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Capitalizing R&E expenditures requires detail focus

• Introduction

Identifying affected expenditures

How are section 174 r&e costs defined, section 41 qre considerations, asc 730: ‘book’ r&d expense, other considerations.

The Tax Cuts and Jobs Act (TCJA) resulted in significant changes to the treatment of research or experimental (R&E) expenditures under Section 174 that will require substantial work for many companies to implement this year.

For tax years beginning after Dec. 31, 2021, taxpayers are required to capitalize and amortize all R&E expenditures that are paid or incurred in connection with their trade or business which represent costs in the experimental or laboratory sense. Specifically, costs for U.S.-based R&E activities must be amortized over five years and costs for foreign R&E activities must be amortized over 15 years; both using a midyear convention.

Although there is bipartisan support for legislation postponing this change under Section 174, Congress failed to defer or repeal the new capitalization rules in 2022. While negotiations may resume this year, any legislation would not apply to financial statements for tax years beginning after Dec. 31, 2021, and ending before legislation was enacted. Therefore, taxpayers should be addressing the impact of amortizing these costs on 2022 financial statements. Given the challenges that legislation faces, companies should all be preparing to implement the changes for tax compliance, planning and payment purposes. 

Grant Thornton Insight:

Because it is not clear when or if this Section 174 capitalization provision will be deferred by Congress in 2023, taxpayers will need to begin to determine its impact on  2022 taxes and financial statements.

Any new Section 174 rules could result in new, and potentially significant, book-tax differences and related deferred tax assets. It also has the potential to impact effective tax rates if a valuation allowance is required for the deferred tax asset or due to the indirect effects on other calculations, including the interest expense limitation under Section 163(j), the base erosion and anti-abuse tax (BEAT), global intangible low-taxed income (GILTI), or foreign-derived intangible income (FDII). 

Taxpayers historically may not have characterized all applicable R&E costs as Section 174 costs. Instead, some R&E costs that were incurred incident to the research activities may have been treated as ordinary and necessary costs deductible under Section 162. Therefore, it is important that taxpayers analyze and potentially revise their methodology for determining Section 174 costs. It may require significant work to identify all costs that may be subject to Section 174 capitalization. Taxpayers will likely need to evaluate several data sources, including:

• Historical Section 174 computations,
• The computation of qualified research expenses (QREs) under Section 41, and
• Costs characterized as ASC 730 “book” R&D expenses for financial reporting purposes.

Taxpayers may have the option of using QREs used for computing the R&D credit under Section 41 or ASC 730 book R&D expense as an appropriate starting point to compute Section 174. The QRE approach would require several steps to "convert" QREs to Section 174 costs and to determine costs incurred incident to the research. The ASC 730 approach will likely require the identification of additional Section 174 costs not captured in book R&D expense.

The discussion below provides insights into the definition of “costs” subject to Section 174 treatment. Because most taxpayers will need to reconcile costs treated as QREs under Section 41 and/or book R&D expense as defined under ASC 740 to determine Section 174 costs, this article also includes an analysis of these costs.

Under Section 174, R&E costs must be for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product, process, software, technique, formula, or invention (collectively referred to as a “product”) that is held for sale, lease, or license, or used in the taxpayer’s trade or business. Uncertainty relates to the capability, methodology, or design of a new or improved product.

The regulations provide further guidance as to the nature of expenses that qualify under Section 174. R&E expenditures are defined as expenditures used in connection with the taxpayer’s trade or business which represent research and development (R&D) costs in the experimental or laboratory sense. The regulations define these expenditures as all such costs incident to the development or improvement of a product, process, formula, invention, computer software, or technique.

While Section 174 and the regulations do not have an exhaustive list of costs that are incurred incident to the research, Treas. Reg. Sec. 1.174-4(c) provides taxpayers with an example where the following expenditures are treated as Section 174:

• Heat, light, and power
• Laboratory materials
• Attorneys’ fees, and
• Depreciation on build attributable to the R&E project

In addition to the examples in the regulations, interpretive guidance has been issued over the years that provides some insight regarding what costs are subject to Section 174 treatment.

In Rev. Rul. 73-275, a taxpayer was engaged in the business of developing and manufacturing specially built automated manufacturing systems. The ruling considered whether expenses connected with a product engineering department—including salaries and overhead—met the requirements of Section 174. The IRS considered that the sole purpose of the product engineering department involved design and development activities for products manufactured and sold by the taxpayer. Ultimately, the IRS ruled that the expenses connected with the product engineering department including the overhead expenses were Section 174 eligible.

Revenue Ruling 73-20 provides another example in which overhead costs were determined to be Section 174 eligible. In Rev. Rul. 73-20, the question of overhead costs arose in the context of a joint research venture in which the taxpayer participated. Two corporations were organized to carry out the venture: one to promote and collect funds from the taxpayer and other contributors for an R&D project, and the other to build and operate the R&D project. Costs for the R&D project were funneled through the promoting corporation to the corporation operating the project. The IRS ruled that the costs incurred by the taxpayer “in connection with” the R&D project and paid to the promoting corporation were Section 174 expenditures, including those costs that related to the administrative expenses of the promoting corporation.

Additionally, Field Attorney Advice (FAA) 20154501F considered what amounts are to be included in compensation when testing for reasonableness of compensation under Section 174(e). The FAA concluded that total compensation (i.e., taxable, non-taxable, and deferred compensation) was a relevant measure for determining whether the reasonableness requirement was met.

The TCJA removed the requirement that a cost can only be a Section 174 R&E expenditure to the extent that the cost is reasonable under the circumstances. The regulations provide that, in general, the amount is reasonable if that amount would ordinarily be paid for like activities by like enterprises under like circumstances. The removal of this broad requirement may mean that taxpayers must capitalize more expenditures that were previously determined to not be reasonable under the circumstances.

The TCJA included a conforming amendment to Section 41 to align with Section 174. More specifically, specified research expenses must be treated as Section 174 capitalized costs in order to be considered QREs under Section 41. Therefore, taxpayers must insure QREs are included in their overall Section 174 computation. As a result, it may be more efficient for taxpayers to begin with Section 41 QREs when determining Section 174 costs.

Under Section 41, Taxpayers are permitted to include certain R&D costs as QREs for purposes of Section 41 related to activities that meet a four-part test defined under Section 41(d)(1). This includes in-house research expenses—such as wages paid to employees performing qualified services, supplies used in the conduct of qualified research, and costs for computer rental (e.g., cloud computing) used in the conduct of qualified research. This also includes contract research expenses, which are 65% of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research.

As defined in Section 3401(a), the term “wages” means all remuneration for services performed by an employee for his employer (i.e., Form W-2, Box 1 amount). For self-employed individuals and owner-employees, the term “wages” includes the earned income (i.e., net earnings) of such employee.

The term “supplies” means any tangible property other than land or improvements to land, and property of a character subject to the allowance for depreciation.

The term “contract research expenses” means 65% of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research.

In addition, qualified research does not include any of the following:

• Research after commercial production
• Adaptation of existing business components
• Duplication of existing business components
• Efficiency surveys
• Activities relating to management function or technique
• Market research, testing, or development (including advertising or promotions
• Routine data collection
• Routine or ordinary testing or inspection for quality control
• Computer software (unless otherwise qualified under the regulations)
• Foreign research
• Any research in the social sciences, arts, or humanities, or
• Funded research

Because the definition of “costs” subject to Section 174 treatment is much broader compared to Section 41 QREs, taxpayers will need to establish a methodology to “convert” wage, supply, computer rental, and contract research QREs. In addition, taxpayers will need to determine an appropriate methodology to identify and allocate costs that are incurred incident to the research.

ASC 730-10-25 requires that all R&D costs be recognized as an expense as incurred. However, some costs associated with R&D activities that have an alternative future use (e.g., materials, equipment, facilities) may be capitalizable.

“Research” is the 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 or service (referred to as product) or a new process or technique (referred to as process) or in bringing about a significant improvement to an existing product or process.

“Development” is the 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 whether intended for sale or use. It includes the conceptual formulation, design, and testing of product alternatives, construction of prototypes, and operation of pilot plants.

Under ASC 730-10-15-3, R&D consists of “those activities aimed at developing or significantly improving a product or service (referred to as product) or a process or technique (referred to as a process) whether the product or process is intended for sale or use.” Furthermore, ASC 730-10-55-1 states that the following activities typically would be considered R&D within the scope of this Topic (unless conducted for others under a contractual arrangement):

• Laboratory research aimed at discovery of new knowledge
• Searching for applications of new research findings or other knowledge
• Conceptual formulation and design of possible product or process alternatives
• Testing in search for or evaluation of product or process alternatives
• Modification of the formulation or design of a product or process
• Design, construction, and testing of preproduction prototypes and models
• Design of tools, jigs, molds, and dies involving new technology
• Design, construction, and operation of a pilot plant that is not of a scale economically feasible to the entity for commercial production
• Engineering activity required to advance the design of a product to the point that it meets specific functional and economic requirements and is ready for manufacture, and
• Design and development of tools used to facilitate R&D or components of a product or process that are undergoing R&D activities.

ASC 730-10-55-2 states that the activities provided below typically would not be considered R&D within the scope of this Topic:

• Engineering follow-through in an early phase of commercial production
• Quality control during commercial production including routine testing of products
• Trouble-shooting in connection with break-downs during commercial production
• Routine, ongoing efforts to refine, enrich, or otherwise improve upon the qualities of an existing product
• Adaptation of an existing capability to a particular requirement or customer's need as part of a continuing commercial activity
• Seasonal or other periodic design changes to existing products
• Routine design of tools, jigs, molds, and dies
• Pilot Plants
• Facilities or equipment whose sole use is for a particular R&D project.
• Legal work in connection with patent applications or litigation, and the sale or licensing of patents.

Unlike Sections 41 and 174, ASC 730 does not rely on the “uncertainty” standard when defining what a R&D cost is. Therefore, taxpayers will need to perform an assessment to document that the costs that are expensed as book R&D meet the uncertainty requirement under Section 174. From a cost perspective, taxpayers will need to determine if the costs included from a book R&D expense perspective properly include all costs incident to the research as defined under Section 174. Taxpayers also will likely need to compute additional Section 174 costs in order to coordinate with costs being treated as QREs under Section 41. In many industries, costs included as book R&D expense will not include all QREs determined under Section 41.

Below are additional considerations to address when implementing the required Section 174 capitalization. This is not intended to be an exhaustive list, but it should illustrate the broad impact of the TCJA rule changes and emphasize the importance of making proper determinations.

Identifying Section 174 expenditures

Taxpayers should consider developing a process for identifying and tracking Section 174 expenditures in addition to implementing appropriate internal controls. Depending on a taxpayer’s facts, it may be reasonable to begin with either expenditures under Section 41 or ASC 730 and make the necessary adjustments to arrive at Section 174.

Expenditures may need to be evaluated at multiple levels (e.g., location, department, etc.) using the available documentation when identifying all costs incident to the research. Taxpayers should carefully account for the technical nuances with each set of requirements and should appropriately document this approach. In addition, all costs incident to the research includes direct and indirect costs which may need to be allocated between Section 174 and Section 162. Taxpayers should evaluate all facts when establishing allocation methodologies. If taxpayers can implement the necessary changes to contemporaneously track these costs, this could ease the administrative burden of identifying these costs after the tax year end.

Timing of the R&E benefit

While taxpayers will still receive a benefit for the R&E costs that are paid or incurred, these costs can no longer be deducted in the current tax year. The required amortization and capitalization will create a timing difference that could impact cashflow and funding activities such as R&D. For example, if a taxpayer incurred $1 million in R&E in the 2022 tax year, the current year benefit will only be $100,000 (i.e., 100% deduction divided into 5 years multiplied by the 50% midyear convention), effectively creating a 90% reduction in benefit for 2022. This reduction would be even greater for foreign R&E costs.

Additionally, if an R&E project is abandoned, then the taxpayer must continue to capitalize and amortize those costs over the five-or 15-year period. This could create a burden on certain taxpayers who have a short product development lifecycle and taxpayers who rely on significant participation from individuals outside of the U.S. Taxpayers may be receiving revenue from an R&E project that created a product, and yet they are still required to amortize the costs related to developing that product for a longer period. With the benefit being extended over a longer recovery period, the benefit could be impaired due to the time-value of money paired with inflation—depending on the magnitude and duration.

Changes to tax planning

Taxpayers will not be able to rely on tax planning strategies that were previously available when optimizing their tax positions. This includes relying on Rev. Proc. 2000-50 for software development costs and using Section 59(e) to amortize the costs over 10 years. Taxpayers will be required to reevaluate their tax planning strategies to account for the TCJA changes, especially if they have historically relied upon Rev. Proc. 2000-50, Section 59(e), or deducting R&E expenditures under Section 174(a).

Change in accounting method

The IRS recently released guidance ( Rev. Proc. 2023-11 ), which modifies and supersedes the recently issued automatic procedures in  Rev. Proc. 2023-08  for taxpayers to change their method of accounting to comply with the new capitalization and amortization rules provided in Section 174, as revised by the TCJA.

The necessary guidance provides administrative relief and allows taxpayers to file a statement with their federal income tax return in lieu of a Form 3115, Application for Change in Accounting Method, provided that the change is made in the first taxable year that the new Section 174 guidance is effective (i.e., the first taxable year beginning after Dec. 31, 2021).

The new procedures also provide favorable transition guidance for taxpayers that have already filed a federal income tax return for a short taxable year for which the new Section 174 guidance was effective.

It could be inferred from the language in Rev. Proc. 2022-14 that the IRS anticipates the Section 174 rules to be delayed since they did not use the language of applying to tax years beginning after Dec. 31, 2021. If not, the expectation is that IRS and Treasury could issue guidance that will enable taxpayers to utilize the automatic method change rules. Presumably the 5-year rule would be waived to adopt this change from expense to capitalization.

Impact on research credit

Since conforming provisions for Section 41(d)(1)(A) were made to align with Section 174, taxpayers must treat costs as Section 174 for them to be includible in computing the research credit under Section 41. Prior to the TCJA changes becoming law, Section 41 only required the expenditures to be eligible for treatment under Section 174; however, the taxpayer may have treated them differently under another code section such as Section 162. A significant decrease in costs being treated as Section 174 could cause taxpayers to have limited or no research credit depending on the client’s facts such as trend in qualified costs.

International tax impact

These new rules could have an impact to the computation of several international tax items including global intangible low-taxed income, foreign-derived intangible income, the base-erosion and anti-abuse tax, and foreign tax credits.

Interest deduction limitations

Taxpayers should consider the impact of this Section 174 provisions on the computation of the limitation on the interest deduction under Section 163(j).

