Accounting rules define an asset as something with future economic benefits, so it's natural to ask why research and development costs can't be capitalized and treated as an asset rather than an expense, which is what the rules require. After all, the whole purpose of "R&D" is to realize future economic benefit. According to the Financial Accounting Standards Board, the rule-making body for U.S. business accounting, the answer lies in the difficulty of quantifying those future benefits.
Accounting rules define an asset as something with future economic benefits, so it's natural to ask why research and development costs can't be treated as an asset. The answer lies in the difficulty of quantifying those future benefits.
Capitalization Effects of Research and Develpment
Whether R&D costs should be capitalized or treated as expenses isn't just a technical question about accounting procedures. It has a direct impact on the most basic calculations of a company's value and profitability. If your business could capitalize its R&D, then your balance sheet would show more assets, which would increase the value of the company.
At the same time, because the costs wouldn't be treated as expenses, your company's profits, at least on paper, would be higher. For a small or start-up company that has significant R&D costs, that could make the difference in securing the investor capital needed to grow.
Uncertain Benefits of Research and Development
The main reason companies aren't allowed to capitalize their research and development costs is that there's no way to reliably measure the future economic benefits of those costs. R&D involves trial and error – a lot of error. When it set the rules for R&D spending in the 1970s, the accounting standards board cited data showing that only 2 percent of product ideas become commercially viable, and only 15 percent of products that actually go into development become viable.
When your company spends money on R&D, you have no way of knowing which projects will pan out – that is, produce future benefits – and which won't. Even if you could identify the projects that will work, you can't put an objective figure on what their benefits will be. And then there's the unresolved question of how to treat "failed" projects when later successes are built on the lessons learned from those failures.
Amortization Issues of Research and Development
Because it's so difficult to draw direct cause-and-effect relationships between specific amounts of R&D spending and future economic benefits, it would be impossible to follow one of the fundamental principles of business accounting: the "matching principle." This principle holds that whenever you report revenue, you must at the same time report the expenses incurred in generating that revenue. This is why companies depreciate "hard assets" such as vehicles and equipment.
If you buy a $25,000 truck that will last 10 years – in other words, help you generate revenue for 10 years – you first capitalize the $25,000 and then take a depreciation expense each year for the next 10 years until the truck is fully depreciated. Similarly, intangible assets – which is what a hypothetical R&D asset would be – are amortized over time to match them with the revenue they produce. If it's not possible to directly match R&D expenses with revenue, then the asset can't be amortized. For these reasons, accounting rules require that all R&D costs be treated as expenses when they are incurred.
"In Process" Research and Development
There's one exception to the rule against capitalizing research and development costs. If your business buys another company, you must capitalize any "in process" R&D projects that come with the purchase. The rationale behind this exception is that some portion of the price you paid to acquire the company was allocated to those projects, so the projects have a definable value that you can list as an asset.
Say you buy out a competitor for $250,000. As you combine your companies' finances, you'll allocate a portion of that $250,000 to the competitor's R&D projects, and then report that amount as an asset. When the R&D project is completed, one of two things will happen. If the project doesn't produce tangible results, you'll report an expense for the full amount of the asset – you'll "write it off," in other words. If the project bears fruit, you'll have to assign a "life span" to the benefits of the project and then amortize the asset over that life span.
FAQs
Uncertain Benefits of Research and Development
Why are research and development expenses not capitalized? ›
SSAP 13 states that expenditure on research does not directly lead to future economic benefits, and capitalising such costs does not comply with the accruals concept. Therefore, the accounting treatment for all research expenditure is to write it off to the profit and loss account as incurred.
Do R&D expenses have to be capitalized? ›
We've heard from many companies who are confused by the change. They ask: if we don't file an R&D credit, do we still have to capitalize our R&D expenses? The short answer is YES.
Why do accounting standards prohibit capitalizing of research costs? ›
They stress the lack of reliable evidence of future economic benefits (e.g., FASB, 1974, Association for Investment Management and Research, 1993, Kothari et al., 2002) or refer to the benefits of consistency and comparability, pointing out that such benefits trump the costs identified by the supporters of ...
Why is R&D not capex? ›
In most cases, R&D is categorized as an operating expenditure since it constitutes the ongoing costs associated with running a business. These costs may include salaries of researchers, costs of materials and supplies, and other expenses related to R&D activities.
Can you capitalize research and development costs under GAAP? ›
R&D capitalization is the process of classifying research and development activity as an asset rather than an expense. Under GAAP, companies must expense their R&D activities within the same year the cost was incurred. Managing your R&D in the most efficient way possible requires a solid strategy.
Can you claim R&D on Capitalised costs? ›
To be eligible as qualifying R&D expenditure, expenditure must be allowable as a deduction in calculating the profits of the trade. Capital expenditure is therefore excluded; it may however qualify for R&D allowances (see CA60000 onwards).
How long do you capitalize R&D expenses? ›
Starting in 2022, companies can no longer write off 100% of costs in the year they were incurred. Instead, to comply with these new rules, companies must amortize most of those costs over five years (15 years for R&D expenses attributed to foreign research).
What are the benefits of capitalizing R&D costs? ›
Capitalisation: Adds R&D assets to the balance sheet, potentially enhancing the company's asset base. Expensing: Does not impact the balance sheet directly, as R&D costs are treated as incurred expenses.
What expenses Cannot be capitalized? ›
Expenses that must be taken in the current period (they cannot be capitalized) include Items like utilities, insurance, office supplies, and any item under a certain capitalization threshold. These are considered expenses because they are directly related to a particular accounting period.
To be capitalized and recognized as an asset in the books of the company, it should be probable that there will be an inflow of future economic benefits to the business from it. Also, the cost should be reliably measured. Research and development costs do not pass any of the criteria to be capitalized.
What are the criteria for capitalizing development costs? ›
Development costs are capitalised as an intangible asset if all of the following criteria are met [IAS 38 para 57]: The technical feasibility of completing the asset so that it will be available for use or sale. The intention to complete the asset and use or sell it. The ability to use or sell the asset.
What is improper capitalization of expenses? ›
Improper capitalization of expenses.
Such improper expense-capitalization decreases current-period expenses, spreading them out over multiple periods. When expenses have been properly capitalized, the associated period is sometimes manipulated as well to change the depreciation or amortization period.
Why not capitalize R&D? ›
The main reason companies aren't allowed to capitalize their research and development costs is that there's no way to reliably measure the future economic benefits of those costs. R&D involves trial and error – a lot of error.
How is R&D treated in accounting? ›
The R&D costs are included in the company's operating expenses and are usually reflected in its income statement.
Is R&D an operating expense or capital expense? ›
R&D may be classified as an operating expense if it is considered necessary for the company to maintain its current level of operation. For example, if a company is developing a new product, the research and development costs associated with that product may be classified as an operating expense.
Does research and development need to be capitalized? ›
As of January 1, 2022, companies are required to capitalize and amortize the cost of research and development—including software development cost.
Is research and development a capital expenditure? ›
A Financial Analysis of Research and Development Expenses
Research and development expenses are designed to generate future growth and should be treated as capital expenditures.
Can you expense research and development costs? ›
Highlights. Specified research and development (R&D) and experimental expenditures no longer are deductible beginning with the 2022 tax year following revisions made to Internal Revenue Code Section 174 as part of the Tax Cuts and Jobs Act.
Which of the following research and development costs should be capitalized? ›
Answer and Explanation:
Research and development expenses such as material, equipment and facilities acquired for Research and Development activities that have future alternative uses are appropriate to capitalize under GAAP ASC 730.
