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
Research and Development Accounting
The basic problem with research and development expenditures is that the future benefits associated with these expenditures are sufficiently uncertain that it is difficult to record the expenditures 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 the 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.