Types of costs of R&D include individual current and capital cost categories for intramural R&D. Types of current costs include labour costs for internal R&D personnel and other current costs (for external R&D personnel, purchases of services, purchases of materials, and other costs not elsewhere classified. Types of capital costs include land and buildings, machinery and equipment, capitalised computer software and other intellectual property products.
Data source
R&D surveys.
Source definition
OECD (2015), Frascati Manual 2015: Guidelines for Collecting and Reporting Data on Research and Experimental Development.
Purpose
To break down R&D expenditure by type of costs.
June 01, 2022 June 01, 2022/ Steven Bragg
The accounting for research and development involves those activities that create or improve products or processes. The core accounting rule in this area is that expenditures be charged to expense as incurred. Examples of activities typically considered to fall within the research and development functional area include the following:
Research to discover new knowledge
Applying new research findings
Formulating product and process designs
Testing products and processes
Modifying formulas, products, or processes
Designing and testing prototypes
Designing tools that involve new technology
Designing and operating a pilot plant
The problem with research and development expenditures is that the future benefits associated with them are sufficiently uncertain that it is difficult to record them as an asset. Given these uncertainties, GAAP mandates that all research and development expenditures be charged to expense as incurred. The chief variance from this guidance is in a business combination, where the acquirer can recognize the fair value of research and development assets.
The basic rule of charging all research and development expenditures to expense is not entirely pervasive, since there are exceptions, as noted below:
Assets. If materials or fixed assets have been acquired that have alternative future uses, record them as assets. The materials should be charged to expense as consumed, while depreciation should be used to gradually reduce the carrying amount of the fixed assets. Conversely, if there are no alternative future uses, charge these costs to expense as incurred.
Computer software. If computer software is acquired for use in a research and development project, charge its cost to expense as incurred. However, if there are future alternative uses for the software, capitalize its cost and depreciate the software over its useful life.
Contracted services. If the company is billed by third parties for research work conducted on behalf of the company, charge these invoices to expense.
Indirect costs. A reasonable amount of overhead expenses should be allocated to research and development activities.
Purchased intangibles. If intangible assets are acquired from third parties and these assets have alternative uses, they are to be accounted for as intangible assets. However, if the intangibles are purchased for a specific research project and there are no alternative future uses, charge them to expense as incurred.
Software development. If software is developed for use in research and development activities, charge the associated costs to expense as incurred, without exception.
Wages. Charge the costs of salaries, wages, and related costs to expense as incurred.
There may also be research and development arrangements where a third party (a sponsor) provides funding for the research and development activities of a business. The arrangements may be designed to shift licensing rights, intellectual property ownership, an equity stake, or a share in the profits to the sponsors. The business conducting the research and development activities may be paid a fixed fee or some form of cost reimbursement arrangement by the sponsors.
These arrangements are frequently constructed as limited partnerships, where a related party fulfills the role of general partner. The general partner may be authorized to obtain additional funding by selling limited-partner interests, or extending loans or advances to the partnership that may be repaid from future royalties.
When an entity is a party to a research and development arrangement, several accounting issues must be resolved, which are:
Loans or advances issued. If the business lends or advances funds to third parties, and repayment is based entirely on whether there are economic benefits associated with the research and development work, charge these amounts to expense.
Nonrefundable advances. Defer the recognition of any nonrefundable advance payments that will be used for research and development activities, and recognize them as expenses when the related goods are delivered or services performed. If at any point it is not expected that the goods will be delivered or services performed, charge the remaining deferred amount to expense.
Obligation to perform services. If repayment of the funds provided by the funding parties is solely dependent upon the results of the related research and development activities, account for the repayment obligation as a contract to perform work for others.
Repayment obligation. If there is an obligation to repay the funding parties or the business has indicated an intent to do so, no matter what the outcome of the research and development may be, recognize a liability for the amount of the repayment, and charge research and development costs to expense as incurred. This accounting is also required if there is a significant related party relationship between the business and the funding entities. This scenario also applies if the funding parties can require the business to purchase their interest in the partnership, or if the funding parties automatically receive securities from the business upon termination of the arrangement.
Warrants issuance. If the business issues warrants as part of a funding arrangement, allocate a portion of paid-in funds to paid-in capital. The amount allocated to warrants should be their fair value as of the date of the arrangement.
June 01, 2022/ Steven Bragg/
Many businesses in the commercial world spend vast amounts of money, on an annual basis, on the research and development of products and services. These entities do this with the intention of developing a product or service that will, in future periods, provide significant amounts of income for years to come.
THE ACCOUNTING PREDICAMENT
If, in the future, economic benefit is expected to flow to the entity as a result of incurring R&D costs, then it can be argued that these costs should be treated as an asset rather than an expense, as they meet the definition of an asset prescribed by both the Statement of Principles and the IASB Framework for the Preparation and Presentation of Financial Statements.
Equally, the argument exists that it may be impossible to predict whether or not a project will give rise to future income. As a result, both the UK and International Accounting Standards provide accountants with more information in order to clarify the situation.
