9.4 Research and development costs
6 min read•august 20, 2024
Research and development costs are crucial for innovation but tricky to account for. Companies must carefully track these expenses, which are typically expensed as incurred due to uncertain future benefits. This approach impacts financial statements and ratios, reflecting the risk inherent in R&D activities.
Proper accounting for R&D costs ensures transparency in financial reporting. While generally expensed, there are exceptions in business combinations and under IFRS. Understanding the treatment of R&D costs is essential for analyzing a company's investment in innovation and its financial position.
Accounting for R&D costs
- Research and development (R&D) costs are expenditures incurred by a company to develop new products, services, or processes
- Accounting for R&D costs is a critical component of financial reporting for companies in industries that heavily rely on innovation and technological advancements
- Proper accounting treatment of R&D costs ensures that financial statements accurately reflect a company's financial position and performance
R&D costs vs capital expenditures
- R&D costs are often confused with capital expenditures, but there are distinct differences between the two
- Capital expenditures are costs incurred to acquire or improve long-term assets, such as property, plant, and equipment
- R&D costs, on the other hand, are expenditures related to the development of new products, services, or processes, which may or may not result in future economic benefits
- Unlike capital expenditures, R&D costs are generally expensed as incurred due to the uncertainty of future benefits
Criteria for R&D activities
Planned search or investigation
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- R&D activities involve a systematic, planned search or investigation to discover new knowledge or develop new products or processes
- This criterion distinguishes R&D from other activities, such as routine testing or quality control
Discovery of new knowledge
- R&D activities aim to discover new knowledge that can be used to create new products, services, or processes
- The discovery of new knowledge is a key component of R&D and sets it apart from other business activities
Uncertainty of future benefits
- R&D activities are characterized by uncertainty regarding the future economic benefits that may result from the research
- The uncertainty of future benefits is a critical factor in determining the accounting treatment of R&D costs
Accounting treatment of R&D costs
Expensing R&D costs
- Under both IFRS and US GAAP, R&D costs are generally expensed as incurred
- Expensing R&D costs means that they are recognized as expenses in the income statement in the period in which they are incurred
Rationale for expensing
- The rationale for expensing R&D costs is based on the uncertainty of future economic benefits
- Since there is no guarantee that R&D activities will result in successful products or services, expensing R&D costs provides a conservative approach to financial reporting
Impact on financial statements
- Expensing R&D costs has a direct impact on a company's financial statements
- R&D expenses reduce a company's net income and earnings per share (EPS) in the period in which they are incurred
- However, expensing R&D costs also ensures that a company's assets are not overstated, as the future benefits of R&D are uncertain
R&D costs on balance sheet
Disclosure requirements
- Although R&D costs are expensed as incurred, companies are required to disclose information about their R&D activities in their financial statements
- Disclosure requirements include the total amount of R&D costs incurred during the period and a description of the company's R&D activities
Notes to financial statements
- Companies typically provide additional information about their R&D activities in the notes to their financial statements
- Notes to financial statements may include details about specific R&D projects, the expected duration of R&D activities, and the anticipated benefits of successful R&D efforts
R&D arrangements
Funding from third parties
- In some cases, companies may receive funding from third parties, such as government agencies or other companies, to support their R&D activities
- Third-party funding for R&D can take various forms, such as grants, contracts, or collaborative agreements
Repayment of R&D costs
- When a company receives funding from third parties for R&D, the accounting treatment depends on the terms of the arrangement
- If the third-party funding is contingent upon the success of the R&D activities and requires repayment, the company may need to record a liability for the potential repayment obligation
- If the third-party funding is non-refundable, the company may recognize the funding as income in the period in which it is received
R&D in business combinations
In-process R&D
- When a company acquires another company, it may obtain in-process R&D (IPR&D) as part of the acquisition
- IPR&D refers to R&D projects that have not yet been completed at the acquisition date and have no alternative future use
Valuation of in-process R&D
- Under US GAAP, IPR&D acquired in a business combination is initially recognized as an indefinite-lived intangible asset at its fair value