Section 263A impact

Taxpayers have likely taken positions that certain costs centers and related costs can be excluded from the Section 263A computation because they are Section 174 costs. These determinations will need to be considered when identifying Section 174 costs under either the Section 41 QRE or book R&D expense methods.

State and local tax impact

The requirement to amortize R&E expenditures rather than fully expensing them in the year they are paid or incurred will likely increase federal taxable income. For states that leverage components of the federal income tax return, this could increase the tax liability at the state level. Additionally, while many states employ a rolling conformity with the IRC, there are states that adopt the IRC as of a static date and do not currently follow the new Section 174 rules. Taxpayers will need to include this within their analysis and implementation of the Section 174 rules and continue to monitor states for further changes.

Taxpayers will be required to establish a methodology for identifying and tracking all R&E expenditures based on the new capitalization requirement under Section 174. This will likely be a significant undertaking for taxpayers to comply with the TCJA changes based on the broad and subjective nature of these provisions.

For more information, contact:

Keith Nickels

National Practice Leader, R&D Tax Credit Services Partner

Keith Nickels is a Tax partner and the national leader of Grant Thornton LLP’s Research and Development (R&D) Tax Credit Services practice, which provides initial-year R&D credit analysis, annual R&D credit reviews

New York, New York

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Kevin Benton

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Building an R&D strategy for modern times

The global investment in research and development (R&D) is staggering. In 2019 alone, organizations around the world spent $2.3 trillion on R&D—the equivalent of roughly 2 percent of global GDP—about half of which came from industry and the remainder from governments and academic institutions. What’s more, that annual investment has been growing at approximately 4 percent per year over the past decade. 1 2.3 trillion on purchasing-power-parity basis; 2019 global R&D funding forecast , Supplement, R&D Magazine, March 2019, rdworldonline.com.

While the pharmaceutical sector garners much attention due to its high R&D spending as a percentage of revenues, a comparison based on industry profits shows that several industries, ranging from high tech to automotive to consumer, are putting more than 20 percent of earnings before interest, taxes, depreciation, and amortization (EBITDA) back into innovation research (Exhibit 1).

What do organizations expect to get in return? At the core, they hope their R&D investments yield the critical technology from which they can develop new products, services, and business models. But for R&D to deliver genuine value, its role must be woven centrally into the organization’s mission. R&D should help to both deliver and shape corporate strategy, so that it develops differentiated offerings for the company’s priority markets and reveals strategic options, highlighting promising ways to reposition the business through new platforms and disruptive breakthroughs.

Yet many enterprises lack an R&D strategy that has the necessary clarity, agility, and conviction to realize the organization’s aspirations. Instead of serving as the company’s innovation engine, R&D ends up isolated from corporate priorities, disconnected from market developments, and out of sync with the speed of business. Amid a growing gap in performance  between those that innovate successfully and those that do not, companies wishing to get ahead and stay ahead of competitors need a robust R&D strategy that makes the most of their innovation investments. Building such a strategy takes three steps: understanding the challenges that often work as barriers to R&D success, choosing the right ingredients for your strategy, and then pressure testing it before enacting it.

Overcoming the barriers to successful R&D

The first step to building an R&D strategy is to understand the four main challenges that modern R&D organizations face:

Innovation cycles are accelerating. The growing reliance on software and the availability of simulation and automation technologies have caused the cost of experimentation to plummet while raising R&D throughput. The pace of corporate innovation is further spurred by the increasing emergence of broadly applicable technologies, such as digital and biotech, from outside the walls of leading industry players.

But incumbent corporations are only one part of the equation. The trillion dollars a year that companies spend on R&D is matched by the public sector. Well-funded start-ups, meanwhile, are developing and rapidly scaling innovations that often threaten to upset established business models or steer industry growth into new areas. Add increasing investor scrutiny of research spending, and the result is rising pressure on R&D leaders to quickly show results for their efforts.

R&D lacks connection to the customer. The R&D group tends to be isolated from the rest of the organization. The complexity of its activities and its specialized lexicon make it difficult for others to understand what the R&D function really does. That sense of working inside a “black box” often exists even within the R&D organization. During a meeting of one large company’s R&D leaders, a significant portion of the discussion focused on simply getting everyone up to speed on what the various divisions were doing, let alone connecting those efforts to the company’s broader goals.

Given the challenges R&D faces in collaborating with other functions, going one step further and connecting with customers becomes all the more difficult. While many organizations pay lip service to customer-centric development, their R&D groups rarely get the opportunity to test products directly with end users. This frequently results in market-back product development that relies on a game of telephone via many intermediaries about what the customers want and need.

Projects have few accountability metrics. R&D groups in most sectors lack effective mechanisms to measure and communicate progress; the pharmaceutical industry, with its standard pipeline for new therapeutics that provides well-understood metrics of progress and valuation implications, is the exception, not the rule. When failure is explained away as experimentation and success is described in terms of patents, rather than profits, corporate leaders find it hard to quantify R&D’s contribution.

Yet proven metrics exist  to effectively measure progress and outcomes. A common challenge we observe at R&D organizations, ranging from automotive to chemical companies, is how to value the contribution of a single component that is a building block of multiple products. One specialty-chemicals company faced this challenge in determining the value of an ingredient it used in its complex formulations. It created categorizations to help develop initial business cases and enable long-term tracking. This allowed pragmatic investment decisions at the start of projects and helped determine the value created after their completion.

Even with outcomes clearly measured, the often-lengthy period between initial investment and finished product can obscure the R&D organization’s performance. Yet, this too can be effectively managed by tracking the overall value and development progress of the pipeline so that the organization can react and, potentially, promptly reorient both the portfolio and individual projects within it.

Incremental projects get priority. Our research indicates that incremental projects account for more than half of an average company’s R&D investment, even though bold bets and aggressive reallocation  of the innovation portfolio deliver higher rates of success. Organizations tend to favor “safe” projects with near-term returns—such as those emerging out of customer requests—that in many cases do little more than maintain existing market share. One consumer-goods company, for example, divided the R&D budget among its business units, whose leaders then used the money to meet their short-term targets rather than the company’s longer-term differentiation and growth objectives.

Focusing innovation solely around the core business may enable a company to coast for a while—until the industry suddenly passes it by. A mindset that views risk as something to be avoided rather than managed can be unwittingly reinforced by how the business case is measured. Transformational projects at one company faced a higher internal-rate-of-return hurdle than incremental R&D, even after the probability of success had been factored into their valuation, reducing their chances of securing funding and tilting the pipeline toward initiatives close to the core.

As organizations mature, innovation-driven growth becomes increasingly important, as their traditional means of organic growth, such as geographic expansion and entry into untapped market segments, diminish. To succeed, they need to develop R&D strategies equipped for the modern era that treat R&D not as a cost center but as the growth engine it can become.

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Choosing the ingredients of a winning r&d strategy.

Given R&D’s role as the innovation driver that advances the corporate agenda, its guiding strategy needs to link board-level priorities with the technologies that are the organization’s focus (Exhibit 2). The R&D strategy must provide clarity and commitment to three central elements: what we want to deliver, what we need to deliver it, and how we will deliver it.

What we want to deliver. To understand what a company wants to and can deliver, the R&D, commercial, and corporate-strategy functions need to collaborate closely, with commercial and corporate-strategy teams anchoring the R&D team on the company’s priorities and the R&D team revealing what is possible. The R&D strategy and the corporate strategy must be in sync while answering questions such as the following: At the highest level, what are the company’s goals? Which of these will require R&D in order to be realized? In short, what is the R&D organization’s purpose?

Bringing the two strategies into alignment is not as easy as it may seem. In some companies, what passes for corporate strategy is merely a five-year business plan. In others, the corporate strategy is detailed but covers only three to five years—too short a time horizon to guide R&D, especially in industries such as pharma or semiconductors where the product-development cycle is much longer than that. To get this first step right, corporate-strategy leaders should actively engage with R&D. That means providing clarity where it is lacking and incorporating R&D feedback that may illuminate opportunities, such as new technologies that unlock growth adjacencies for the company or enable completely new business models.

Secondly, the R&D and commercial functions need to align on core battlegrounds and solutions. Chief technology officers want to be close to and shape the market by delivering innovative solutions that define new levels of customer expectations. Aligning R&D strategy provides a powerful forum for identifying those opportunities by forcing conversations about customer needs and possible solutions that, in many companies, occur only rarely. Just as with the corporate strategy alignment, the commercial and R&D teams need to clearly articulate their aspirations by asking questions such as the following: Which markets will make or break us as a company? What does a winning product or service look like for customers?

When defining these essential battlegrounds, companies should not feel bound by conventional market definitions based on product groups, geographies, or customer segments. One agricultural player instead defined its markets by the challenges customers faced that its solutions could address. For example, drought resistance was a key battleground no matter where in the world it occurred. That framing clarified the R&D–commercial strategy link: if an R&D project could improve drought resistance, it was aligned to the strategy.

The dialogue between the R&D, commercial, and strategy functions cannot stop once the R&D strategy is set. Over time, leaders of all three groups should reexamine the strategic direction and continuously refine target product profiles as customer needs and the competitive landscape evolve.

What we need to deliver it. This part of the R&D strategy determines what capabilities and technologies the R&D organization must have in place to bring the desired solutions to market. The distinction between the two is subtle but important. Simply put, R&D capabilities are the technical abilities to discover, develop, or scale marketable solutions. Capabilities are unlocked by a combination of technologies and assets, and focus on the outcomes. Technologies, however, focus on the inputs—for example, CRISPR is a technology that enables the genome-editing capability.

This delineation protects against the common pitfall of the R&D organization fixating on components of a capability instead of the capability itself—potentially missing the fact that the capability itself has evolved. Consider the dawn of the digital age: in many engineering fields, a historical reliance on talent (human number crunchers) was suddenly replaced by the need for assets (computers). Those who focused on hiring the fastest mathematicians were soon overtaken by rivals who recognized the capability provided by emerging technologies.

The simplest way to identify the needed capabilities is to go through the development processes of priority solutions step by step—what will it take to produce a new product or feature? Being exhaustive is not the point; the goal is to identify high-priority capabilities, not to log standard operating procedures.

Prioritizing capabilities is a critical but often contentious aspect of developing an R&D strategy. For some capabilities, being good is sufficient. For others, being best in class is vital because it enables a faster path to market or the development of a better product than those of competitors. Take computer-aided design (CAD), which is used to design and prototype engineering components in numerous industries, such as aerospace or automotive. While companies in those sectors need that capability, it is unlikely that being the best at it will deliver a meaningful advantage. Furthermore, organizations should strive to anticipate which capabilities will be most important in the future, not what has mattered most to the business historically.

Once capabilities are prioritized, the R&D organization needs to define what being “good” and “the best” at them will mean over the course of the strategy. The bar rises rapidly in many fields. Between 2009 and 2019, the cost of sequencing a genome dropped 150-fold, for example. 2 Kris A. Wetterstrand, “DNA sequencing costs: Data,” NHGRI Genome Sequencing Program (GSP), August 25, 2020, genome.gov. Next, the organization needs to determine how to develop, acquire, or access the needed capabilities. The decision of whether to look internally or externally is crucial. An automatic “we can build it better” mindset diminishes the benefits of specialization and dilutes focus. Additionally, the bias to building everything in-house can cut off or delay access to the best the world has to offer—something that may be essential for high-priority capabilities. At Procter & Gamble, it famously took the clearly articulated aspiration of former CEO A. G. Lafley to break the company’s focus on in-house R&D and set targets for sourcing innovation externally. As R&D organizations increasingly source capabilities externally, finding partners and collaborating with them effectively is becoming a critical capability in its own right.

How we will do it. The choices of operating model and organizational design will ultimately determine how well the R&D strategy is executed. During the strategy’s development, however, the focus should be on enablers that represent cross-cutting skills and ways of working. A strategy for attracting, developing, and retaining talent is one common example.

Another is digital enablement, which today touches nearly every aspect of what the R&D function does. Artificial intelligence can be used at the discovery phase to identify emerging market needs or new uses of existing technology. Automation and advanced analytics approaches to experimentation can enable high throughput screening at a small scale and distinguish the signal from the noise. Digital (“in silico”) simulations are particularly valuable when physical experiments are expensive or dangerous. Collaboration tools are addressing the connectivity challenges common among geographically dispersed project teams. They have become indispensable in bringing together existing collaborators, but the next horizon is to generate the serendipity of chance encounters that are the hallmark of so many innovations.

Testing your R&D strategy

Developing a strategy for the R&D organization entails some unique challenges that other functions do not face. For one, scientists and engineers have to weigh considerations beyond their core expertise, such as customer, market, and economic factors. Stakeholders outside R&D labs, meanwhile, need to understand complex technologies and development processes and think along much longer time horizons than those to which they are accustomed.

For an R&D strategy to be robust and comprehensive enough to serve as a blueprint to guide the organization, it needs to involve stakeholders both inside and outside the R&D group, from leading scientists to chief commercial officers. What’s more, its definition of capabilities, technologies, talent, and assets should become progressively more granular as the strategy is brought to life at deeper levels of the R&D organization. So how can an organization tell if its new strategy passes muster? In our experience, McKinsey’s ten timeless tests of strategy  apply just as well to R&D strategy as to corporate and business-unit strategies. The following two tests are the most important in the R&D context:

• Does the organization’s strategy tap the true source of advantage? Too often, R&D organizations conflate technical necessity (what is needed to develop a solution) with strategic importance (distinctive capabilities that allow an organization to develop a meaningfully better solution than those of their competitors). It is also vital for organizations to regularly review their answers to this question, as capabilities that once provided differentiation can become commoditized and no longer serve as sources of advantage.
• Does the organization’s strategy balance commitment-rich choices with flexibility and learning? R&D strategies may have relatively long time horizons but that does not mean they should be insulated from changes in the outside world and never revisited. Companies should establish technical, regulatory, or other milestones that serve as clear decision points for shifting resources to or away from certain research areas. Such milestones can also help mark progress and gauge whether strategy execution is on track.

Additionally, the R&D strategy should be simply and clearly communicated to other functions within the company and to external stakeholders. To boost its clarity, organizations might try this exercise: distill the strategy into a set of fill-in-the-blank components that define, first, how the world will evolve and how the company plans to refocus accordingly (for example, industry trends that may lead the organization to pursue new target markets or segments); next, the choices the R&D function will make in order to support the company’s new focus (which capabilities will be prioritized and which de-emphasized); and finally, how the R&D team will execute the strategy in terms of concrete actions and milestones. If a company cannot fit the exercise on a single page, it has not sufficiently synthesized the strategy—as the famed physicist Richard Feynman observed, the ultimate test of comprehension is the ability to convey something to others in a simple manner.

