Accounting for Research and Development Costs: Capitalization vs. Expense

Research and Development (R&D) costs represent one of the most important drivers of innovation and competitive advantage. However, accounting for these costs is complex, with different rules depending on whether the activity is classified as research or development, and whether the accounting standards follow U.S. GAAP or IFRS.

R&D accounting directly affects profitability, asset recognition, and investment valuation, especially in technology, pharmaceuticals, and manufacturing.

This article explores how R&D costs are treated under both U.S. GAAP and IFRS, and provides clear examples of expense recognition and capitalization.

1. What Are Research and Development Costs?

Research and Development (R&D) refers to the systematic pursuit of new knowledge, products, or processes that result in innovation.

✦ Research is aimed at discovering new ideas or understanding scientific phenomena

✦ Development refers to translating research findings into a commercially viable product or process

Examples include:

✦ Laboratory studies and experiments

✦ Product prototypes

✦ Engineering design of new equipment

✦ Testing new software or drugs

✦ Patent applications

2. U.S. GAAP Treatment (ASC 730)

Under ASC 730, all R&D costs must be expensed as incurred — regardless of the likelihood of future benefits.

Key Features:

✦ No capitalization of R&D costs (with very limited exceptions)

✦ Applies to both internal and contract R&D

✦ Expense recognition ensures conservative reporting

✦ Capitalization permitted only for certain software development (see ASC 985-20 or ASC 350-40)

Journal Entry Example:

If a company incurs $100,000 in R&D expenses:

Debit: R&D Expense – $100,000

Credit: Cash (or Accounts Payable) – $100,000

These costs reduce operating profit immediately, regardless of future commercialization.

3. IFRS Treatment (IAS 38)

Under IAS 38, the accounting for R&D differs between research and development:

Research Costs:

✦ Always expensed as incurred

Development Costs:

Can be capitalized as an intangible asset if the entity can demonstrate all of the following six criteria:

① Technical feasibility of completing the asset

② Intention to complete and use/sell the asset

③ Ability to use/sell the asset

④ Probability of future economic benefits

⑤ Availability of resources to complete the development

⑥ Ability to measure costs reliably

If all six are met, development costs are capitalized and amortized over the useful life of the asset.

Example – IFRS Capitalization:

A company spends $200,000 on developing a new software platform. It meets all six IAS 38 criteria by mid-year.

• First half (research phase): $80,000 → expensed

• Second half (development phase): $120,000 → capitalized

Journal Entries:

For research:

Debit: R&D Expense – $80,000

Credit: Cash – $80,000

For development:

Debit: Intangible Asset (Software Development) – $120,000

Credit: Cash – $120,000

Later, the capitalized cost will be amortized over its useful life.

4. Software Development (Special Case)

Under U.S. GAAP, software development has separate guidance:

✦ ASC 985-20: For software to be sold, capitalized after technological feasibility is established

✦ ASC 350-40: For internal-use software, capitalize after preliminary project stage

All costs before these thresholds are expensed.

5. Tax Implications and Deferred Tax Assets

While R&D is typically expensed for book purposes, some jurisdictions allow:

✦ Immediate deduction or

✦ Tax credit or

✦ Capitalization and amortization

Differences between book and tax treatment may lead to deferred tax assets and affect effective tax rates.

6. Disclosure Requirements

Entities must disclose:

✦ Total R&D expense (on the income statement or in the notes)

✦ Nature of the R&D activities

✦ Method of determining amortization period for capitalized development (IFRS)

✦ Reconciliation of carrying amount of intangible assets (IFRS)

✦ Impairment tests for capitalized R&D assets

7. Financial Analysis Considerations

Analysts often:

✦ Adjust earnings to reflect capitalized development as R&D

✦ Compare R&D-to-sales ratios across firms

✦ Evaluate R&D productivity (e.g., revenue or margin generated per dollar of R&D)

✦ Review trend consistency and capitalization policy

Because R&D affects long-term value, aggressive capitalization or erratic expense patterns can distort profitability.

8. Summary of R&D Accounting Rules

Standard	Research Costs	Development Costs
U.S. GAAP	Expensed as incurred	Expensed as incurred (except software)
IFRS (IAS 38)	Expensed as incurred	Capitalized if six criteria are met