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R&D Expenses: Capitalised or Expensed? Pros and Cons

A question we often hear from tech startup founders and entrepreneurs is how they should report their research & development (R&D) expenses: should they be capitalised or simply expensed?

There a number of considerations to take into account when deciding whether you should opt for R&D capitalisation, what expenses are concerned and how much you should capitalise.

If you aren’t familiar with R&D capitalisation and need help deciding what is best for your business, read on!

R&D Capitalisation: What Is It Exactly?

Capitalising expenses means recognising expenses over a given time period (by “amortising” or “depreciating” the costs) instead of incurring the costs as they occur in your profit-and-loss (P&L).

By doing so, we move capitalised costs from their respective expenses line in your profit-and-loss (above Earnings Before Interest and Depreciation and Amortisation i.e. EBITDA) to depreciation and amortisation expenses (below EBITDA).

There are a number of R&D expenses qualify as capitalised expenses. Usually for tech startups, they are:

  • Salaries of developing / engineering team
  • Hardware and software acquisition
  • Third party development fees

R&D Capitalization: Case study

Let’s assume you spent $25,000 in software development costs in September 2022. These are the salary expenses of your tech team.

These expenses can either be:

  • Capitalized: you recognize expenses under depreciation & amortization (D&A) instead of overheads in your profit-and-loss. Now, assuming you capitalise these expenses over 3 years, you would recognise $694 in D&A in September 2022 ($25,000 / 36 months), and the same $694 for the next 35 months
  • Expensed: you simply add the $25,000 in salary expenses in your profit-and-loss

Why do we capitalize R&D?

The reason why we do amortise capitalised expenses is so that the expenses (for instance, software development) match the corresponding expected revenues.

In our example earlier, we assume that the $25,000 expenses incurred in September 2022 will generate revenues over the next x months. It can 12, 24 months or even 8 years.

Indeed, your team might have been working on a product feature you will release and will generate a new revenue over time. The obvious problem is that we can’t reasonably how much revenue, and for how long, this $25,000 will generate.

That’s why the number of months over which we must amortise R&D is defined by regulation. The rules differ by countries though. For example, the rule is to amortize R&D expenses over 5 years for US companies.

So in our example, instead of incurring $25,000 expenses in September, we record $416.67 R&D amortization expense for the next 5 years instead.

Capitalised R&D: Pros

Most tech startups opt for R&D capitalisation for 2 main reasons:

R&D capitalisation inflates EBITDA

As shown in the example above, capitalisation artificially increases EBITDA by moving expenses that were originally above EBITDA under D&A instead.

There are 2 resulting advantages:

  • First, as most investors use EBITDA as a measure of a company’s profitability, your company looks more profitable
  • Second, when using a EBITDA multiple approach valuation methodology to assess your business valuation, your company is more valuable.
Note that this is purely optics, and any experienced investor will know this. Your company will unfortunately not be more or less profitable. Same goes for your valuation.

R&D capitalisation inflates balance sheet

By recognising expenses as D&A costs we effectively consider them as a capital investment (Capex) which we depreciate over time.

As such, capitalised expenses increase assets in your balance sheet.

It is particularly used amongst startups as the increase in your company’s balance sheet gives the impression of an increase in your business valuation.

Let’s assume you have spent $25k in software development costs in September 2022: your balance sheet goes up by ~$24k (=$25,000 – $694 amortisation expenses). Therefore, one can argue your business is ~$24k more valuable.\

Same comment above applies here: this is purely optics, and any experienced investor will know this.

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Capitalised R&D: Cons

Whilst opting for R&D capitalisation might seem a no-brainer from an accounting and valuation perspective, there is one main catch.

As we saw earlier, capitalising expenses mean higher profits. As such, it also means higher taxes.

Let’s use our example above: by capitalising $25k R&D expenses, your profits increase by ~$24k. As a result, taxes increase as well: assuming 20% corporate tax rate, you will pay ~$5k more in taxes as we can see in the example below.

Luckily, most countries have specific tax regulations when it comes to R&D capitalisation. As such, you may have the right to deduct part of your R&D amortisation expenses from your corporate tax burden.

In order to check whether your business is eligible to R&D tax credits, reach out to your accountant or a tax specialist in your jurisdiction.

R&D: Capitalised or Expensed?

Your financial statement should reflect the situation of your company as closely as possible. As such, if some of your expenses are considered as an asset, you should capitalise them.

To understand what falls into capitalised expenses, let’s use 2 separate examples: an hotel and a SaaS company.

  • Hotel company: an hotel would recognise the purchase expense of a building it will turn into a hotel as a capital investment expense (“capex”). Indeed, this expense is expected to generate revenue over time. As such, the expense would fall into its cash flow statement instead of its P&L, and the company would depreciate the expense over time
  • SaaS company: the software development will be used by users and generate revenue over time in the future. As such, the expense also is considered as R&D and can be capitalised. It would fall into the cash flow statement under Capex, and the depreciation would fall into D&A in the profit-and-loss.

The same way an hotel would consider the purchase of a building as a capital expense (Capex) instead of an operating expense, a SaaS company investing into software development does so in order for the software (as for the hotel) to generate revenues in the future.

Both the hotel building and the software development are considered as assets instead of operating expenses. That’s why we should always recognise R&D expenses that qualify as assets as capitalised expenses.

Yet, not all R&D expenses can qualify as capitalised expenses. The definition varies whether you apply GAAP or IFRS accounting principles. Also, the tax impact depends on your jurisdiction. Reach out to your consultant or tax advisor for more details.

More Resources On R&D For Startups

Do you know that startups can save a lot via R&D tax credit programs? R&D tax incentive schemes vary by country, but in most cases, startups can get a percentage of their R&D costs refunded back in cash (up to 43% in Australia)..!

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