1. Measuring and Capitalising R&D in ESA 2010
ESA 2010 course, January 2014
Daniel Ker
UK Office for National Statistics 1

2. Measuring and Capitalising R&D in ESA 2010
Overview
What is R&D?
Who does R&D?
Measuring R&D
Theory
Practice: business R&D
Case of Government R&D
Impacts of capitalisation
OECD guidance revision
Measuring and Capitalising R&D in ESA 2010

3. Measuring and Capitalising R&D in ESA 2010
Learning objectives
By the end of this session you should:
Understand what R&D is and the rationale for including it in National Accounts
Be able to explain the main sources, methods, and assumptions for measuring R&D in National Accounts
Understand some key challenges faced in measuring and capitalising R&D
Measuring and Capitalising R&D in ESA 2010

4. Measuring and Capitalising R&D in ESA 2010
What is R&D?
‘Research and Development (R&D) is creative work undertaken on a systematic basis to increase the stock of knowledge, and use of this stock of knowledge for the purpose of discovering or developing new products, including improved versions or qualities of existing products, or discovering or developing new or more efficient processes of production’ (ESA )
Measuring and Capitalising R&D in ESA 2010

5. What is R&D? Knowledge R&D is a productive process: Consumes inputs
Produces outputs – knowledge (but we call it ‘R&D output’)
e.g. that new spiral radio waves can be used for 5G phones
e.g. that reducing night working improves quality and productivity
or even the knowledge that something does not work!
Knowledge
Int. inputs
Capital
Labour
 we should measure in the National Accounts

6. What is R&D? Terminology
R&D produces ‘knowledge’
but National Accountants refer to the results of R&D as ‘R&D Output’ or ‘R&D Services’
In theoretical terms these are not the same but in practice they are often used interchangeably
Measuring and Capitalising R&D in ESA 2010

7. Measuring and Capitalising R&D in ESA 2010
The role of R&D
R&D/knowledge stocks believed to be a key explanation of differing economic performance between countries (Solow Model)
 reflect in the NA framework to enable analysis
Measuring and Capitalising R&D in ESA 2010

8. Measuring and Capitalising R&D in ESA 2010
Why not measure R&D?
Its hard!
Knowledge is intangible
Most often not sold in markets
 usually cannot directly observe value
‘Non-excludable’  need for Intellectual Property
‘Non-Rivalrous in consumption’
 benefits for others (spill-overs)
Need to ensure economic meaning and international comparability
Measuring and Capitalising R&D in ESA 2010

9. Measuring and Capitalising R&D in ESA 2010
Who does R&D?
Businesses
Government
Charities
Universities
Hospitals
Households?
R&D can take place in any area of the economy
Measuring and Capitalising R&D in ESA 2010

10. Measuring and Capitalising R&D in ESA 2010
Why do they do R&D?
New products – market creation
Improved products – sell for a premium
More efficient production – reduce costs
Government: policies, services
Universities: research papers or contracts
Hospitals: medical procedures, save money and lives
Benefits accrue across multiple periods
 We should treat (most) R&D as capital
Measuring and Capitalising R&D in ESA 2010

11. Measuring and Capitalising R&D in ESA 2010
Some history
Measurement of R&D (including non-market, own account) was in SNA1993 and ESA95 (3.64)
Output treated as Intermediate Consumption
Countries could not agree on capitalisation
Some countries developed satellite accounts
Following much work (and 2 EU task forces), most R&D is treated as capital in SNA08/ESA 2010
Measuring and Capitalising R&D in ESA 2010

12. Measuring and Capitalising R&D in ESA 2010
3 key questions
In order to measure and capitalise R&D there are 3 key questions which must be answered:
How much R&D is there?
Who uses it?
How long is it useful for?
Measuring and Capitalising R&D in ESA 2010

13. Measuring and Capitalising R&D in ESA 2010
How much R&D is there?
Uses
Resources
Output (Sales)
Typically, the National Accounts take the resources available from sales…
Measuring and Capitalising R&D in ESA 2010

14. How much R&D is there? Uses Resources Intermediate consumption
Output (Sales)
Compensation of Employees
Taxes (less subsidies)
Operating surplus
…and look at the ‘costs’ charged against them
Measuring and Capitalising R&D in ESA 2010

