Is Research & Development Expensed or Capitalized?

Research and Development (R&D) activities are a significant investment for many companies, especially in industries like technology, pharmaceuticals, and healthcare. These expenditures aim to create new knowledge or improve existing products and processes, driving future growth. The accounting treatment of these costs—whether they are “expensed” immediately or “capitalized” and recognized over time—is a fundamental aspect of financial reporting. Understanding this distinction is important for interpreting a company’s financial health, as the chosen method significantly alters reported financial figures and impacts profitability and asset base.

Defining Research and Development

For accounting purposes, Research and Development encompasses activities aimed at new discoveries or significant improvements. Research involves original investigations to gain new scientific or technical understanding, without a particular product or process in mind. Development applies these research findings or other knowledge to design new or substantially improved materials, devices, products, processes, or services before commercial production.

Activities typically included in R&D are laboratory research, the design and testing of prototypes, and the formulation of new product and process designs. This also extends to testing new products or processes and modifying existing formulas or products. However, many activities are excluded from the accounting definition. Routine quality control, market research, and commercial production activities do not qualify, nor do routine alterations to existing products. The distinction focuses on the investigative nature of the work, differentiating true innovation from standard operational improvements.

Expensing Research and Development Costs

Under U.S. Generally Accepted Accounting Principles (GAAP), the general rule for Research and Development costs is that they must be expensed as incurred. This means the full amount of R&D spending is recognized as an expense on the income statement in the period it is paid or accrued. The rationale for immediate expensing is the uncertainty of future economic benefits from R&D activities. There is no guarantee that the R&D will result in a commercially viable product or process that generates future revenue.

Common R&D costs that are expensed include salaries of personnel directly involved in R&D, the cost of materials and supplies used in experiments, and depreciation of equipment or facilities that do not have an alternative future use beyond the specific R&D project. Payments for external research services and costs associated with designing and testing prototypes also fall into this category. This immediate expensing approach ensures that financial statements do not overstate assets based on speculative activities, presenting a more conservative view of a company’s financial position.

Capitalizing Research and Development Costs

While U.S. GAAP generally requires expensing R&D costs, capitalization is permitted in specific, limited circumstances. The most common exception involves software development costs. ASC 985-20 governs software developed for external use, while ASC 350-40 applies to software developed for internal use.

For software developed for external use, costs are expensed until “technological feasibility” is established. This is achieved when a company completes all planning, designing, coding, and testing necessary to determine the product will meet its design specifications. This often means a detailed program design or working model is completed. Once technological feasibility is reached, subsequent development costs can be capitalized until the product is available for general release. These capitalized costs are then amortized over the software’s estimated economic life.

For software developed for internal use, capitalization generally begins after the preliminary project stage and once management authorizes funding. Costs incurred during the application development stage, including direct costs like salaries of development personnel and fees paid to third parties, can be capitalized. The post-implementation/operating stage involves costs for maintenance and training, which are typically expensed. Other limited instances where R&D-related costs might be capitalized include materials, equipment, or facilities that have an “alternative future use” beyond the specific R&D project. Additionally, in-process R&D acquired as part of a business combination is capitalized at its fair value.

Impact on Financial Statements

The accounting treatment of Research and Development costs significantly influences a company’s financial statements, affecting the income statement, balance sheet, and cash flow statement. When R&D costs are expensed as incurred, they immediately reduce current period net income on the income statement. This also leads to a direct reduction in retained earnings on the balance sheet. On the cash flow statement, expensed R&D is typically classified as an operating cash outflow, reflecting the immediate use of cash for these activities.

Conversely, when R&D costs are capitalized, they are initially recorded as an asset on the balance sheet. This means there is no immediate impact on the income statement from the initial spending. Instead, the capitalized asset is systematically expensed over its useful life through amortization or depreciation, which reduces net income in future periods. This amortization expense appears on the income statement, spreading the cost recognition over several years. On the cash flow statement, the initial capitalization of R&D costs is reported as an investing cash outflow. Over subsequent periods, the non-cash amortization expense affects net income but does not involve a cash outflow.