Accounting Treatment for Research and Development Costs

Research and Development CostsResearch and development (commonly shorten as R&D) activities are increased and increased. Equally, research and development related costs are a growing portion of the expenses recognized by companies. Given their growing size, accountants are increasingly concerned with their impact on the financial statements. It’s been years, research and development costs in software industry became a big notion. Generally speaking, any costs occurred are driven by at least an activity. Therefore, to be able to properly account the research and development costs, accountants, first should clearly understand what research and development activity is, what activity is conducted exactly, how the activities consume company’s resources (so it becomes costs), and finally, how financial statements’ elements are impacted by the costs. Both research and development activities can be conducted by an in-house department, or they can be bought from another company, perhaps as part of an ongoing research contract or through the outright purchase of another business. It is also possible for a company to be formed for the sole purpose of conducting research and development activities, followed by the transference of any new knowledge, products, or processes to another entity that has sponsored the work.

This post reviews the definition of research and development costs, how it is reported if conducted in-house, purchased, and from the perspective of a contract research and development organization. I will also specifically overview research and development costs in the software industry at the and of this post. Follow on…

 

What Economic Activity Research and Development Is

We immediately can see that research and development is consisted of two group of activities that may related or unrelated: (1) Research; and (2) Development:

  • Research Activity – is the planned search for the discovery of new knowledge. Obviously, the intent of research is that it will result in either an improvement in an existing product or process, or the creation of a new one. However, there is no assurance that this will happen, so the primary definition of research is the search for new knowledge.
  • Development Activity – is the enhancement of existing products or processes, or the creation of entirely new ones. This process does not have to be the direct outgrowth of in-house research efforts, for the knowledge gained from new research can be acquired from any source.

 

Paragraph 8 of SFAS No. 2 states that development:

“includes the conceptual formulation, design, and testing of product alternatives, construction of prototypes, and operation of pilot plants. It does not include routine or periodic alterations to existing products, production lines, manufacturing processes, and other on-going operations even though these operations may represent improvements and it does not include market research or market testing activities.”

 

So, I can safely say: development is essentially the application of knowledge for specific business purposes.

However, as I have mentioned at the beginning of this post, both research and development activities can be conducted by an in-house department, bought from another company. The next sections provide guidelines on how to account each of those possibilities. Read on…

 

In-house Research and Development Costs

Basically, any research and development costs incurred by a company must be charged to expense in the current period, unless they have alternative future uses (such as fixed assets). And it must be reported in the financial statements. The costs can’t be included in an overhead cost pool, since these costs might then be deferred into a future period.

Here are type of specific activities includes the costs that must be expensed:

  • Contract services – This is research and development work performed by an outside entity on behalf of the company, and for which the company pays, must be charged to expense as a research and development cost.
  • Indirect costs – These are costs that can be reasonably allocated to research and development activities through a consistently applied cost allocation system shall be charged to research and development expense.
  • Intangibles purchased from others.
  • Materials, equipment, and facilities – These are costs that are acquired for research and development work, and which have no alternative future value, must be expensed. If they do have an alternative future value, then they must be capitalized and amortized over time as a cost of research and development.
  • Personnel – These are personnel costs, such as salaries, wages, benefits, and payroll taxes that are associated with personnel engaged in R&D work. It shall be charged as a research and development expense.

 

The above rule covers all research activities plus:

  • testing and modification of product alternatives;
  • prototypes and models;
  • design of new tools and dies;
  • pilot plants not commercially feasible; and
  • engineering work conducted prior to being ready for manufacture

 

There are also a number of costs that are not to be included in the research and development expense category: costs that must be expensed as incurred, rather than capitalized, and so are not different from research and development costs in terms of their treatment.

Note: There is possibility that unethical management of companies would artificially increase their reported research and development expense (which is a separate line item in the financial statements) if they were to include these items in the cost category, which might give investors an artificial impression of the size of funding being directed toward research and development activities.

 

However, here are costs not to be included in research and development:

  • Engineering costs – These are efforts to make minor incremental enhancements to existing products, or to make minor customized adjustments to products for existing customers, as well as the design of tools and dies on a routine basis.
  • Facility costs – These are the start-up cost of new facilities that are not intended for use as R&D facilities.
  • Legal costs – These are the cost of patent applications, the cost of litigation to support them, and the costs associated with their licensing to or from other parties.
  • Production costs – These are industrial engineering, quality, and troubleshooting work engaged in during the commercial production of a product.

