Why Is R&D Capitalized and How Do You Account For It?

Businesses constantly innovate, developing new products, improving existing ones, or creating more efficient processes. This often involves significant investment in Research and Development (R&D). How these R&D costs are accounted for substantially impacts a company’s financial statements and tax obligations. Understanding the treatment of R&D expenses, especially the shift towards capitalization for tax purposes, is important for businesses.

Defining Research and Development Costs

Research and Development (R&D) generally refers to activities aimed at discovering new knowledge or applying research findings to create or significantly improve products, processes, or services. For accounting purposes, under Accounting Standards Codification (ASC) 730, R&D includes conceptual formulation, design, and testing of product alternatives, construction of prototypes, and operation of pilot plants. Examples of R&D activities include designing or testing new products, developing prototypes, or creating new software. However, not all related activities qualify; routine product testing, quality control, or market research are excluded from this classification. While financial accounting standards provide a framework, tax definitions also exist, generally aligning with the goal of advancing science or technology through systematic experimentation to eliminate uncertainty.

Prior Treatment of R&D Expenses

Historically, businesses in the United States enjoyed beneficial tax treatment for R&D expenditures. Under Internal Revenue Code Section 174, companies could immediately deduct the full amount of their research and experimental (R&E) expenses in the year incurred. This immediate expensing significantly reduced taxable income in the year the R&D investment was made.

The rationale for this long-standing rule, in place for nearly 70 years, was to encourage innovation and investment in new technologies within the U.S. This allowed the entire cost of qualified R&D to be written off against current income, directly impacting a company’s tax liability.

The Current Capitalization Requirement

A significant change to the tax treatment of R&D costs came with the Tax Cuts and Jobs Act of 2017. This legislation mandated that for tax years beginning after December 31, 2021, businesses can no longer immediately expense R&D costs. Instead, these expenditures, now called specified research and experimental (SRE) expenditures, must be capitalized and amortized over a specified period.

This shift means R&D costs are treated as an asset on the balance sheet, not an immediate deduction. Domestic R&D costs are amortized over five years, while foreign R&D costs are amortized over 15 years. This distinction incentivizes companies to conduct research and development activities within the United States. The change was primarily enacted as a revenue-generating measure to help offset the tax cuts.

Accounting for Capitalized R&D

The practical implication of capitalizing R&D costs is that the expenditure is no longer fully deductible in the year incurred. For domestic R&D, one-fifth of the cost is deducted each year over five years, beginning with the midpoint of the taxable year in which the expenses are paid or incurred. For foreign R&D, the deduction is spread over 15 years.

On the income statement, companies now report an amortization expense each year over the specified period, rather than a large R&D expense. This change can lead to higher reported profits initially, but it also increases taxable income, potentially resulting in higher tax payments and impacting cash flow. On the balance sheet, capitalized R&D appears as an asset, systematically reduced over its useful life through accumulated amortization. This treatment can make a company’s balance sheet appear stronger due to increased assets, but it also means the tax benefit of R&D investment is delayed.