INTANGIBLE ASSETS
Intangible assets are business assets that have no physical form. Unlike a tangible asset, such as a computer, you can’t see or touch an intangible asset.
There are two types of intangible assets: those that are purchased and those that are internally generated. The accounting treatment of purchased intangibles is relatively straightforward in that the purchase price is capitalised in the same way as for a tangible asset. Accounting for internally-generated assets, however, requires more thought.
R&D costs fall into the category of internally-generated intangible assets, and are therefore subject to specific recognition criteria under both the UK and international standards.
R&D – DEFINITIONS
Research is original and planned investigation, undertaken with the prospect of gaining new scientific or technical knowledge and understanding. An example of research could be a company in the pharmaceuticals industry undertaking activities or tests aimed at obtaining new knowledge to develop a new vaccine. The company is researching the unknown, and therefore, at this early stage, no future economic benefit can be expected to flow to the entity.
Development is the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems, or services, before the start of commercial production or use. An example of development is a car manufacturer undertaking the design, construction, and testing of a pre-production model.
UK TREATMENT OF R&D
So far we have established that expenditure on R&D can fall into the category of intangible assets. Under UK accounting standards, intangible assets are accounted for using the rules from FRS 10, Goodwill and Intangibles.
Even though R&D can be an intangible asset in the UK, accounting for R&D is governed by its own accounting standard – SSAP 13, Accounting for Research and Development.
Recognition
Research
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.
Development
As a basic rule, expenditure on development costs should be written off to the profit and loss account as incurred, as with the expenditure on research. However, under SSAP 13, there is an option to defer the development expenditure and carry it forward as an intangible asset if the following criteria are met:
- there is a clearly defined project
- expenditure is separately identifiable
- the project is commercially viable
- the project is technically feasible
- project income is expected to outweigh cost
- resources are available to complete the project.
If these criteria are met, the entity may choose to either capitalise the costs, bringing them ‘on balance sheet’, or maintain the policy to write the costs off to the profit and loss account. Note that if an accounting policy of capitalisation is adopted it should be applied consistently to all development projects that meet that criteria.
Treatment of capitalised development costs SSAP 13 requires that where development costs are recognised as an asset, they should be amortised over the periods expected to benefit from them. Amortisation should begin only once commercial production has started or when the developed product or service comes into use.
Every capitalised project should be reviewed at the end of every accounting period to ensure that the recognition criteria are still met. Where the conditions no longer exist or are doubtful, the capitalised costs should be written off to the profit and loss account immediately.
Problems with SSAP 13 SSAP 13 is not in line with the newer International Accounting Standard covering this area. As seen previously, the UK allows a choice over capitalisation; this can lead to inconsistencies between companies and, as some of the criteria are subjective, this ‘choice’ can be manipulated by companies wishing to capitalise development costs.
INTERNATIONAL TREATMENT OF R&D
One notable difference between the UK and international treatment is that the UK has a separate standard for the treatment of R&D (SSAP 13), whereas under International Accounting Standards the accounting for R&D is dealt with under IAS 38, Intangible Assets.
Recognition
IAS 38 states that an intangible asset is to be recognised if, and only if, the following criteria are met:
- it is probable that future economic benefits from the asset will flow to the entity
- the cost of the asset can be reliably measured.
The above recognition criteria look straightforward enough, but in reality it can prove to be very difficult to assess whether or not these have been met. In order to make the recognition of internally-generated intangibles more clear-cut, IAS 38 separates an R&D project into a research phase and a development phase.
Research phase
It is impossible to demonstrate whether or not a product or service at the research stage will generate any probable future economic benefit. As a result, IAS 38 states that all expenditure incurred at the research stage should be written off to the income statement as an expense when incurred, and will never be capitalised as an intangible asset.
Development phase
Under IAS 38, an intangible asset arising from development must be capitalised if an entity can demonstrate all of the following criteria:
- the technical feasibility of completing the intangible asset (so that it will be available for use or sale)
- intention to complete and use or sell the asset
- ability to use or sell the asset
- existence of a market or, if to be used internally, the usefulness of the asset
- availability of adequate technical, financial, and other resources to complete the asset
- the cost of the asset can be measured reliably.
If any of the recognition criteria are not met then the expenditure must be charged to the income statement as incurred. Note that if the recognition criteria have been met, capitalisation must take place.
Treatment of capitalised development costs
Once development costs have been capitalised, the asset should be amortised in accordance with the accruals concept over its finite life. Amortisation must only begin when commercial production has commenced (hence matching the income and expenditure to the period in which it relates).
Each development project must be reviewed at the end of each accounting period to ensure that the recognition criteria are still met. If the criteria are no longer met, then the previously capitalised costs must be written off to the income statement immediately.
EXAMPLE
A company incurs research costs, during one year, amounting to $125,000, and development costs of $490,000. The accountant informs you that the recognition criteria (as prescribed by both SSAP 13 and IAS 38) have been met. What effect will the above transactions have on the financial statements when following either the UK or International Accounting Standards? (See 'Related links' for the solution.)
Bobbie Retallack is a lecturer at Kaplan Financial in Birmingham, UK