Understanding How R&D Capitalization Works

Research and development (R&D) capitalization means classifying R&D costs as assets rather than expenses. As of tax year 2022, companies are required to perform R&D expense capitalization per the Tax Cuts and Jobs Act (TCJA) for tax purposes.  

However, under GAAP, for accounting purposes, R&D costs must be expensed in the year they were accrued, with some notable exceptions, of course. 

So, to capitalize or not to capitalize? That's the question. While R&D capitalization has benefits, such as boosting long-term profitability, it's also a confusing process that, if done wrong, could derail your R&D investments. 

In this guide, we'll walk you through the benefits of R&D capitalization and the process of capitalizing expenses. We'll also introduce you to common challenges you might experience with R&D capitalization and how to overcome them. 

Table of Contents: 

• Key Benefits of R&D Capitalization 
• When Should R&D Costs Be Capitalized? 
• The Process of R&D Capitalization 
• Common R&D Challenges and How to Overcome Them 

Key Benefits of R&D Capitalization 

R&D capitalization has many benefits for organizations across industries, from improving financial metrics to enhancing investor confidence. 

Improved Financial Metrics 

One of the most important benefits of R&D capitalization, especially for scaling organizations, is the improvement of profitability metrics. 

For example, R&D expense capitalization moves R&D expenses to the balance sheet as assets. When this happens, it reduces your current operating expenses, increasing your EBITDA. As a result, you boost your perceived profitability. 

An example of how this works is a software company spends $2 million developing a new platform. By capitalizing these costs, the company reports higher EBITDA and net income in the current year, as the expense is spread over future years rather than fully deducted  

Improving financial metrics through capitalization helps companies identify areas of improvement, make better strategic decisions, and even attract investors who want to get in on the success. 

Alignment with Long-Term Value Creation 

Long-term value creation is a critical strategy that works to build sustainable value for your organization. Key components of this long-term value include healthy growth over time. Prioritizing R&D showcases your company's dedication to growth, while R&D capitalization is proof of that dedication. 

By capitalizing your costs over a certain time period, you're showing long-term value and growth. For example, a biotech firm might develop a new drug and incurs $20 million in R&D costs. By capitalizing and amortizing these costs over the drug’s 10-year patent life, the firm demonstrates ongoing investment and value creation over a decade. 

R&D capitalization can also inspire additional innovation. When expenses are spread out over time, it's simpler to take on other projects due to the reduction in upfront R&D costs. 

Enhanced Investor Confidence 

As discussed above, R&D capitalization improves financial metrics, including profitability. Better financial metrics enhance investor confidence, which can inspire them to invest in your company, helping you reach your growth goals. 

When Should R&D Costs Be Capitalized? 

There are various R&D capitalization rules organizations must follow, as well as specifics on capitalizable vs. non-capitalizable costs. Let's break it all down. 

Guidelines for Capitalization 

For tax years beginning after December 31st, 2021, companies must capitalize all R&D expenses per the Tax Cuts and Jobs Acts for tax purposes.  

For domestic research and development, you must capitalize and amortize R&D expenses over a period of five years. However, foreign research expenses must be capitalized and amortized over a period of 15 years. 

For accounting purposes, Generally Accepted Accounting Principles (GAAP) as well as ASC 730 guidelines require companies to recognize R&D costs as expenses in the same year the cost was incurred. 

However, capitalization becomes a possibility when R&D projects are proven to have an alternative future use. These costs can be capitalized under GAAP in your financial statements. 

Examples of Capitalizable vs. Non-Capitalizable Costs 

According to ASC 730, capitalization is only appropriate for expenses that include materials, equipment, and facilities acquired or built for R&D projects. Some examples of capitalizable costs include: 

• Prototype development 
  Example: Building a working model of an electric vehicle to test new battery technology. 
• Testing phase expenditures 
  Example: Costs incurred during field trials of a new agricultural drone system. 
• Labor costs of those directly involved in R&D projects 
  Example: Salaries of engineers designing a new medical device. 
• Contract research expenses 
  Example: Payments to a university lab for conducting specialized material analysis. 
• Materials and supplies used during research 
  Example: Chemicals and lab equipment used in developing a new pharmaceutical compound.  

Other expenses typically accrued during R&D activities may not be capitalizable. Examples of non-capitalizable expenses include: 

• Pure research costs 
  Example: Theoretical research on quantum computing with no immediate commercial application. 
• Brainstorming sessions 
  Example: Team meetings to generate ideas for future product lines. 
• Advertising and marketing costs 
  Example: Launch campaign for a new software product. 
• Administrative costs like utilities 
  Example: Monthly electricity bills for the R&D facility. 
• Testing for quality control purposes 
  Example: Routine quality checks on existing products. 

Industry-Specific Applications 

R&D capitalization impacts virtually every industry. To help illustrate what capitalization looks like, here are some industry-specific applications: 

• Tech: Capitalization of software development costs after achieving technical feasibility. 
  Example: A SaaS company capitalizes costs incurred after the software product design is finalized and coding begins. 
• Pharma: Capitalization of clinical trial costs after successful preclinical studies. 
  Example: Expenses for Phase I, II, and III clinical trials for a new drug candidate after animal testing shows promising results. 
• Telecommunications: Capitalization of the costs to develop new network technologies set to generate future revenue. 
  Example: Costs to develop 5G infrastructure components that will be deployed commercially. 
• Manufacturing: Capitalization of the costs to develop a prototype in preparation for testing phases. 
  Example: Building a prototype of a new energy-efficient refrigerator model for regulatory testing. 