- The fair value of IPR&D is determined using valuation techniques, such as the multi-period excess earnings method or the relief-from-royalty method
- Subsequent to initial recognition, IPR&D is subject to impairment testing until the completion or abandonment of the R&D project
Financial ratios impacted by R&D
R&D intensity ratio
- The ratio is a financial metric that measures a company's investment in R&D relative to its size
- It is calculated by dividing R&D expenses by total revenues for a given period
- A higher R&D intensity ratio indicates that a company is investing more heavily in R&D compared to its peers
R&D to sales ratio
- The R&D to sales ratio is another financial metric that assesses a company's R&D investment relative to its sales
- It is calculated by dividing R&D expenses by total sales for a given period
- This ratio helps investors and analysts understand the proportion of a company's sales that are being reinvested into R&D activities
Tax treatment of R&D costs
R&D tax credits
- Many countries offer tax incentives to encourage companies to invest in R&D activities
- R&D tax credits allow companies to reduce their tax liability based on the amount of R&D expenses incurred during the tax year
- The specific requirements and benefits of R&D tax credits vary by jurisdiction
Timing differences vs permanent differences
- The tax treatment of R&D costs can create timing differences between a company's financial reporting and tax reporting
- Timing differences arise when the recognition of R&D expenses for financial reporting purposes differs from the recognition for tax purposes
- In some cases, R&D expenses may result in permanent differences, where the expense is not deductible for tax purposes at all
Comparison of IFRS vs US GAAP
Capitalization of development costs under IFRS
- One key difference between IFRS and US GAAP in the treatment of R&D costs is the of development costs
- Under IFRS, companies are required to capitalize development costs when certain criteria are met, such as technical feasibility and the intention to complete the development project
Criteria for capitalization under IFRS
- For development costs to be capitalized under IFRS, the following criteria must be met:
- Technical feasibility of completing the intangible asset
- Intention to complete the intangible asset and use or sell it
- Ability to use or sell the intangible asset
- Demonstration of how the intangible asset will generate probable future economic benefits
- Availability of adequate technical, financial, and other resources to complete the development and to use or sell the intangible asset
- Ability to measure reliably the expenditure attributable to the intangible asset during its development
- If these criteria are not met, development costs are expensed as incurred, similar to the treatment under US GAAP
Key Terms to Review (18)
Amortization of R&D: Amortization of research and development (R&D) refers to the systematic allocation of the costs associated with R&D activities over time. This process is important for accounting purposes, as it helps reflect the value generated from these expenditures on financial statements. Amortization allows companies to match the expense of R&D with the revenues they generate from new products or technologies developed as a result of those investments.
ASC 730: ASC 730 refers to the Accounting Standards Codification topic that governs the accounting for research and development (R&D) costs. This standard outlines how entities should recognize, measure, and report R&D expenditures, focusing on the importance of distinguishing between research activities aimed at discovering new knowledge and development activities aimed at translating that knowledge into marketable products.
Budget variance: Budget variance refers to the difference between the budgeted amount of expense or revenue and the actual amount incurred or received. This concept is vital in evaluating a company's financial performance, as it highlights discrepancies that may arise due to various factors, such as operational inefficiencies or market changes. Understanding budget variance can help organizations assess their financial strategies and adjust future budgets accordingly.
Capitalization: Capitalization refers to the accounting practice of recognizing and recording an expenditure as an asset rather than an expense. This process allows costs associated with acquiring assets to be spread out over time, reflecting their ongoing utility and value. By capitalizing costs, businesses can better match expenses with revenues, especially in relation to acquiring tangible and intangible assets, and managing research and development investments.
Development stage: The development stage refers to the phase in the lifecycle of a product or project where research findings are transformed into a viable product or service. This stage involves activities such as designing, prototyping, testing, and refining the product before it can be introduced to the market. It is a crucial phase that bridges the gap between idea conception and actual production, ensuring that the end product meets the required specifications and market needs.
