Research and development (R&D) is key to creating new products and improving a company’s growth. However, R&D tends to have a significant upfront cost, which can burden businesses.
One way to manage these costs is through R&D capitalization. This allows the effects of the cost to be eased over several years, which aligns with the future benefits of the investments made.
What Is R&D Capitalization?
There are two approaches to handle the costs of R&D in companies:
- Expensing R&D costs immediately: These costs are recorded as expenses in the current financial period.
- Capitalizing R&D costs: Certain development costs are treated as assets, reflecting their long-term value to the company.
R&D capitalization records certain research and development costs as assets instead of expenses. This approach acknowledges that some R&D work, especially in the development phase, benefits the company for a long time.
Understanding R&D Capitalization Rules
International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) provide clear criteria for R&D capitalization. Although they have different approaches, both aim to ensure that only expenditures with a clear link to future benefits are capitalized.
According to IAS 38, development costs may be included in the report if they are met with the following criteria:
- Technical feasibility.
- Intent to complete.
- Future economic benefits.
- Reliable cost measurement.
How R&D Capitalization Works
Since you now understand what R&D capitalization is, let’s discuss how it works:
1. Identify Eligible Costs
- The first step is to separate research costs from development costs.
- Research costs are expenses for exploring new ideas and are recorded immediately as expenses.
- Development costs are tied to creating new products, processes, or technologies and may qualify as assets.
Examples of capitalizable development costs include:
- Salaries of developers, engineers, or other technical staff directly involved in development.
- Costs of prototypes, testing, or third-party services.
- Software or hardware purchased explicitly for the development project.
2. Assess Capitalization Criteria
Ensure the project meets the criteria for capitalization outlined under R&D capitalization rules. Key factors to evaluate include:
- Technical feasibility: Can the project realistically be completed?
- Intent to complete: Does the organization plan to finish and use/sell the asset?
- Future benefits: Can the asset generate economic returns?
If the answers to these are yes, the costs can be capitalized.
3. Record Costs as Assets
- Capitalizable expenses are recorded as intangible assets. They appear on the balance sheet, not the income statement.
- Each transaction must be tracked accurately. This ensures compliance with accounting standards.
4. Amortization of Capitalized R&D Costs
- When the intangible asset is ready, capitalized R&D costs are amortized. This happens over the asset’s useful life.
- Amortization spreads the cost over multiple periods and reflects the gradual benefit from the asset.
5. Ongoing Review
- Regularly evaluate the asset for impairment.
- The remaining value must be written off if it is determined that the project will no longer generate future benefits.
Benefits of Capitalized R&D Costs
Choosing R&D capitalization has several advantages:
- Improved profitability: Spreading costs over multiple years reduces the impact on profits in the year of investment.
- Stronger balance sheet: Recognizing R&D as an asset can increase the company’s overall asset value.
- Attracting investors: A consistent profit margin can make the company more appealing to investors.
Challenges in R&D Capitalization
While the benefits are evident, the process of R&D capitalization also comes with complexities:
- Research vs. Development: Clear documentation is essential to segregate research costs (expensed) from development costs (capitalized).
- Satisfying the necessary criteria for capitalization: This is not always straightforward to do, particularly in terms of convincing that a project can indeed be successfully executed.
- Cost tracking: Allocating costs to specific projects may be complicated and cumbersome, particularly where the organization is big or teams are multi-functional.
- Regulatory compliance: Different accounting standards, such as IFRS and GAAP, have varying rules for R&D capitalization.
- Intangible assets: Deciding the useful life of intangible assets needs proper judgment. It is easy to get it wrong, which may cause financial entry errors.
- Audit risks: R&D capitalization costs may be throughly questioned by auditors. Hence, you need to keep robust documentation and evidence.
How to Benefit from the R&D Tax Credit
The R&D tax credit is an incentive from the government. It rewards companies for investing in innovation. Combining this credit with R&D expense capitalization reduces financial strain and helps ease the costs of development projects.
- Understand eligibility: Activities must aim to develop new or improved products, processes, or software. Salaries, supplies, and contracted research are eligible for this.
- Use tax credits: Some regulations allow businesses to use a portion of their capitalized R&D costs against tax liabilities. This can lower the effective cost of R&D investments.
- Document thoroughly: Maintain records of eligible activities, costs, and outcomes to maximize claims.
- Seek expert guidance: Consult tax advisors or R&D specialists to ensure compliance with regulations and optimize credit claims.
Conclusion
R&D capitalization provides a strategic advantage by helping businesses align financial reporting with growth goals. By following the rules, companies can turn R&D expenses into long-term assets to improve financial health and attract investors.
However, managing development cost capitalization is complex. Successfully managing R&D capitalization requires careful planning, clear documentation, and a deep understanding of regulatory requirements.
