What Are R&D Costs & How Are They Accounted For?

Research and development (R&D) costs represent the costs a company incurs to create new or improved products, processes, or services, or pursue new knowledge. They are fundamental to innovation, enabling businesses to enhance offerings, refine operations, and maintain a competitive edge. R&D is a strategic investment, driving future growth and ensuring relevance in evolving markets.

Core Characteristics of Research and Development Costs

R&D costs are defined by characteristics distinguishing them from routine business operations. A primary characteristic is inherent uncertainty. R&D involves systematic investigation to discover new knowledge, with uncertain outcomes. Uncertainty applies to both technical feasibility and commercial viability of the resulting product or process.

R&D also involves a planned search or critical investigation, indicating a structured, systematic approach. The objective is to achieve new scientific or technological knowledge, or significantly improve existing products, processes, or techniques. Activities apply research findings and knowledge to design new or substantially improved offerings. The goal is to discover technological information useful for developing new or improved business components.

Activities Included as Research and Development Costs

Specific activities and expenditures qualify as R&D costs, reflecting efforts to advance technological capabilities and create innovative solutions. These include costs for conceptual formulation, design, and testing of product alternatives. Building and testing prototypes or operating pilot plants to refine designs are typical R&D activities. Clinical trials for new drugs also fall under R&D, involving systematic investigation to establish safety and efficacy before commercialization.

Software development costs often qualify, particularly when involving technological uncertainty in creating new or improved applications. This includes designing, programming, and testing new software or mobile applications for sale, licensing, or internal operational optimization. Researching alternative materials, designs, or methods for products and manufacturing processes is also considered R&D, aiming for efficiency or quality improvements.

Qualifying expenditures encompass direct costs. These include wages and salaries of personnel engaged in R&D activities, such as researchers, engineers, and support staff. Supplies consumed during R&D, like raw materials for prototypes, are also included. Payments to third-party contractors, such as product designers or research institutions, for qualified R&D activities can also be included. Costs for using computers, including cloud hosting for development and testing, may also qualify.

Activities Excluded from Research and Development Costs

Certain expenditures are not classified as R&D costs because they do not meet the criteria of systematic investigation into technological uncertainty. Routine or periodic alterations to existing products, production lines, or ongoing operations do not qualify. Minor cosmetic changes to a product’s appearance that do not involve significant technological advancement are excluded.

Quality control or routine product testing activities are also excluded from R&D. These processes verify a product meets established standards, rather than seeking new knowledge or significant improvements. Market research, consumer surveys, and routine data collection are not considered R&D, as they are non-technical and do not involve scientific or technological experimentation.

Commercial production, including engineering follow-up, is explicitly excluded from R&D. Once a product or process moves into commercial production, associated costs are considered manufacturing or operational expenses, not R&D. General administrative or selling expenses, even if indirectly related to innovation, are not classified as R&D costs. Research related to arts, social sciences, or humanities is also excluded, as the R&D definition requires a technological or scientific basis.

Financial Reporting of Research and Development Costs

Under U.S. Generally Accepted Accounting Principles (GAAP) ASC 730, R&D costs must be expensed as incurred. This means the full cost of R&D activities is recognized on the income statement in the period it occurs, reducing reported profits. This expensing treatment reflects the inherent uncertainty of R&D outcomes and the difficulty in reliably predicting future economic benefits.

An exception to this immediate expensing rule exists for materials, equipment, or facilities acquired for R&D that have an alternative future use. Such assets may be capitalized and then depreciated over their useful lives, with depreciation subsequently recognized as R&D cost. Certain software development costs, once technological feasibility is established, may also be capitalized rather than expensed.

In contrast, International Financial Reporting Standards (IFRS), under IAS 38, differentiates between research and development phases for accounting treatment. Research costs are expensed as incurred, similar to US GAAP. However, development costs can be capitalized as an intangible asset if specific criteria are met, indicating probable future economic benefits. These criteria include:

• Demonstrating technical feasibility
• The intention and ability to complete and use or sell the asset
• The likelihood of future economic benefits
• The ability to reliably measure the expenditure

This difference can lead to varying impacts on a company’s financial statements, with IFRS potentially showing higher assets and net income in periods of significant development capitalization compared to US GAAP.

Tax Treatment of Research and Development Costs

For tax purposes in the United States, R&D costs have specific treatments designed to incentivize innovation. Historically, businesses could immediately deduct research and experimental (R&E) expenditures in the year they were incurred under Internal Revenue Code Section 174. However, a significant change enacted by the Tax Cuts and Jobs Act of 2017 requires R&E expenditures incurred after December 31, 2021, to be capitalized and amortized. Domestic R&E expenses are amortized over five years, while those for foreign research are amortized over fifteen years. This change has increased the taxable income for many companies, particularly those with substantial R&D investments, by delaying the tax deduction.

Separate from the deductibility under Section 174, businesses may also qualify for the R&D tax credit under Internal Revenue Code Section 41. This credit is a direct reduction in tax liability for qualified research expenses, serving as a significant incentive for innovation. Eligible costs for the credit include wages paid for qualified research services, supplies used in research, and a percentage of amounts paid to third parties for contract research. The R&D tax credit is applied against income tax liability, and for qualified small businesses, it can even offset certain payroll taxes, up to $250,000 per year for up to five years.

While Section 174 amortization is currently mandatory, legislative efforts are ongoing to reverse this requirement. As of early August 2025, a House-passed bill proposes full expensing for domestic R&D for tax years 2025-2029, with potential retroactive amendments for 2022-2024. This discussion highlights government recognition of R&D as a driver of economic competitiveness and potential for future tax policy changes.