Capitalizing R&D Expenses

What is Capitalizing R&D Expenses?

Businesses employ a strategic process known as capitalizing to categorize research and development (R&D) activities as assets rather than expenses. This move, termed "capitalized R&D," relocates R&D expenses to the bottom of the balance sheet.

Capitalizing on development costs can boost your business's profitability. This is the best way to demonstrate the genuine profitability of a firm to creditors and investors.

By displaying them as assets, R&D capitalization also transfers costs from the profit and loss (P&L) statements to the balance sheets. Companies must expense research and development expenses in the same fiscal year that they are incurred. 

Measuring the rates of return on assets and investments for many organizations is difficult, which leads to much volatility in earnings (or losses).

Their total assets or invested capital may only accurately reflect the amount financed if R&D is capitalized. As a result, the business's Return on Assets (ROA) and Return on Invested Capital (ROIC) may be affected. 

The portion of R&D spending that is capitalized is typically a tiny portion of research and development. However, most businesses gain from R&D spending through learned expertise. 

This acquired expertise is a priceless asset that will provide future cash flow. The value of R&D expenditures should be included in the balance sheet, providing useful information to analysts and investors.

They should be treated as any other investment, subject to capitalization, just like conventional assets such as buildings.

Capitalizing R&D Expenses: GAAP Vs. IFRS

Comparing Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) unveils distinct approaches to handling research and development (R&D) expenditures.

Under both GAAP and IFRS, research expenditures are treated as expenses annually.

However, if the business can demonstrate that the asset under development will become commercially viable (i.e., that the technology or product will likely pass muster and produce revenue), development costs may be capitalized.

The advantage of the IFRS system is that at least certain expenditures associated with research and development can be capitalized or changed from an expense to an asset on the company's balance sheet. 

The trade-off is that IFRS demands subjectivity and judgment, which raises the possibility that managers will be too optimistic about how commercially viable a new technology is. This can lead to discrepancies in the financial statements of various companies.

Capitalizing R&D Expenses: Process of Recapitalization

From an economic standpoint, it seems appropriate to capitalize on research and development costs, even if it is unknown how much future benefit they will provide. 

An analyst must project how long a technology or product will create benefits for (its economic life) to capitalize and estimate the value of these assets and utilize that projection as an assumption for the amortization term.

The amortizable life varies from asset to asset and represents the economic life of the various products. 

For instance, since patents take a long time to be authorized and there is some patent protection, the products generated by a pharmaceutical business would likely endure for many years (and hence have an extended amortization period). 

During this time, they may enjoy monopoly revenues. However, a mobile phone company's R&D amortization should be amortized much more quickly (in a lower number of years), given new phones often come out much more frequently and have shorter shelf lives.

The capitalized R&D expenses would then be amortized equally over the asset's seven-year life after determining the asset's economic vitality. In the following example, the asset is amortized using a straight-line method.

Capitalization of R&D cost

Research and development (R&D) capitalization is an accounting technique where certain costs are treated as assets on the balance sheet rather than as direct expenses on the income statement. 

This strategy is appropriate for spending on supplies, machinery, and facilities acquired or built, especially for R&D operations, but serves another use down the road.

Capitalization is acceptable for costs associated with materials, tools, and facilities purchased or built for R&D activities and are anticipated to serve a secondary function after the current R&D project.

Tangible assets, such as laboratory equipment, research facilities, or machinery purchased for research and development and anticipated to have future applications, should be capitalized. 

Capitalizing these expenses instead of immediately deducting them from income allows them to be recorded as assets on the balance sheet, enabling cost amortization.

Intangible assets, like copyrights or patents, obtained through asset acquisitions specifically for research and development should likewise be capitalized. This enables the assurance of equal costs and benefits throughout their useful lives.

After capitalization, R&D expenses, such as the cost of materials used, the amortization of acquired intangible assets, and the depreciation of facilities and equipment used, should be shown as such on the income statement. 

Intangible assets bought only for R&D and with no foreseen alternative applications should likewise be considered R&D expenses.

R&D costs may also include indirect R&D costs, payments for outside sources' R&D services, and employee-related expenditures in addition to material and equipment costs. These costs should be accurately accounted for and recognized as R&D expenses when they are incurred.

Intangible assets purchased by corporations, particularly for R&D purposes, are notable exceptions. Regardless of whether they may have future alternate uses, these assets should be capitalized as part of the acquisition accounting procedure in such circumstances.

Accounting for R&D costs

All R&D expenses must be recorded as expenses as soon as they are incurred, following ASC 730, Research and Development. 

However, some expenses for R&D activities that could have other applications, such as those for supplies, machinery, and buildings, might be eligible for capitalization. 

It is crucial to note that ASC 730-10-25 excludes expenses linked with more significant R&D categories, such as market research, routine product testing, quality control, standard tool design, and commercial production troubleshooting.

Additionally, the following charges are not covered under ASC 730:

1. R&D Operations for Other Parties: R&D operations carried out on behalf of other parties through contractual agreements, including indirect expenses covered by the agreement's terms.

2. Internal Procedure Creation, Purchase, or Improvement: Costs associated with the creation, purchase, or improvement of internal procedures, including the price of computer software used for administrative or sales tasks. 

3. Prospecting, Mineral Rights, and Extractive Industries: Expenses related to prospecting, acquiring mineral rights, exploration, drilling, mining, and related mineral development are exclusive to the extractive industries. 