Cascading the strategy down through the R&D organization will further reinforce its impact. For example, asking managers to communicate the strategy to their subordinates will deepen their own understanding. A useful corollary is that those hearing the strategy for the first time are introduced to it by their immediate supervisors rather than more distant R&D leaders. One R&D group demonstrated the broad benefits of this communication model: involving employees in developing and communicating the R&D strategy helped it double its Organizational Health Index  strategic clarity score, which measures one of the four “power practices”  highly connected to organizational performance.

R&D represents a massive innovation investment, but as companies confront globalized competition, rapidly changing customer needs, and technological shifts coming from an ever-wider range of fields, they are struggling to deliver on R&D’s full potential. A clearly articulated R&D strategy that supports and informs the corporate strategy is necessary to maximize the innovation investment and long-term company value.

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How Are Research and Development Costs Accounted For?

Research and development (R&D) is an essential part of any business’s success, yet it can also be a costly endeavor. To ensure that the money invested in R&D pays off, companies must understand: how are research and development costs accounted for?

It’s important to have strategies in place for managing these expenses as well as tools to help optimize processes. This blog post will discuss how businesses should approach accounting for research and development costs while providing tips on controlling associated expenditures. We’ll explain what needs to be taken into consideration when calculating R&D expenses, explore different methods of managing such spending, and how to use tools that can help in your management process.

So let’s answer: how are research and development costs accounted for?

Table of Contents

Understanding Research and Development Costs

Tracking research and development costs, direct and indirect expenses, accounting for research and development expenses, accrual vs cash basis accounting, capitalizing vs expensing taxation, strategies for managing research and development costs, automation of data collection and analysis processes, leveraging technology to streamline workflows, utilizing outsourcing solutions, conclusion: how are research and development costs accounted for.

R&D costs are the expenses associated with researching and developing new products, services, or processes. They can include direct costs such as salaries, materials, and equipment; indirect costs such as overhead; and capital investments in research facilities.

Tracking R&D costs is important because it allows companies to measure the effectiveness of their investment in innovation. It also helps them identify areas where they may be able to save money or increase efficiency.

Tracking R&D costs can provide several benefits for businesses. By understanding how much is being spent on research and development activities, companies can make more informed decisions about which projects should be pursued and which ones should be abandoned before too much time or money has been invested in them. Additionally, tracking R&D costs provides insight into the performance of individual teams or departments within an organization so that resources can be allocated accordingly.

When calculating total R&D costs, there are two main categories to consider: direct and indirect expenses.

Direct expenses refer to those related directly to a project’s completion, such as salaries for researchers working on the project, materials used during testing phases, operating expenses, and travel expenses incurred while attending conferences related to the project’s progress.

Indirect expenses refer to those not directly related but still necessary for completing a project. These include office supplies needed by researchers working on the project or software licenses required for running simulations.

In addition, there may also be capital investments made in research facilities or intangible assets that need to be accounted for when calculating total R&D cost figures over periods longer than one year. These types of expenditures typically have long-term implications on future returns from any given product under development at any given point in time.

Tracking and understanding research and development costs are essential for efficient R&D management. By calculating these costs accurately, teams can gain valuable insights into their projects’ progress and make better decisions about resource allocation.

How are research and development costs accounted for? Accounting for research and development (R&D) expenses requires careful consideration due to their impact on cash flow statements (accrual vs. cash basis accounting) as well as taxation rules (capitalizing vs. expensing).

Companies typically choose between accrual basis accounting, which recognizes revenue when earned regardless of payment, and cash-basis accounting, which only recognizes revenue once payment has been received.

Accrual basis accounting records transactions when they occur, regardless of when the money is exchanged. This method allows companies to keep track of their financial obligations in real-time and gives them an accurate picture of their current financial position. Cash basis accounting only records transactions once money has been exchanged between parties involved in the transaction.

Most organizations tend towards accrual-based approaches due to their better matching of revenues with corresponding expenditure items over extended periods. This provides more accurate financial reporting results overall.

As far as taxation goes, most countries allow businesses to capitalize on certain types of expenditures associated with developing products. With this, companies treat R&D like intangible assets instead of regular operating expense items, thereby allowing deductions over multiple years against taxable income.

Others allow businesses to simply expense out all associated expenditure items immediately without having the ability to deduct anything beyond the current tax period. Again depending upon what works best financially speaking at any given point in time.

Managing research and development costs is a key factor in the success of any R&D team. Automation of data collection and analysis processes can help reduce overhead costs while leveraging technology to streamline workflows can increase efficiency. Utilizing outsourcing solutions to cut down on labor-intensive tasks can also be beneficial for reducing expenses.

Automating data collection processes helps reduce the manual labor associated with collecting information from various sources. This not only reduces overhead costs but also increases accuracy as it eliminates potential human errors that may occur during manual entry or transcription.

Additionally, automating analysis processes such as statistical modeling or predictive analytics allows teams to gain insights faster than ever before, helping them make better decisions quickly and efficiently.

Leveraging technology such as artificial intelligence (AI) or machine learning (ML) algorithms can help automate tedious tasks like document review or image recognition which would otherwise require significant manual effort. By using these technologies, teams can save time and money while still getting accurate results in a fraction of the time compared to traditional methods.

Additionally, utilizing cloud computing services such as Amazon Web Services (AWS) or Microsoft Azure enables teams to access powerful resources without having to invest heavily in physical infrastructure which further reduces overhead costs associated with running an R&D team.

Outsourcing certain tasks such as market research or product testing can significantly reduce labor-intensive activities required by an R&D team while still providing quality results at a lower cost than hiring full-time employees for those roles would entail.

In addition, outsourcing allows teams access to specialized skillsets they may not have internally which could prove invaluable when working on complex projects requiring specific expertise that isn’t available within their organization’s current staff roster.

By utilizing the strategies discussed in this article, research and development teams can reduce costs while still achieving their desired results.

Key Takeaway: Research and development teams can reduce costs by automating data collection and analysis processes, leveraging technology to streamline workflows, and utilizing outsourcing solutions for labor-intensive tasks. By taking these steps, R&D teams can save time and money while still getting accurate results in a fraction of the time compared to traditional methods.

Research and development costs are a necessary part of any R&D or innovation process. But how are research and development costs accounted for?

We learned in this article that proper tracking of direct and indirect costs, as well as choosing the accounting method fit for your business are key steps in proper R&D costs accounting. With this, you can also start properly managing development and research costs, and streamlining your workflow.

Are you looking for a way to streamline your R&D and innovation teams’ data sources? Cypris is the perfect solution. Our platform centralizes all of your team’s needs into one place, allowing them to quickly gain insights that can help drive their projects forward. With our user-friendly interface, easy integration with existing systems, and comprehensive analytics tools – it has never been easier to get the most out of your research efforts! Try us today and see how we can help take your business to the next level!

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• Introduction
• Conclusions
• Article Information

FDA indicates the US Food and Drug Administration; R&D, research and development.

a Includes firms that went public while developing the therapeutic agent in question but for which US Securities and Exchange Commission (SEC) filings were missing for more than 3 years of the drug development period.

Indicates the estimated research and development investment needed for an average company to bring one of these products to market based on aggregate clinical trial success rates. Individual companies may have spent more or less on their respective development pipelines, based on their individual success rates.

eTable 1. Characteristics of Therapeutic Agents Included in the Analysis

eTable 2. Quality Score of the Research and Development Estimate for Each Therapeutic Agent

eTable 3. Median Research and Development Outlays (2018 US $, Millions) by Product Category, Without Adjustment for Costs of Failures

eTable 4. Research and Development Costs (2018 US $, Millions), Broken Down by Phase of Clinical Development, for All Therapeutic Agents Included in the Analysis

eTable 5. Dates of Clinical Trial Phase Changes for all Therapeutic Agents Included in the Analysis

eTable 6. Estimated Research and Development Costs (2018 US $, Millions) for All Therapeutic Agents Included in the Analysis

• Affording Medicines for Today’s Patients and Sustaining Innovation for Tomorrow JAMA Editorial March 3, 2020 Kenneth C. Frazier, JD
• Are Pharmaceutical Companies Earning Too Much? JAMA Editorial March 3, 2020 David M. Cutler, PhD
• Relentless Prescription Drug Price Increases JAMA Editorial March 3, 2020 Chaarushena Deb; Gregory Curfman, MD
• Research and Development Costs of New Drugs JAMA Comment & Response August 4, 2020 Bart Dierynck, PhD; Philip Joos, PhD
• Research and Development Costs of New Drugs JAMA Comment & Response August 4, 2020 Luis W. Dominguez, MD, MPH; Joel S. Willis, DO, PA, MA, MPhil
• Research and Development Costs of New Drugs JAMA Comment & Response August 4, 2020 Joseph A. DiMasi, PhD
• Research and Development Costs of New Drugs—Reply JAMA Comment & Response August 4, 2020 Olivier J. Wouters, PhD; Martin McKee, MD, DSc; Jeroen Luyten, PhD
• Errors in Source Data for Study of Drug Development Costs JAMA Comment & Response September 20, 2022 Olivier J. Wouters, PhD; Martin McKee, MD, DSc; Jeroen Luyten, PhD
• Error in Data in Study of Estimated Cost of Bringing a Drug to Market JAMA Correction September 20, 2022
• Cost of Developing a Single Cancer Drug JAMA Internal Medicine Original Investigation November 1, 2017 This analysis of US Securities and Exchange Commission filings provides a contemporary estimate of research and development spending to develop 10 new cancer drugs. Vinay Prasad, MD, MPH; Sham Mailankody, MBBS
• Lobbying Expenditures and Campaign Contributions by the Drug Industry in the United States JAMA Internal Medicine Original Investigation May 1, 2020 This observational study uses publicly available data to analyze how much the pharmaceutical and health product industry spent on campaign contributions and lobbying in the US from 1999 to 2018. Olivier J. Wouters, PhD
• Lobbying Expenditures, Campaign Contributions, and Health Care JAMA Internal Medicine Editorial May 1, 2020 Robert Steinbrook, MD

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Wouters OJ , McKee M , Luyten J. Estimated Research and Development Investment Needed to Bring a New Medicine to Market, 2009-2018. JAMA. 2020;323(9):844–853. doi:10.1001/jama.2020.1166

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Estimated Research and Development Investment Needed to Bring a New Medicine to Market, 2009-2018

• 1 Department of Health Policy, London School of Economics and Political Science, London, United Kingdom
• 2 Department of Health Services Research and Policy, London School of Hygiene and Tropical Medicine, London, United Kingdom
• 3 Leuven Institute for Healthcare Policy, Department of Public Health and Primary Care, KU Leuven, Belgium
• Editorial Affording Medicines for Today’s Patients and Sustaining Innovation for Tomorrow Kenneth C. Frazier, JD JAMA
• Editorial Are Pharmaceutical Companies Earning Too Much? David M. Cutler, PhD JAMA
• Editorial Relentless Prescription Drug Price Increases Chaarushena Deb; Gregory Curfman, MD JAMA
• Editorial Lobbying Expenditures, Campaign Contributions, and Health Care Robert Steinbrook, MD JAMA Internal Medicine
• Comment & Response Research and Development Costs of New Drugs Bart Dierynck, PhD; Philip Joos, PhD JAMA
• Comment & Response Research and Development Costs of New Drugs Luis W. Dominguez, MD, MPH; Joel S. Willis, DO, PA, MA, MPhil JAMA
• Comment & Response Research and Development Costs of New Drugs Joseph A. DiMasi, PhD JAMA
• Comment & Response Research and Development Costs of New Drugs—Reply Olivier J. Wouters, PhD; Martin McKee, MD, DSc; Jeroen Luyten, PhD JAMA
• Comment & Response Errors in Source Data for Study of Drug Development Costs Olivier J. Wouters, PhD; Martin McKee, MD, DSc; Jeroen Luyten, PhD JAMA
• Correction Error in Data in Study of Estimated Cost of Bringing a Drug to Market JAMA
• Original Investigation Cost of Developing a Single Cancer Drug Vinay Prasad, MD, MPH; Sham Mailankody, MBBS JAMA Internal Medicine
• Original Investigation Lobbying Expenditures and Campaign Contributions by the Drug Industry in the United States Olivier J. Wouters, PhD JAMA Internal Medicine

Question   How much do drug companies spend on research and development to bring a new medicine to market?

Findings   In this study, which included 63 of 355 new therapeutic drugs and biologic agents approved by the US Food and Drug Administration between 2009 and 2018, the estimated median capitalized research and development cost per product was $1.1 billion, counting expenditures on failed trials. Data were mainly accessible for smaller firms, products in certain therapeutic areas, orphan drugs, first-in-class drugs, therapeutic agents that received accelerated approval, and products approved between 2014 and 2018.

Meaning   This study provides an estimate of research and development costs for new therapeutic agents based on publicly available data; differences from previous studies may reflect the spectrum of products analyzed and the restricted availability of data in the public domain.

Importance   The mean cost of developing a new drug has been the subject of debate, with recent estimates ranging from $314 million to $2.8 billion.

Objective   To estimate the research and development investment required to bring a new therapeutic agent to market, using publicly available data.

Design and Setting   Data were analyzed on new therapeutic agents approved by the US Food and Drug Administration (FDA) between 2009 and 2018 to estimate the research and development expenditure required to bring a new medicine to market. Data were accessed from the US Securities and Exchange Commission, Drugs@FDA database, and ClinicalTrials.gov, alongside published data on clinical trial success rates.

Exposures   Conduct of preclinical and clinical studies of new therapeutic agents.

Main Outcomes and Measures   Median and mean research and development spending on new therapeutic agents approved by the FDA, capitalized at a real cost of capital rate (the required rate of return for an investor) of 10.5% per year, with bootstrapped CIs. All amounts were reported in 2018 US dollars.

Results   The FDA approved 355 new drugs and biologics over the study period. Research and development expenditures were available for 63 (18%) products, developed by 47 different companies. After accounting for the costs of failed trials, the median capitalized research and development investment to bring a new drug to market was estimated at $1141.7 million (95% CI, $888.1 million-$1480.8 million), and the mean investment was estimated at $1559.1 million (95% CI, $1271.0 million-$1893.8 million) in the base case analysis. Median estimates by therapeutic area (for areas with ≥5 drugs) ranged from $765.9 million (95% CI, $323.0 million-$1473.5 million) for nervous system agents to $2771.6 million (95% CI, $2051.8 million-$5366.2 million) for antineoplastic and immunomodulating agents. Data were mainly accessible for smaller firms, orphan drugs, products in certain therapeutic areas, first-in-class drugs, therapeutic agents that received accelerated approval, and products approved between 2014 and 2018. Results varied in sensitivity analyses using different estimates of clinical trial success rates, preclinical expenditures, and cost of capital.

