Research and development expense

Research and Development Expense

Research and development (R&D) expense refers to the costs a company incurs to create new products, services, or processes, or to significantly improve existing ones. This crucial component of corporate finance reflects a company's commitment to innovation and future growth. Under generally accepted accounting principles (GAAP) in the United States, most research and development expenses are treated as operating expenses and are recorded on the income statement in the period they are incurred. This immediate expensing contrasts with the capitalization of costs that yield a long-term asset.

History and Origin

The accounting treatment of research and development expense has evolved over time. A pivotal moment for U.S. GAAP was the issuance of Statement of Financial Accounting Standards (SFAS) No. 2, "Accounting for Research and Development Costs," by the Financial Accounting Standards Board (FASB) in October 1974. This standard mandated that all research and development costs be charged to expense as incurred, with limited exceptions.⁵, ⁶, ⁷, ⁸ The objective was to reduce the variety of accounting practices for R&D and provide more consistent financial information.⁴ Prior to this, companies had more flexibility, sometimes capitalizing certain development costs. The FASB argued that the future benefits of R&D activities were too uncertain to warrant capitalization, leading to the decision for immediate expensing.

Key Takeaways

• Research and development (R&D) expense represents costs undertaken to innovate and develop new products or processes.
• Under U.S. GAAP, R&D costs are generally expensed on the income statement as they are incurred, rather than capitalized as assets.
• It is a significant indicator of a company's investment in future growth and its potential for long-term competitive advantage.
• Analyzing R&D expense is vital for understanding a company's strategic direction and potential for future profitability.

Formula and Calculation

Research and development expense is typically presented as a single line item on a company's income statement. There isn't a complex formula to calculate the expense itself; it is the sum of all qualifying costs incurred during an accounting period. These costs include:

• Salaries, wages, and other related costs of personnel engaged in R&D activities.
• Costs of materials, equipment, and facilities that are acquired or constructed for a specific R&D project and have no alternative future use. If they have alternative uses, only the depreciation or amortization of these items used in R&D is expensed.
• Costs of services performed by others in connection with R&D activities.
• A reasonable allocation of indirect costs related to R&D.

The overall reported R&D expense can be expressed simply as:

Where:

• Direct Costs = Salaries, materials, equipment consumed, and external services directly tied to R&D projects.
• Allocated Indirect Costs = A portion of overhead expenses attributed to R&D activities.

Interpreting the Research and Development Expense

Interpreting a company's research and development expense involves looking beyond the absolute number. A high R&D expense can signal a company's aggressive pursuit of new technologies or market disruption, potentially leading to significant future growth and higher market capitalization. Conversely, a low or declining R&D expense might suggest a lack of investment in future innovation, which could hinder long-term prospects.

Analysts often examine R&D expense as a percentage of revenue or total expenses to gauge its intensity relative to the company's size and industry. Companies in sectors such as pharmaceuticals, technology, and biotechnology typically have higher R&D expenses due to the continuous need for new discoveries and product development. Investors also scrutinize trends in R&D spending to understand management's long-term strategy and its impact on future earnings per share.

Hypothetical Example

Consider "TechInnovate Inc.," a hypothetical software company. In its latest fiscal year, TechInnovate incurred the following costs related to developing a new artificial intelligence platform:

• Salaries for software engineers and researchers: $5,000,000
• Cost of specialized lab equipment (no alternative use): $1,500,000
• Fees paid to an external AI research consultancy: $700,000
• Allocated overhead (rent, utilities for R&D lab): $300,000

Under U.S. GAAP, all these costs would be immediately expensed as research and development expense on TechInnovate's income statement.

So, for the fiscal year, TechInnovate's research and development expense would be:

$5,000,000 (Salaries) + $1,500,000 (Equipment) + $700,000 (Consultancy) + $300,000 (Overhead) = $7,500,000

This $7,500,000 would be reported on the income statement, reducing the company's reported profit for that period, even though the new AI platform is expected to generate significant cash flow in future years.

Practical Applications

Research and development expense is a closely watched metric by investors, analysts, and regulators. For instance, publicly traded companies in the United States disclose their research and development expense in their annual Form 10-K filings with the Securities and Exchange Commission (SEC).³ This allows stakeholders to assess a company's investment in future growth initiatives.

Globally, organizations like the Organisation for Economic Co-operation and Development (OECD) track and publish data on research and development expenditure as a key indicator of national innovation and economic competitiveness. Such statistics provide insights into which countries and industries are investing most heavily in creating new knowledge and technologies. Governments may also offer R&D tax credits or incentives to encourage companies to increase their spending in this area, recognizing its long-term benefits for the economy and societal well-being. Analyzing R&D expense is crucial for performing a thorough valuation of technology-intensive firms, as it represents a significant investment in future revenue streams.

Limitations and Criticisms

While expensing research and development costs provides conservatism and simplifies accounting, it also faces criticisms. A primary concern is that immediate expensing may understate a company's asset base, as successful R&D efforts often create valuable intangible assets that are not recognized on the balance sheet. This can lead to a mismatch between the reported financial performance and the underlying economic reality of a company, potentially making capital-intensive R&D firms appear less profitable in the short term.

Academics and practitioners have long debated whether expensing all R&D adequately reflects the long-term value created. Some argue that the mandated expensing can even influence managerial behavior, potentially discouraging companies from investing in long-horizon R&D projects that would benefit future periods but negatively impact current reported profitability. Research has suggested that the accounting method chosen for R&D can indeed affect the amount that firms invest.² This discussion highlights the ongoing tension in financial accounting between relevance and reliability.

Research and Development Expense vs. Capital Expenditure

Research and development expense is often confused with capital expenditure (CapEx), but there's a fundamental difference in their accounting treatment and impact on financial statements. Capital expenditure refers to funds used by a company to acquire, upgrade, and maintain physical assets such as property, plants, buildings, and equipment. These expenditures are "capitalized" on the balance sheet and then depreciated over their useful life, meaning their cost is spread out over many accounting periods.

In contrast, under U.S. GAAP, research and development expense is generally expensed immediately in the period it's incurred, as discussed. The rationale is the inherent uncertainty of R&D outcomes; the future economic benefits are not sufficiently assured to qualify as an asset. While both represent investments by a company, CapEx creates a tangible or identifiable intangible asset with predictable future benefits, whereas R&D expense, by convention, reflects a more uncertain investment in innovation, impacting the return on investment calculation differently.

FAQs

What types of costs are included in research and development expense?

Research and development expense includes all direct and indirect costs associated with creating new products, processes, or significant improvements. This typically covers salaries for R&D personnel, materials used in research, and the depreciation of equipment dedicated solely to R&D activities.¹

Why are R&D costs usually expensed rather than capitalized?

Under U.S. GAAP, R&D costs are generally expensed immediately because the future economic benefits of research and development activities are considered highly uncertain and difficult to measure reliably. This conservative approach aims to prevent overstating a company's asset values on the balance sheet.

How does research and development expense impact a company's financial statements?

Research and development expense directly reduces a company's reported profit on the income statement in the period it is incurred. This can lead to lower net income and, consequently, lower earnings per share in the short term, even if the R&D efforts are expected to generate significant future revenues.