Should you capitalise your Research and Development Costs?
In this series of articles Alicia Crisp discusses some of the frequently asked questions tech businesses have about development costs and intangible assets.
One such question is whether they should capitalise their research and development work, so that it becomes an asset of the company, rather than all costs being written off as an expense as incurred.
There are three key aspects for consideration as part of this process:
- Accounting and audit criteria – what options are available to the company?
- Tax implications and interaction with Research & Development tax credits (R&D)
- Commercial considerations – practicalities and the impact for the company
Accounting and Audit Criteria
In this, the first article in this series, Alicia, along with technical specialist Neil Parsons, will consider the accounting considerations around recognising development costs on the balance sheet for tech companies. This will be done at a fairly high level, for more detailed guidance reference should always be made to either the UK accounting standards (FRS102) or the International Financial Reporting Standards (IFRS).
What options are available?
The first aspect to consider is what options exist to companies around accounting for research and development costs.
Both FRS 102 and the IFRS are clear that research costs must be deducted as an expense in the income statement (or P&L), as there is too much uncertainty around any future economic benefit. For tech companies research may include the search for alternative products, processes and systems to deliver a software or app solution.
In contrast, for development costs, UK accounting standards specifically state ‘An entity may recognise an intangible asset arising from development’, thereby, leaving the decision making to business owners or managers to make an accounting policy choice to capitalise all development costs when the appropriate criteria are met.
It should be noted that once a decision has been made to capitalise development costs within intangible assets this has to be consistently applied and adjustment has to be retrospectively applied with significant justification and implications.
For more established tech businesses with a working concept, developing new applications, processes or better ways of working within a SaaS solution are likely to be development costs.
Note that under IFRS where the appropriate criteria are met to enable the capitalisation of development costs, then development costs must be capitalised and there is no choice to expense them.
Considerations around development costs
Summarising the accounting standards, when considering capitalising development costs, companies need to understand the following and need to demonstrate all of the following:
- The technical feasibility of completing the intangible asset so that it will be available for use or sale;
- The intention to complete the intangible asset and use or sell it;
- The ability to use or sell the intangible asset.
- How the intangible asset will generate probable future economic benefits. Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset.
- The availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset.
- The ability to measure reliably the expenditure attributable to the intangible asset during its development.
While clients with a strong technical team may be confident with these concepts, it may fall to a combination of the tech and finance teams to address measurement and future recognition.
It should be noted that if the development phase cannot be easily separated from research, then all costs must be treated as research and expensed.
For tech focussed companies, that future economic benefit is likely to be in the form of a software, system or piece of kit that can be licensed or sold to customers to generate revenue.
A regular review on a project by project basis would be required to identify when all of the criteria are met, thus identifying for accounting purposes the appropriate time from when development costs meet the capitalisation company.
Measurement and initial recognition
Identifying specific development costs and maintaining records of this will be key. While there may be directly attributable ancillary costs such as the cost of materials, services, software, licenses and patents, the most significant cost will relate to the amount of time incurred by developer staff or contractors.
Work will need to be done to understand how much time is taken up with development work and applying a proportion to wages and other benefits. The maintenance of detailed time records by staff or contractors is the most reliable way of ensuring that time is appropriately identified. Such costs that are directly attributable to developments may be capitalised. General administrative time, costs of management and directors’ remuneration would not generally fall to directly attributable and hence are expensed.
Each development project should be identified separately, with each developer’s time allocated across projects, including research or maintenance which is then written off.
The company can then maintain a register of the costs behind each project, building on them year on year if the projects are longer term. These costs then form part of the capitalisation.
Records should be kept demonstrating the basis of decision making, how reviews are done and the underlying costs that are put into workings.
Under FRS 102 and IFRS capitalised development expenditure is recognised at historical cost.
Amortisation, impairment and revaluation
Management will need to consider the potential useful life for a development project. If this cannot be easily identified the maximum amortisation period is 10 years under UK GAAP, unless a longer life can be justified. However, for SaaS businesses, constant improvement and adaptations mean projects are superseded within a much shorter time span. Spreading the costs over three to five years is likely to give a more accurate reflection of the life span of a project, rather than writing all costs off when incurred or over ten years. IFRS does not contain ant restriction on the amortisation period of a development project. In reality the estimate of the amortisation period under FRS 102 and IFRS should be the same.
While we would hope all projects will be successful, it may be that a technological change that wasn’t previously anticipated makes certain elements obsolete or irrelevant. At this point, the remaining value of an asset would need to be written off, in part or in full. This is why it is important, as noted above, to keep a clear record of the costs associated with specific projects.
In the absence of an active market for development projects a policy of revaluing development costs is not permitted under FRS 102 or IFRS.
Audit considerations
From the auditor’s perspective there will be several key areas to consider including:
- Ensuring the recognition criteria above are met including the specific point in time they were met;
- Confirming the costs included are appropriately calculated and accounted for;
- The management estimate of the useful life;
- Any indications of impairment.
As several of these areas include management estimates, this may be a key audit risk for technology clients, where annual development costs to expand and develop the product can easily be material. See our separate article on preparing for your first audit as a scale up business here, however, documenting decision making and workings will be a vital part of providing the audit evidence required.
Over the next couple of articles, we will consider the tax and commercial considerations.
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We hope you find this insight useful and informative. If you have any questions or would like guidance related to your individual circumstances, please get in touch
