Research and Development Expenses Accounting Treatment: Intangible Assets or Expenses?

Now that our company has been established, raw materials and fixed assets procured, and first sales made, it appears that our company is moving toward the right direction. We can take a breath ... for now.

Next, we are going to take a slightly longer view, and prepare for next year. 

To make sure we are ready for next year's operations, we will prepay 1.5 million dollars to our supplier and secure raw material supplies. Since 1.5 million dollars are prepaid, our cash position is reduced by this amount. At the same time, we should record 1.5 million dollars as prepaid accounts because we have the right to receive goods from the supplier in the future, making it an asset. After this economic activity, we can see that the the total amount of assets is not changed. 

During this year while we were selling our products, our company also spent 4 million dollars in cash, 2.5 of which on salaries of sales personnel and sales related expenses, and 1.5 of which on salaries of managers and managerial expenses. Our cash position was further reduced by 4 million dollars on the balance sheet. At the same time, we should put the 2.5 million dollars under operating expenses, and 1.5 million dollars under administrative expenses.

Next, we've decided to invest half a million dollars to developing a pollution treatment technology, which is a research and development activity. How does this affect our financial statements?

Well, it's easy to know that our cash is further reduced by 500,000 dollars on the balance sheet. On the surface, we might be tempted to put 500,000 dollars under intangible asset, since technology appears to be a type of intangible asset. However, this is actually wrong. Let's see why that is the case.

The accounting principles stipulate that R&D expenses shall be recorded as expenses, specifically, administrative expenses in the Income Statement. If and only if the R&D is in the product development stage and it meets certain criteria could it be recorded under intangible assets. Here research means the true, hardcore development of a new technology, and product development means things like design of packages, etc., that happens after the development of the core tech.

The accounting principles also stipulate that after we successfully developed a technology and applied for a patent, ONLY the application fees for the patent may be recorded in intangible assets. For example, if we spent 500,000 dollars in researching a technology and another 5,000 dollars on the patent application, only the 5,000 can be recorded in intangible assets.

This might seem strange, and unreasonable at first glance. We all think that research and development is actually a thing that impacts long-term development of a company in the future, and because of that, we should record it as an asset item - intangible asset.

The reason it doesn't work that way is that R&D is an activity with high uncertainty. When a tech is being developed in the lab, it's very difficult to say whether it will be successfully productized and commercialized. Let us look at some data.

For the American pharmaceutical industry, the average length of drug development is about 14.9 years with the cost of around 500 million dollars, among which 200 million is invested before the clinical experiment stage. However, only 18% of all drugs can actually enter the clinical experiment stage, meaning that 82% of all drug development investments are pure expenses.

This stat shows that R&D activity has crazy high uncertainty. The accounting profession, however, hates uncertainty, and whenever there appears uncertainty, accounting will treat it as - failure, by default, even if there is still chance for it to succeed.

And that is why all R&D activities are treated as expenses, i.e. useless for the future.

Now let's go back to our company and push the scenario one step further. What if our 500,000 dollars of research investment does succeed, i.e. we have created a successful technology? Can we record it in intangible assets?

Unfortunately, still no.

The reason is that technological success does NOT equal commercial success. We can see lots of examples that a technology creates no commercial value at last. So it still has considerable uncertainty even after the tech is developed.

Lastly, the accounting principles stipulate that technology purchased externally should be recorded in intangible assets. The reason is that our purchase equals our acknowledgment in the commercial value of the tech, so only by then could we record it with a value equal to the purchase price. 

From the aforementioned three principles on R&D, we see that research itself will not result in increase of intangible assets. Looking reversely, if there is indeed intangible asserts such as technology in a company's balance sheet, it almost always means that the company has purchased the tech from external parties. 

We can further draw a conclusion that all self-generated intangible assets of the company will not be reflected on the balance sheet. Let's look at another example.

Say we want to invest in building a brand for our product by investing in advertisements. When we pay for the ads, the ad costs go into operating expenses. We will never record these types of costs as intangible assets for the reason that we have no idea how much value of intangible assets can be created by the ads we make.

This is not to say that self-generated intangible assets are worthless. On the contrary, these assets are at the very core of a company's competence, but are left off the balance sheet. In other words, a company will have many important off-balance-sheet assets. For example, a company may own important technology, brands as well as other valuable assets that according to accounting principles, must be left off the balance sheet. These "assets" are valuable and important, but because of their uniqueness, their values are hard to determine.

Then what are the intangible assets that we see on the balance sheet? They are all purchased from others by the company. 

This unique characteristic of intangible assets being off the statement and valuable at the same time can be used by companies for their own advantages. For example, sometimes a company might need to reflect their R&D investment in the balance sheet, and to do so they might sell the technology and buy it back. But most companies would not do something like this; instead, a more common way is that the company will establish a separate entity - an independent R&D subsidiary - to handle all the R&D. The company will then procure technology from this independent legal entity, resulting in the R&D cost showing up as intangible assets on the company's balance sheet.

From this example, we see that the accounting principles stay the same. But by using different organizational structures, we can get different results. There is no good or bad in either practice; different companies might pursue different practices to suit their objectives. For some very profitable companies, for instance, they may prefer to record R&D as expenses so they could reduce the tax burdens. For some other companies, e.g. startups, they might want to record R&D as intangible assets so their profits look good. 

So coming back to our original case, the 500,000 dollars research expense will cause a corresponding dip of cash in balance sheet. We should also record this amount as administrative expense in the income statement.