 

Acquired Research and Development Costs

Here is the rule:

1. If a company purchases its research and development work from some other entity, then the cost of this work to the company must be expensed in the period incurred.

2. If a company acquires intangibles that may be used in research and development activities (e.g., through a corporate acquisition), and which have alternative future uses, the intangibles must be amortized over time. For example: if a company were to purchase another entity, then under the purchase method of accounting, it could assign intangible costs to identifiable assets that are related to R&D, such as patents, formulas, and new product designs, as well as to more concrete items, such as equipment used in research and development experiments.

Note:

The above second rule possibly result in inconsistent accounting treatment for the following reason:

Acquiring companies sometimes make the assumption that some acquired intangibles are directly associated with research and development costs (rather than being capitalized under the assumption that they have alternative future uses), and using this assumption as the basis for writing them off at once rather than amortizing their cost over a number of years.

 

Under this scenario, if there is any doubt regarding the proper treatment of intangibles associated with research and development it is best to amortize the cost.

 

Research and Development Costs Contracted To Other Party

For a company specializes in the provision of research and development to other businesses, the accounting for these costs will essentially be determined by the contents of each research and development contract signed. For example: If a contract states that R&D work will be billed to a client on a time and materials basis, then the expense can easily be recorded in conjunction with any associated billings.

A more common case is that the Research and Development dept receives a large amount of initial funding, here is the rule:

  • If there is no obligation to return the funds, they may be recorded at once as revenue.
  • If there is a requirement that the funds be used for specific research and development works or else be returned, then the funds must be recorded as a liability that will gradually be drawn down as offsetting research and development costs are incurred.

 

Research and Development Cost In the Software Industry

The basic rule regarding the recognition of research and development expenses for software development (for software to be sold to customers, as opposed to software developed strictly for in-house use) is a somewhat more liberal treatment than under the traditional research and development rules, since there is a short time period during which some costs can be deferred through capitalization.

Here is the rule:

  • Development is considered to be research and development (and therefore to be expensed at once) until the point is reached when technological feasibility has been demonstrated.
  • All costs incurred from the point when that demonstration occurs to the time when commercial products are delivered can be capitalized and amortized over time (which is the period over which some economic benefit is expected from the sale of the software).

 

Note, however, the point at which technological feasibility is most easily demonstrated is the release of a beta test version of the software, which may be so close to the commercial release date (usually a matter of months) that the amount of costs that can be capitalized during this short period is relatively small.

A more aggressive approach is available if a company uses detailed program designs, which allows it to prove technological feasibility at an earlier point in the software development process. Under this approach, feasibility occurs when the product design is complete, when the design has been traced back to initial product specifications, and when it can be proved that all high risk elements in the product design have been investigated and resolved through coding and testing.

If a company is developing software strictly for internal use, a different set of rules applies. Here is the rule:

  • All costs associated with the development work can be capitalized (Note: It must not be the intention of management at the time of development to externally market the software in which case the preceding rule applies).
  • If management subsequently decides to market software that was originally intended solely for internal use, then any profits received will first be offset against the carrying value of the software; once the carrying value is reduced to zero, subsequent profits may be recognized as such.
  • Costs that cannot be capitalized under this approach are those associated with: The conceptual formulation of the software; the review and testing of alternative systems; and any overhead and training costs associated with the project.
  • If the total price of a purchased software package includes the cost of training and maintenance, then the training cost must be split out and expensed as training is incurred, while the maintenance fee must be spread equably over the period to which it applies.
  • Costs that can be capitalized for internal software projects are all those incurred during the coding and system implementation phases of the project (these costs typically include the salaries of all personnel involved in the project, as well as their related payroll tax and benefit costs, plus the cost of outside services required to assist with the project. (Note: This capitalization rule also applies to the internal cost required to modify purchased software that is intended for internal use). Amortization of these costs must begin at the point when essentially all testing has been completed, even if there is no one currently using the system.
  • If an internal development project appears to be in danger of not being completed (as defined by lack of completion funding, significant programming difficulties, major cost overruns, or lack of profits within the sponsoring business unit), then all related costs that have thus far been capitalized must be expensed in the current period.