Is Research and Development an Operating Expense?

Research and Development (R&D) activities, aimed at discovering new knowledge or improving existing products and processes, are fundamental for business innovation and growth, helping companies maintain a competitive edge. How businesses account for R&D costs has financial implications, influencing how a company’s financial health and future prospects are viewed by stakeholders. Understanding the classification of these costs is important for anyone analyzing a company’s financial standing.

Accounting Treatment of Research and Development Costs

Generally Accepted Accounting Principles (GAAP) in the United States, specifically ASC 730, generally require that R&D costs be expensed as they are incurred. This means R&D spending is expensed in the period it occurs, rather than recognized as an asset on the balance sheet. This approach is due to the inherent uncertainty of future economic benefits from R&D activities, as it is often difficult to predict whether a research project will lead to a commercially viable product or process.

This expensing rule applies to a broad range of costs associated with R&D. Examples include salaries and wages for R&D personnel, the cost of materials and supplies consumed in research, depreciation of equipment and facilities used for R&D purposes, and payments for outsourced R&D services.

While expensing R&D costs as incurred is the primary treatment under GAAP, exceptions exist. For instance, certain software development costs may be capitalized once technological feasibility has been established. Materials, equipment, and facilities acquired for R&D activities that have an alternative future use beyond the specific R&D project can also be capitalized, with their depreciation then expensed as R&D over time. However, for most internal R&D efforts, the general rule under GAAP remains immediate expensing.

International Financial Reporting Standards (IFRS) generally require research costs to be expensed as incurred due to the uncertainty of future economic benefits. However, IFRS allows for the capitalization of development costs if specific criteria are met, indicating the probable commercial viability and technical feasibility of the asset under development. This distinction makes IFRS accounting for R&D more complex than GAAP.

Impact on Financial Statements

Expensing R&D costs immediately has direct effects on a company’s financial statements. On the income statement, recording R&D as an operating expense in the period it is incurred directly reduces reported net income and earnings per share. For companies that invest heavily in R&D, this can make them appear less profitable in the short term, even if these investments are intended to generate future revenue.

The balance sheet is also affected because expensed R&D does not appear as an asset. This means the balance sheet may not fully reflect the intangible value a company’s innovation efforts could bring in the future. While R&D can lead to valuable intellectual property, the immediate expensing rule means this potential future value is not recognized as an asset.

On the cash flow statement, R&D expenses are classified as operating cash outflows. Expensing or capitalizing R&D primarily impacts the income statement and balance sheet presentation, but not the actual cash spent. Analysts and investors often view R&D spending as an investment in future growth, despite its immediate impact of reducing reported earnings.

Tax Treatment of Research and Development Costs

The tax treatment of R&D costs in the United States differs from their financial accounting treatment. Section 174 of the Tax Cuts and Jobs Act (TCJA) of 2017 introduced a change. Previously, businesses could deduct R&D expenditures in the same tax year they were incurred.

However, for tax years beginning on or after January 1, 2022, Section 174 requires that specified research or experimental expenditures must be capitalized and amortized. Instead of a full deduction in the year incurred, these expenses are spread out over time. For domestic R&D, the amortization period is 5 years, while for foreign R&D, it is 15 years.

Amortization means a portion of the capitalized R&D cost is deducted each year over the specified period. This change has implications for businesses’ taxable income and tax liabilities. It results in higher taxable income in the short term compared to the previous immediate deduction, leading to increased tax payments. This tax treatment is distinct from financial accounting rules, where R&D is expensed as incurred.

Under Section 174, “specified research or experimental expenditures” refers to costs paid or incurred by a taxpayer in connection with their trade or business, representing R&D costs in the experimental or laboratory sense. These expenditures include all costs incident to the development or improvement of a product. The IRS has provided guidance on this, including the treatment of software development and research performed under contract.

Identifying Research and Development Activities

Understanding what constitutes R&D is important for both accounting and tax purposes. R&D activities involve efforts aimed at discovering new knowledge or creating new or significantly improved products, processes, or software. This includes developing new products or processes, making significant improvements to existing ones, designing and testing prototypes, and evaluating product or process feasibility.

Costs include compensation for R&D employees, materials and supplies, and payments to third-party contractors. Computer rental or cloud computing expenses related to development and testing also qualify. Companies must maintain detailed documentation of these expenses to support their classification.

Conversely, certain activities do not qualify as R&D. Exclusions include routine quality control or testing, market research, and consumer surveys. Commercial production, distribution, or routine alterations to existing products are also not considered R&D.