Chapter 8 demonstrated how conservative accounting that expenses particularly risky investments conveys risk to investors. Put differently, it says: Do not book an asset to the balance sheet when the payoff to the investment is highly uncertain; do not book the asset with the pretense that it provides collateral, making the firm safer. That is formalized in accounting standards where the criteria for capitalizing an investment on the balance sheet is the probability of future benefits. In FASB Statement No. 2, R&D is expensed because of “the uncertainty of future benefits.” In IAS 38, IFRS distinguishes Research which is expensed and Development that is booked to the balance sheet. The two are distinguished by the probability of future benefits. Even for property, plant, and equipment, IAS 16 requires benefits to be “probable” for the asset to be booked to the balance sheet.
This accounting suits the value investor: With high risk, be conservative. But there is another point: Conservatism can protest investors from “overbetting.” Founded in the work of financial mathematicians, investors are hurt more by overbetting—betting too much based on one’s beliefs—than under betting—betting too little. A quick way to grasp this idea is to remember that a loss of 50% of wealth takes a 100% return to reverse. To be rational, an investor underbets his or her beliefs about the probability of payoffs. Booking an asset with relatively low probability of payoff with the pretense it has “asset quality” payoffs encourages not only poor assessment of payoff probabilities but also overbetting. In terms more familiar to this book, it encourages speculation: If an investor is really keen of the prospects of a certain R&D project, the accounting seemingly confirms, enticing him or her into overbetting. Expensing the R&D warns: Be careful, this is risky.