Conclusions and Relevance   This study provides an estimate of research and development costs for new therapeutic agents based on publicly available data. Differences from previous studies may reflect the spectrum of products analyzed, the restricted availability of data in the public domain, and differences in underlying assumptions in the cost calculations.

Rising drug prices have attracted public debate in the United States and abroad on fairness of drug pricing and revenues. 1 Central to this debate is the scale of research and development investment by biopharmaceutical companies that is required to bring new medicines to market. 2

The most widely cited studies of the cost of developing a new drug (DiMasi et al 3 , 4 ) reported a sharp increase in the mean cost of developing a single new therapeutic agent from $1.1 billion in 2003 to $2.8 billion in 2013 (in 2018 US dollars), based on a real cost of capital rate of 11% per year in the former study 3 and of 10.5% per year in the latter. 4 Other studies in this period, most of which relied on confidential or proprietary data, reported figures from $314 million to $2.1 billion (in 2018 US dollars). 5 - 11

In 2017, Prasad and Mailankody estimated the research and development costs of new cancer drugs using public data reported by pharmaceutical firms to the US Securities and Exchange Commission (SEC). 12 They estimated the median research and development cost of bringing a single cancer drug to market to be $780 million (in 2018 US dollars), capitalized at a real cost of capital rate of 7% per year, based on a sample of 10 drugs. 12

This present study estimates the research and development investment required to bring a new therapeutic agent to market using publicly available data for products approved by the US Food and Drug Administration (FDA) between 2009 and 2018.

Quiz Ref ID We identified all new therapeutic agents, ie, new drug applications and biologics license applications approved by the FDA between 2009 and 2018, in the Drugs@FDA database. 13 For each, we extracted the date of approval, date of submission of investigational new drug application, date of submission of new drug application or biologics license application, indication, type (pharmacologic or biologic), expedited programs (priority review, accelerated approval, fast track, or breakthrough), orphan status, route of administration (oral, injection, intravenous, or other), and manufacturer (eTable 1 in the Supplement ). To capture innovation, we determined whether an agent was first in class using publications by FDA officials. 14 , 15 We checked the data for consistency with published reports. 15 , 16

Therapeutic areas were obtained from the anatomical therapeutic chemical classification system database. 17 For agents that were not yet classified, we based our decision on the approved indication.

For each agent, we identified start and end dates of clinical studies (phases 1, 2, and 3 for the FDA-approved indication) from ClinicalTrials.gov (search conducted on April 4, 2019). If there were multiple studies in the same phase, the earliest start date was selected. We verified these dates with reports in SEC filings and used the dates from SEC filings if there were discrepancies. We classified combined phase 1 and 2 trials as phase 2 and combined phase 2 and 3 trials as phase 3, consistent with other studies. 18 - 20 Dates of submission of investigational new drug applications were used to approximate the end of preclinical testing; these dates were checked for consistency with filings to ensure clinical testing had not already begun outside the United States.

No data were collected from human participants, and all data in this study were publicly available.

Quiz Ref ID Publicly traded US companies are legally required by the SEC to file annual 10-K and quarterly 10-Q forms, which are reports of key financial performance indicators that include audited financial statements and data on research and development expenditures. For every agent in our sample, we searched the SEC website for reports from the firm that received FDA approval for it. 21

As reports for private US drug firms and foreign companies listed on non-US stock exchanges were unavailable, their products were excluded. For firms with available reports, we screened 10-K and 10-Q filings for data on research and development expenditures on individual drug candidates. We excluded products developed by companies that only reported total research and development expenditures across all drug candidates or across therapeutic areas.

For excluded products, we searched the 10-K and 10-Q forms and online press releases of manufacturers at the time that agents were approved to see if any were developed in collaboration with other firms via licensing deals. If so, we searched for 10-K and 10-Q forms from those firms in case there were research and development data for the product in question.

For each therapeutic agent with available data, we extracted direct and indirect research and development expenditures in each year of development. Drugs were tracked across years in SEC filings using the brand, generic, or compound names of agents, as appropriate.

Direct research and development expenses included all resources directly allocated to a particular agent. Indirect research and development expenses, which included personnel and overhead costs, were sometimes reported as a lump sum across all drug development programs. If so, we applied the same percentage of direct research and development costs attributable to a particular agent to estimate indirect costs for the same agent. The proportional allocation of personnel and overhead expenses is common practice in costing studies. 22

Costs were tracked from the year a company started reporting costs for a particular drug candidate in their financial statements until the quarter of approval, which often included 1 or more years of preclinical costs. In some cases, at the first mention of the candidate in SEC filings, companies reported the costs incurred since inception of the drug development program. Certain companies only started tracking costs at late stages of preclinical development or at the start of phase 1 of development, resulting in an underreporting of preclinical costs.

Some drugs were initially developed by companies that subsequently licensed out their drug candidates to other firms, which then brought these products to market. In these cases, it was assumed that any preclinical and clinical costs incurred during initial development was included in licensing fees and milestone payments. Hence, where these fees and payments were recorded as research and development expenses for the agent in question, these costs were extracted. Data on costs incurred by the originator firms were not collected.

If SEC filings were missing for 3 or fewer years since the inception of the drug development program (eg, if a company was privately held during early years of development) and the product did not move between development phases (ie, either from 1 to 2 or 2 to 3), we extrapolated costs from the closest available year. Products were excluded if more than 3 years of SEC filings were missing.

Three investigators independently extracted all research and development data used in this study. Discrepancies were resolved through discussions. Where disagreements existed, we assumed the higher estimate of research and development expenditures.

Consistency and completeness of company reporting in SEC filings varied over time. Many reported detailed research and development costs, which allowed us to track outlays over time for individual candidates. Others reported costs inconsistently or with missing data for some years, requiring various assumptions, for example on timings of transitions between phases and extrapolations when SEC filings were missing.

To aid interpretation, we categorized each estimate as high, medium, or low quality, depending on the availability and consistency of reported data. The categorization was developed through discussion between all authors.

High-quality estimates comprised drugs discovered internally, allowing tracking of costs back to inception of the development program, and products licensed at preclinical or phase 1 stages with minimal up-front fees or milestone payments captured in SEC filings. Late commercialization deals related to marketing of products in non-US markets were also deemed high-quality estimates, as they would have had little or no effect on research and development expenses incurred on trials required for FDA approval.

Low-quality estimates comprised all acquisitions, licensing deals, or other collaboration agreements in phases 2 or 3, earlier deals in which it was unclear whether all costs were captured in data extraction, and estimates requiring extrapolation of 2 to 3 years of data. We classified estimates as medium quality when other judgment calls regarding financial reporting, as agreed upon by the authors, had to be made.

Two investigators independently categorized the quality of estimates and resolved discrepancies through discussions.

Accurate information on costs of failures, ie, research and development outlays on candidates being developed by companies but not ultimately approved, is essential to estimating the costs of drug development. We accounted for failures using data on aggregate clinical trial success rates from a recent study by Wong et al ( Table 1 ). 18

Wong et al reported that the percentages of FDA approvals were 13.8% for therapeutic agents entering phase 1, 21.0% for those entering phase 2, and 59.0% for those entering phase 3. 18

Wong et al 18 provided success rates through phase 3. We supplemented these rates with a recent estimate of the proportion of biologics license applications and new drug applications that are approved by the FDA (83.2%). 20

For each agent, we estimated the expected research and development investment to bring the drug to market in 3 steps.

First, we summed direct and indirect research and development spending on a therapeutic agent in each year. All sums were inflation adjusted to 2018 dollars using the US consumer price index.

Second, we accounted for failed projects by dividing total research and development expenditures on a drug in a particular year by the corresponding aggregate phase-specific probability of success, similar to what was done in previous studies of costs of drug development. 3 - 7 For example, for each drug, we divided phase 1 costs in each year by 0.138, which accounted for spending on the other 6.2 phase 1 trials that would fail, on average, for each successful development program. We used phase 1 rates to adjust preclinical expenditures, and we used the proportion of biologics license applications and new drug applications that are approved by the FDA to adjust costs once these applications were submitted to the agency for regulatory approval. Licensing fees and milestone payments, where captured, were adjusted using the success rate for the trial phase that was ongoing when the payments were made. When a phase shift took place within the financial year, we allocated the cost proportionally to the time spent in each phase. For example, if development moved from phase 1 to phase 2 on July 1 of a given year, we divided the costs equally between each phase. Similarly, in the year of approval, we multiplied the total cost by the fraction of the year elapsed by the time of approval. Hence, if a drug was approved on July 1, we only counted 50% of the costs in the year of approval since firms often incurred postapproval costs related to pharmacovigilance or testing in other indications.

Third, we applied a real cost of capital rate of 10.5% per year (ie, weighted average cost of capital in the pharmaceutical industry), as in the DiMasi et al study. 4 Cost of capital is the required rate of return for an investor and encapsulates a risk-free rate (ie, opportunity cost) and premium based on the likelihood of business failure. 24

We ran 4 univariate sensitivity analyses. First, as the results were sensitive to the choice of aggregate clinical trial success rates (by phase), we recalculated the results using aggregate rates reported in 2 other studies ( Table 1 ). 19 , 20 Next, we calculated a second estimate of research and development costs using therapeutic-area–specific rates reported by Wong et al ( Table 1 ), instead of aggregate rates. For example, oncology drugs in phase 1 have a 3.4% chance of ultimately receiving FDA approval, so we divided each year of phase 1 costs for these products by 0.034. Third, we performed a rerun of the analyses using a real cost of capital rate of 7% (as done by Prasad and Mailankody 12 ) and 0% (to show noncapitalized outlays). Fourth, to account for potentially missing preclinical expenditures, we adopted the same assumption around preclinical costs as DiMasi et al, who reported that preclinical costs represented 42.9% of their total research and development estimate. 4 Thus, for each product in our sample, we isolated clinical expenditures and imputed a preclinical cost that amounted to this percentage. No imputations were performed for products acquired through purchase after clinical development had begun since it was assumed that licensing fees and milestone payments reflected preclinical costs incurred by the company that sold the rights to the product. Additionally, we ran another sensitivity analysis but with imputations done for all products, including agents acquired through purchase.

As a subgroup analysis, we reported mean and median amounts by therapeutic area, using area-specific rates to adjust for costs of failure.

We estimated the mean and median research and development investments across our sample in the base case and sensitivity analyses. We then restricted the sample to high-quality estimates and recalculated the mean and median amounts.

We conducted a nonparametric bootstrapped resampling with replacement (1000 iterations) to calculate 95% CIs around the estimated mean and median investments in research and development in our sample. We used χ 2 tests to identify statistically significant differences in characteristics of the study sample vs therapeutic agents approved by the FDA between 2009 and 2018 that were excluded from our analysis. We used Kruskal-Wallis and Mann-Whitney U tests, as appropriate, to identify statistically significant differences in median estimated research and development investments across therapeutic areas and other drug characteristics.

All statistical tests were 2-tailed and used a type I error rate of 0.05. The data were analyzed using Stata version 15 (StataCorp).

Between 2009 and 2018, the FDA approved 355 new drugs and biologics. Research and development expenditures from SEC government filings were available for 63 of these products, developed by 47 different companies ( Figure 1 ). The sample covered 17.7% (63/355) of all new therapeutic agents approved by the FDA over this 10-year period. Twenty-three of the estimates were judged of high quality, 18 medium quality, and 22 low quality. eTable 2 in the Supplement provides the rationale for the quality categorization of each agent.

Table 2 presents statistics for the 63 included therapeutic agents. The sample contained a larger proportion of orphan drugs, therapeutic agents that benefited from expedited development or approval pathways, and first-in-class drugs compared with all FDA-approved products between 2009 and 2018, although these differences were not statistically significant. Differences in the breakdown of products by therapeutic area, accelerated vs regular approval, and approval dates were statistically significant.

Without adjustments for costs of failed trials, no statistically significant differences in the median research and development investment required to bring a new drug to market were observed across any of the drug characteristics shown in Table 2 , except median costs for biologic drugs that were higher than those for pharmacologic drugs (eTable 3 in the Supplement ). For the 63 agents included in the analysis, outlays for research and development (ie, total noncapitalized direct and indirect expenses incurred during preclinical and clinical testing) were estimated at a median of $319.3 million (95% CI, $236.4 million-$351.4 million), and the estimated mean outlay was $374.1 million (95 CI, $301.9 million-$464.2 million), (eTable 4 in the Supplement ). The mean (SD) number of years of data per drug was 8.3 (2.8) years. eTable 5 in the Supplement shows the dates of phase changes for clinical trials of each included agent.

Quiz Ref ID After accounting for costs of failed trials, the estimated median research and development investment required to bring a new drug to market, capitalized at a rate of 10.5% per year, was $1141.7 million (95% CI, $888.1 million-$1480.8 million), and the estimated mean was $1559.1 million (95% CI, $1271.0 million-$1893.8 million) ( Table 3 ). Figure 2 shows point estimates for each of the 63 agents, which ranged from $143.2 million for Mytesi (crofelemer) to $7424.2 million for Dupixent (dupilumab).

Restricting the analysis to high-quality estimates (n = 23), the estimated median research and development investment increased from $1141.7 million to $1310.5 million (95% CI, $963.0 million-$1392.2 million), while the estimated mean declined from $1559.1 million to $1383.8 million (95% CI, $1077.7 million-$1751.3 million).

Table 3 shows the results of univariate sensitivity analyses. When the aggregate success rates reported by Hay et al 20 were used instead of those reported by Wong et al, 18 the estimated median research and development investment, capitalized at a rate of 10.5% per year, increased from $1141.7 million to $1404.9 million (95% CI, $1102.2 million-$1773.4 million), while the estimated mean increased from $1559.1 million to $1976.6 million (95% CI, $1595.5 million-$2454.8 million). When the rates from Thomas et al 19 were used, the estimated median research and development investment, capitalized at an annual rate of 10.5%, was $1465.8 million (95% CI, $1121.5 million-$1887.1 million), and the estimated mean was $2059.5 million (95% CI, $1639.9 million-$2511.7 million).

When therapeutic-area–specific rates from Wong et al, 18 rather than aggregate rates, were used to account for costs of failed trials for each agent, the estimated median research and development investment, capitalized at a rate of 10.5% per year, increased from $1141.7 million to $1385.2 million (95% CI, $1053.9 million-$1971.8 million), and the estimated mean rose from $1559.1 million to $2307.2 million (95% CI, $1726.9 million-$3013.0 million).

