Title

The Market-Implied Economic Lives of Advertising Expenses and R&D Expenses

Department

Economics, Finance, & Quantitative Analysis

Document Type

Article

Publication Date

8-2005

Abstract

Advertising expenses and research and development expenses are typically treated as operating expenses that affect current income. Managers often view advertising expenses and research and development expenses as costs and have difficulty identifying any associated benefits. However, they both may be capital expenses (investments) in the sense that they generate benefits over multiple periods affecting future income, future cash flows, and the current market value of the firm (Chauvin and Hirschey 1993; Graham and Frankenberger 2000; Han and Manry 2004; Kim and Morris 2003). Advertising expenses may have multi-period effects because they provide information, increase customer awareness, create communication channels for customers, produce differentiation, and build brand name and brand image. Research and development expenses have multi-period effects because they produce proactive and reactive repositioning that restructures competitive advantages in the marketplace. From a financial valuation perspective, the generally accepted measures of earnings, cash flows, and invested capital should be adjusted to reflect the extent to which advertising expenses and research and development expenses are capital expenses (investments) as opposed to being operating expenses (current costs). Advertising expenses and research and development expenses should be capitalized to reflect how long it takes for them to be converted into revenue streams that affect the market value of the firm (Damodaran 2002). These lengths of time are referred to as the economic lives of advertising expenses and research and development expenses. Their economic lives are measures of the time involved in converting these expenses into revenue and how long they affect the market value of the firm. Advertising expenses and research and development expenses should be capitalized and amortized on the basis of the respective economic lives. Invested capital should be increased by the amount of unamortized capitalized advertising expenses and research and development expenses. Operating income should be increased by current advertising expenses and research and development expenses and should be decreased by the current amortization of the capitalized advertising expenses and research and development expenses.

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