In the infancy stages, or as your business expands, research and development is a common business activity. Research and development can be an exciting time for a business, whether it’s creating the first product or improving your core business offering. For new business owners, research and development can be a bit confusing when it comes to accounting for the associated costs. Below you will find a brief explanation of business research and development, how to account for costs, and its impact on taxes.
What is research and development?
Research and development, also commonly referred to as R&D, refers to activities related to research, design, or improvements with the goal of improving or developing new products, technologies, services, or systems in order to benefit the bottom line.
Businesses of all sizes conduct R&D at different scales, spending time and resources to improve their business offerings. Oftentimes businesses conduct R&D to create or update new products and technologies. Businesses will also conduct R&D to expand their product line with additional flavors, scents, ingredients, and sizes. While we often associate R&D with large pharmaceutical companies developing new life-saving medications, R&D can be as simple as creating a new candle scent, cupcake flavor, or pasta sauce variation.
How to account for research and development expenses
It is important to accurately account for research and development expenses as they can be tax-saving opportunities. Because future benefits associated with research and development are uncertain, they are typically not recorded as an asset, but as an expense.
Common qualifying research and development expenses include:
- Research to discover new knowledge
- Applying new knowledge
- Designing new products or technologies
- Testing new products or technologies
- Formulating processes, ingredients, and recipes
- Clinical trials
It is important to note that there are exceptions to the rule of recording R&D as expenses. In some cases, when a business can recognize the fair value of research and development costs, they can be recorded as an asset and treated as such. An example may be a specialized software developed or purchased for research purposes, or a fixed asset that has an alternative future use.
Although all research and development costs are recorded as expenses, it is important to keep track of the type of R&D for proper internal reporting (non-tax related). There are two different types of R&D:
- Basic research and development is used to acquire new knowledge, but without a specific purpose in mind (general research).
- Applied research and development is also used to acquire new knowledge but is used for a specific product or goal in mind (e.g. how to create a stronger fabric).
By keeping track of product or technology-specific R&D expenses with a cloud-based accounting app, businesses are able to accurately identify costs associated with each product/technology. Using an app such as Xero will allow you to present direct R&D costs to investors, board members, or business partners when needed (such as when applying for loans, grants, or regulatory approvals).
Accounting support for R&D expenses
Properly recording R&D costs can be confusing at times, creating a bookkeeping headache, especially for small business owners. We recommend consulting with an experienced business CPA to discuss your R&D goals, and how to properly account for associated costs. Utilizing a cloud-based accounting app can help you record all transactions to their proper accounts ensuring you don’t miss any expense. Properly accounting for R&D is vital to your business tax return, and taking advantage of possible deductions.
If research and development is a large part of your business plan, it can quickly eat up your funds. Working with an outsourced CFO can provide your business with financial expertise without the full-time commitment. An outsourced CFO can help create R&D budgets, reports, financial projections, and analyze data.
Research and development tax-saving opportunities
When conducting research and development, make sure to record every expense, no matter how small. Every little expense could add up to a tax-saving research and development credit, which can reduce your taxable income. That said, claiming the credit is fairly complex and requires that you adhere to many specific rules. We strongly recommend speaking with a qualified business CPA to ensure your R&D expenses are eligible. There is one blanket statement we can make on this topic: extensive documentation of all expenses is key.
If you’re a small business owner navigating a research and development project, properly accounting for the costs is just as important as the actual R&D itself. Our business CPAs have experience in helping businesses implement accounting tools and procedures in order to properly record all relevant expenses and are up to date on the recently changed R&D tax credit laws. Send us a message to schedule a consultation to ensure your R&D is sitting on a solid foundation.