Friday, September 24, 2021

Ruminating on R&D investment capitalization

When organizations invest in R&D activities, there are accounting rules for claiming tax credits. The reason governments give tax credits is to encourage innovation thorough R&D spending. 

Earlier, the accounting rules mandated all R&D investments to be shown as "expenses" on the Profit and Loss (P&L) statement in the same year, the investments were made. But this poses a problem as the return of a R&D investment could be over multiple future years. Also R&D investments can vary widely every year and its net profit can be significantly higher or lower because of the timing of R&D spending. 

Hence in the new accounting rules, instead of treating R&D investments as an "expense" in the P&L statement, it is treated as an "Asset" in the balance sheet. This is referred to as "Capitalizing the R&D expense". 

Once the R&D investment is treated like an "Asset", the company can claim amortization (or depreciation) benefits on it over multiple years. For example - A software firm has invested 1 MM USD in R&D to build a product in 2021. The economic life of the built product is 5 years.  The company can then amortize/depreciate the capitalized R&D expenses equally over the five-year life. This amortized amout per year is a line item in the yearly P&L statement. 

A good explanation of this concept is given here - https://corporatefinanceinstitute.com/resources/knowledge/accounting/capitalizing-rd-expenses/

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