There was a time when a computer occupied a full room but performed only the most basic of functions. A couple of decades later, there are smart wearable devices that perform more complex functions than these computers that occupied the whole room. From riding horses to travelling in bullet trains and the evolution of modern medicine, how did the world around us evolve?

Simple, the solution can be found in two words — Research and Development (R&D).

Research means a detailed study of a subject to discover new information and achieve a higher understanding. Some characteristics of research include collecting information, organising, and analysing the same, to draw reasonable and insightful conclusions. The results of the research phase form the building blocks for growth often dubbed as development. Simply put, development is progressing with the knowledge gathered during the research phrase.

Building R&D capabilities

Businesses constantly aim for improving the efficiency and effectiveness of existing processes. To thrive in a competitive market, innovativeness and unique core competencies are a must, and R&D is the path to achieve them. In the current business context, innovation and resilience are synonymous with survival.

When a company’s financial statements feature R&D expenditure, it reassures investors that the company is making efforts to gain a competitive advantage in the market. R&D expenditure also has a lot of importance in the start-up ecosystem.

For instance, the automobile manufacturing company — Tata Motors — was the largest spender on R&D in FY20 with a total of ₹3,100 crore which accounts for 7.10 per cent of its total revenue. Dr Reddy’s Laboratories spent ₹1,541 crores, which is 9 per cent of its revenue, on R&D.

Globally, e-commerce giant Amazon spent $22.62 billion — 12.7 per cent of its net sales on R&D in 2017 and Alphabet (previously known as Google) spent $16.62 billion on R&D, 15 per cent of revenue, in the same year. These examples convey that R&D is a game-changing expenditure.

Examining R&D expenditure

Against this backdrop, it is critical to understand how this expenditure is treated in financial statements. In doing so, one must understand the principles of classification of expenditures.

In accounting terms, revenue expenditures are short-term expenses incurred within a financial year comprising twelve months. They are essential for the day-to-day activities of running a business and are operational in nature. Some examples include material procurement, salaries, travel expenses, utilities, and rent. The revenue expenditure is usually charged in the same year of it being incurred using the principles of accrual and matching concepts.

Capital expenditures are the expenses incurred for the acquisition of assets or to undertake new projects, the benefits of which are expected to be derived over a longer period of time spanning many years. The capital expenditure is, therefore, amortised over the period of usual life and is referred as depreciation.

Research activities, by their nature, do not guarantee any specific output. For the same reason, it is treated as expenditure as there is no certainty of any revenue out of it. They are experimental in nature and are taken to the profit and loss account.

On the other hand, development activities, when carried out result in a tangible output, which can be further used to generate revenue. As this meets the definition of capital expenditure, development expenses are generally capitalised. The general ambiguity that is encountered in the process is the uncertainty of the future benefits associated with the expenditure, which makes the classification a difficult process.

Let’s take two instances:

1. Research expenditure incurred by a start-up company to invent a new process or product, the result of which is totally uncertain, and hence it is to be treated as revenue expenditure.
2. When a new software has been coded after incurring research expenditure and the company aims to generate revenue by licensing the same, all the further expenses incurred to increase the finesse, speed, and security of the software, are to be treated as development expenses, which will later be capitalised.

Due to the complex nature of R&D activities, there exists an equal level of doubt in the accounting treatment of the same. Intensive discussions with the research department and the management will help the accounting department get a better understanding of the nature and the expected future outcome of the expenditure.

The company’s internal policy and guidelines play a crucial role as to when to do the cut-off for both the expenses incurred. One company may decide to capitalise right after an invention is made, whereas other companies wait till the same is patented or market-tested.

Similar to depreciation for tangible assets, the intangible assets generated after R&D need to be amortised. The basic matching concept plays a significant role in this process and the asset is amortised over its useful period against the revenue it generates for the company. Accounting for R&D is crucial and can make or break investors’ opinion of the company’s efforts to progress and achieve innovation goals.

(The writer is CA Article Assistant, RVKS and Associates, Chennai.)