What Are Development Costs in Accounting and How Are They Classified?
Explore how development costs are identified, categorized, and treated in accounting to support accurate financial reporting and decision-making.
Businesses invest significantly in creating new products, enhancing services, or developing internal systems. These activities generate various costs that affect financial statements and tax liabilities. Properly accounting for these development-related expenses is necessary for accurate reporting and sound decision-making.
This subject affects accountants, business owners, investors, and anyone involved in budgeting or strategic planning. Misclassifying these costs can lead to compliance problems or misrepresent a company’s financial position.
Let’s examine how development costs are treated in accounting.
Differences from Other Expenditures
Understanding the distinction between development costs and other business expenses is key for correct financial reporting. One major difference is between development and research activities. According to the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 730, research involves planned investigation aimed at discovering new knowledge for creating or improving products, services, or processes. Development translates research findings or other knowledge into a plan or design for new or substantially improved products or processes.1National Science Foundation. Definitions of Research and Development: An Annotated Compilation of Official Sources This includes formulating concepts, designing and testing alternatives, building prototypes, and operating pilot plants. Research seeks knowledge, while development applies it.
Development costs also differ from start-up costs, which are covered in ASC Topic 720-15. Start-up costs relate to organizing a new entity, opening facilities, introducing products to new areas, or initiating new processes. These are typically one-time expenses incurred before significant revenue generation begins or when launching operations in a new territory. While development might occur during a start-up phase, its costs are tied specifically to creating or improving a product or process, not the broader organizational setup activities.
Development costs must also be separated from routine operating expenses, which are the daily costs of running a business like rent, utilities, general administrative salaries, and marketing. Operating expenses support current functions and usually provide benefits within the current period. Development costs, however, are investments aimed at future economic benefits through innovation. Routine quality control, minor product modifications, or troubleshooting during production are typically treated as operating expenses, not development costs.
Categories
Proper accounting requires identifying the specific types of expenditures that make up development costs. These generally fall into categories based on the resources used.
Materials and Supplies
This includes tangible items directly consumed in development. Examples are raw materials for experimental prototypes, components for testing new designs, specialized lab supplies, or materials for operating a pilot plant before commercial production. These differ from materials used in finished inventory or for routine maintenance. The focus is on consumption directly linked to a specific development project.
Employee Costs
Personnel expenses are often a large part of development costs. Salaries, wages, and related costs for personnel engaged in development activities are included. This covers engineers designing specifications, scientists conducting tests, technicians building prototypes, software developers writing code during specific stages, and their direct supervisors. Allocation should reflect time spent on development tasks, separate from routine production or administration. Associated payroll taxes and benefits are also typically included.
Overhead
Development activities often use supporting resources, leading to indirect costs or overhead. A reasonable allocation of indirect costs can be included in development expenses. Examples include depreciation on buildings and equipment used for development (like labs or testing facilities), rent for development space, and utilities consumed in these areas. General administrative overhead not clearly related to development is usually excluded unless a direct link and reasonable allocation basis exist. The allocation method should be rational, systematic, and applied consistently.
Capitalization vs Expense
Deciding whether to capitalize development costs or expense them immediately affects a company’s financial statements. Under U.S. Generally Accepted Accounting Principles (GAAP), specifically ASC Topic 730, most research and development costs are expensed as incurred.2AICPA. To Capitalize, or Not: That Is the Question! This reflects the uncertainty about the future economic benefits of these activities.
However, exceptions exist where capitalization is allowed or required. Costs for developing software are a significant exception. ASC Subtopic 350-40 guides accounting for internal-use software. Costs in the preliminary project stage are expensed, while costs during the application development stage are generally capitalized. Capitalization begins when management authorizes and commits funding, making project completion and software use probable. It stops when the software is substantially ready for use.
ASC Subtopic 985-20 addresses software intended for sale or lease. Costs incurred after establishing “technological feasibility” but before general release are capitalized. Technological feasibility is typically met when planning, designing, coding, and testing confirm the product meets specifications, often shown by a detailed design or working model.
Expenditures for materials, equipment, facilities, and intangible assets acquired for R&D should be capitalized if they have an alternative future use beyond the specific project. The depreciation or amortization of these assets is then allocated as R&D expense over their useful lives. Intangible assets related to in-process research and development (IPR&D) acquired in a business combination are capitalized at fair value under ASC 805, regardless of alternative future use, though subsequent spending on that IPR&D is typically expensed.
The tax treatment under the U.S. tax code differs from GAAP. Historically, Internal Revenue Code (IRC) Section 174 allowed taxpayers to choose between deducting research or experimental (R&E) expenditures immediately or capitalizing and amortizing them. The Tax Cuts and Jobs Act of 2017 changed this. For tax years beginning after December 31, 2021, taxpayers must capitalize specified R&E expenditures. These costs are amortized over five years for U.S.-based research or 15 years for foreign research, starting mid-year. This mandatory capitalization applies broadly, including to software development, creating a significant difference from the general GAAP practice. Companies must maintain separate records for financial reporting and tax compliance.
Adjustments
Initial recording of development costs might require later adjustments. These ensure financial statements accurately reflect the ongoing economic substance of development activities.
Changes in accounting estimates are common. If capitalized development costs, like internal-use software, require estimates for useful life or overhead allocation, subsequent information might show these estimates were inaccurate. Under ASC Topic 250, changes in estimates are handled prospectively, affecting current and future periods without restating prior ones. Material changes require disclosure.
Capitalized development costs must be monitored for impairment. Impairment occurs if an asset’s carrying amount exceeds its recoverable amount and fair value. ASC 360 provides the framework for testing long-lived assets, including those used in development and capitalized software. Triggering events, like adverse changes in usage, legal factors, or projected losses, prompt testing. If impairment exists, a loss is recognized, reducing the asset’s carrying value. Acquired IPR&D is tested annually or more often if impairment indicators arise.
Adjustments may also arise if a project’s intended use or scope changes. Software initially for internal use might later be planned for external sale, potentially shifting accounting treatment prospectively under ASC 985-20. Conversely, abandoning a project intended for sale could trigger impairment testing or different amortization under ASC 350-40.
Correcting errors from previous periods requires retrospective restatement according to ASC 250.3Journal of Accountancy. Changes in Accounting for Changes Errors could involve math mistakes, misapplying GAAP (like improper capitalization or expensing), or misusing facts. Restatement involves revising prior financial statements and adjusting retained earnings.
Tax compliance activities can also lead to adjustments. If errors are found in classifying or calculating capitalized R&E expenditures under IRC Section 174 during tax preparation or audits, adjustments to capitalized amounts and amortization schedules are needed for tax purposes. If property associated with these capitalized costs is disposed of, tax rules require amortization to continue over the prescribed period, potentially requiring adjustments in tracking book-tax differences.