Demystifying R&D Accounting: A Simple Guide to Properly Tracking Your Research and Development Expenses

For companies that invest heavily in developing new products and technologies, research and development (R&D) costs are a major expenditure. But accounting for these investments accurately can be complex and confusing.

In this comprehensive guide I’ll walk through the key concepts and best practices step-by-step to help demystify R&D accounting for non-accountants. Whether you work at a startup or large corporation you’ll learn how to properly track R&D expenses to make sound financial decisions and meet reporting requirements.

What Counts as R&D Spending?

First, let’s clarify exactly what types of activities and costs should be classed as R&D:

• Researching and testing new technological or scientific theories

• Designing and engineering new products or features

• Software development including designing algorithms and writing code

• Building product prototypes and beta versions

• Conducting clinical trials for drugs and medical devices

• Experimenting to improve manufacturing/production processes

• Obtaining and protecting patents around innovations

Common costs include salaries for engineers and scientists, contracted services, materials, software, equipment, and allocated overhead.

Why Proper R&D Accounting Matters

Tracking R&D spending accurately serves several important purposes:

• Helps managers understand true costs of innovation initiatives

• Allows comparison of spending across different projects

• Enables better forecasting of budgets and timelines

• Supports capitalization and amortization for accounting compliance

• Provides data to analyze ROI on R&D investments

• Qualifies companies for tax credits and other R&D incentives

Flawed accounting skews financial reporting and limits visibility into what drives expenses. This ultimately hampers smart decision making.

R&D Accounting Challenges

However, appropriately categorizing R&D costs presents some unique challenges:

• R&D projects span multiple reporting periods, making accruals complicated

• Outcomes of R&D are uncertain, so future benefits are hard to predict

• Many expenses like salaries support a mix of R&D and regular business activities

• Software development costs must be allocated between R&D vs. maintenance

• Judgement is required to determine when R&D ends and commercial production begins

Thorough understanding of accounting principles allows you to overcome these hurdles.

Key R&D Accounting Principles and Standards

In the U.S., generally accepted accounting principles (GAAP) provide the main guidelines to govern R&D cost accounting:

• R&D costs must be disclosed separately on financial statements

• Expenses are recorded as incurred, not based on expected future benefit

• Only certain development costs with proven future value can be capitalized

• Capitalized costs are amortized over useful life of the developed asset

• Impairment losses should be recognized on unsuccessful R&D

Adhering to these principles enhances accuracy and transparency for stakeholders.

Step-by-Step Guide to Managing R&D Expenses

Now let’s walk through the key steps to properly account for R&D spending:

1. Define Budgets for Each Project

• Gather input from managers to estimate costs for materials, salaries, contractors, equipment, etc.

• Build in contingencies for unexpected expenses or delays

• Clearly assign ownership for tracking budget vs. actuals

2. Track All Direct Costs in Real Time

• Establish project codes for time tracking and transaction coding

• Require detailed logging of hours, invoices, purchases etc. against codes

• Run reports frequently to identify variances from budgets

3. Allocate Shared Costs

• For shared resources like IT infrastructure, facilities or testing apparatus, determine % used for R&D vs other activities

• Assign shared cost pool expenses to R&D projects using predetermined allocation percentages

4. Carefully Evaluate Development Costs for Capitalization

• Analyze criteria like alternative future use, technical/commercial feasibility, intent and ability to complete development

• For costs that qualify, record as assets and determine useful life estimate for amortization schedule

5. Monitor Progress and Make Adjustments

• Each period, evaluate whether indicators of impairment exist requiring write-downs

• If projects are cancelled, immediately recognize loss by expensing any unamortized capitalized development costs

• Adjust amortization schedules for any changes in useful life estimates

6. Comply With Disclosure Requirements

• Separately break out R&D expenses on income statement reporting

• Disclose capitalization policies, impairment losses recognized, and details of any material R&D projects in financial statement footnotes

Automating aspects like time and inventory tracking provides greater accuracy with less effort.

Signs Your R&D Accounting Needs Improvement

Watch for these red flags that your R&D spending may be inaccurately tracked:

• No audit trail for how costs were allocated to projects

• Expenses lumped into a general “R&D” budget without segmentation

• Capitalized development costs remain on books unchanged for years

• Impairment losses not recognized for failed projects

• Delays or cost overruns frequently transpire

• Reporting focused on operational metrics vs. financials

Addressing these gaps will strengthen financial controls.

Best Practices for Streamlined R&D Accounting

Implementing these tips will make R&D expense tracking more efficient:

• Automate workflows – Use software to automatically capture time and expenses against project codes

• Educate team – Ensure everyone involved understands policies for tracking direct costs and making allocations

• Offer refreshers – Occasionally retrain teams on processes as practices evolve

• Review frequently – Don’t just look at reporting annually. Spot patterns monthly.

• Document thoroughly – Comprehensive records of accounting treatment, rationales, and project details are key for auditors.

• Collaborate cross-functionally – Finance working closely with R&D and IT makes policies practically enforceable.

Well-designed workflows, clear expectations, and collaboration enable accuracy.

Evaluating R&D Investments and Informing Decisions

The ultimate goal of proper R&D accounting is providing data to guide wise strategy. Analyze spending trends and project outcomes to:

• Identify research areas and methodologies that are generating the highest ROI

• Shift investments toward innovations that drive growth and away from declining ones

• Refine project planning and resource allocation practices

• Determine the payback period needed to recoup investments

• Quantify product margin improvements realized from R&D efforts

• Assess the implications of capitalization and amortization treatment for cash flows

These insights empower leadership to double down on what moves the needle.

Key Takeaways

Hopefully this overview clarified some of the complexities of R&D accounting while offering actionable steps to refine your tracking process. Just remember:

• Carefully classify costs as R&D according to accepted definitions

• Follow GAAP principles including expensing most investments immediately

• Capitalize qualifying development costs and amortize over useful project life

• Maintain thorough documentation and clearly allocate shared expenses

• Analyze reporting frequently to make projections and inform decisions

Implementing robust R&D accounting ultimately supports growth by instilling financial discipline into innovation.