Why Most Organizations Aren't Funding Innovation

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 always expensed, same as FASB. But development costs can be capitalized as an asset on the balance sheet once a company can demonstrate technical feasibility, intent to complete, ability to use or sell the result, likely future economic benefit, adequate resources, and reliable cost measurement.

A European company that capitalizes its development phase carries those costs as an asset: lower expenses in the period, higher total assets. An identical US company expensing everything under FASB takes the full hit immediately: higher expenses, lower assets. Same underlying investment. Incomparable financial pictures.

Run the standard industry benchmark, R&D as a percentage of revenue, and you may conclude the US company is investing more aggressively. You may be comparing the same dollar invested under two different accounting regimes. Roughly 169 jurisdictions use IFRS. The United States does not. India uses an adapted version. Japan maintains its own standards board. The benchmark the industry trusts most is meaningless for cross-border comparison, and almost nobody says so.

Section 174: Built for Tax Authorities

The Internal Revenue Code adds another layer. Section 174 governs the deductibility of what the US tax authority calls "research or experimental expenditures," and the definition is not the same as FASB Topic 730.

A company's R&D for tax purposes and its R&D for financial reporting can cover different activities and produce different numbers. The Tax Cuts and Jobs Act of 2017 tightened this further: domestic R&D expenses that were previously deductible immediately now must be amortized over five years, international over fifteen. The definition of what qualifies shifted when the timing rules changed.

Within one country, one company, three definitional regimes apply simultaneously: Frascati for any government reporting, FASB for the income statement, and Section 174 for taxes. A single dollar of R&D spending can be classified three different ways depending on who's asking.

The Gap None of Them Fill

Four frameworks, built by four institutions, for four different purposes. Not one was built for the question that actually matters.

Is this investment creating new knowledge that gives us a capability nobody else can easily replicate?

The gap between them is where innovation decisions actually live. The National Science Foundation recognized the problem clearly enough that it publishes a separate annotated document just to catalog the competing definitions, because they're too inconsistent to assume any two readers are using the same one. That gap isn't an oversight. It's a structural consequence of four institutions doing their own jobs well. The question practitioners need answered was nobody's institutional job.

You've been in the room. The R&D number is on the slide. Nobody asks what's inside it, because the accounting standard doesn't require an answer, and the room has learned not to expect one.

So it went unanswered. Until now.

A Better Definition for R&D

Research is work directed at creating new knowledge where the outcome is genuinely uncertain and the knowledge cannot be readily obtained from existing sources. Development is the translation of that knowledge into products, services, or processes that meaningfully advance an organization's capability in ways competitors cannot easily replicate.

Four elements define it:

• Genuinely uncertain outcome. If you know what you're going to get before the work starts, it's engineering execution, not research. The uncertainty doesn't have to be total. Most applied research has a likely direction. But there has to be real doubt about whether the approach works, whether the knowledge emerges.
  
  

• Cannot be obtained from existing sources. This is the one nobody puts in writing. If the knowledge is already in the literature, available from a consulting engagement, or present in a competitor's published work, finding it again isn't research. Generating new knowledge and capturing existing knowledge are different activities. Only one belongs here. This criterion alone would reclassify a significant portion of what companies currently call R&D.
  
  

• Advances capability competitors cannot easily replicate. Development only qualifies when it translates research into something that genuinely moves the organization forward competitively. Sustaining engineering doesn't pass it. Feature parity doesn't. Competitive catch-up doesn't. All real work, none of it development under this definition.
  
  

• Agnostic to accounting jurisdiction. This definition doesn't tell you how to expense or capitalize anything. That's already governed by whichever standard applies. What it does is establish what genuinely belongs in each category, regardless of where the company files. That makes it usable across FASB and IFRS companies without translation.
  
  

There is a simpler way to put it. For any project in your R&D budget, ask two questions. First: are we creating new knowledge, or executing against something we already know? If you're executing, it's not research. Second: does this translate into a capability competitors cannot easily replicate? If not, it's not development either. It's product engineering, valuable and necessary, but a different budget category entirely. Three buckets: Research, Development, and Product Engineering. That taxonomy, applied honestly across a typical portfolio, would reclassify a significant share of what most companies are currently reporting as R&D.

The Call

I'm not asking FASB to rewrite Topic 730.

What I am asking: that the people who actually make innovation decisions start applying a definition built for the question they're trying to answer.

If you run an R&D function: apply this definition to your current portfolio. Not to change the accounting. To see what's actually in the category and what isn't. The gap between what your budget calls R&D and what this definition calls R&D will tell you something worth knowing.

If you sit on a board: ask what portion of the R&D line is directed at new knowledge creation versus sustaining existing products. If no one in the room can answer, you're governing a number you don't understand.

And if you think the definition is wrong, tell me. Where should the line be drawn differently? What element doesn't hold? What did I miss? That's not a polite invitation. That's the actual point of this episode.

Definitions become standards when enough serious people apply them consistently and make the case until the institutions catch up. The four frameworks we inherited were each built by an institution serving its own purpose. This one is built for the people making the decisions.

The most consequential line in any company's budget is the one separating what builds the future from what protects the present. Nobody drew it clearly. It's past time someone did.

The idea was never the hard part. It never is. The call is.

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Until next time. See the pattern. Make the call. The Innovators Studio | philmckinney.com