When the costs were capitalized at an annual rate of 7% instead of 10.5%, the median expected investment decreased from $1141.7 million to $998.2 million (95% CI, $801.0 million-$1317.8 million), and the mean decreased from $1559.1 million to $1352.4 million (95% CI, $1085.9 million-$1653.7 million). When costs were not capitalized, rather than capitalized at an annual rate of 10.5%, the median expected investment decreased from $1141.7 million to $770.2 million (95% CI, $645.6 million-$939.1 million), and the mean decreased from $1559.1 million to $1032.0 million (95% CI, $845.2 million-$1243.3 million).

With the adjustments for potentially missing preclinical costs done for 33 of 63 products (ie, excluding agents acquired through purchase), based on the DiMasi et al 4 approach, the estimated median research and development investment increased from $1141.7 million to $1620.5 million (95% CI, $1139.8 million-$2255.1 million), while the estimated mean increased from $1559.1 million to $2123.1 million (95% CI, $1671.2 million-$2670.3 million). With the adjustments for potentially missing preclinical costs done for all 63 products, the estimated median research and development investment increased to $1787.2 million (95% CI, $1514.5 million-$2438.2 million), while the estimated mean increased to $2600.6 million (95% CI, $2071.7 million-$3200.7 million).

Restricting the sensitivity analyses to high-quality estimates (n = 23), the estimated median and mean research and development investments required to bring a new drug to market increased in most cases ( Table 3 ). eTable 6 in the Supplement shows the estimates for each agent in the base case and sensitivity analyses.

Quiz Ref ID Median estimates by therapeutic area (for areas with ≥5 drugs), adjusted using area-specific rates and capitalized at 10.5% per year, ranged from $765.9 million (95% CI, $323.0 million-$1473.5 million) for nervous system agents to $2771.6 million (95% CI, $2051.8 million-$5366.2 million) for antineoplastic and immunomodulating agents. The corresponding mean estimates ranged from $1076.9 million (95% CI, $508.7 million-$1847.1 million) for nervous system agents to $4461.2 million (95% CI, $3114.0 million-$6001.3 million) for antineoplastic and immunomodulating agents ( Table 4 ).

Based on data for 63 therapeutic agents developed by 47 companies between 2009 and 2018, the median research and development investment required to bring a new drug to market was estimated to be $1142 million, and the mean was estimated to be $1559 million. Estimates differed across therapeutic areas, with costs of developing cancer drugs the highest. The results included costs of failed clinical trials and varied in sensitivity analyses using different estimates of trial success, preclinical expenditures, and cost of capital.

These figures were higher than the median capitalized research and development cost of $780 million (in 2018 US dollars) reported by Prasad and Mailankody for oncology drugs. 12 This may be because adjustments based on clinical trial success rates were applied in the present study to account for costs of failures, whereas Prasad and Mailankody restricted their analysis to companies bringing their first drug to market and then summed the total research and development expenditures of each company during the development periods of the drugs in their sample. Most of the companies included in their study appeared to be more successful than the average company. 25 - 27 Moreover, their analysis was based on data for 10 oncology drugs, which limits the comparability of their results with the present study.

The mean estimate of $1.6 billion in the present study was lower than the $2.8 billion (in 2018 US dollars) reported by DiMasi et al, which was based on data for 106 products developed by 10 large firms. 4 The estimate by DiMasi et al used confidential data on costs voluntarily submitted by anonymous companies without independent verification, making them difficult to validate. 12 , 28 - 30 Quiz Ref ID The higher estimate of DiMasi et al seems to reflect a combination of higher clinical costs incurred by larger drug developers, lower estimates of trial success for each stage of development compared to the more recent data presented by Wong et al, and different assumptions about preclinical expenditures as their data set did not permit allocating these expenditures to specific agents.

The results of the present study varied widely when subject to sensitivity analyses, especially using different success rates. The methods employed by Wong et al to handle missing data were an improvement on earlier studies of trial success rates, and their study was based on a larger sample. 18 Wong et al also noted that the most cited studies of success rates 19 , 20 , 31 originated from researchers with ties to the pharmaceutical industry, and elaborated that “previous estimates of drug development success rates [relied] on relatively small samples from databases curated by the pharmaceutical industry and [were] subject to potential selection biases.” 18 Also, compared with these earlier studies of success rates, 19 , 20 , 31 the timing of the work by Wong et al 18 more closely aligned with that of the present study, thereby improving its internal validity.

There are challenges in isolating preclinical investments by drug companies. It is especially difficult to identify the exact date from which costs should start being allocated to individual agents during the early stages of preclinical research. The base case scenario in this study relied on preclinical costs reported by firms in SEC filings, which were likely underestimated since many companies did not attribute costs during the drug discovery stages to individual candidates. DiMasi et al estimated that preclinical costs accounted, on average, for 42.9% of total capitalized costs, based on aggregated data on preclinical spending and assumptions around the duration of preclinical testing. 4 Although preclinical costs were variously estimated in the present study, including indirectly through license fees, preclinical data were directly captured for 19 products. For these products, preclinical costs generally accounted for a lower share of the total capitalized costs (ranging from 0.3% to 40.5%; median 9.6%) than what was estimated by DiMasi et al (eTable 4 in the Supplement ). For comparison, however, the 42.9% estimate was used to impute preclinical costs in sensitivity analyses in this study. Further validation work is needed to establish the preclinical share of research and development estimates for individual products.

Greater transparency around research and development costs is essential for analysts to check the veracity of claims by companies that the steep prices of new drugs are driven by high development outlays. While these expenditures are undoubtedly high, as shown in this study, it is important for policy makers, regulators, and payers to know the exact scale of these investments. This knowledge can inform the design of pricing policies that give adequate rewards for innovative drugs that bring value to health care systems.

This study has several limitations. First, data were unavailable for many products approved by the FDA during the study period. No data were available for products developed by non-US companies not listed on a US stock exchange and large drug firms that did not report research and development figures for individual drug candidates. Thus, there was likely an overrepresentation of smaller firms, which may have run leaner operations than larger ones. This limited the generalizability of the results to all products.

Second, the included agents differed from other drugs approved by the FDA between 2009 and 2018, although not all differences were statistically significant. The sample included a larger proportion of orphan drugs, products in certain therapeutic areas, first-in-class drugs, therapeutic agents that received accelerated approval, and products approved between 2014 and 2018.

Third, there were inconsistencies in research and development reporting between companies, which made it difficult to ensure perfect comparability of research and development figures between firms. These inconsistencies may have been explained by differences in accounting policies. For instance, some firms allocated overhead and administrative costs to direct research and development figures, while others reported these costs separately. Some reported preclinical research costs as a separate line item, while others incorporated them in overhead costs. Companies also reported costs associated with licensing deals, drug acquisitions, and collaboration agreements differently, so it is likely that not all costs were fully reflected in some estimates.

Fourth, uncertainties in the analysis may have resulted in under- or overestimations of research and development expenditures for some products. It is difficult to attribute costs to individual drug candidates in the early stages of preclinical development, so only the costs reported by firms in SEC filings were considered in the base case analysis. However, since preclinical costs may have been underreported by some companies, sensitivity analyses were conducted to produce an upper-bound estimate of preclinical expenditures. Conversely, many drug firms conducted trials for a particular candidate for multiple indications, which may have led to overestimations of costs since trial expenditures were not broken down by indication but instead reported as annual lump sums for each agent. Also, the estimates did not reflect any public tax credits or subsidies, which may have led to further overestimations of costs incurred by companies.

This study provides an estimate of research and development costs for new therapeutic agents based on publicly available data. Differences from previous studies may reflect the spectrum of products analyzed, the restricted availability of data in the public domain, and differences in underlying assumptions in the cost calculations.

Corresponding Author: Olivier J. Wouters, PhD, Department of Health Policy, London School of Economics and Political Science, Houghton Street, London WC2A 2AE, United Kingdom ( [email protected] ).

Accepted for Publication: January 28, 2020.

Correction: This article was corrected on September 20, 2022, to fix multiple data points affected by a correction in one of the sources used in some of the original calculations; affected data were corrected in the abstract, text, several tables, Figure 2, and the Supplement.

Author Contributions: Dr Wouters had full access to all of the data in the study and takes responsibility for the integrity of the data and the accuracy of the data analysis.

Concept and design: Wouters.

Acquisition, analysis, or interpretation of data: All authors.

Drafting of the manuscript: Wouters.

Critical revision of the manuscript for important intellectual content: All authors.

Statistical analysis: Wouters.

Administrative, technical, or material support: All authors.

Supervision: Wouters.

Conflict of Interest Disclosures: Dr McKee reported receipt of grants from the Wellcome Trust, European Commission, and United Kingdom Research and Innovation outside the submitted work. No other disclosures were reported.

Data Sharing Statement: All data used in this study were in the public domain. An example data extraction file is available from the corresponding author upon request.

Additional Contributions: We thank Evelyn S. Warner, MSc (Duff and Phelps, UK), for her contribution to the study design and data collection, as well as her comments on an earlier draft of the manuscript. We thank Jouni Kuha, PhD (London School of Economics and Political Science, UK), and Geert Verbeke, PhD (KU Leuven, Belgium), for input on the statistical analysis, as well as Alistair Milne, PhD (Loughborough University, UK), and Max King, BA (retired; formerly Investec Asset Management, UK), for advice on costing capital investments. None of the individuals listed in the acknowledgments received compensation for their role in the study.

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Research and Development Costs: How to Calculate and Reduce

Research and development (r&d) costs are a critical process that allows businesses to innovate and stay competitive in their respective industries. however, r&d expenses can be a significant financial burden, and companies must be strategic in managing their research and development costs. accurately calculating r&d expenses is critical to understanding the costs involved in developing top-quality products or services., that includes identifying direct and indirect costs associated with r&d activities, as well as costs that can be capitalized as an asset., reducing research and development costs can be a formidable task, especially when companies aim to maintain top quality and value for their money., what is research and development, and why is it important for companies, the actions taken to create and launch new goods and services are referred to as research and development activities. r&d cost definition is essential for firms to keep their competitive edge and react to shifting market conditions. a firm has two options for handling these tasks: internal execution or outsourcing., r&d often concentrates on addressing issues and providing answers pertaining to the business’s operations. research and development costs should be an integral part of any company in order to secure healthy growth., how to calculate your research and development cost, research and development costs are necessary for any company. still, you can’t miss out on new opportunities to optimize them; otherwise, you risk falling behind. let’s see a few quick steps., categorize projects that you want to target, to get started, make a list of all the research and development projects that may be filed under this particular heading. the following are some examples of costs associated with research and development: innovative products or services, as well as alterations to manufacturing processes or resource allocation., calculate work-related costs, the actual expenses you incur to produce the goods are known as a direct outlay. for instance, your direct cost would be $100,000 if your business spent $50,000 on raw materials and another 50 grand on labor to manufacture a widget., you must first calculate your direct labor costs by dividing the number of employees by the total employee salary for your business (or simply multiply your employee salaries by 0.75). it can provide you with an approximate estimate of how much is spent each month on expenses for each employee., direct costs do not need to be attributed to particular projects. instead, use them as a starting point for any additional research and development costs., non-work related cost, non-labor-related costs are a key component of r&d expenses and can be broken down into the following categories:.

• Materials and Supplies : These are the expenses related to purchasing the tools , chemicals, and raw materials needed for R&D projects. Track the costs of each item and sum them up to determine this component .
• Prototyping and Testing : R&D often involves creating prototypes or conducting experiments. Include costs for prototype production, test equipment, and testing facilities, as well as any fees for external testing services.
• Intellectual Property : Costs related to patent filing, maintenance, and legal fees should be factored in. Also, consider any licensing fees for existing technologies or software you may be using in your R&D.
• Travel and Conferences : R&D projects often require collaboration and information exchange. Include expenses related to travel, conferences, workshops, and other networking events relevant to your research.

Research and development cost examples

Research and development (r&d) costs can vary greatly depending on the industry, project size, and specific goals. we’ll provide you with one example of r&d costs:, software dev : the expenses in software may include purchasing development tools, licensing fees for existing software, cloud services, and payments related to testing and debugging. costs can range from thousands to millions of dollars., how to reduce r&d expenses, cutting r&d expenses can be an artful dance between efficiency and innovation. collaborate with academic institutions for fresh insights at a lower cost. embrace open-source platforms and tools to dodge hefty fees. engage in strategic partnerships to share the r&d burden. and finally, optimize your processes because nothing says “savings” like a well-oiled innovation machine. just remember, don’t skimp on the essentials, or you’ll end up with more “d” (development) than “r” (research), r&d expenses, although huge, are crucial for the thriving of any business, big or small. we hope we have helped you..

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The accounting for research and development costs under IFRS can be significantly more complex than under US GAAP.

IFRS Perspectives: Update on IFRS issues in the US

Companies often incur costs to develop products and services that they intend to use or sell. The accounting for these research and development costs under IFRS can be significantly more complex than under US GAAP

Under US GAAP, R&D costs within the scope of ASC 730 1  are expensed as incurred. US GAAP also has specific requirements for motion picture films, website development, cloud computing costs and software development costs.

Under IFRS (IAS 38 2 ), research costs are expensed, like US GAAP. However, unlike US GAAP, IFRS has broad-based guidance that requires companies to capitalize development expenditures, including internal costs, when certain criteria are met.

Based on these criteria, internally developed intangible assets (e.g. development expenses related to a prototype in the automotive industry) are generally capitalized and amortized under IFRS and expensed under US GAAP. This difference gives rise to two complexities in applying IFRS: distinguishing development activities from research activities, and analyzing whether and when the criteria for capitalizing development expenditures are met.

Separating development from research

The starting point for companies applying IFRS is to differentiate between costs that are related to ‘research’ activities versus those related to ‘development’ activities. While the definition of what constitutes ‘research’ versus ‘development’ is very similar between IFRS and US GAAP, neither provides a bright line on separating the two. Instead, a company needs to develop processes and controls that allow it to make that distinction based on the nature of different activities.

Analyzing when to start capitalizing development costs

Expenditures incurred in the development phase of a project are capitalized from the point in time that the company is able to demonstrate all of the following.

• The technical feasibility of completing the intangible asset so that it will be available for use or sale.
• Its intention to complete the intangible asset and use or sell it.
• Its ability to use or sell the intangible asset.
• How the intangible asset will generate probable future economic benefits.
• The availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset.
• Its ability to reliably measure the expenditure attributable to the intangible asset during its development.

In our experience, the key factor in the above list is  technical feasibility . There is no definition or further guidance to help determine when a project crosses that threshold. Instead, companies need to evaluate technical feasibility in relation to each specific project. Projects related to new product developments are generally more difficult to substantiate than projects in which the entity has more experience.  