15. Measuring and Capitalising R&D in ESA 2010
How much R&D is there?
But most R&D is not performed for sale – it is produced on own-account e.g. Research by the UK Office for National Statistics found that 72% of business’ R&D and 75% of Government R&D was for own use  cannot observe sales directly, need to estimate value of R&D indirectly
Measuring and Capitalising R&D in ESA 2010

16. Measuring and Capitalising R&D in ESA 2010
Measuring R&D
The output of R&D services is measured as follows (ESA ):
a) R&D by specialised commercial research laboratories or institutes is valued at the revenues from sales, contracts, commissions, fees, etc. in the usual way
Note this wording has barely changed from ESA95
Measuring and Capitalising R&D in ESA 2010

17. Measuring and Capitalising R&D in ESA 2010
Measuring R&D
b) the output of R&D for use within the same enterprise is valued on the basis of the estimated basic prices that would be paid if the research were subcontracted. In the absence of a market for subcontracting R&D of a similar nature, it is valued as the sum of production costs plus a mark-up (except for non-market producers) for NOS or mixed income
Note this wording has barely changed from ESA95
Measuring and Capitalising R&D in ESA 2010

18. Measuring and Capitalising R&D in ESA 2010
Measuring R&D
c) R&D by government units, universities and non- profit research institutes is valued as the sum of the costs of production. Revenues from the sale of R&D by non- market producers of R&D are to be recorded as revenues from secondary market output.
Note this wording has barely changed from ESA95
Measuring and Capitalising R&D in ESA 2010

19. Measuring and Capitalising R&D in ESA 2010
Measuring R&D
For own-account and non-market R&D we cannot observe sales…
Uses
Resources
Output? (Sales)
Measuring and Capitalising R&D in ESA 2010

20. Measuring R&D Uses Resources Intermediate consumption Output
(own-account)
Compensation of Employees
Taxes (less subsidies)
Operating surplus
…estimate by reversing the approach.
R&D output must be worth at least as much as the resources invested in producing it.
Measuring and Capitalising R&D in ESA 2010

21. What about all the money spent on ‘unsuccessful’ R&D?
Success is very difficult to define
A R&D project may totally fail to meet the objectives originally intended but have other benefits
e.g. creating unexpected products or markets
may not be useful today but highly profitable in future
Practicality – the data does not tell us about success vs failure
Measuring and Capitalising R&D in ESA 2010

22. What about all the money spent on ‘unsuccessful’ R&D?
Convenient assumption:
rational investors will only invest in R&D so long as they do not expect to lose money
i.e. R&D investments must at least break even on average (every € lost on R&D is balanced by a
€ made)
 Include the costs of all R&D
Measuring and Capitalising R&D in ESA 2010

23. Measuring and Capitalising R&D in ESA 2010
Data Sources
OECD Frascati Manual
Methods for surveys of R&D ‘performers’
Basis of ESA R&D definition
First published in 1963  long time-series
EU countries required to collect data on R&D inputs
Measuring and Capitalising R&D in ESA 2010

24. The Frascati Manual sources
Separate surveys of different sectors:
Business Enterprise R&D (BERD) - 64%
GovERD – Government (central focus) – 9%
Higher Education R&D (HERD) – 26%
Private Non-Profit R&D (PNPERD) – 2%
(% of UK GERD, 2011)
Usually annual surveys
Aim to cover ALL R&D performed in the economy
Amount of detail varies, most detail for businesses
Measuring and Capitalising R&D in ESA 2010

25. Measuring and Capitalising R&D in ESA 2010
Frascati sources
All collect data on expenditures on R&D inputs
 Can use to estimate R&D output by sum-of-costs
But:
Need to align sectors with NA
Different treatment of capital
Risk of double-counting with software
Measuring and Capitalising R&D in ESA 2010

26. Alignment of sectors OECD FM Sectors ESA Business Enterprise sector
Non-Financial Corporations
Financial Corporations
Government Sector
General Government
Private Non-Profit sector
NPISH
Households (?)
Higher Education sector
Corporations and quasi-corporations
Abroad
Rest of World

27. Treatment of capital inputs
computer
£600
time
use of
computer
£200
use of
computer
£200
use of
computer
£200
FM records purchase of capital in year 1 only
NAs record: capital asset in balance sheet
and use of asset over time

