12.3 Research and Development and Software Costs

Research & Development (R&D) and Software Costs

Under US GAAP, costs incurred to create intellectual property and computer software are subject to restrictive rules designed to prevent companies from capitalizing speculative expenditures. Research and Development (R&D) costs must generally be expensed as incurred under ASC 730. However, software development costs have unique capitalization rules depending on whether the software is intended for external sale (ASC 985-20) or internal use (ASC 350-40). This section details the specific accounting treatments, capitalization thresholds, and amortization requirements for these activities.

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1. Research and Development (R&D) Costs (ASC 730)

US GAAP requires all R&D costs to be expensed as incurred. The FASB adopted this conservative stance due to the high degree of uncertainty regarding whether R&D expenditures will result in future economic benefits.

Definitions

• Research: Planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product, service, process, or technique.
• Development: Translation of research findings or other knowledge into a plan or design for a new product or process, or for a significant improvement to an existing product or process.

R&D Expenses Include:

• Salaries, wages, and benefits of personnel engaged in R&D activities.
• Materials consumed and services used in R&D activities.
• Depreciation of equipment or facilities used in R&D activities (if they have alternative uses).
• Overhead costs directly allocated to R&D activities.
• Costs of intangible assets purchased from others that do not have alternative future uses.

Crucial Capitalization Exceptions

An entity must capitalize expenditures in the following two circumstances:

1. Alternative Future Uses: If materials, equipment, or facilities purchased for R&D have alternative future uses (either in other R&D projects or in commercial production), they must be capitalized as assets. However, the depreciation or amortization of these assets while they are being used for R&D must be expensed as R&D expense.
2. R&D Performed for Others: If an entity performs R&D activities under contract for another firm, the costs are not R&D expense. Instead, they are capitalized as contract costs (inventory or receivables) and matched against the contract revenue.

[!NOTE] IFRS Convergence Note: Unlike US GAAP, which expenses all internal development costs, IFRS (IAS 38) requires development costs to be capitalized if the entity can demonstrate six criteria, including technical feasibility, intention to complete, and ability to generate future economic benefits. Research costs are expensed under both frameworks.

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2. Software to be Sold, Leased, or Marketed (External Use - ASC 985-20)

The accounting treatment for software developed for commercial sale, lease, or marketing depends on whether technological feasibility has been established.

Key Milestones:

1. Before Technological Feasibility: All costs (coding, testing, program design) are expensed as R&D.
2. Technological Feasibility Milestone: Established when the entity has completed either:
   • A detailed program design (including product specifications and coding/testing details).
   • A working model of the software that is complete and consistent with the design.
3. After Feasibility and Before General Release: All coding, testing, and product master preparation costs must be capitalized.
4. After General Release: Capitalization ceases. All subsequent costs (maintenance, customer support, training, minor bug fixes) are expensed as cost of sales or operating expenses.

Amortization of Capitalized Software

Amortization begins when the software is released to customers. The annual amortization is the greater of the following two methods:

1. Percentage of Revenue Method: Amortization = Capitalized Asset Value * (Current Period Gross Revenue / (Current Period Gross Revenue + Estimated Future Gross Revenue))
2. Straight-Line Method: Amortization = Capitalized Asset Value / Remaining Estimated Useful Life

Subsequent Valuation

Capitalized software must be valued at the lower of amortized cost or net realizable value (NRV). If the NRV of the software drops below its carrying value, the asset is written down, and the loss is recognized in the income statement. This write-down cannot be reversed.

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3. Software for Internal Use (Internal Use - ASC 350-40)

Software developed solely for the entity's internal needs (or hosting arrangements where the entity has a license to run the software on its own hardware) is governed by different rules.

Three Stages of Internal-Use Software Development:

• Preliminary Project Stage: Expensed as incurred. Includes conceptual formulation of alternatives, evaluation of alternative technologies, and final selection of alternatives.
• Application Development Stage: Capitalized. Includes coding, software hardware installation, design of chosen path, and testing of security or performance.
• Post-Implementation / Operation Stage: Expensed as incurred. Includes training, maintenance, data conversion (unless necessary to make the application operational), and ongoing operations.

Amortization

Internal-use software is amortized on a straight-line basis over its estimated useful life. The revenue method is not used because the software is not sold to generate revenue.

Cloud Computing Arrangements (CCA)

If a cloud arrangement does not include a software license (i.e., it is a pure software-as-a-service hosting arrangement), implementation costs (e.g., integration and configuration costs) incurred during the application development stage are capitalized as a deferred asset and amortized over the term of the hosting arrangement.

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4. Comprehensive Worked Examples

Example 1: R&D Cost Allocation

During 2026, Echo Corporation incurs the following costs:

• Salaries of R&D scientists: $300,000.
• Quality control testing during commercial production: $80,000.
• Purchase of a specialized laboratory building for R&D with a useful life of 20 years and no alternative future uses: $1,000,000.
• Purchase of computer equipment for R&D with a useful life of 5 years that will be used in other projects after this one: $200,000.

Analysis:

• R&D Scientist Salaries: Expensed immediately ($300,000).
• Quality Control Testing: Expensed as cost of goods sold, not R&D, because it occurred during commercial production.
• Laboratory Building: Expensed immediately as R&D ($1,000,000) because it has no alternative future uses.
• Computer Equipment: Capitalized as PP&E ($200,000) because it has alternative future uses. However, its annual depreciation ($200,000 / 5 = $40,000) must be recorded as R&D expense for the year.
• Total R&D Expense for 2026: Total R&D Expense = $300,000 (Salaries) + $1,000,000 (Building) + $40,000 (Equipment Depreciation) = $1,340,000

Example 2: External-Use Software Amortization

On June 30, 2026, Foxtrot Inc. establishes technological feasibility for a software application. Foxtrot incurs capitalization-eligible coding and testing costs of $500,000 between July 1 and December 31, 2026. The software is released to the public on January 1, 2027. Foxtrot estimates the software will have a useful life of 5 years. For the year ended December 31, 2027, Foxtrot reports the following:

• Gross software sales in Year 1: $300,000.
• Estimated future gross software sales: $1,200,000.

Amortization Calculations:

1. Percentage of Revenue Method: Amortization = $500,000 * ($300,000 / ($300,000 + $1,200,000)) = $500,000 * 20% = $100,000
2. Straight-Line Method: Amortization = $500,000 / 5 = $100,000

• Selection: Since both methods result in $100,000, Foxtrot recognizes $100,000 of amortization.

Suppose in Year 2 (2028), sales are $400,000 and estimated future sales are $400,000. The remaining carrying value at Jan 1, 2028 is $400,000 ($500,000 - $100,000). Remaining life is 4 years.

1. Percentage of Revenue Method: Amortization = $400,000 * ($400,000 / ($400,000 + $400,000)) = $400,000 * 50% = $200,000
2. Straight-Line Method: Amortization = Carrying Value / 4 = $400,000 / 4 = $100,000

• Selection: Foxtrot must use the greater amount, which is $200,000 under the percentage of revenue method.