To learn more about the differences between IFRS and US GAAP, see KPMG’s publication,  IFRS compared to US GAAP .

• ASC 730, Research and Development
• IAS 38, Intangible Assets

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How to Expense R&D Costs on Financial Statements

At first glance, life sciences and innovation have very little to do with financial statements. After all, professionals working in this field are passionate about the research they are conducting and how it will affect the world. That’s where investors, banks or the government enter the picture—after all, someone is providing the money to advance your company’s dream.

So let’s take a minute to talk about your research and development costs.

According to Accounting Standards Codification (ASC) 730, research and development costs are activities aimed at developing or significantly improving a product, service, process or technique that’s intended for either sale or use. The ASC also excludes a number of items from this classification including research and development work that’s under contract, routine or periodic alterations to existing products, and market research or market testing, just to name a few.

Based on ASC 730, research and development costs should be expensed as they’re incurred because any future benefits (i.e., revenues or cash coming in the door) that may be derived from these costs are too uncertain. Even if it becomes likely that revenues will be generated, they typically can’t be estimated or measured. That means you can’t capitalize these expenses as an asset on your balance sheet. In other words, these costs have to hit your bottom line.

The good news? You can identify your research and development costs on your statement of operations so that readers of your financials can understand that these costs may not be part of your typical operations and are instead an investment in the future.  These costs can include materials, equipment, facilities, salaries and wages, contract services and even an allocation of indirect costs, as long as it’s reasonable, but they have to fall under the definition of research and development according to ASC 730.

It can be difficult to get excited and passionate about ASCs, but when you think about the reason for ensuring the debits and credits are handled appropriately (funding from investors, the bank or government grants) it might help pique your interest.

For more information about ASC 730 financial statement requirements, contact your MarksNelson professional at 816-743-7700.

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• What Is R&D?
• Understanding R&D
• Types of R&D
• Pros and Cons
• Considerations
• R&D vs. Applied Research
• Who Spends the Most?

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Research and Development (R&D) Definition, Types, and Importance

Investopedia / Ellen Lindner

What Is Research and Development (R&D)?

The term research and development (R&D) is used to describe a series of activities that companies undertake to innovate and introduce new products and services. R&D is often the first stage in the development process. Companies require knowledge, talent, and investment in order to further their R&D needs and goals. The purpose of research and development is generally to take new products and services to market and add to the company's bottom line .

Key Takeaways

• Research and development represents the activities companies undertake to innovate and introduce new products and services or to improve their existing offerings.
• R&D allows a company to stay ahead of its competition by catering to new wants or needs in the market.
• Companies in different sectors and industries conduct R&D—pharmaceuticals, semiconductors, and technology companies generally spend the most.
• R&D is often a broad approach to exploratory advancement, while applied research is more geared towards researching a more narrow scope.
• The accounting for treatment for R&D costs can materially impact a company's income statement and balance sheet.

Understanding Research and Development (R&D)

The concept of research and development is widely linked to innovation both in the corporate and government sectors. R&D allows a company to stay ahead of its competition. Without an R&D program, a company may not survive on its own and may have to rely on other ways to innovate such as engaging in mergers and acquisitions (M&A) or partnerships. Through R&D, companies can design new products and improve their existing offerings.

R&D is distinct from most operational activities performed by a corporation. The research and/or development is typically not performed with the expectation of immediate profit. Instead, it is expected to contribute to the long-term profitability of a company. R&D may often allow companies to secure intellectual property, including patents , copyrights, and trademarks as discoveries are made and products created.

Companies that set up and employ departments dedicated entirely to R&D commit substantial capital to the effort. They must estimate the risk-adjusted return on their R&D expenditures, which inevitably involves risk of capital. That's because there is no immediate payoff, and the return on investment (ROI) is uncertain. As more money is invested in R&D, the level of capital risk increases. Other companies may choose to outsource their R&D for a variety of reasons including size and cost.

Companies across all sectors and industries undergo R&D activities. Corporations experience growth through these improvements and the development of new goods and services. Pharmaceuticals, semiconductors , and software/technology companies tend to spend the most on R&D. In Europe, R&D is known as research and technical or technological development.

Many small and mid-sized businesses may choose to outsource their R&D efforts because they don't have the right staff in-house to meet their needs.

Types of R&D

There are several different types of R&D that exist in the corporate world and within government. The type used depends entirely on the entity undertaking it and the results can differ.

Basic Research

There are business incubators and accelerators, where corporations invest in startups and provide funding assistance and guidance to entrepreneurs in the hope that innovations will result that they can use to their benefit.

M&As and partnerships are also forms of R&D as companies join forces to take advantage of other companies' institutional knowledge and talent.

Applied Research

One R&D model is a department staffed primarily by engineers who develop new products —a task that typically involves extensive research. There is no specific goal or application in mind with this model. Instead, the research is done for the sake of research.

Development Research

This model involves a department composed of industrial scientists or researchers, all of who are tasked with applied research in technical, scientific, or industrial fields. This model facilitates the development of future products or the improvement of current products and/or operating procedures.

$42.7 billion of research and development costs later, Amazon was granted 2,244 new patents in 2020. Their patents included advancements in artificial intelligence, machine learning, and cloud computing.

Advantages and Disadvantages of R&D

There are several key benefits to research and development. It facilitates innovation, allowing companies to improve existing products and services or by letting them develop new ones to bring to the market.

Because R&D also is a key component of innovation, it requires a greater degree of skill from employees who take part. This allows companies to expand their talent pool, which often comes with special skill sets.

The advantages go beyond corporations. Consumers stand to benefit from R&D because it gives them better, high-quality products and services as well as a wider range of options. Corporations can, therefore, rely on consumers to remain loyal to their brands. It also helps drive productivity and economic growth.

Disadvantages

One of the major drawbacks to R&D is the cost. First, there is the financial expense as it requires a significant investment of cash upfront. This can include setting up a separate R&D department, hiring talent, and product and service testing, among others.

Innovation doesn't happen overnight so there is also a time factor to consider. This means that it takes a lot of time to bring products and services to market from conception to production to delivery.

Because it does take time to go from concept to product, companies stand the risk of being at the mercy of changing market trends . So what they thought may be a great seller at one time may reach the market too late and not fly off the shelves once it's ready.

Facilitates innovation

Improved or new products and services

Expands knowledge and talent pool

Increased consumer choice and brand loyalty

Economic driver

Financial investment

Shifting market trends

R&D Accounting

R&D may be beneficial to a company's bottom line, but it is considered an expense . After all, companies spend substantial amounts on research and trying to develop new products and services. As such, these expenses are often reported for accounting purposes on the income statement and do not carry long-term value.

There are certain situations where R&D costs are capitalized and reported on the balance sheet. Some examples include but are not limited to:

• Materials, fixed assets, or other assets have alternative future uses with an estimable value and useful life.
• Software that can be converted or applied elsewhere in the company to have a useful life beyond a specific single R&D project.
• Indirect costs or overhead expenses allocated between projects.
• R&D purchased from a third party that is accompanied by intangible value. That intangible asset may be recorded as a separate balance sheet asset.

R&D Considerations

Before taking on the task of research and development, it's important for companies and governments to consider some of the key factors associated with it. Some of the most notable considerations are:

• Objectives and Outcome: One of the most important factors to consider is the intended goals of the R&D project. Is it to innovate and fill a need for certain products that aren't being sold? Or is it to make improvements on existing ones? Whatever the reason, it's always important to note that there should be some flexibility as things can change over time.
• Timing: R&D requires a lot of time. This involves reviewing the market to see where there may be a lack of certain products and services or finding ways to improve on those that are already on the shelves.
• Cost: R&D costs a great deal of money, especially when it comes to the upfront costs. And there may be higher costs associated with the conception and production of new products rather than updating existing ones.
• Risks: As with any venture, R&D does come with risks. R&D doesn't come with any guarantees, no matter the time and money that goes into it. This means that companies and governments may sacrifice their ROI if the end product isn't successful.

Research and Development vs. Applied Research

Basic research is aimed at a fuller, more complete understanding of the fundamental aspects of a concept or phenomenon. This understanding is generally the first step in R&D. These activities provide a basis of information without directed applications toward products, policies, or operational processes .

Applied research entails the activities used to gain knowledge with a specific goal in mind. The activities may be to determine and develop new products, policies, or operational processes. While basic research is time-consuming, applied research is painstaking and more costly because of its detailed and complex nature.

Who Spends the Most on R&D?

Companies spend billions of dollars on R&D to produce the newest, most sought-after products. According to public company filings, these companies incurred the highest research and development spending in 2020:

• Amazon: $42.7 billion
• Alphabet.: $27.6 billion
• Huawei: $22.0 billion
• Microsoft: $19.3 billion
• Apple: $18.8 billion
• Samsung: $18.8 billion
• Facebook: $18.5 billion

What Types of Activities Can Be Found in Research and Development?

Research and development activities focus on the innovation of new products or services in a company. Among the primary purposes of R&D activities is for a company to remain competitive as it produces products that advance and elevate its current product line. Since R&D typically operates on a longer-term horizon, its activities are not anticipated to generate immediate returns. However, in time, R&D projects may lead to patents, trademarks, or breakthrough discoveries with lasting benefits to the company. 

What Is an Example of Research and Development?

Alphabet allocated over $16 billion annually to R&D in 2018. Under its R&D arm X, the moonshot factory, it has developed Waymo self-driving cars. Meanwhile, Amazon has spent even more on R&D projects, with key developments in cloud computing and its cashier-less store Amazon Go. At the same time, R&D can take the approach of a merger & acquisition, where a company will leverage the talent and intel of another company to create a competitive edge. The same can be said with company investment in accelerators and incubators, whose developments it could later leverage.

Why Is Research and Development Important?

Given the rapid rate of technological advancement, R&D is important for companies to stay competitive. Specifically, R&D allows companies to create products that are difficult for their competitors to replicate. Meanwhile, R&D efforts can lead to improved productivity that helps increase margins, further creating an edge in outpacing competitors. From a broader perspective, R&D can allow a company to stay ahead of the curve, anticipating customer demands or trends.

There are many things companies can do in order to advance in their industries and the overall market. Research and development is just one way they can set themselves apart from their competition. It opens up the potential for innovation and increasing sales. But it does come with some drawbacks—the most obvious being the financial cost and the time it takes to innovate.

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How Much Do Research and Development Cost?

R and D (research and development) is a crucial function for enterprises and corporations. It gives new products and increases market leadership. However, many business leaders wonder how they can access affordable R & D solutions for their startups and SMBs with a priority towards survival and growth.

The first hindrance to getting a meaningful answer to such inquiry is that many leaders still consider R&D prices as costs, rather than investments. Yet, indeed, research and development expenses are growth investments that can help you edge out your competition.

Hence, startup leaders should reorient themselves towards counting the potential profits, rather than the cost. This article shows you how to do so.

What is R&D?

R&D cost meaning describes activities businesses undertake to innovate and introduce new products and services. R&D cost definition is critical to the long-term survival of organizations, as it allows them to adapt to changing market conditions and maintain their competitive advantage. These activities can be undertaken internally by employees of a business, or they can be outsourced. R&D is typically focused on solving problems and answering questions that are central to the operations of the business.

R&D’s Role in future profits

Profits are the lifeblood of any organization. This is especially so in a free market, where competition is fierce and customers have many options. For companies that want to stay profitable, it is important to know what drives their profits.

Innovation is a key driver of competitive advantage. Research and development costs should be able to help companies to bring innovative products to market ahead of their competitors and can thereby capture the bulk of profits before the competition responds.

The purpose of investing in R&D is to increase the company’s long-term profits. The company can improve its products, develop new products and create new markets for its products. It can also reduce the costs of manufacturing and marketing those products, for example, e-commerce app development cost , which increases profit margins.

The answer to the question of what role R&D should play in a company’s strategy ultimately depends on the business goals of each individual company. Many companies rely on R&D for more than just product research. These companies may hire dedicated team or use their R&D departments for market research, strategic planning, or even sales and marketing assistance.

International Treatment of R&D

The comprehension of R&D costs in international practice might be different from your country. So, let’s have a look at international standard approaches to understanding the research and development costs.

R&D costs: expenses or investments?

As we have identified, R&D costs should rightly be identified as investments towards the growth of the business, rather than expenses that make the business lose money. Successful businesses and corporations reach greater heights, innovate their product lines, and find opportunities to boost revenue through investments in R&D.

Research and Development (R&D) Tax Credit

The R&D Tax Credit, also known in USA as the Research and Experimentation (R&E) tax credit, is a federal benefit that provides companies dollar-for-dollar cash savings for performing activities related to the development, design, or improvement of products, processes, formulas, or software.

This credit provides much needed cash to hire additional employees, increase R&D, expand facilities, and more. If in the US, you cannot determine what is research and development cost without this consideration. The credit was enacted in 1981 to stimulate innovation and encourage investment in development in the US. Since then, many states have also passed the R&D Tax Credit. As such, this benefit is available across a wide variety of industries.

There are several benefits to realizing the R&D tax credit. These benefits can include the following:

• Receive up to 12-16 cents of federal and state R&D tax credits for every qualified dollar
• Create a dollar-for-dollar reduction in your federal and state income tax liability
• Increase earnings-per-share
• Reduce your effective tax rate
• Improve cash flow
• Carry forward the credit up to 20 years
• Perform look back studies to recognize unclaimed credits for open tax years (generally 3 or 4 years)
• Utilize the federal R&D tax credit against payroll tax (applicable to certain startup companies).

So if you want to invest in R&D and reduce costs at the same time, please check out the financial law in your country for more information about R&D tax credit cost.

How Much Does R&D Cost?

Research and development (R&D) activities are directed toward the creation or identification of new products or services. This is the point where you stop counting the costs and start counting the profits. So, when we turn our focus from costs to return of investments, we start moving to the business blue ocean, full of opportunities, blind niches and new profits.

Indeed, the costs, including R&D expenses for IT staff augmentation services can vary according to various company needs (just like the cost to hire an app developer , for example). Therefore, it is impossible to quote a specific sum without considering the peculiar objectives and goals of various companies.

R&D Costs Arrangements

Some companies have arrangements with other entities (such as universities) for conducting research projects and determining how to estimate R&D costs. In such cases, a portion of the costs associated with these projects is often paid for by the company that engages in R&D work.

Capitalized Costs

There are some situations where it makes sense for a company to capitalize research and development expenses rather than deducting them from profits. Generally speaking, if a company is creating an asset through its R&D investments (like new technology), then it should be recorded as an asset rather than an expense.

Software R&D Expenditure

This type of spending includes all software-related R and D costs related to developing new products or enhancing existing ones. This is an especially important consideration for companies whose primary business is software development.