The Process of R&D Capitalization 

The process of R&D capitalization includes various steps, from identifying your qualifying expenses to adjusting your financial statements. 

Identify Qualifying Expenses 

The first step is identifying which R&D expenses qualify for capitalization. For tax purposes, all expenses accrued during R&D activities relating to materials, equipment, and facilities qualify for capitalization. 

R&D activities generally refer to those required to develop new products, services, or processes. Qualifying expenses for these activities range from prototype development and testing costs to salaries of the engineers working on finalizing products. 

If you choose to pursue R&D capitalization for accounting purposes (instead of expensing as incurred), you'll need to follow GAAP guidelines. This means considering which tangible and intangible expenses are tied to R&D projects proven to have an alternative future use. 

Alternative future use means that an R&D asset can be used for a different purpose beyond its current intended use. An example would be software developed through one R&D project that could be adapted for another purpose later on. 

Estimating Expenses & Amortization Periods 

The next step is to estimate the qualifying expenses and determine how long to amortize. Under current tax law, qualifying R&D expenses must be amortized over a five-year period for domestic R&D. They should be amortized over a period of 15 years for foreign research projects. 

Once you determine the amount of expenses, you'll need to divide them by the number of years required. For example, a software company working to develop a new platform would amortize costs such as prototyping and testing over a five-year period. 

If you choose to capitalize for accounting purposes, you'll need to identify the qualifying R&D costs and then amortize the costs over their estimated useful life.  

Estimated useful life (EUL) refers to the time in which an asset will remain financially beneficial for your organization. 

For example, if you estimate an R&D product to provide benefits for 10 years, this is the length of time you'll need to amortize costs. 

Example: 
A robotics manufacturer estimates a new automation system will provide benefits for 10 years. The $4 million in capitalized R&D costs are amortized at $400,000 per year. 

Adjust Financial Statements 

To capitalize R&D costs, you'll need to move them from your Profit and Loss (P&L) statement to your balance sheet and record them as assets.  

After calculating the amortization period and amounts for each year, you'll need to debit the amortization expense account and reduce the capitalized R&D asset by a credit to the accumulated amortization account annually. 

As adjusting your financial statements to account for R&D capitalization is complex, we recommend reaching out to a tax or accounting professional first. 

Maintain Robust Documentation 

You should keep appropriate documentation of all R&D activities and their expenses to ensure you remain in compliance and can move swiftly in the case of an audit. There are many documents you'll want to maintain, including: 

• An audit-ready log of all project milestones and their qualifying expenses 
• Wage information, such as W-2 forms and timesheets for employees involved in R&D activities 
• Contractor information, such as service contracts and purchase orders for any expenses accrued from contracted work 
• Receipts and invoices of all expenses with matching entries in the general ledger 
• Accurate financial statements, including income statements, balance sheets, and statements of cash flows 

Common Challenges with R&D and How to Overcome Them 

There are many challenges involved with capitalization, from determining qualifying expenses to ensuring you remain in compliance. Here are three of the most common challenges with R&D and solutions to help you overcome them. 

Determining Feasibility 

When it comes to your taxes, determining which projects meet capitalization criteria is quite simple. As mentioned before, expenses accrued during R&D projects must be capitalized for five or 15 years under current tax laws. 

However, understanding when projects meet capitalization criteria for accounting purposes can be a bit more challenging. Qualifying costs for R&D projects must have a clear alternative future use (be able to generate future value) before they can be capitalized. But how do you know which costs fit the bill? 

Determining feasibility can be fuzzy. As a solution, we recommend reaching out to a tax and accounting professional who understands the tax code and relevant directives, such as the ASC 730. They'll be able to help you classify expenses and ensure you're remaining in compliance. 

Regulatory Compliance 

Speaking of compliance, this is another gray area that's complex when accounting for R&D expenses. There are various directives and principles you must align with, including the US GAAP (ASC 730), the IFRS (IAS 38), and the US tax code. 

To ensure you're aligning with all requirements, familiarize yourself with those relevant to your organization. Then, develop internal policies that align with those applicable standards. These internal policies should be used across your organization for consistency. 

Accurate Cost Allocation 

When capitalizing costs for accounting purposes, it's critical to understand which costs are direct vs. indirect, as most indirect costs shouldn't be capitalized. Direct costs are those directly tied to an R&D project, such as product development. Indirect costs are those not necessarily tied to the project but necessary for its completion, like utilities.  

All R&D projects generate a ton of expenses. And over time, it can become increasingly difficult to separate costs into buckets. What expenses were tied to what tasks? Was that invoice for rent or prototyping? These are questions you must know the answers to for accurate cost allocation.  

We recommend utilizing R&D cost-tracking tools that can organize costs on your behalf. For example, many of these tools include expense categorization, helping you separate costs accordingly. Plus, they often integrate with your accounting systems, helping you keep your financial reports accurate and consistent. 

Navigate R&D with 8020 Consulting 

R&D capitalization is nothing short of complex. And with current tax law, R&D capitalization is a requirement you can't ignore. To navigate R&D effectively, we recommend reaching out to accounting and finance experts, such as those at 8020 Consulting. 

Our experts bring decades of combined experience across industries, providing specialized knowledge in various disciplines, from financial planning to interim financial management. We understand the complexities of R&D and are here to guide you through the capitalization process. Connect with an expert today.