Understanding How R&D Capitalization Works

June 20, 2022
Computer calculator

We're here to help.

business tech
Eide Bailly is a Top 25 CPA and business advisory firm specializing in helping you with the R&D tax credit.
Let's Talk

Key Takeaways

  • R&D capitalization is the process of classifying research and development activity as an asset rather than an expense.
  • Under GAAP, companies must expense their R&D activities within the same year the cost was incurred.
  • Managing your R&D in the most efficient way possible requires a solid strategy.

Innovation is the driving force that maintains your competitive edge in the business landscape. Larger companies will produce financial valuations based on revenues, but research and development costs are also part of revenue generation.

Generating a profit based on successful R&D increases profitability and allows business leaders to recognize R&D expenses as the source of this profit. However, you need to understand the rules and regulations regarding R&D capitalization, development expenses vs. development costs, and what’s changing in 2022.

What is R&D Capitalization?

Capitalizing R&D is the process a business will use to classify a research and development activity as an asset rather than an expense. Capitalized R&D moves the costs of research and development from the top of the balance sheet to the bottom.

When you capitalize development costs, you’re doing something that can increase your company's profitability. Doing so is ideal when showing investors and creditors the true profitability of an organization.

R&D capitalization also converts the costs from the P&L sheet statement to the balance sheets by representing them as assets.

Do You Need to Capitalize R&D Expenses?

Under Generally Accepted Accounting Principles (GAAP), companies must expense their R&D activities within the same year the cost was incurred. The risk of doing so means that companies can experience tremendous volatility when reporting their profits.

It can present serious challenges when measuring the rate of return on both its assets and its investments. If you don’t capitalize your R&D, the total assets and total invested capital may not produce an accurate reflection of your research and development expense for that year.

Overall, it can provide an incorrect picture of the return on assets and return on invested capital.

Background on R&D Laws

2022 is a year like no other because the research and development costs tax treatment is changing. Historically, the U.S. government has worked to keep research and development onshore for the good of the economy. They have always allowed companies to expense their costs and receive a tax credit immediately. It’s why there are lots of R&D tax incentives for major companies.

In the last few years, legislation has made significant changes to the way things work. The Tax Cuts and Jobs Act of 2017 removed the ability of companies to expense their R&D costs starting in 2022.

In 2021, bipartisan legislation was introduced to Congress to repeal this law. Unfortunately, the law has yet to pass.

In practice, these changes mean your company cannot deduct R&D costs in the fiscal year they were incurred. The new system means you’ll need to amortize those expenses over the last five or 15 years.

These developments will significantly impact company balance sheets across the country.

How these New R&D Laws Could Impact Your Cash Flow

These new R&D laws have been the biggest shakeup of the R&D system in decades. Companies need to prepare for significant changes in their balance sheets in 2022 and beyond.

For example, let’s say a pharmaceutical company has reported a $10 million figure for revenue and has spent $100 million in drug development in an offshore facility.

Traditionally, the company would expense these drug development costs and report a $90 million loss for tax purposes. From 2022 onwards, that same company would report a $6.7 million taxable profit instead.

You need to understand that what you deduct for R&D may not be deductible for tax purposes.

Capitalizing R&D: A How-To Guide

R&D capitalization requires you to estimate the value of an asset and how long its economic life will be. Many assumptions need to be made, and different R&D projects within your company will likely have different amortization periods.

For example, if you estimate an R&D product will provide economic benefits for seven years, you will need to amortize over this set period. Another product may be amortized over a different period. As you can see, it’s becoming increasingly complicated to manage capitalized R&D in a tax-efficient way.

Preparing for R&D Capitalization

How do you prepare for the new rules and regulations governing capitalized R&D?

There are several aspects on which you need to focus. Let’s discuss them briefly. For further information, get in touch with the Eide Bailly team.

  • Cash Flow Planning – Consider the cash flow impact of tax credits, R&D costs, and limited loss carryforwards. Optimize your cash flow tax planning.
  • FASB ASC Topic 740 – This is the process of analyzing and disclosing income tax risks according to GAAP. Consider the impacts on your income tax when capitalizing your research and development activities, particularly in relation to the Biden tax proposals.
  • Supporting Tax Credit Documentation – Claiming R&D tax credits is relatively simple, but companies often forget to provide supporting documentation. Review the tax credits available to you and document your credits according to current IRS standards.
  • Review Accounting Methods – The right accounting methods enable you to ensure tax compliance while limiting tax liability. Look into accelerated deductions and deferred revenue. Your accounting methods will also form part of your cash flow strategy.
  • Technical Accounting – Consider hiring a technical accounting team to analyze your cost centers and identify any research and development expenses that can be recategorized under general and administrative expenditure.

Managing your R&D in the most efficient way possible requires a strategy. You may need to reconsider your current accounting methods and pivot to meet the latest rules and regulations in 2022.

Capitalizing Your R&D Expenses: An Example

The preparatory steps above can enable you to remain tax compliant. Hiring professionals who understand the latest laws can help ensure your company is ready for the future.

Here’s how capitalization can work today to make life easier.

Company A is interested in taking advantage of an R&D product developed by a cell phone manufacturing company. The analyst must determine how long that product will generate a profit.

Since mobile phones tend to emerge and disappear quickly, Company A calculates that they can expect to create a profit from this R&D product for the next three years. When capitalizing, the company will be using a three-year amortization period.

The current amortization amount must equal one-third of the company’s total R&D expense from three years ago, one-third two years ago, and one-third one year ago.

The analyst will use the following formula to determine the current amortization amount during capitalization.

Current Amortization Amount = ⅓ (year 1 of R&D) + ⅓ (year 2 of R&D) + ⅓ (year 3 of R&D)

The analyst in charge at Company A has figured out the profitable value of the produce was $100,000 during year one, $75,000 in year two, and $25,000 in year three.

If we plug the numbers in, the formula looks like this:

Current Amortization Amount = $33,000 + $25,000 + $8,333

In other words, Company A has discovered that the amortization value of that particular R&D product is $66,000 over its economic life. The point of capitalization here is to more accurately match the revenues and expenses found on the balance sheet.

Of course, depending on the product, there may be a longer or shorter economic life. Every R&D activity must be measured in this way. It’s why major corporations spend so much on large accounting teams.

The Bottom Line

Companies must prepare for these changes. With little prospect of the law being repealed, this is the new reality for companies and R&D.

Expand Full Article