Research and development costs

Welcome to Research and Development (R&D)!

Hello there! Today, we are diving into one of the most interesting areas of the BAR exam: Research and Development (R&D) costs. While companies spend billions trying to find the "next big thing," the accounting rules for these costs are actually quite conservative.

Don't worry if this seems a bit dry at first—we're going to break it down using simple analogies and clear rules so you can confidently tackle any R&D question the exam throws at you. Let's get started!

1. What Exactly is R&D?

Before we look at the numbers, we need to know what we are talking about. Think of R&D as a two-step process:

Research: This is the "discovery" phase. It’s searching for new knowledge. Example: A pharmaceutical company testing different chemicals to see if they can kill a specific virus.

Development: This is the "application" phase. It’s taking that knowledge and turning it into a plan or design for a new product. Example: That same company designing the specific pill and the manufacturing process to mass-produce it.

Key Rule: The Expense Rule

Under US GAAP, the general rule is very simple: Expense R&D costs as they are incurred.

Why? Because R&D is risky! We don't know if that new chemical will actually become a blockbuster drug. To be conservative, we don't want companies putting "hope" on the balance sheet as an asset. We want them to show it as an expense immediately.

Quick Review: Most R&D = Immediate Expense.

2. The Important Exceptions (When to Capitalize)

This is where the CPA exam loves to test you. There are a few situations where you do not expense the cost immediately. Instead, you capitalize it (put it on the balance sheet as an asset).

Materials, Equipment, and Facilities

If you buy a piece of equipment for R&D, how you account for it depends on its future:

1. No Alternative Future Use: If the machine can only be used for this specific R&D project and nothing else, expense it immediately.

2. Alternative Future Use: If the machine can be used for other R&D projects or for general production in the future, capitalize it. You then record depreciation on that machine, and that depreciation becomes an R&D expense each year.

Analogy: If you buy a special one-time-use mold for a prototype, it's an expense. If you buy a high-end 3D printer that you will use for many different projects over the next five years, it's an asset (capitalize it!).

R&D Conducted for Others

If Company A pays Company B to do research for them, Company B is just performing a service. Company B does not record R&D expense; they record "Cost of Sales" or "Contract Expenses." The company paying for the work (Company A) is the one recording the R&D expense.

US GAAP generally expenses internal R&D as incurred, but this is not an absolute rule. Equipment or materials with alternative future uses are capitalized and their use in R&D is expensed. Acquired in-process R&D in a business combination is recognized as an intangible asset; separately acquired R&D without alternative future use is generally expensed. Software development follows its applicable specialized guidance. Legal registration or successful-defense costs require their own capitalization assessment.

3. Computer Software Development

Software is a "special case" in the BAR curriculum. The rules change depending on who the software is for.

A. Software to be SOLD (External Use)

Imagine you are Microsoft developing the next version of Windows. You follow these steps:

1. Expense: All costs incurred before Technological Feasibility is established. (This means you've proven the software will actually work, usually via a working model).
2. Capitalize: All costs incurred after Technological Feasibility but before the product is released to the public.
3. Amortization: Once the product is sold, you start amortizing (spreading out) those capitalized costs.

How to calculate Software Amortization:

You must use the greater of these two methods:

1. Percentage of Revenue Method: \( \text{Capitalized Cost} \times \left( \frac{\text{Current Gross Revenue}}{\text{Total Anticipated Gross Revenue}} \right) \)

2. Straight-Line Method: \( \frac{\text{Capitalized Cost}}{\text{Remaining Economic Life}} \)

B. Software for INTERNAL Use Only

Imagine you are a bank building a new internal portal for your employees. The rules are slightly different:

State which internal-use software guidance applies. Before adoption of ASU 2025-06, ASC 350-40 uses project stages, with qualifying application-development costs capitalized and preliminary, training and maintenance costs generally expensed. ASU 2025-06 removes the stage model; capitalization begins when management authorizes and commits funding and completion and intended use are probable, considering significant development uncertainty. It is effective for annual periods beginning after December 15, 2027, with early adoption permitted.

Did you know? If you decide to sell "internal use" software later, you don't go back and change the accounting. You just apply any future proceeds to reduce the carrying amount of the asset to zero, then recognize income!

4. Items that are NOT R&D

Don't let the exam trick you! These things might look like R&D, but they aren't:

• Routine design changes: Making a car's bumper look slightly shinier is just regular business, not R&D.
• Market Research: Surveying customers to see if they like blue or red packaging is a "selling and administrative" expense, not R&D.
• Quality Control: Testing products on the assembly line is "manufacturing overhead," not R&D.
• Legal costs for patents: These are capitalized as part of the Intangible Asset (Patents), not R&D expense.

5. Summary and Common Mistakes

Quick Review Table

Item: R&D Salaries/Materials
Treatment: Expense immediately.

Item: Equipment with alternative future use
Treatment: Capitalize and Depreciate.

Item: Software costs after Technological Feasibility (for sale)
Treatment: Capitalize.

Item: Training for new software (internal use)
Treatment: Expense immediately.

Common Mistakes to Avoid:

• Mistake: Capitalizing the legal fees for a patent as R&D.
  Correction: Legal fees to successfully defend or register a patent are capitalized to the "Patent" account, not "R&D Expense."
• Mistake: Forgetting to check for "alternative future use."
  Correction: Always look for this phrase! It changes an expense into a capitalized asset.
• Mistake: Using the "lower" of the two amortization methods for software.
  Correction: GAAP requires you to use the Greater (more conservative) amount for amortization.

US GAAP generally expenses internal R&D as incurred, but this is not an absolute rule. Equipment or materials with alternative future uses are capitalized and their use in R&D is expensed. Acquired in-process R&D in a business combination is recognized as an intangible asset; separately acquired R&D without alternative future use is generally expensed. Software development follows its applicable specialized guidance. Legal registration or successful-defense costs require their own capitalization assessment.

You've got this! Keep practicing those software amortization problems, and you'll be an R&D expert in no time.