These changes result in enhancements, routine, or periodic alterations to current goods, production lines, manufacturing techniques, and operations.

Example of Capitalizing R&D

The following are examples of capitalizing research and development expenses. 

Scenario 1: Tax Impact on R&D Investment

In this instance, a business with $10 million in annual revenues has allocated a large $100 million to the global development of pharmaceuticals. The tax deduction for this much research and development (R&D) investment is usually rather large.

R&D spending is tax deductible, but this company would report a $90 million taxable loss if typical accounting procedures were followed.

Through the Accounting Rules Codification (ARC), specifically Topic 740, the Financial Accounting Standards Board (FASB) has developed a set of guidelines and rules for the financial accounting industry. 

When dealing with this issue of income tax accounting, businesses must consider how recent tax legislation may impact their financial statements. 

The recent change in tax law serves as a remarkable example of the significant impact these constraints can have on a company's financial status, income, and reporting.

Scenario 2: Amortization in the Mobile Phone Industry

In this situation, a financial analyst is attempting to profit from the R&D operations of a mobile phone manufacturer. 

The mobile phone industry is developing swiftly since new products frequently join the market. The analyst calculates the amortization amount for the cell phone product by assuming a three-year economic life.

This amortization calculation is predicated on the notion that R&D costs ought to be dispersed throughout the product's useful life. 

Current amortization amount = ⅓ (year 1 of R&D) + ⅓ (year 2 of R&D) + ⅓ (year 3 of R&D)

Using the formula, the analyst establishes the current amortization amount to be $66,666 for the mobile phone product's three-year economic life.

This process emphasizes how important it is to carefully track R&D expenses and allocate them over the product's useful life span. 

By doing this, businesses ensure that the cost of developing a product is appropriately reflected in their financial statements and adhere to the accounting principle of matching expenses to revenues.

These hypothetical situations highlight the complicated interplay between tax laws, financial accounting principles, and the actual effects of capitalizing R&D spending on a company's financial statements and profitability. 

Businesses must adhere to accounting standards to efficiently manage their finances and make wise decisions.

Advantages of Capitalizing R&D

Companies and organizations may benefit significantly from capitalizing on their research and development (R&D) costs. Here are some additional justifications and a restated list of the advantages:

1. Tax Benefits

Companies that decide to capitalize on their R&D expenses may be qualified for tax advantages related to depreciating the assets employed in these operations. 

This strategy may result in immediate tax payment reductions, generating extra revenue that may be allotted to potential growth and development projects.

2. Financial Flexibility

Companies can spread their research and development costs over time by capitalizing on R&D costs.

These expenses are handled as long-term assets instead of being recorded as current costs. In the long term, this strategy may assist in establishing a more balanced net income profile. 

It enables businesses to more accurately depict their financial situation by allowing them to connect the recognition of R&D expenses with the benefits and income resulting from these investments.

3. Asset Gain, Unaffected by Liability

One benefit of R&D capitalization is that it raises a company's asset balance without affecting its liability. 

This can be extremely helpful when presenting financial statements to stakeholders and investors. It displays the expenditure on priceless R&D assets while preserving a steady liabilities position.

An Alternative Approach to R&D Treatment

Under current Generally Accepted Accounting Principles (GAAP), expenses for internally generated intangibles, such as costs associated with research and development (R&D), are often recorded immediately.

In contrast, costs associated with comparable acquired intangibles, such as in-process R&D, are capitalized by a long-standing accounting tradition from 1974. 

This accounting approach had its origins in a time when the economy was heavily dependent on physical assets like buildings and machines.

The capitalization of R&D expenses as opposed to their expense is suggested by academia as an alternative accounting perspective. 

This alternate strategy significantly affects a company's financial statements:

1. Balance sheet: R&D costs are capitalized and added to the company's intangible assets. Then, over time, these assets deteriorate at a predictable rate. Due to the buildup of unamortized R&D capital, this process raises the company's book value.
2. Income Statement: The new strategy substitutes annual depreciation of the R&D capital for the prior practice of accounting for R&D costs as immediate charges.
3. Cash Flow Statement: R&D spending is now included in Cash Flow from Investing Activities, alongside capital expenditures, rather than in Cash Flow from Operations.

Conclusion

Capitalizing research and development expenditures affects a company's tax position in the real world and is a strategic financial move. 

The possibility of tax advantages, as demonstrated in the scenarios presented, adds an additional layer of financial flexibility. Companies can navigate tax implications strategically, resulting in immediate tax savings and additional resources for future projects and expansion.

Furthermore, the benefits of investing in R&D include a more balanced net income profile over time. 

Businesses can more accurately represent their financial situation by spreading R&D costs as long-term assets, matching the recognition of expenses with the benefits derived from these investments. 

A more dynamic depiction of a company's financial health is made possible by this practice's more nuanced viewpoint compared to traditional accounting methods.

In the end, determining whether to capitalize on R&D expenses should consider a company's financial targets, accounting standards, and strategic goals. 

Research and development (R&D) capitalization is an attractive option for businesses seeking a comprehensive and strategic approach to financial management due to the advantages of asset gain without affecting liability, potential tax benefits, and financial flexibility.

Researched and authored by Lavanya Purushothaman | Linkedin

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Capital Expenditure

• Capitalized Cost

• Depreciation Expense

• Research and Development (R&D)

• IFRS vs. US GAAP