How to Save on R&D and get more profits?

Note that R&D costs may not yield profit immediately. They may do so after 1 or 3 years, or even after 5 years. However, you can still gain regular benefits in terms of tax credit, for instance, although this depends on the tax laws of the country in which a business is resident. In any case, to gain more profits from R&D a business must be as fast as possible with research, development, testing, and launching. Also, they must be able to work with the location and cost model, as the points are expanded below:

Nearshore R&D

How much does R&D cost? And how can SMEs reduce it? The high cost of R&D in in-house projects has caused the nearshore approach to become not only a cost-effective option but also a powerful tool for companies that seek to be agile, fast, and efficient in their R&D efforts. This approach is an increasingly attractive one for companies that want to advance their technology at a faster pace and realize greater R&D efficiencies.

Best practices from TOP giants.

Estonia, which is located in the Central part of Europe, has been for a long time a center for scientific research. The area is extremely fertile, and home to world-class universities. Estonia has already become a leading country in IT outsourcing, and it is only the beginning. With developed infrastructure, a highly qualified workforce, and low rates for office spaces, Estonia has become a popular place for international companies to set up their R&D offices.

• Microsoft Development Center Estonia: Microsoft is a notable name in corporate R&D examples as it is one of today’s most valuable tech companies. Microsoft’s research office in Estonia is one of the company’s most ambitious and remote projects. The reason why Microsoft chose Estonia as the location for its R&D centers is the great talent pool of local engineers with experience working at other top IT companies.
• Twilio R & D Center Estonia was opened in 2015 in Tallinn, the capital of Estonia. The value proposition of the institute is quite simple: Twilio established the center to support its operations and help the company adapt to its fast-growing customer base.
• Fujitsu Estonia: Fujitsu’s team in Tallinn is working on new features for the platform and testing them with users. Fujitsu’s goal is to expand its technology and service vision by creating people-centred solutions.

Software R&D Service from ProCoders for successful business up to date

To know how much does research and development cost in software development, perhaps the phase that ProCoders takes most seriously is the discovery phase . This is where adequate research must be conducted to determine the precise needs of the project and set appropriate plans. It has always been a guiding principle in all our projects, although two come to mind now.

When Roth River contacted us for IoT development, our in-depth research enabled us to determine the company’s exact problems and how to best design an app solution fit for the company and its customers. Because of this, our expert developers were able to cut development time by 25% by introducing new flexibility to the team.

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Similarly, in building the fitness app Dryft , our team conducted detailed research to understand the scope of the work and determine the best tools and approaches to creating a solution. The discovery phase was 4 weeks of extensive surveys after assembling a vetted team in days. The result was accelerating time-to-market by 30% despite the complex requirements.

Research and development allow a company to research new products or improve their current ones, which in turn can attract more customers and make those customers happier. A large portion of profits for many businesses is used for research and development, as this is an investment in the future rather than a cost, and it is important to keep up with the competition in order to maintain a strong market share. Profits from R&D may come in the form of sale augmentation, enhancing customer loyalty, adopting premium pricing for greater revenue, as well as innovation towards market leadership status.

R&D isn’t just about creating something from nothing—it’s about researching your market and finding ways to meet the needs of your customers better than anyone else. SMBs tend to have a lot more flexibility and adaptability when it comes to new products and services. If you’ve got a good idea that’s worth putting money into, you can do it without having to worry about the same level of red tape and bureaucracy that would bog down a larger company. SMBs win can be in niche products and services that are left in corporations’ blind zone. R-n-D is exactly about that: find this enhancement and implement it to customers’ journey in your business.

For startups, the key software R&D Services are quick prototyping, discovery phase to determine key features and how we can transfer our business value for our customers, MVP development, fast features development and testing market feedback, fixing bugs, implementing integrations and legal changes. Startups aim to find market fit, launch an MVP, and finally develop a viable product to gain the market. R&D can help startups accelerate 2 to 3 times faster in finding a market fit and increasing success chances.

Conclusion: Key Takeways

• Research and development expenses are growth investments that can help you edge out your competition.
• The purpose of an R&D department is to push the boundaries of existing technology and create breakthroughs.
• The huge billions of US dollars spent on R&D by enterprises such as Intel, Google, Amazon, and Apple might make it seem like the real benefits of R&D might be out of the reach of startups and SMBs.
• However, startups and SMBs can access similar benefits by offshoring R&D and adopting a reasonable cost model.

So how can you improve your company’s R&D strategy and how to reduce R&D cost? You can start by outsourcing. ProCoders has gained extensive experience working with various clients to supercharge their software development projects by elevating R&D through the discovery phase. To see how we can be of help, contact our stellar team today.

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Research and development (R&D) expensing update

July 5, 2023   //    Tax    //   By PKF Mueller Solutions

Section 174 of the Internal Revenue Code (IRC) in the United States pertains to the tax treatment of research and development (R&D) expenses. It provides guidelines for businesses to deduct their qualified R&D expenses as ordinary and necessary business expenses.

Under Section 174, businesses were allowed to deduct R&D expenses incurred in the development or improvement of a product, process, software, formula, or invention. These expenses could include wages, supplies, contract research expenses, and other costs directly related to R&D activities.

The deduction for R&D expenses under Section 174 was taken in the year the expenses were incurred. This means that businesses could immediately deduct the expenses rather than capitalizing and amortizing them over multiple years.

When the Tax Cuts and Jobs Act of 2017 was enacted, this changed. For tax years beginning after 12/31/21, taxpayers had to capitalize and amortize the R&D expenditures incurred in connection with their business over time—five years for domestic and 15 years for foreign incurred R&D. Business reaction was generally unfavorable.

On June 12, 2023, though, the US House and Ways Committee passed their initial tax reform bill out of committee, and it includes the immediate expensing of Section 174 Research & Development expenses and also includes retroactivity to the expiration at the end of 2021. Bipartisan support in the Senate will be needed to finalize. We will continue to monitor this situation for our clients, and we will let you know of any new developments.

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Lesson: Research and development costs - Practice Questions

Research and development costs are costs associated with activities that aim to create new products or improve existing products. These costs can include salaries of researchers, laboratory supplies, and any other expenses incurred in the research and development process. Companies must carefully track these costs as they can be tax deductible. Additionally, research and development costs can be capitalized on the balance sheet, meaning that the costs are spread out over a period of time. This allows companies to spread out the costs over multiple years, resulting in lower costs in the short term.

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US GAAP - Issues and Solutions for Pharmaceutical and Life Sciences: Chapter 8

Chapter 8: research & development.

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8-1 In-licensing agreements

Company A and Company B enter into an agreement in which Company A will in-license Company B’s technology to manufacture a compound to treat HIV. Company A cannot use the technology for any other project or otherwise assign or transfer the technology. Company A has not yet concluded if economic benefits are likely to flow from the compound or if relevant regulatory approval will be granted.

The agreement stipulates that Company A will be permitted to use Company B’s technology in its own facilities for a period of three years. Company A will make a non-refundable payment of $3 million to Company B for access to the technology. Company B will also receive a 20% royalty from any future sales of the compound.

Question: How should Company A account for the in-licensing agreement?

Company A should expense the $3 million when incurred (normally when paid) as research and development costs since the technology has no alternative future uses.

If there are subsequent sales of the compound, the royalty payments of 20% would generally be presented in the income statement within cost of sales as incurred.

Relevant guidance

ASC 730-10-25-1: Research and development costs… shall be charged to expense when incurred...

ASC 730-10-25-2(c): ...the costs of intangible assets that are purchased from others for a particular research and development project and that have no alternative future uses and thus have no separate economic values are research and development costs at the time the costs are incurred.

8-2 Non-refundable upfront payments to conduct research

Company A engages a contract research organization (CRO) to perform research activities for a period of two years in connection with a drug compound related to the treatment of HIV. The CRO is well known in the industry for having modern facilities and good practitioners dedicated to investigation. Company A pays the CRO a non-refundable, upfront payment of $3 million in order to carry out the research under the agreement. The CRO will have to present a quarterly report to Company A with the results of its research. Company A has full rights to the research performed, including the ability to control the research undertaken on the potential cure for HIV. The CRO has no rights to use the results of the research for its own purposes.

Question: How should Company A account for the upfront payment made to the CRO?

Although the payment is non-refundable, Company A will receive a future benefit (the rights to the research) as the CRO performs the research services over the two-year period. Therefore, the upfront payment should be capitalized as a prepayment and recognized in the income statement (as research and development expense) based upon the pattern of performance of the CRO in order to properly expense the costs under the arrangement based upon the level of effort necessary to perform the research services. Company A should continue to evaluate whether it expects the goods to be delivered or services to be rendered each reporting period to assess recoverability.

If the payment from Company A to the CRO (or a portion thereof) represents an advance payment for specific materials, equipment, or facilities that will be used for future research and development activities, it would be capitalized as a prepayment and recognized in the income statement as research and development expense when the related goods are delivered. If at any point Company A does not expect the goods to be delivered, the capitalized prepayment should be charged to expense.

ASC 730-10-25-1: Research and development costs… shall be charged to expense when incurred.

ASC 730-20-25-13: Non-refundable advance payments for goods or services that have the characteristics that will be used or rendered for future research and development activities pursuant to an executory contractual arrangement shall be deferred and capitalized.

8-3 Payments made to conduct research

Company A needs to conduct clinical trials to obtain regulatory approvals for its products. Substantial portions of the company’s clinical trials are contracted with third parties, such as CROs. The financial terms of these contracts are subject to negotiations, may vary from contract to contract and may result in uneven payment flows and timing of expense recognition. For example, CROs commonly require payments in advance of performing clinical trial management services. These advance payments are commonly nonrefundable and made three to six months prior to the start of the research and development activity.

Question: How should Company A account for clinical trial payments?

Company A should record clinical trial expense for work performed by CROs in the period when services are performed, not necessarily when payments are made. An accrual should be recorded based on estimates of services received and efforts expended pursuant to agreements established with CROs and other outside service providers. These estimates are typically based on contracted amounts applied to the number of patients enrolled, the number of active clinical sites, the duration for which the patients will be enrolled in the study and the percentage of work completed to date.

Nonrefundable advance payments for future clinical trial management services should initially be capitalized and then expensed as the related services are performed. Company A should continue to evaluate whether it expects the services to be rendered. If services are not expected to be rendered, the capitalized advance payment should be charged to expense in the period in which this determination is made.

ASC 730-20-25-13: Nonrefundable advance payments for goods or services that have the characteristics that will be used or rendered for future research and development activities pursuant to an executory contractual arrangement shall be deferred and capitalized.

ASC 730-20-35-1: Nonrefundable advance payments... shall be recognized as an expense as the related goods are delivered or the related services are performed.

8-4 Fixed-fee contract research arrangements

Company A enters into a contract research arrangement with Company B. Company B will perform research on a library of molecules and will catalogue the research results in a database.

Company A will pay Company B $3 million only upon completion of the contracted work. The payment is based on delivery of the research services. There are no success-based contingencies.

Question: How should Company A account for the contract research arrangement?

Company A should accrue a liability for the costs of the contract research arrangement (with an offset to research expenses) as Company B performs the services. Company A will need some visibility into Company B’s pattern of performance in order to properly expense the contract research costs under the arrangement based upon the level of effort necessary to perform the research services. The timing of the payment does not alter the timing of the expense recognition.

ASC 730-10-25-2(d): Contract services. The costs of services performed by others in connection with the research and development activities of an entity, including research and development conducted by others [on] behalf of the entity, shall be included in research and development costs.

8-5 Third-party development of intellectual property

Company A has appointed Company B, an independent third party, to develop an existing compound owned by Company A on its behalf. Company B will act purely as a service provider without taking any risks during the development phase and will have no further involvement after regulatory approval. Company A will retain full ownership of the compound. Company B will not participate in any marketing or production arrangements. Company A will make a $2 million non-refundable payments to Company B on signing the agreement, and an additional payment of $3 million on successful completion of Phase II testing.

Question: How should Company A account for the upfront and subsequent milestone payments?

The initial upfront payment represents a prepayment for future development by a third party and should be capitalized and then amortized as Company B performs the research using a pattern that accurately depicts performance. Company A should expense the milestone payment when it is probable the payment will be made unless the milestone payment is intended to compensate Company B for future development services. In such instance, Company A should capitalize the milestone payment and amortize it over the performance period in a pattern consistent with the pattern of underlying performance.

ASC 730-10-25-1: Research and development costs... shall be charged to expense when incurred.

8-6 Recording a milestone payment due to a counterparty

Company A entered into a collaboration arrangement with Company B. Company A paid Company B an upfront fee upon signing the arrangement and will pay Company B a discrete milestone payment of $2 million upon FDA approval.

Question: When should Company A record the milestone payment due to Company B?

Under the contractual terms of the agreement, the milestone payment becomes payable upon the resolution of a contingency. Company A should accrue the milestone payment when the achievement of the milestone is probable (the amount of the payment is reasonably estimable, as it is a fixed amount under the terms of the arrangement).

Due to the uncertainties associated with the FDA approval process, it may be difficult for Company A to conclude that achievement of the milestone is probable prior to notification of FDA approval. All facts and circumstances regarding the nature of the milestone should be considered when evaluating when the achievement of a milestone is probable.

ASC 450-20-25-2: An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

Information available before the financial statements are issued or are available to be issued... indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements...

The amount of the loss can be reasonably estimated

8-7 External development of intellectual property with buy-back options

Company A has out-licensed the development of an existing compound to Company B, an independent third party, multi-national public company. There was no upfront consideration paid between the parties. Company A will neither retain any involvement in the development of its compound nor participate in the funding of the development. The out-license agreement includes the following terms:

If the development fails, Company B bears all the costs it incurred without any compensation.

If the development is successful, Company A can elect to buy-back the rights to the compound and pay Company B an agreed fixed buy-back payment.

• If the development is successful and Company A does not buy back the compound, Company B can commercialize the compound on its own.

Question: How should Company A account for payments in an arrangement in which a third party develops its intellectual property?

Company A effectively removes its exposure to failure of the development of its compound, having transferred all development risks to Company B. In this case, there are no indicators that would lead to a presumption that the buyback will occur and that a liability should be recognized before any decision to reacquire the rights occurs.

If  Company A  exercised the buy-back option, it would reacquire the rights to commercialize the intangible asset. Since exercisability of the buy-back option is only triggered upon regulatory approval, the payment made by Company A to reacquire the rights would be capitalized when the option is exercised and then amortized over the useful life of the right.

ASC 730-20-25-3: If the entity is obligated to repay any of the funds provided by the other parties regardless of the outcome of the research and development, the entity shall estimate and recognize that liability. This requirement applies whether the entity may settle the liability by paying cash, by issuing securities, or by some other means.

