After long days in the lab and countless
sleepless nights, you have developed a
product that can have a real impact.
Companies are expressing interest in your
discovery, which creates new problems and
questions about how to account for research
and development expenses, whether R&D
expenditures create tax credits to offset
future taxable income (they can) or how the
R&D expenses qualify for tax credits (they
will if certain requirements are met).
As Mark Werling of Burr, Pilger & Mayer
LLP notes, “As these initiatives progress,
more eyes will be examining your company’s
financial statements and looking to ensure
your compliance with generally accepted
accounting guidance to help judge their ultimate investment decision.”
Smart Business spoke to Werling to learn
more about how R&D is defined, R&D credits, their treatment by the IRS regarding
income, how to facilitate the compliance
process and when to consult with qualified
R&D accounting specialists.
How is R&D defined?
SFAS 2, Accounting for Research and
Development Costs, defines the research
component of R&D as a ‘planned search or
critical investigation aimed at discovery of
new knowledge’ that could result in a new
discovery. The development component of
R&D requires translating ‘research findings
or other knowledge into a plan or design’ for
a new discovery. This can include conceptual formulation, design, construction of prototypes and operation of pilot plant. Routine
alterations to existing products, processes or
operations are excluded from this definition.
Materials, equipment and facilities used in
R&D activities are expensed as incurred,
including depreciation. R&D costs may
include salaries and other personnel costs,
contract services and a reasonable allocation
of indirect corporate costs, unless they are
not related clearly to R&D activities.
How does the treatment of R&D change
through a product’s development?
FASB defines three unique stages of development in determining the accounting treatment of R&D costs. Stage one coincides with
the beginning of a product’s development
cycle and ends when technological feasibility
is established, either upon the completion of
a detailed program design or of a working
prototype. Until that point, all costs related to
R&D expenditures are expensed as incurred.
Once technological feasibility has been
achieved, the product moves into stage two
and all R&D costs are capitalized and amortized according to its useful life or as a percentage of expected future revenue. Once
the product is available for general release to
customers, it enters stage three. All subsequent outlays are again expensed as they are
incurred. Recognizing these three phases and
the inflection points that separate them is key
in accounting properly for R&D treatment.
What do these accounting treatments mean
for a company?
Applying this methodology increases net
income by capitalizing the costs during the
development of the full product roll-out period and then spreading the expenses into
future periods. It also prevents companies
from artificially ‘propping up’ their net
income as they pursue technological feasibility by moving too much expense off the
income statement. Until a company has
something that works in prototype form,
everything gets expensed.
From a cash flow perspective, there is little
change to the financial statements, as there is
still a real capital outflow regardless of
whether it is capitalized or expensed. In an
acquisition scenario, a misrecording of R&D
expenses could have a significant impact on
the purchase price of a business. If a portion
of a purchased company’s value is represented by R&D assets that have no alternative
future use, GAAP requires that this part of the
acquisition price be written off. This could
greatly impact the price that the company is
acquired for. Because the SEC has made it a
priority to minimize opportunities to manipulate earnings, proper valuation of in-process
R&D for acquired enterprises is critical.
When are outlays considered R&D for federal tax purposes?
Outlays can be classified as R&D for federal tax purposes if they are intended to discover information that would eliminate
uncertainty regarding the development or
improvement of a product. As specified in
Treasury Regulations section 1.174-2(a), this
can include costs to create a pilot model,
process, formula, invention, technique,
patent, or similar property that contributes
toward the development of a product. Any
R&D costs should be clearly intended to
establish the capability or method for developing, improving or designing the property.
Do R&D credits offset future taxable income?
If properly utilized, they will provide a tax
credit of 20 percent of certain increases in
qualified research expenses — with a few
additional caveats. Alternatively, the taxpayer may elect to take the full R&D deduction
but reduce the credit by 35 percent (the maximum corporate tax rate). There are other
nuances that may require additional examination, but generally, this is how these transactions are approached. These nuances and
the requirements that the research expenditures must meet to qualify for tax credits can
be explained by qualified R&D accounting
professionals.
MARK WERLING is a manager with Burr, Pilger & Mayer. Reach him at (415) 421-5757 or [email protected].
