In 2018, Paul Romer won Noble for his long-standing work on how investments fuels microeconomic growth. His words of caution were- Quit seeing research and development (R&D) as optional spending. Champion a new approach: turn your development costs into assets.
It was one of those wakeup calls for engineering leadership to embrace cost capitalization, and streamline engineering expenses.
Fast forward to 2023, software companies are adopting aggressive growth goals. For engineering leaders, the top financial hurdle to hit these goals revolves around dissecting engineering expenses and pinpointing where value truly originates. Enter R&D cost capitalization, a strategic avenue to tackle this challenge head-on.
R&D cost capitalization is a legal accounting practice where software R&D costs, like FTE wages, and software licenses, are listed as investment, rather than an expense. In simpler terms, you're not just spending money; you're investing in your company’s future.
Today, every engineering team is working on the next big thing, and software development demands resources - be it time, or scientific manpower. These development costs can run in millions, often costing upto 63% of a project’s budget- making their financial sustainability a center point of C-suite discussions. While a significant portion is recognized as expenses, R&D cost capitalization helps turn some immediate expenditure into long-term, strategic costs.
The cost capitalization framework is solidly outlined under the International Financial Reporting Standards (IFRS) and the US Generally-Accepted Accounting Principles (GAAP) regulations. However, as of now, GAAP has stayed silent on the proportion of software expenses eligible for capitalization. Nevertheless, over the past half-decade, the US has successfully capitalized approximately 17% of their expenditures, with an eye on capitalizing an additional 12%.
Continuous innovation is the lifeblood of engineering teams today. It requires resources to thrive, and cost capitalization as a financial strategy makes it achievable. Here are some reasons why engineering teams should adopt R&D cost capitalization:
Adopting R&D cost capitalization enables companies to treat certain strategic costs as assets instead of keeping them under the profit and loss (P&L) section of their balance sheets.
That way, balance sheets create a more accurate representation of an org’s financial health, and they can distribute their costs over time, avoiding a hefty one-time hit in a fiscal year. This might attract investors and stakeholders, showing them the value created for the company's future.
These costs are spread using the straight-line method over a period of two to five years, to create a revenue-time continuum for the developed product.
Organizations with higher R&D assets experience increased profitability. Reported profits have seen a jump of 14% after companies began to capitalize their R&D expenses.
Capitalizing R&D costs acknowledges that innovation is an investment, not just an expense. It aligns financial reporting with the reality that these expenditures can yield returns beyond the current fiscal year.
Capitalizing some percentage of software costs comes handy in leveraging tax incentives, and effectively streamlining Ebitda (earnings before interest, tax, depreciation and amortization). A higher Ebitda translates into better company financials, and higher profits in books.
According to a recent Livingstone analysis, the average EBITDA margin settles at approximately -6% after factoring in the R&D cost capitalization. However, this figure drops further to -8.5%, when R&D costs are treated as regular expenses.
Financial clarity is a must for engineering leaders. Or it is becoming more so now because dollars don’t come in easy. Capitalizing R&D costs translates into effectively assessing project RoIs. This informed decision-making can lead to allocating resources to initiatives with higher potential– paving the way for engineering success.
Not all expenses can be transformed into assets, and the GAAP rules have been pretty clear about what qualifies for cost capitalization.R&D costs must meet certain criteria to earn their spot as an asset on the balance sheet:
Technology feasibility: The Capitalizable costs must translate into a tangible product or process.
Intent to complete: A clear commitment snowballs into a well-defined plan, and filters out half-baked endeavors.
Economic potential: Go-to market projections, and proof that the product will yield financial returns down the line.
GAAP’s FASB Account Standard Codification ASC Topic 350 – Intangibles deals with internal-use only software eligible for capitalization:
Software developed for internal-use only. The moment a company intends to sell the prototype, it will become an expense.
Activities undertaken during development stage- testing, coding, and installation
Software maintenance, and user training
FTE compensation of engineers involved in the development for aforesaid period
On the other hand, FASB Accounting Standards Codification (ASC) Topic 985 – Software deals with sellable software for external use. It includes:
Costs incurred in the technology feasibility stage
Activities undertaken during development stage- testing, coding, and installation, independent consultations, product development, and FTE compensation
However, costs associated with initial planning, and prototyping cannot be capitalized, and hence not exempted for tax calculations.
Generally, tech companies capitalize engineering compensation, product owners, and third-party platforms, algos, cloud services, and development tools. Moreover, in some cases, an organization’s acquisition targets too can be capitalized, and amortized.
While software capitalization helps engineering organizations to revamp their balance sheets, it has been increasingly difficult to capitalize R&D costs over the years.
Originally, the GAAP practices were invented when software companies were still following the traditional waterfall model. However, times have changed, and so has the approach to building tech products. Today, companies no longer follow the linear method of development. The feedback loops are more dynamic now, and teams do not have to follow a fixed approach to software engineering.
When teams analyze, plan, design, and develop simultaneously in real-time, it becomes difficult for engineering teams to capitalize R&D costs at each stage. The term ‘technological feasibility’ itself leaves a lot of room for interpretation. With cutting-edge tools and platforms emerging constantly, assessing the feasibility of your next product against ever-changing benchmarks is a daunting task.
Another challenge for teams is around quantifying efforts under cost capitalization. Engineering leadership is under constant pressure to deliver multiple projects at once, making it increasingly difficult to log work hours manually for each IC. Currently, a lot of engineering managers, and senior leadership are trying their luck with Jira issues, and HR outputs to calculate capitalizable costs for FTEs. The process is too time-consuming, plagued by accuracy and precision concerns, and prone to human errors.
At times, this issue can snowball into micromanaging, and bossware, where ICs are constantly on their toes to report the exact number of hours spent on specific projects and dissecting the balance between core and non-core responsibilities. Moreover, when devs are constantly context switching between debugging, reviewing PRs, and writing code– pinpointing exact hours devoted to strategic initiatives becomes an intricate challenge.
The struggle to maintain a seamless input flow for calculating capitalizable costs sometimes feels like trying to hold water in cupped hands. Moreover, a lot of vagueness, and guesswork creeps in when engineering teams are unsure about how each engineering activity ties to the end business results, and falls under the overall schema of R&D costs.
This kind of expense tracking is culturally prohibitive for software teams, and comes at the cost of overwhelmed developers, team performance, and developer autonomy- all creating challenges for engineering managers, and the top-brass leadership.
R&D cost capitalization is a potent, and perfectly legal accounting practice. It demands not just adherence to rules but a deep understanding of the engineering pulse. The balance between financial precision and the fluidity of technology is a tightrope to walk. However, it does get easier with the right set of tools, and objectively tracking software spending.
For companies considering R&D cost capitalization, a systematic approach is essential. It involves collaboration between finance, accounting, and R&D teams, to strike a balance between short-term profitability and long-term growth.
The best way forward is data-driven engineering analytics. Manually collating data-points comes with enormous opportunity cost, and even lacks insights for engineering leadership to make sense of the outputs that lack outright precision, and accuracy.
Engineering analytics help teams to move away from excel sheets, towards an automated, objective, and real-time tracking of engineering effort, and spending. This way, teams can produce traceable data from all workapps without having to put manual, yet crucial hours into fetching numbers across a digital toolstack.
The path to effective R&D cost capitalization requires collaboration, transparency, and a keen understanding of accounting principles. It involves harmonizing the visions of R&D teams and financial experts to make informed decisions that resonate with both growth, and fiscal prudence.