinct official definitions across agencies, accounting standards, tax authorities, and international bodies. Not one agrees with the others on where research ends and development begins. Trillions of dollars flow through R&D budgets every year. Boards approve them. Investors evaluate them. Governments subsidize them. Analysts benchmark them. And the term at the center of all of it has no settled definition. A company can gut its research investment without triggering a single alarm on its income statement. Researchers who gained rare access to confidential federal R&D data found exactly this: when companies face financial pressure, they cut research while leaving development essentially untouched, and the combined number barely moves. Every benchmark, every board conversation, every investment thesis built around the R&D line may be built on sand. Innovation, ideas made real, requires both. Research is how you find the idea. Development is how you make it real. Strip out the research and you're not innovating, you're iterating on what already exists. Strip out the development and you're just experimenting. The problem is that nobody in the room knows which one they're actually funding, because the definition that would tell them doesn't exist. Someone needs to draw the line. This episode is about why nobody has, and the definition I think should replace the chaos. By the end, I'm going to put that definition in front of you and ask you to push back on it. Not to agree. To tell me where it breaks. How We Got Here Four institutions took a run at defining R&D. Each one got it right for their own purposes. None of them got it right for yours. Frascati: Built for Governments In June 1963, OECD economists met at a villa in Frascati, Italy, south of Rome, and produced what became the international standard for measuring R&D across nations. Now in its seventh edition. The Frascati Manual divides R&D into three tiers: basic research (theoretical work with no application in view), applied research (original investigation toward a specific practical objective), and experimental development (using existing knowledge to produce new products or processes). To qualify, an activity must be novel, creative, uncertain in outcome, systematic, and transferable. Used by governments across roughly 75 countries. Solid for what it was designed to do: let nations compare R&D investment on consistent terms. What Frascati cannot tell you: whether a specific company's spending is creating competitive advantage. It counts the type of activity. It doesn't assess what the activity produces for the organization doing the spending. A company can satisfy every Frascati criterion investigating something every competitor already knows. The knowledge is new to them. That is enough. The accountants drew a different line, for a different reason, with a different consequence. FASB: Built for Accountants In October 1974, the Financial Accounting Standards Board issued Statement No. 2, Accounting for Research and Development Costs, now codified as Topic 730. Every public company filing under US GAAP operates under it. The rule: all R&D costs expensed as incurred. Research, development, basic, applied: one line on the income statement. Their definition: research is a planned search aimed at discovery of new knowledge. Development is the translation of research findings into a plan or design for a new product. The rationale is explicit in the original standard. Future benefits from R&D are, in FASB's language, "at best uncertain." Expense everything immediately. The standard solved the problem it was asked to solve, which was accounting treatment: when to recognize the cost, not whether the cost was strategically sound. The consequence: sustaining engineering, feature maintenance, and incremental product updates all land on the same line as genuine exploratory research. Nobody looking at the income statement from outside can see the difference. The number is technically accurate and analytically opaque. Abraham Briloff, the late accounting professor at Baruch College, put it plainly: "Accounting statements are like bikinis. What they show is interesting, but what they conceal is significant." He was talking about financial reporting broadly. He could have been writing specifically about the R&D line. Researchers at Duke and London Business School spent years tracking corporate scientific output and found that it declined steadily across industries even as headline R&D spending kept rising. The combined number was hiding a substitution. Nobody on the outside could see it. Outside the United States, a different standard governs, and it creates a comparison problem most analysts never account for. IFRS: Built for International Investors IAS 38 governs R&D under IFRS, and its treatment differs from FASB in one significant way. Research costs are ...

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