Direct costs: Direct costs are expenses that can be directly traced to a specific product, service, or project. These costs are crucial for determining the overall cost of goods sold (COGS) and for evaluating the profitability of individual projects. In the context of research and development, understanding direct costs helps in budgeting and financial planning, ensuring resources are allocated effectively towards innovations.
Expense recognition: Expense recognition is the accounting principle that dictates when expenses should be recorded in the financial statements. This principle is crucial for accurately reflecting a company's financial performance and position, as it ensures that expenses are matched with the revenues they help to generate. Understanding this concept allows businesses to apply proper timing for recording costs, which directly impacts profit calculation and financial analysis.
Feasibility stage: The feasibility stage is a critical phase in the research and development process where the potential for a project or product is assessed to determine if it can be successfully developed and brought to market. This stage includes evaluating technical, financial, and operational aspects to ensure that the proposed idea is viable before significant resources are committed. By conducting thorough assessments during this stage, companies can mitigate risks and focus on projects that are likely to succeed.
Government grants: Government grants are financial awards given by government entities to support specific projects or initiatives, often aimed at promoting research and development, innovation, and public welfare. These grants can help offset costs associated with research and development activities, making it easier for organizations to pursue new technologies or products without bearing the full financial burden themselves. They serve as a crucial funding source for various sectors, including healthcare, education, and technology.
IFRS 38: IFRS 38 is an international financial reporting standard that provides guidelines for the recognition, measurement, and disclosure of intangible assets. It emphasizes that intangible assets should be identified separately from tangible assets and sets out specific criteria for their recognition, including the requirement that the asset is identifiable, controlled by the entity, and expected to provide future economic benefits.
Indirect costs: Indirect costs are expenses that cannot be directly traced to a specific product, service, or project. These costs support overall operations and are typically allocated across multiple projects or departments. Understanding indirect costs is crucial because they can significantly impact the financial analysis of research and development activities.
Matching principle: The matching principle is an accounting concept that requires expenses to be matched with the revenues they help to generate in the same period. This principle ensures that a company's financial statements accurately reflect its profitability and financial performance by aligning income and related expenses within the same time frame.
Product Development: Product development is the process of designing, creating, and bringing a new product to market. This involves several stages, including ideation, design, testing, and commercialization, aimed at fulfilling market needs or enhancing existing offerings. The process often requires significant investment in research and development to ensure that the final product meets quality standards and customer expectations.
Project feasibility analysis: Project feasibility analysis is the process of evaluating the potential success of a proposed project by assessing its viability in terms of economic, technical, legal, and operational aspects. This analysis helps determine whether a project is worth pursuing based on its anticipated costs and benefits, including the associated research and development costs that may arise during the project's lifecycle.
Prototype costs: Prototype costs are the expenses incurred during the development of a preliminary model or sample of a product that is used for testing and evaluation before full-scale production. These costs can include materials, labor, and overhead associated with creating and refining the prototype, which is crucial in research and development processes to assess feasibility and design options.
R&d intensity: R&D intensity refers to the ratio of a company's research and development (R&D) expenditures to its total sales revenue. This metric provides insight into how much a company is investing in innovation relative to its size, indicating its commitment to developing new products and technologies. A higher R&D intensity suggests a strong focus on innovation, which can be crucial for long-term growth and competitiveness in rapidly evolving industries.
Return on Investment (ROI) in R&D: Return on Investment (ROI) in Research and Development (R&D) is a performance measure used to evaluate the efficiency or profitability of an investment in R&D activities. It is calculated by comparing the net profit gained from R&D projects to the costs incurred during those projects. This metric helps organizations determine whether their investment in innovation and product development is yielding sufficient returns and can guide future funding decisions.
Tax Credits for R&D: Tax credits for R&D are incentives offered by the government to businesses that invest in research and development activities. These credits reduce the tax liability of companies, encouraging them to innovate and develop new products or processes, which can lead to economic growth and increased competitiveness in the market.