28. Measuring and Capitalising R&D in ESA 2010
Treatment of Capital
Need to convert from capital expenditure to (costs of) capital consumption
 Perpetual Inventory Method (PIM)
Compile investment data to estimate stock of capital inputs
Estimate capital consumption (and operating surplus) from this stock
See OECD Measuring Capital (2009)
Measuring and Capitalising R&D in ESA 2010

29. Risk of double-counting w/software
Software development involves considerable R&D
Software produced for sale treated as capital -value of licenses to use
Software produced on own account capitalised since ESA95 – valued by sum of costs (same as R&D)
 risk of counting the costs twice
Measuring and Capitalising R&D in ESA 2010

30. Risk of double-counting w/software
‘Expenditure on R&D does not include the costs of developing software as a principal or secondary activity (ESA )’  need to adjust R&D costs to remove software development Some countries adjust the R&D output directly rather than the input costs This adjustment causes R&D to be under-stated
BUT this is not a neutral decision – it will lead to R&D being understated, particularly as software development becomes more commonplace
Measuring and Capitalising R&D in ESA 2010

31. Measuring and Capitalising R&D in ESA 2010
Activity
Complete the template to estimate R&D output
Measuring and Capitalising R&D in ESA 2010

32. Imports and Exports of R&D
FM sources provide some indicators of trade:
R&D purchased from overseas
Funding for R&D from overseas (may imply export)
However, FM surveys only cover R&D performers
The trade surveys record trade in ‘R&D services’
Measuring and Capitalising R&D in ESA 2010

33. Imports and Exports of R&D
The trade surveys record trade in ‘R&D services’
However:
The definition of R&D is broader
Recording issues
National Accounts record R&D output and use in period of expenditure – even for multi-year R&D projects
By contrast, the surveys will record the export value of the finished R&D at the time ownership is transferred
 need to reconcile/adjust for consistency
Measuring and Capitalising R&D in ESA 2010

34. Supply to use: who uses R&D?
performer
own use
Transfer (“sell”?) to parent
Sell to customer
Measuring and Capitalising R&D in ESA 2010

35. Supply to use: who uses R&D?
FM sources also provide information on the sources of funding for R&D including:
Own funds
Domestic government, businesses, other orgs
Orgs overseas (businesses, govt, EU, etc)
How should we use this?
Assume funding implies ownership?
Differences between sectors?
e.g. businesses own all R&D they fund, gov doesn’t
Measuring and Capitalising R&D in ESA 2010

36. Supply to use: who uses R&D?
UK ONS asked respondents who would own/use the R&D they were performing
Owner
% by Funder
% by Owner
Business Enterprise 69 76
General Government 9 6
NPIs 1
Rest of World 21 17
Freely available
In both approaches, allocation to industries is a challenge (only have sector of funder)
Measuring and Capitalising R&D in ESA 2010

37. Supply to use: how is R&D used?
R&D purchased as an input to R&D – IC
(R&D sector firms only)
Other purchased R&D – GFCF
R&D made freely available by businesses – IC
only where specifically identified
Own-account R&D – GFCF
All non-market R&D - GFCF
Measuring and Capitalising R&D in ESA 2010

38. How long is it useful for? ‘service life’
Service lives are key inputs to the PIM
One of the 2 main determinants of the R&D stocks
EU Task-Force Recommendation:
Estimate from survey or other sources
Use estimates from comparable economies
If no alternative use 10 years
3 is not theoretically robust:
service lives vary between industries
national average lives will vary with industrial mix
Measuring and Capitalising R&D in ESA 2010

39. Estimating R&D service lives
2 main approaches:
Survey questions – favoured by OECD, implemented by UK, Slovakia, USA, Israel…
Infer from patent renewals – Netherlands, Australia…
2 sources, various methods for estimating
most basic level, mean vs median lives
 Wide range of estimates possible
Measuring and Capitalising R&D in ESA 2010

40. Impact of different life estimates
UK compared both
Variation from alternative sources (surveys, patent data)
ALSO from methods applied to those sources
 need for further standardisation
Measuring and Capitalising R&D in ESA 2010

41. The case of Government R&D
In principle the approach for government is the same
but NO rate of return in PIM (proxies net operating surplus)
All government R&D is capitalised
unless specific evidence of secondary market output
even R&D made freely available – held on behalf of the nation
Most Govt output measured by summing costs
 reclassify from final consumption to GFCF
Only effect on output is from consumption of new R&D assets (the only additional cost)

