In the modern-day business environment, you must have noticed that all the big companies have sophisticated R&D departments and so much capital is invested on research and development (R&D). In the current rapidly changing world, businesses must innovate and evolve if they want to thrive and be successful, instead of being stagnant and risking their survival. That is why R&D programs are so important for businesses and huge amounts are spent with the expectations that the fruits of R&D investment will be enjoyed by the businesses in future.
For the purpose of accounting, how do we treat such research and development expenditure? First, we’ll try to understand both phases of R&D process i.e. research phase and development phase and then we’ll discuss the accounting of research and development expenditure.
Research is the systematic investigation and study of various resources with the aim to achieve new knowledge or understanding of various phenomenon.
Development is the application of successful research findings with the aim to create new or improved systems, processes, services, products, materials, etc. that will add value to the business.
Accounting of research and development expenditure
Research and development expenditure are incurred with the objective to obtain greater economic benefits in future. However, an asset cannot be recorded just on the basis of this objective. For an asset to be recorded, it should be probable that the economic benefits associated with a particular activity or expenditure will flow to the entity and costs can be measured reliably. So, let’s see how each of them are treated in accounting.
As the research phase is an initial stage, and one cannot say that the research will be successful and will result in generation of economic benefits for the entity in future. Therefore, all the expenditure incurred in research phase is charged as expense in income statement.
Furthermore, if the development phase cannot be distinguished from the research phase, all the expenditure incurred on R&D project is considered as research expenditure and is charged as expense in the income statement.
Development phase starts only if the research findings are considered successful and it is expected that development of new or improved systems, processes, services, products ,materials, etc. will generate future economic benefits. As the probability of inflow of economic benefits has increased in this phase compared to research phase, therefore, development expenditure can be capitalized if, and only if, certain conditions are met.
Development expenditure is capitalized and recorded as an intangible asset if all of the following conditions are met:
- The project is technically feasible, and the company has the capability in terms of resources to complete the development project.
- The company has the intention to complete the development of intangible asset and then to use or sell it.
- Inflow of economic benefits is probable.
- The project is expected to be profitable.
- Costs of development expenditure can be measured reliably.
It must be noted that any expenditure incurred in the development phase will be charged as expense in income statement even if only one of the above conditions is not met. Capitalization of development expenditure will start once the above conditions are met and capitalization of expenditure will be ceased on commencement of commercial production. Any expenditure that has been charged to income statement will not be reversed upon satisfaction of above-mentioned conditions.
Amortization of development expenditure
Development expenditure is an internally generated intangible asset which will be amortized over its useful life. Amortization of development expenditure will start once the development phase is complete and commercial production begins. Calculation of amortization is explained in our chapter “Amortization of intangible assets”.
Let’s further clarify our concepts related to research and expenditure by studying the following example.
On 1 January 20×0, a pharmaceutical company started its research for a COVID-19 vaccine. Initially, during the first three months of this project, the company incurred $185,000 on various research expenditures such as remuneration of scientists, cost of laboratory materials, etc.
After three months, the company was confident it had found a formula for a vaccine that could end the COVID-19 pandemic. Therefore, the company entered the development phase of this vaccine on 1 April 20×0. However, during the first two months of this phase, the company was not sure about the project’s technical feasibility, but it kept on working, hoping for a breakthrough in its development plan. All other conditions of capitalizing development expenditure were satisfied. Development expenditure of $155,000 was incurred during these two months.
After the first two months of the development phase, the team scientists had a breakthrough and a new, technically feasible method was devised for developing the vaccine. A further 15 months were spent on the development phase which included various activities such as developing mechanisms for the preparation of vaccine, various trials and later included human trials. $1,200,000 was spent on these development activities in these 15 months and after successful completion of the development, the company started commercial production of the vaccine from 1 September 20×1.
In the above scenario, which costs will be charged as expense in the income statement and which costs will be capitalized as intangible asset?
- Following expenditure will be charged as expense in the income statement.
- Research expenditure of $185,000
- Development expenditure of $155,000*
* It is charged as expense in income statement as the recognition criteria for capitalizing development cost is not met as the project was not technically feasible at that time.
- Development expenditure of $1,200,000 incurred after the recognition criteria is satisfied will be capitalized as an intangible asset.