Capitalization of Assets

Capitalizing R&D Expenses
Learn how and when to capitalize research and development costs
Written by CFI Team

Updated December 4, 2022
R&D Capitalization vs Expense

Under the United States Generally Accepted Accounting Principles (GAAP),
companies are obligated to expense Research and Development
(R&D) expenditures in the same fiscal year they are spent. It often creates a
lot of volatility in profits (or losses) for many companies, as well
as difficulty in measuring their rates of return on assets and investments.
A lack of R&D capitalization could mean that their total assets or their total
invested capital do not properly reflect the amount that has been invested
into them. As a result, there can be an impact on the company’s Return on
Assets (ROA) and Return on Invested Capital (ROIC). Below, we analyze the
practice of capitalizing R&D expenses on the balance sheet versus
expensing them on the income statement.
Let us compare GAAP with the International Financial Reporting Standards

(IFRS). Under IFRS rules, research spending is treated as an expense each
year, just as with GAAP. By contrast, though, development costs can be
capitalized if the company can prove that the asset in development will
become commercially viable (meaning the technology or product in
development is likely to make it through the approval process and generate
revenue).
The benefit of the IFRS approach is that at least some research and
development costs can be capitalized (i.e., turned into an asset on the
company’s balance sheet) instead of being incurred as an expense on the
statement of Profit and Loss (P&L). The trade-off, however, is that IFRS
requires judgment and subjectivity, which creates a risk that managers will
be overly optimistic about how commercially viable a new technology is,
which can cause inconsistencies in different companies’ financial
statements.
R&D Expense and Earnings Volatility
R&D spending can vary widely from one year to another, which has a
significant impact on a company’s profitability. Many businesses in the
technology, healthcare, consumer discretionary, energy, and industrial
sectors experience this problem.
If a company doesn’t capitalize research and development, its net income

can be significantly higher or lower because of the timing of R&D spending.
It’s important to note that net income doesn’t include the significant
investments in R&D under its cash flow from investing activities.
Additionally, this issue seems to contradict one of the main accounting
principles, which is that expenses should be matched to the same period
when the corresponding revenue is generated.
Research and development is a long-term investment for most companies

resulting in many years of revenue, cash flow, and profit, and, thus, should
theoretically be capitalized as an asset, not expensed. Without the
capitalization of R&D spending, it is more challenging to compare
companies in the same industry, as the timing of their research spending
can have a big impact on their bottom line in a given year.
The Process of R&D Capitalization vs Expense
From an economic perspective, it seems reasonable that research and

development costs should be capitalized, even though it’s unclear how
much future benefit they will create. To capitalize and estimate the value of
these assets, an analyst needs to estimate how many years a product or
technology will generate benefit for (its economic life) and use that as an
assumption for the amortization period.
The amortizable life will differ from asset to asset and reflects the economic
life of the various products. For example, R&D products developed by a
pharmaceutical company would likely last many years (and thus have a long
amortization period), since it takes a long time for patents to be approved
and there is also some patent protection they can enjoy monopolistic sales
for several years. R&D amortization for a mobile phone company, however,
should be amortized much faster (a smaller number of years) since new
phones tend to emerge much more quickly and, thus, come with shorter
shelf lives.
After estimating the economic life of an asset with a life of seven years, a
company would then amortize the capitalized R&D expenses equally over
the seven-year life. In the example below, we will assume the amortization
of the asset uses the straight-line approach.
R&D Capitalization Example
Below is an example of the R&D capitalization and amortization

calculations in an Excel spreadsheet. The key assumptions are that a total of
$100,000 has been spent on research and development, there is a $20,000
residual value, the product developed has a commercial life of 5 years, and
the amortization expense uses the straight-line method.
Based on these assumptions, the company would have a $16,000

amortization expense each year, for five years, until it reaches the residual
value of $20,000. By amortizing the cost over five years, the net income of
the business is smoothed out and expenses are more closely matched to
revenues.

Capitalization of Assets

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Capitalizing R&D Expenses

Learn how and when to capitalize research and development costs

Written by CFI Team

R&D Capitalization vs Expense

Let us compare GAAP with the International Financial Reporting Standards

If a company doesn’t capitalize research and development, its net income

Research and development is a long-term investment for most companies

The Process of R&D Capitalization vs Expense

From an economic perspective, it seems reasonable that research and

R&D Capitalization Example

Below is an example of the R&D capitalization and amortization

Based on these assumptions, the company would have a $16,000

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