What Is R&D in Accounting? Costs and Tax Credits

Research and development (R&D) plays a significant role in fostering innovation and driving growth for businesses. It encompasses activities companies undertake to discover new knowledge or create new products, processes, or services, as well as to improve existing ones. Understanding how R&D is treated in accounting is important for financial reporting and for businesses seeking to maximize financial health through tax incentives. This area of accounting helps entities accurately reflect their investment in future capabilities and guides how these expenditures impact financial statements.

Defining Research and Development for Financial Reporting

From an accounting perspective, research and development activities aim to gain new scientific or technical knowledge, or to apply such knowledge to create new or significantly improved offerings. Research involves original investigations to acquire new scientific or technical understanding without a specific commercial application. This might include exploratory studies.

Development activities apply research findings or other knowledge to a plan or design for producing new or substantially improved materials, devices, products, processes, systems, or services before commercial production. This could involve designing and testing prototypes or constructing pilot plants. The distinction between research and development is based on the project stage and the certainty of future economic benefits.

Activities generally not qualifying as R&D for financial reporting include routine alterations to existing products or processes. This also covers market research, routine quality control, general administrative functions, or post-production activities. Accounting classification focuses on the inherent uncertainty and the pursuit of new knowledge or significant technological advancement, not incremental improvements.

Accounting for R&D Costs

Under U.S. Generally Accepted Accounting Principles (GAAP), R&D costs are generally expensed as they are incurred. This means the full cost of R&D activities is recognized immediately on the income statement, reducing current period net income. The primary rationale for this immediate expensing is the inherent uncertainty of future economic benefits. It is often unclear whether R&D efforts will result in a commercially viable product or process that generates future revenue.

While the general rule is to expense R&D costs, some nuances exist. Costs for materials, equipment, or facilities with an alternative future use beyond a specific R&D project can be capitalized and depreciated. The depreciation expense related to their use in R&D activities is then expensed as R&D costs. Software development costs have specific guidance; costs incurred before technological feasibility is established are expensed, while some costs after this point may be capitalized.

Expensing R&D costs directly reduces a company’s reported profit, and no corresponding asset is typically recorded on the balance sheet for the R&D efforts themselves. This financial reporting treatment can differ from tax treatment, where R&D costs may be capitalized and amortized for tax purposes. International Financial Reporting Standards (IFRS) sometimes allow for the capitalization of development costs if certain criteria, such as technical feasibility, are met.

Qualifying for the R&D Tax Credit

Research and development activities can qualify for significant tax benefits through the federal R&D Tax Credit, outlined in Internal Revenue Code Section 41. To claim this credit, activities must meet specific criteria, often called the “four-part test.” This test ensures the research is innovative and involves technical risk.

The four parts of the test are:

Permitted Purpose: The activity must intend to develop or improve the functionality, performance, reliability, or quality of a new or existing business component.
Elimination of Uncertainty: The activity must seek to discover information that would eliminate technical uncertainty regarding the development or improvement of the business component.
Technological in Nature: The research must fundamentally rely on principles of the physical or biological sciences, engineering, or computer science.
Process of Experimentation: The activity must involve a systematic approach, such as trial and error, testing, modeling, or simulation, to evaluate alternatives and resolve technical uncertainty.

All four parts must be satisfied for an activity to be considered “qualified research” for tax credit purposes. Qualified research expenses (QREs) generally fall into three main categories: wages, supplies, and contract research expenses. Wages paid to employees for directly performing, supervising, or supporting qualified research activities are eligible. Supplies include tangible property used in the conduct of qualified research, such as materials consumed in developing prototypes. For contract research, 65% of amounts paid to third parties for qualified research can be included, provided the taxpayer bears the economic risk and retains substantial rights to the research. Activities typically excluded from the credit are research conducted outside the United States, research in social sciences, arts, or humanities, and research funded by another entity.

Claiming the R&D Tax Credit

The R&D Tax Credit is primarily claimed on IRS Form 6765, “Credit for Increasing Research Activities.” This form is typically filed as part of a company’s annual federal income tax return. Form 6765 includes sections for the regular credit and the alternative simplified credit, allowing businesses to choose the method that maximizes their benefit. For qualified small businesses, a portion of the credit can be claimed against payroll taxes. To be considered a qualified small business for this payroll tax offset, a company must generally have gross receipts of less than $5 million for the current year and no gross receipts for any tax year more than five years prior.

Accurate and comprehensive documentation is essential when claiming the R&D Tax Credit. Businesses should maintain detailed records to support their claim during potential IRS review. This includes:

Project plans
Technical reports
Communications describing objectives, technical uncertainties, and the systematic process of experimentation
Financial documentation, such as time sheets, payroll records, invoices for supplies, and contracts with third-party researchers

The IRS requires specific information with refund claims based on the research credit, including identification of business components, descriptions of research activities, and total qualified expenses by category.