The accounting rule for research and development costs, or R&D, is simple: R&D is an expense. In theory, R&D outlays may lead to substantial assets for a company in the future; however, they may not. This uncertainty is why financial accounting rules treat R&D as an expense rather than allowing a company to capitalize the cost as it would for depreciation of tangible assets, which have an ascertainable cost and useful life.
Research and Development
R&D has a significant impact on the economy, having produced some of the very creature comforts and technological advancements we enjoy today. Companies spend billions on R&D in an effort to generate future earnings, but not all R&D leads to successful income-producing assets. For this reason, accounting rules do not allow companies to capitalize R&D expenses. Furthermore, unlike a tangible asset, R&D may not have a definitive useful life. Allowing companies to capitalize R&D costs, which treats it as an asset, allows for the manipulation of earnings.
Under U.S. generally accepted accounting principles rules, SFAS 2, Accounting for Research and Development Costs, companies must charge R&D as an expense in the year incurred. Companies also must disclose total R&D costs in their financial statements. SFAS 2 recognizes the research component of R&D as "planned research or criminal investigation aimed at discovery of new knowledge" that may result in a new or improved product, service, process or technique. The operative word is "may," as a company never knows if its research efforts will bear fruit. The development aspect of R&D is the conceptual formulation, design and testing. Companies expense materials, equipment and facilities used in R&D activities as incurred including depreciation of the tangible portions of R&D.
Capitalization allows a company to spread the cost of an asset into future periods. For example, depreciation allows a company to spread the cost of its tangible assets over an estimated useful life. In contrast, R&D is an expense that may or may not lead to an asset. For example, a pharmaceutical company may spend a significant amount of R&D on the next miracle drug and expect it to generate $1 billion in sales over the life of the drug's patent. However, if the miracle drug doesn't meet Federal Drug Administration approval, it will never come to market.
Allowing a company to capitalize rather than expense its R&D costs opens the door for a manipulation of earnings. For instance, a company capitalizing a large R&D charge shows better earnings results than a company that does not capitalize. Furthermore, capitalization of R&D expenses evens out earnings, an unrealistic assumption because management does not know if its current capital outlays will lead to a future benefit to earnings.