9.4 Research and development costs

Research and development costs are crucial for innovation but tricky to account for. Companies must carefully track these expenses, which are typically expensed as incurred due to uncertain future benefits. This approach impacts financial statements and ratios, reflecting the risk inherent in R&D activities.

Proper accounting for R&D costs ensures transparency in financial reporting. While generally expensed, there are exceptions in business combinations and under IFRS. Understanding the treatment of R&D costs is essential for analyzing a company's investment in innovation and its financial position.

Accounting for R&D costs

• Research and development (R&D) costs are expenditures incurred by a company to develop new products, services, or processes
• Accounting for R&D costs is a critical component of financial reporting for companies in industries that heavily rely on innovation and technological advancements
• Proper accounting treatment of R&D costs ensures that financial statements accurately reflect a company's financial position and performance

R&D costs vs capital expenditures

• R&D costs are often confused with capital expenditures, but there are distinct differences between the two
• Capital expenditures are costs incurred to acquire or improve long-term assets, such as property, plant, and equipment
• R&D costs, on the other hand, are expenditures related to the development of new products, services, or processes, which may or may not result in future economic benefits
• Unlike capital expenditures, R&D costs are generally expensed as incurred due to the uncertainty of future benefits

Criteria for R&D activities

Planned search or investigation

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• R&D activities involve a systematic, planned search or investigation to discover new knowledge or develop new products or processes
• This criterion distinguishes R&D from other activities, such as routine testing or quality control

Discovery of new knowledge

• R&D activities aim to discover new knowledge that can be used to create new products, services, or processes
• The discovery of new knowledge is a key component of R&D and sets it apart from other business activities

Uncertainty of future benefits

• R&D activities are characterized by uncertainty regarding the future economic benefits that may result from the research
• The uncertainty of future benefits is a critical factor in determining the accounting treatment of R&D costs

Accounting treatment of R&D costs

Expensing R&D costs

• Under both IFRS and US GAAP, R&D costs are generally expensed as incurred
• Expensing R&D costs means that they are recognized as expenses in the income statement in the period in which they are incurred

Rationale for expensing

• The rationale for expensing R&D costs is based on the uncertainty of future economic benefits
• Since there is no guarantee that R&D activities will result in successful products or services, expensing R&D costs provides a conservative approach to financial reporting

Impact on financial statements

• Expensing R&D costs has a direct impact on a company's financial statements
• R&D expenses reduce a company's net income and earnings per share (EPS) in the period in which they are incurred
• However, expensing R&D costs also ensures that a company's assets are not overstated, as the future benefits of R&D are uncertain

R&D costs on balance sheet

Disclosure requirements

• Although R&D costs are expensed as incurred, companies are required to disclose information about their R&D activities in their financial statements
• Disclosure requirements include the total amount of R&D costs incurred during the period and a description of the company's R&D activities

Notes to financial statements

• Companies typically provide additional information about their R&D activities in the notes to their financial statements
• Notes to financial statements may include details about specific R&D projects, the expected duration of R&D activities, and the anticipated benefits of successful R&D efforts

R&D arrangements

Funding from third parties

• In some cases, companies may receive funding from third parties, such as government agencies or other companies, to support their R&D activities
• Third-party funding for R&D can take various forms, such as grants, contracts, or collaborative agreements

Repayment of R&D costs

• When a company receives funding from third parties for R&D, the accounting treatment depends on the terms of the arrangement
• If the third-party funding is contingent upon the success of the R&D activities and requires repayment, the company may need to record a liability for the potential repayment obligation
• If the third-party funding is non-refundable, the company may recognize the funding as income in the period in which it is received

R&D in business combinations

In-process R&D

• When a company acquires another company, it may obtain in-process R&D (IPR&D) as part of the acquisition
• IPR&D refers to R&D projects that have not yet been completed at the acquisition date and have no alternative future use

Valuation of in-process R&D

• Under US GAAP, IPR&D acquired in a business combination is initially recognized as an indefinite-lived intangible asset at its fair value
• The fair value of IPR&D is determined using valuation techniques, such as the multi-period excess earnings method or the relief-from-royalty method
• Subsequent to initial recognition, IPR&D is subject to impairment testing until the completion or abandonment of the R&D project

Financial ratios impacted by R&D

R&D intensity ratio

• The R&D intensity ratio is a financial metric that measures a company's investment in R&D relative to its size
• It is calculated by dividing R&D expenses by total revenues for a given period
• A higher R&D intensity ratio indicates that a company is investing more heavily in R&D compared to its peers

R&D to sales ratio

• The R&D to sales ratio is another financial metric that assesses a company's R&D investment relative to its sales
• It is calculated by dividing R&D expenses by total sales for a given period
• This ratio helps investors and analysts understand the proportion of a company's sales that are being reinvested into R&D activities

Tax treatment of R&D costs

R&D tax credits

• Many countries offer tax incentives to encourage companies to invest in R&D activities
• R&D tax credits allow companies to reduce their tax liability based on the amount of R&D expenses incurred during the tax year
• The specific requirements and benefits of R&D tax credits vary by jurisdiction

Timing differences vs permanent differences

• The tax treatment of R&D costs can create timing differences between a company's financial reporting and tax reporting
• Timing differences arise when the recognition of R&D expenses for financial reporting purposes differs from the recognition for tax purposes
• In some cases, R&D expenses may result in permanent differences, where the expense is not deductible for tax purposes at all

Comparison of IFRS vs US GAAP

Capitalization of development costs under IFRS

• One key difference between IFRS and US GAAP in the treatment of R&D costs is the capitalization of development costs
• Under IFRS, companies are required to capitalize development costs when certain criteria are met, such as technical feasibility and the intention to complete the development project

Criteria for capitalization under IFRS

• For development costs to be capitalized under IFRS, the following criteria must be met:
  1. Technical feasibility of completing the intangible asset
  2. Intention to complete the intangible asset and use or sell it
  3. Ability to use or sell the intangible asset
  4. Demonstration of how the intangible asset will generate probable future economic benefits
  5. Availability of adequate technical, financial, and other resources to complete the development and to use or sell the intangible asset
  6. Ability to measure reliably the expenditure attributable to the intangible asset during its development
• If these criteria are not met, development costs are expensed as incurred, similar to the treatment under US GAAP