Principles of Financial Accounting: Plant Assets and Intangibles - Research and Development Costs

What It Is

Research and development (R&D) costs are expenses incurred by a company to create new products, processes, or technologies. These costs are crucial in financial accounting as they impact a company's profitability and financial position. For instance, if a company spends $50,000 on R&D for a new product, it will directly affect its net income and financial statements.

Key Concepts & Formulas

• Research and Development Expense (R&D Expense): A cost incurred to create new products, processes, or technologies. Example: A company spends $10,000 on salaries for R&D personnel.
• Capitalization of R&D Costs: R&D costs can be capitalized if they meet specific criteria, such as being related to a specific product or process, and being expected to generate future economic benefits. Example: A company spends $20,000 on designing a new product, which is expected to generate significant revenue in the future.
• Amortization of R&D Costs: Capitalized R&D costs are amortized over their useful life, typically 5-10 years. Example: A company capitalizes $50,000 in R&D costs and amortizes them over 5 years.
• Direct R&D Costs: Costs directly related to R&D activities, such as salaries, materials, and equipment. Example: A company spends $15,000 on direct R&D costs.
• Indirect R&D Costs: Costs indirectly related to R&D activities, such as rent, utilities, and administrative expenses. Example: A company spends $10,000 on indirect R&D costs.
• R&D Asset: An asset representing the capitalized R&D costs. Example: A company has a R&D asset of $30,000.
• R&D Expense Ratio: A ratio showing the percentage of R&D expenses to total expenses. Example: A company has R&D expenses of $50,000 and total expenses of $200,000, resulting in an R&D expense ratio of 25%.
• GAAP for R&D Costs: Under GAAP, R&D costs are expensed as incurred, unless they meet specific criteria for capitalization. Example: A company spends $20,000 on R&D costs, which are expensed as incurred.

Journal Entry Examples

1. Dr. Research and Development Expense $10,000 Cr. Cash $10,000

Explanation: The company incurs $10,000 in direct R&D costs, which are expensed immediately.

1. Dr. Research and Development Asset $50,000 Cr. Cash $50,000

Explanation: The company capitalizes $50,000 in R&D costs, which are expected to generate future economic benefits.

1. Dr. Research and Development Expense $20,000 Cr. Research and Development Asset $20,000

Explanation: The company amortizes $20,000 in capitalized R&D costs over their useful life.

Common Mistakes

• Mistake: Confusing direct and indirect R&D costs.
• Correction: Direct R&D costs are those directly related to R&D activities, while indirect R&D costs are those indirectly related to R&D activities. Example: Salaries for R&D personnel are direct R&D costs, while rent for the R&D facility is an indirect R&D cost.
• Mistake: Not distinguishing between R&D expenses and R&D assets.
• Correction: R&D expenses are costs incurred to create new products, processes, or technologies, while R&D assets are the capitalized costs that are expected to generate future economic benefits. Example: R&D expenses are $10,000, while the R&D asset is $50,000.
• Mistake: Not considering the criteria for capitalization of R&D costs.
• Correction: R&D costs can be capitalized if they meet specific criteria, such as being related to a specific product or process, and being expected to generate future economic benefits. Example: A company spends $20,000 on designing a new product, which is expected to generate significant revenue in the future.

Exam Tips

• Tip: Be careful with the distinction between R&D expenses and R&D assets. Remember that R&D expenses are costs incurred to create new products, processes, or technologies, while R&D assets are the capitalized costs that are expected to generate future economic benefits.
• Tip: Consider the criteria for capitalization of R&D costs. Remember that R&D costs can be capitalized if they meet specific criteria, such as being related to a specific product or process, and being expected to generate future economic benefits.
• Tip: Be careful with the amortization of R&D costs. Remember that capitalized R&D costs are amortized over their useful life, typically 5-10 years.

Quick Practice

1. A company incurs $10,000 in direct R&D costs. What is the adjusting entry for these costs? Answer: Dr. Research and Development Expense $10,000 Cr. Cash $10,000 Explanation: The company incurs $10,000 in direct R&D costs, which are expensed immediately.

2. A company capitalizes $50,000 in R&D costs. What is the adjusting entry for these costs? Answer: Dr. Research and Development Asset $50,000 Cr. Cash $50,000 Explanation: The company capitalizes $50,000 in R&D costs, which are expected to generate future economic benefits.

3. A company amortizes $20,000 in capitalized R&D costs over their useful life. What is the adjusting entry for these costs? Answer: Dr. Research and Development Expense $20,000 Cr. Research and Development Asset $20,000 Explanation: The company amortizes $20,000 in capitalized R&D costs over their useful life.

Last-Minute Cram Sheet

1. R&D costs are expensed as incurred, unless they meet specific criteria for capitalization.
2. Capitalized R&D costs are amortized over their useful life, typically 5-10 years.
3. Direct R&D costs are those directly related to R&D activities, while indirect R&D costs are those indirectly related to R&D activities.
4. R&D expenses are costs incurred to create new products, processes, or technologies, while R&D assets are the capitalized costs that are expected to generate future economic benefits.
5. R&D costs can be capitalized if they meet specific criteria, such as being related to a specific product or process, and being expected to generate future economic benefits.
6. R&D expense ratio is a ratio showing the percentage of R&D expenses to total expenses.
7. GAAP for R&D costs requires expensing R&D costs as incurred, unless they meet specific criteria for capitalization.
8. Dividends are NOT an expense – they go directly to retained earnings.
9. R&D costs can be capitalized if they meet specific criteria, such as being related to a specific product or process, and being expected to generate future economic benefits.
10. Amortization of R&D costs is typically done over their useful life, typically 5-10 years.