Is R&D an Asset? When to Capitalize R&D Costs

Research and Development (R&D) activities are foundational for innovation, encompassing efforts to discover new knowledge or create new products and processes. In a business setting, R&D can drive significant advancements, from developing novel pharmaceuticals to pioneering software solutions. A common question arises regarding the accounting treatment of these costs: should they be considered an asset on a company’s balance sheet, or are they simply an expense that reduces current period profits? The answer is nuanced, as accounting standards dictate specific conditions under which R&D costs can be capitalized rather than expensed, reflecting the inherent uncertainties and varying outcomes of innovative pursuits.

General Accounting Treatment of R&D

Under U.S. Generally Accepted Accounting Principles (GAAP), the primary rule for R&D costs is that they are expensed as incurred. This means costs are recognized as an expense in the income statement during the period they are spent, immediately reducing current period profit. This treatment is largely driven by the inherent uncertainty surrounding the future economic benefits of R&D activities. At the time R&D costs are incurred, it is often not clear whether the research will lead to a commercially viable product or process, or if it will generate future revenues.

The Financial Accounting Standards Board (FASB) established this principle in ASC 730, recognizing that the connection between R&D expenditures and future benefits is often tenuous. These costs can include materials, equipment, facilities, salaries and wages of personnel, and contract services, provided they fall under the definition of R&D activities. The immediate expensing of these costs contrasts with the capitalization of other assets, where costs are recorded on the balance sheet and then systematically expensed over their useful life through depreciation or amortization.

Specific Scenarios for R&D Capitalization

While GAAP generally mandates expensing R&D costs as incurred, certain specific circumstances and alternative accounting standards allow for capitalization. These exceptions acknowledge instances where the future economic benefits of R&D-related expenditures are considered more certain and measurable.

International Financial Reporting Standards (IFRS)

International Financial Reporting Standards (IFRS) present a different approach compared to GAAP. Under IFRS, specifically IAS 38, research costs are expensed as incurred, similar to GAAP, because it is difficult to demonstrate that future economic benefits will flow from the research phase. However, development costs can be capitalized as an intangible asset if certain criteria are met, indicating technical feasibility and commercial viability. If these conditions are met, capitalization is mandatory under IFRS. The criteria include:
Demonstrating the technical feasibility of completing the asset
The intention to complete and use or sell it
The ability to use or sell it
How it will generate probable future economic benefits
The availability of adequate technical and financial resources
The ability to reliably measure the expenditure

R&D in Business Combinations

R&D assets acquired as part of a business combination are treated differently. When a company acquires another business, any in-process R&D (IPR&D) assets obtained are capitalized at fair value on the balance sheet. This occurs because, at acquisition, the future economic benefits of these R&D efforts are considered more certain and reliably valued. Under GAAP, this applies to IPR&D acquired in a business combination, while subsequent expenditures on that IPR&D are generally expensed.

Software Development Costs

Software development costs have specific GAAP rules for their accounting treatment, primarily under ASC 985-20 for software to be sold, leased, or marketed, and ASC 350-40 for internal-use software. For software intended for external sale or marketing, costs are expensed as R&D until technological feasibility is established. This is achieved when all planning, designing, coding, and testing confirm the product meets its design specifications, often evidenced by a detailed program design or a working model. Once technological feasibility is reached, subsequent development costs are capitalized until the software is ready for general release. For internal-use software, capitalization of costs begins after the preliminary project stage is complete and management authorizes and commits to funding the project, with probable completion and intended use; costs incurred during the preliminary stage and post-implementation are expensed.

Tangible Assets for R&D

Tangible assets, such as equipment or buildings, purchased for R&D purposes are generally capitalized and depreciated over their useful lives, even if the R&D costs they facilitate are expensed. The key distinction is whether the asset has an “alternative future use” beyond the specific R&D project. If the asset can be used in other R&D activities or for other purposes, its cost is capitalized and depreciated. However, if a tangible asset is acquired solely for a particular R&D project and has no alternative future use, its cost is expensed as R&D.

Financial Statement Impact

The accounting treatment of R&D costs significantly influences a company’s financial statements, affecting profitability, asset valuation, and cash flows. Expensed R&D costs directly reduce net income on the income statement in the current period, which can lead to lower reported earnings per share.

Conversely, capitalized R&D costs are recorded as an intangible asset on the balance sheet, increasing total assets and equity. The capitalized amount is amortized over the asset’s estimated useful life, resulting in an amortization expense in future periods. This can initially lead to higher reported net income compared to immediate expensing, but future periods will then reflect the amortization.

On the cash flow statement, expensed R&D typically appears as an operating cash outflow. Capitalized R&D might be classified as an investing cash outflow, similar to purchasing other long-term assets. The subsequent amortization of capitalized R&D is a non-cash expense added back to net income when calculating cash flow from operations.

The choice between expensing and capitalizing R&D also impacts key financial ratios. Expensing R&D can result in lower Return on Assets (ROA) and profit margins due to reduced net income and no corresponding increase in assets. Capitalizing R&D, by increasing assets, can affect ratios like Return on Assets and Debt-to-Equity, depending on the amortization period and the initial amount capitalized. While capitalization can make a company’s profitability metrics appear more favorable initially, the long-term impact involves spreading the cost over time through amortization.