ASC 730-20-25-4: To conclude that a liability does not exist, the transfer of the financial risk involved with research and development from the entity to the other parties must be substantive and genuine. To the extent that the entity is committed to repay any of the funds provided by the other parties regardless of the outcome of the research and development, all or part of the risk has not been transferred...

ASC 730-20-25-6: Examples of conditions leading to the presumption that the entity will repay the other parties include any of the following:

The entity has indicated an intent to repay all or a portion of the funds provided regardless of the outcome of the research and development.

The entity would suffer a severe economic penalty if it failed to repay any of the funds provided to it regardless of the outcome of the research and development...

A significant related party relationship between the entity and the parties funding the research and development exists at the time the entity enters into the arrangement.

The entity has essentially completed the project before entering into the arrangement.

ASC 730-20-25-9: If the entity’s obligation is to perform research and development for others and the entity subsequently decides to exercise an option to purchase the other parties’ interests in the research and development arrangement or to obtain the exclusive rights to the results of the research and development, the nature of those results and their future use shall determine the accounting for the purchase transaction or business combination…

8-8 Donation payment for research

Company A has made a non-refundable gift of $3 million to a university. The donation must be used to fund research activities in the area of infectious diseases over a two-year period. Company A has no right to access the research findings.

Question: How should Company A recognize the donation?

Company A should expense the donation (generally as selling, general and administrative expense) when incurred (normally when paid) or at the time an unconditional promise to give cash is made, whichever is sooner.

ASC 720-25-25-1: Contributions shall be recognized as expenses in the period made and as decreases of assets or increases of liabilities depending on the form of benefits given. For example...unconditional promises to give cash are recognized as payables and contribution expenses...

ASC 958-720-25-2:  Unconditional promises to give  shall be recognized at the time the donor has an obligation to transfer the promised assets in the future, which generally occurs when the donor approves a specific grant or when the recipient of the promise is notified...If payments of the unconditional promise to give are to be made to a recipient over several fiscal periods and the recipient is subject only to routine performance requirements, a liability and an expense for the entire amount payable shall be recognized.

8-9 Capitalization of interest incurred on loans received to fund research and development

Company A has obtained a loan from Company B, another pharmaceutical company, to finance the late-stage development of a drug to treat cancer.

Question: Can Company A capitalize the interest incurred for borrowings obtained to finance research and development activities?

Borrowing costs associated with research and development projects should be expensed as incurred as they do not qualify for capitalization.

ASC 835-20-15-5: Interest shall be capitalized for the following types of assets (qualifying assets):

Assets that are constructed or otherwise produced for an entity’s own use, including assets constructed or produced for the entity by others for which deposits or progress payments have been made.

Assets intended for sale or lease that are constructed or otherwise produced as discrete projects (for example ships or real estate developments).

Investments (equity, loans, and advances) accounted for by the equity method while the investee has activities in progress necessary to commence its planned principal operations provided that the investee’s activities include the use of funds to acquire qualifying assets for its operations. The investor’s investment in the investee, not the individual assets or projects of the investee, is the qualifying asset for purposes of interest capitalization.

8-10 Treatment of trial batches in development

Company A, a commercial laboratory, is manufacturing a stock of 20,000 doses (trial batches) of a newly-developed drug using various raw materials. The doses can only be used in patient trials during Phase III clinical testing, and cannot be used for any other purpose. The raw materials can be used in the production of other approved drugs.

Question: How should Company A account for the raw materials and trial batches?

Company A should initially recognize the raw materials acquired for the production of trial batches as inventory since the raw materials have alternative future use in the production of other approved drugs. As the trial batches do not have any alternative future use and the technical feasibility of the drug is not proven (the drug is in Phase III), the cost of the trial batches (including the cost of the raw materials used in their production) should be charged to research and development expense as they are produced.

ASC 730-10-25-2(a): Materials, equipment, and facilities. The costs of materials (whether from the entity’s normal inventory or acquired specially for research and development activities) and equipment or facilities, that are acquired or constructed for research and development activities and that have alternative future uses (in research and development projects or otherwise) shall be capitalized as tangible assets when acquired or constructed…

However, the cost of materials, equipment or facilities that are acquired or constructed for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred.

8-11 Fixed asset purchases used in research and development

Company A incurs costs to construct the plant and facility that will be used to produce a medical device that has not yet received FDA approval. The plant and facility will be used to produce the device, at commercially viable levels, once regulatory approval has been obtained.

The project is in an advanced stage and Company A believes regulatory approval will be obtained and that recovery of the costs to construct the plant and facility via future cash flows is probable.

Question: Should Company A expense costs associated with the construction of tangible assets as incurred, or is there a basis for capitalization of those expenditures?

The important distinction is whether the construction costs represent research and development costs subject to the guidance in ASC 730. Because the construction activities pertain to tangible assets that will be used to produce the end product at commercially viable levels, rather than costs associated with testing the product or the construction of a pilot facility or pre-production prototype not involving a scale that is economically feasible for commercial production, the costs of construction would not be considered research and development cost as contemplated in ASC 730.

The costs would be subject to the more general concepts of fixed asset accounting and the related impairment considerations. Company A should capitalize the construction costs incurred as plant and equipment. The assets would be subject to impairment testing based on the expected future cash flows of the assets, which would consider the various potential outcomes of the regulatory approval process and their associated likelihoods.

ASC 730–10–20, Research and development: Research is 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 or service (referred to as product) or a new process or technique (referred to as process) or in bringing about a significant improvement to an existing product or process.

Development is the 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 whether intended for sale or use. It includes the conceptual formulation, design, and testing of product alternatives, construction of prototypes, and operation of pilot plants.

8-12 Accounting for funded research and development arrangements

Company A partners with Investor B, an unrelated financial investor, for the development of selected compounds that are in Phase II development. Investor B commits a specified dollar amount to fund the research and development of the selected compounds. In exchange for the funding, Investor B will receive royalties on future sales of product resulting from the compounds being developed. Investor B will not be repaid if the compounds are not successfully developed (i.e., the transfer of financial risk for the research and development is substantive). Investor B does not participate in any of the development or commercialization activities.

Question: What factors should Company A consider to determine the most appropriate accounting model for the research and development funding?

While ASC 730–20 only relates to research and development funding, ASC 470–10–25 does not specifically exclude research and development funding arrangements from its scope. If the research and development risk is substantive, such that it is not yet probable the development will be successful, the guidance in ASC 730-20 would generally be followed. However, if the successful completion of the research and development is already probable at the time the funding is received, the guidance in ASC 470-10-25 is applicable.

Company A should assess whether the contractual arrangement with Investor B meets all of the characteristics of a derivative, and if so, whether any of the scope exceptions to derivative accounting are applicable. Since Investor B would only receive royalties on future sales (assuming the development is successful), the settlement provisions under this contract are based on specified volumes of items sold. Therefore, the royalty exception would apply and Company A would not account for this arrangement as a derivative.

To conclude that a liability does not exist, the transfer of financial risk involved with the research and development from Company A to Investor B must be substantive and genuine. When assessing the substance of the transfer of financial risk, Company A should consider any explicit or implicit obligations to repay any or all of the funding and consider the examples in ASC 730-20-25-6.

If Company A determines that there is significant risk associated with the research and development and that successful development is not probable, Company A would apply the guidance in ASC 730-20 to evaluate whether the research and development funding is a liability to repay the funding party or an obligation to perform contractual services.

In this example, Company A has no explicit or implicit obligation to repay any of the funds and therefore determines that the arrangement is an obligation to perform contractual research and development services.

ASC 730-20-05, Research and development arrangements, this subtopic provides guidance on research and development arrangements.  Research and development arrangements have been used to finance the research and development of a variety of new products, such as…medical technology, experimental drugs…

ASC 730-20-25-1: This Subtopic deals with transactions in which the issue is whether, at the time an entity enters into a  research and development  arrangement:

The entity is committed to repay any of the funds provided by the other parties regardless of the outcome of the research and development.

Existing conditions indicate that it is likely that the entity will repay the other parties regardless of the outcome.

The entity is obligated only to perform research and development work for others.

ASC 470-10-25-1: An entity receives cash from an investor and agrees to pay to the investor for a defined period a specified percentage or amount of the revenue or of a measure of income (for example, gross margin, operating income, or pretax income) of a particular product line, business segment, trademark, patent, or contractual right.  It is assumed that immediate income recognition is not appropriate due to the facts and circumstances.

ASC 815-10-15-59(d): Contracts that are not exchange-traded are not subject to the requirements of this Subtopic if the underlying on which the settlement is based is any one of the following… Specified volumes of sales or service revenues of one of the parties to the contract. (This scope exception applies to contracts with settlements based on the volume of items sold or services rendered, for example, royalty agreements. This scope exception does not apply to contracts based on changes in sales or revenues due to changes in market prices.)

8-13 Research and development reimbursed by a third party

Company A is a medical diagnostics company that is conducting research and development for a new diagnostic test. The research and development activities are funded by Company B. If the research and development activities are not successful, Company A is not obligated to refund any payment previously received from Company B. Any intellectual property developed under this arrangement would belong to Company B.

Question: How should Company A report the research and development funding it receives from Company B?

Guidance related to determining whether a liability exists for research and development funding arrangements is provided in ASC 730–20, Research and Development Arrangements.

Company A should consider that the financial risk associated with the research and development remains with Company B. Therefore, Company A should not recognize a liability associated with this funding. Company A should record contract revenue as it performs the contractual research and development services.

This scenario assumes the research and development is the only performance obligation in the arrangement. If there were other performance obligations, revenue would be allocated to each based on relative standalone selling price (ASC 606-10-65-1).

ASC 808, Collaborative Arrangements, provides guidance on reporting requirements and income statement classification for transactions between participants in a collaborative arrangement.

For government-sponsored research and development grants, the AICPA industry guide, Audits of Federal Government Contractors, addresses the accounting for certain best-efforts research and development cost-sharing arrangements.

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• 10 April 2024

How to supercharge cancer-fighting cells: give them stem-cell skills

• Sara Reardon 0

Sara Reardon is a freelance journalist based in Bozeman, Montana.

You can also search for this author in PubMed   Google Scholar

A CAR T cell (orange; artificially coloured) attacks a cancer cell (green). Credit: Eye Of Science/SPL

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Bioengineered immune cells have been shown to attack and even cure cancer , but they tend to get exhausted if the fight goes on for a long time. Now, two separate research teams have found a way to rejuvenate these cells: make them more like stem cells .

Both teams found that the bespoke immune cells called CAR T cells gain new vigour if engineered to have high levels of a particular protein. These boosted CAR T cells have gene activity similar to that of stem cells and a renewed ability to fend off cancer . Both papers were published today in Nature 1 , 2 .

The papers “open a new avenue for engineering therapeutic T cells for cancer patients”, says Tuoqi Wu, an immunologist at the University of Texas Southwestern in Dallas who was not involved in the research.

Reviving exhausted cells

CAR T cells are made from the immune cells called T cells, which are isolated from the blood of person who is going to receive treatment for cancer or another disease. The cells are genetically modified to recognize and attack specific proteins — called chimeric antigen receptors (CARs) — on the surface of disease-causing cells and reinfused into the person being treated.

But keeping the cells active for long enough to eliminate cancer has proved challenging, especially in solid tumours such as those of the breast and lung. (CAR T cells have been more effective in treating leukaemia and other blood cancers.) So scientists are searching for better ways to help CAR T cells to multiply more quickly and last longer in the body.

Cutting-edge CAR-T cancer therapy is now made in India — at one-tenth the cost

With this goal in mind, a team led by immunologist Crystal Mackall at Stanford University in California and cell and gene therapy researcher Evan Weber at the University of Pennsylvania in Philadelphia compared samples of CAR T cells used to treat people with leukaemia 1 . In some of the recipients, the cancer had responded well to treatment; in others, it had not.

The researchers analysed the role of cellular proteins that regulate gene activity and serve as master switches in the T cells. They found a set of 41 genes that were more active in the CAR T cells associated with a good response to treatment than in cells associated with a poor response. All 41 genes seemed to be regulated by a master-switch protein called FOXO1.

The researchers then altered CAR T cells to make them produce more FOXO1 than usual. Gene activity in these cells began to look like that of T memory stem cells, which recognize cancer and respond to it quickly.

The researchers then injected the engineered cells into mice with various types of cancer. Extra FOXO1 made the CAR T cells better at reducing both solid tumours and blood cancers. The stem-cell-like cells shrank a mouse’s tumour more completely and lasted longer in the body than did standard CAR T cells.

Master-switch molecule

A separate team led by immunologists Phillip Darcy, Junyun Lai and Paul Beavis at Peter MacCallum Cancer Centre in Melbourne, Australia, reached the same conclusion with different methods 2 . Their team was examining the effect of IL-15, an immune-signalling molecule that is administered alongside CAR T cells in some clinical trials. IL-15 helps to switch T cells to a stem-like state, but the cells can get stuck there instead of maturing to fight cancer.

The team analysed gene activity in CAR T cells and found that IL-15 turned on genes associated with FOXO1. The researchers engineered CAR T cells to produce extra-high levels of FOXO1 and showed that they became more stem-like, but also reached maturity and fought cancer without becoming exhausted. “It’s the ideal situation,” Darcy says.

Stem-cell and genetic therapies make a healthy marriage

The team also found that extra-high levels of FOXO1 improved the CAR T cells’ metabolism, allowing them to last much longer when infused into mice. “We were surprised by the magnitude of the effect,” says Beavis.

Mackall says she was excited to see that FOXO1 worked the same way in mice and humans. “It means this is pretty fundamental,” she says.

Engineering CAR T cells that overexpress FOXO1 might be fairly simple to test in people with cancer, although Mackall says researchers will need to determine which people and types of cancer are most likely to respond well to rejuvenated cells. Darcy says that his team is already speaking to clinical researchers about testing FOXO1 in CAR T cells — trials that could start within two years.

And Weber points to an ongoing clinical trial in which people with leukaemia are receiving CAR T cells genetically engineered to produce unusually high levels of another master-switch protein called c-Jun, which also helps T cells avoid exhaustion. The trial’s results have not been released yet, but Mackall says she suspects the same system could be applied to FOXO1 and that overexpressing both proteins might make the cells even more powerful.

Nature 628 , 486 (2024)

doi: https://doi.org/10.1038/d41586-024-01043-2

Doan, A. et al. Nature https://doi.org/10.1038/s41586-024-07300-8 (2024).

Article   Google Scholar  

Chan, J. D. et al. Nature https://doi.org/10.1038/s41586-024-07242-1 (2024).

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