Why Are R&D Expenses Not Capitalized?

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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.

Accounting Treatement

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

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.

Earnings

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.

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