A development cost definition will tell you it's the cost a company incurs while researching and developing a new product or service. General practice dictates the research and development costs should be immediately expensed when costs are incurred.

Research and development decreases a company's profits in the short-term but creates higher profits in the medium to long-term. Most analysts will agree that it is a positive sign when a company is devoting their resources to research and development.

Research and Development Accounting

Accounting for research and development projects involves all the activities that improve or create processes or products. It's important to remember to charge expenditures to the expense as incurred. Activities that are typically considered as research and development include:

  • Research to bring about new knowledge
  • Creation of product and process designs
  • Testing processes and products
  • Modifying processes and products
  • Designing prototypes
  • Testing prototypes
  • Designing new tools

Companies may experience trouble with research and development expenditures because future benefits cannot be guaranteed. Also, it is difficult to attach an expenditure to an asset. Because of these uncertainties, companies have a requirement to charge expenditures directly to the expense from which it incurred.

What's Not Included in Research and Development Accounting?

Charging research and development expenditures to its expense is not entirely pervasive in the business world. The following exceptions apply:

  • If any materials or assets have future uses, they must be recorded as assets. Use depreciation to gradually reduce the fixed assets' carrying amount. If there won't be any future use, charge the cost to the expense as incurred.
  • If you acquire computer software throughout the course of the company's research and development efforts, charge the cost to the expense as incurred. If there will be future uses for the computer software, capitalize on its cost because it will depreciate over time.
  • If you reach out to a third-party to conduct research, charge those invoices to the expense. These will be indirect costs. Allocate a reasonable amount of overhead to research and development.
  • If you receive intangibles from a third-party and they have alternative uses, account for them as intangible assets. However, if you received the intangibles for a specific project and they don't have any future uses, charge them as incurred to the expense.
  • Charge wages and salaries to the expense as incurred.

There have been instances where a third-party, or a sponsor, will fund the research and development plans for a business. The reasons for this vary but can include the transfer of intellectual property, licensing rights, equity, or profits. The sponsor may choose to pay the company conducting the research and development at a fixed rate or provide some form of reimbursement at a later date.

These arrangements are often developed as limited partnerships. This allows the related party to act as a partner for a designated amount of time. As such, the partner may secure even more funding through the sale of limited-partner interests or by extending any loans to the partnership that will be repaid through royalties in the future.

Accounting Issues to be Resolved

When a business entity partners with research and development arrangements, there are numerous accounting issues to address before moving forward with the work.

  • If funds are lent or advanced to a third-party, and repayment is based on the economic benefits associated with the research and development, those amounts must be charged to the expense.
  • Defer any nonrefundable advance payments for research and development. Mark them as an expense only when the products are delivered or the services are rendered.
  • If the repayment of the funds to the funding party is dependent on the results of the research and development, consider the repayment as a contract to perform work.
  • If the funding parties must be repaid no matter how the research and development turns out, be sure to recognize liability for the amount of the repayment and charge the cost of the research and development to the expense as incurred.
  • If the third party issues a warrant as part of the funding arrangement, set aside a portion of your paid-in funds to serve as paid-in capital.

If you need help with absorption pricing, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.