42. The case of Government R&D
There are several potential data sources:
GovERD survey
Data by Classifications of Functions of Government (COFOG)
Measuring and Capitalising R&D in ESA 2010

43. GovERD survey
Consistent with Frascati Manual definitions and principles
The most authoritative source on Government R&D spending
Estimate in way described previously
However:
may not align with R&D spending in sources used to compile Government Accounts
 difficult to decide what to adjust in order to incorporate without affecting total Govt output

44. Data classified by COFOG
Most countries collect data on Government expenditures classified by COFOG
COFOG includes R&D categories within its branches
e.g. there is an R&D category within the ‘health’ branch
Often, this is the data used to compile the Government accounts
 using this source avoids the difficulty of integrating a separate different source for Government R&D
Measuring and Capitalising R&D in ESA 2010

45. Data classified by COFOG
Need to identify/estimate elements related to R&D:
P.2 intermediate consumption
Materials and services inputs to R&D (‘P.2a’)
Will also include bought-in R&D (‘P.2b’)-can be hard to isolate
D.1 compensation of employees working on R&D
P.5 GFCF of capital inputs to R&D
K.1 depreciation of capital used for R&D
Govt R&D output = ‘P.2a’ + D.1 + K.1
Govt R&D GFCF = output (minus any known sales of secondary output) + ‘P.2b’

46. Data classified by COFOG
HOWEVER
The definition of R&D used is not consistent with the Frascati Manual
Items often classified as ‘R&D’ based on the interpretation of the respondent (usually in accounting department)
Quality/detail can vary between respondents
e.g UK defence department provides little detail
OECD explicitly advises against using ‘COFOG R&D’
due to this incompatibility
very little further info provided – address in new FM

47. Measuring and Capitalising R&D in ESA 2010
R&D and Weapons
Weapons are also treated as capital under ESA 2010
Projects to deliver weapons (e.g. new fighter jets) may involve R&D phases
 risk of double counting when weapons produced by Government on own account
Timing issue – R&D capitalised in period performed, weapons not capitalised until completion (WIPs)
Measuring and Capitalising R&D in ESA 2010

48. Impacts in the National Accounts
Item
ESA95 Treatment
ESA10 Treatment
Impact on key aggregates
Purchased R&D
Output of producer IC of purchaser
Output of producer
GFCF of purchaser
↑ Value Added, GDP, GOS, Kstock
Business own-account R&D
Expenditures are IC
Adds to output of producer
↑ Output, Value Added, GDP, GOS, Kstock
Government (and other non-market) R&D
Expenditures included in output and final consumption
Expenditures still contribute to output but now output treated as GFCF
CFC (K.1) of new R&D assets is final consumption
↑ output due to CFC of new R&D assets, GDP, Kstock
No impact on deficit, extra K.1 offset by extra operating surplus

49. Measuring and Capitalising R&D in ESA 2010
FM revision
OECD revising Frascati Manual. Various improvements to help National Accountants:
More detailed expenditure breakdowns
Split Government funding into ‘grants’, ‘purchases’
Identify R&D expenditure on software development
Explanation of issues with COFOG
‘knowledge of man people, culture, and society’
 women (and children) can now have knowledge too!
Measuring and Capitalising R&D in ESA 2010

50. Measuring and Capitalising R&D in ESA 2010
Further reading
Frascati Manual
OECD Handbook on Deriving Capital Measures of Intellectual Property Products (2010)
Final Report of the Second European Task-Force on R&D Capitalisation, Eurostat (2012)
(Draft) Manual on Measuring R&D in ESA10, Eurostat (2013)
Service Lives of R&D Assets, ONS/Ker (2013)
Ownership of R&D Assets, ONS/Ker/Steer (2013)
Measuring and Capitalising R&D in ESA 2010

51. Measuring and Capitalising R&D in ESA 2010
Notes
At the October 2013 Expert Meeting, Eurostat confirmed that countries will be held to account for implementing the Task Force recommendations NOT the content of the draft manual This is important because the Manual is NOT consistent with the TF recommendations in some aspects (notably the treatment of R&D as an input to further R&D)
Measuring and Capitalising R&D in ESA 2010