What Are Research and Development (R&D) Expenses?

Research and Development (R&D) expenses represent the financial investment companies make to foster innovation and maintain a competitive edge. These expenditures are fundamental for businesses aiming to discover new knowledge, create novel products or services, or significantly enhance existing ones. Understanding what qualifies as an R&D expense is important for both businesses and those analyzing their financial performance.

Understanding Research and Development Activities

Research and development activities are systematic investigations characterized by an element of novelty and uncertainty. These activities aim to discover new knowledge or apply research findings to develop new products, services, or processes, or to significantly improve existing ones.

Research involves planned searches or critical investigations aimed at discovering new knowledge useful for developing new products or services. This phase focuses on theoretical exploration and experimentation. Development then translates these research findings or other knowledge into a tangible plan or design for a new product, service, or significant improvement, often involving prototypes or pilot plants.

Activities are considered R&D when they involve overcoming scientific or technological challenges. This investigation aims to achieve an advance in science or technology, rather than making routine improvements or cosmetic changes.

Accounting Recognition of R&D Costs

Under U.S. Generally Accepted Accounting Principles (GAAP), specifically ASC 730, the general rule is that all research and development costs must be expensed as they are incurred. This immediate expensing is due to the inherent uncertainty surrounding the future economic benefits of R&D activities. It is often difficult to ascertain whether R&D efforts will result in a commercially viable product or process.

If these costs were capitalized, they would be treated as an asset and amortized over time, potentially misrepresenting a company’s financial position given the high risk of failure in R&D endeavors. This approach ensures that financial statements reflect the speculative nature of R&D investments.

Exceptions exist where capitalization of certain R&D-related costs might occur. Materials or fixed assets acquired for R&D activities that have alternative future uses beyond the current R&D project are capitalized. These assets are then depreciated over their useful lives, and the depreciation expense related to their R&D use is recognized as an R&D expense.

Software development costs also present a capitalization exception under ASC 985-20 for software to be sold, leased, or marketed to others. Costs incurred before technological feasibility is established are expensed as R&D. Once technological feasibility is reached—meaning all necessary planning, designing, coding, and testing are completed—certain development costs can be capitalized until the product is ready for general release.

Types of R&D Expenses

Research and development expenses encompass various costs directly related to R&D activities. These costs are categorized as operating expenses on a company’s income statement. They include both direct and indirect expenditures necessary to conduct the research and development process.

A significant portion of R&D expenses consists of labor costs, including salaries, wages, and related benefits for personnel directly engaged in R&D activities. This includes scientists, engineers, and technical staff involved in research, direct supervision, and direct support. General administrative staff, even within a research department, do not qualify.

Materials and supplies consumed in R&D activities, such as raw materials used for experiments or prototypes, are classified as R&D expenses. Depreciation of equipment and facilities dedicated to R&D, like laboratory equipment and research facilities, is another expense category. Costs of services performed by others, such as payments to external organizations or consultants for research work, are included.

Indirect costs, or overhead, are allocated to R&D activities based on their direct benefit to the R&D function. These include utilities for research facilities, rental costs, a reasonable portion of administrative salaries directly supporting R&D, and cloud infrastructure costs dedicated to R&D used for experimentation to resolve technical uncertainty.

Activities Excluded from R&D

Not all activities related to product or process improvements qualify as R&D for accounting purposes. Certain activities, despite appearing innovative, lack the inherent novelty and uncertainty required under GAAP to be classified as R&D. These exclusions help maintain a clear distinction between R&D and routine business operations.

Routine or periodic alterations to existing products, production lines, or processes are excluded from R&D expenses, including minor modifications or enhancements that do not involve significant technological uncertainty. Quality control activities, routine testing of products, and troubleshooting in connection with commercial production are not considered R&D because they aim to ensure existing functionality rather than discover new knowledge or apply it to new designs.

Market research, consumer surveys, advertising, and sales promotion activities are excluded, as they focus on commercialization and understanding market needs rather than scientific or technological advancement. General administrative expenses, such as those related to human resources or accounting, are not considered R&D, even if they indirectly support R&D personnel.

The acquisition of another entity’s patent, model, production, or process, and research conducted after commercial production begins, are excluded. Activities involving cosmetic changes to a product’s appearance or duplicating previously completed projects without new technological advancements do not qualify as R&D.