Research and

Development
(R & D)
Expenses
Research and
Development (R&D)
expenses are crucial
investments for companies
aiming to innovate and
stay competitive in their
industries. These expenses
cover a wide range of
activities aimed at
developing new products,
improving existing ones,
and discovering new
knowledge that can lead to
better business practices.
This carousel explores the
various facets of R&D
expenses, types of R&D
expenses, industries with the
highest R&D cost, their
importance, impact on
financial analysis, and how it
is interpreted by the analyst,
challenges of high R&D cost,
how they are accounted for
and its impact on the
financial statements.
Definition of R & D
Expense
R&D expenses encompass all
costs associated with the
research and development of
a company’s products or
services. These costs typically
include:
Personnel
Costs
Salaries, wages, and
benefits for employees
directly involved in R&D
activities.
Materials and
Supplies
Costs of raw materials
and supplies used in
R&D projects.
Contract
Services
Payments to third-
party contractors or
consultants for R&D
services
Personnel
Costs
Salaries, wages, and
benefits for employees
directly involved in R&D
activities.
Software and
Technology
Expenditures for
specialized software and
technology utilized in
research and
development activities
 Industries
with highest
R&D
expenses with
examples
Industries with the
highest R&D costs are
typically those that are
highly innovation-
driven and require
significant investments
in technology and
product development.
The most notable
industries include:
Pharmaceuticals and
Biotechnology
Nature of R&D: Drug discovery,
clinical trials, and regulatory
approvals.
R&D Intensity: Extremely high due to
the long development cycles, high
failure rates, and stringent
regulatory requirements.
Impact: New drug development
and biotechnological
advancements.
Examples: Pfizer, Roche, Merck & Co.
Technology and
Software
Nature of R&D: Development of new
software, hardware, and IT services.
R&D Intensity: High, as companies
continuously innovate to keep up with
rapid technological changes and
consumer demands.
Impact: Advances in software,
cybersecurity, AI, and consumer
electronics.
Examples: Apple, Alphabet(Google),
Nvidia
Automotive
Nature of R&D: Development of new
vehicle models, electric vehicles (EVs),
autonomous driving technologies, and
safety features.
R&D Intensity: High, driven by the need
for innovation in efficiency, safety, and
environmental standards.
Impact: Development of electric
vehicles (EVs), autonomous cars, and
advanced driver-assistance systems
(ADAS).
Examples: Tesla, Toyota, Volkswagen
Telecommunications

Nature of R&D: Development of new

communication technologies,
infrastructure, and devices.
R&D Intensity: High, with a focus on
enhancing connectivity, data
transmission, and network security.
Impact: Advances in 5G technology,
network equipment, and consumer
communication devices.
Examples: Huawei, AT&T Inc., Verizon
Communication, Qualcomm
Incorporated
Aerospace and
Defence
Nature of R&D: Development of new
aircraft, defense systems, and space
exploration technologies.
R&D Intensity: High due to the
complexity, safety standards, and
cutting-edge technologies involved.
Impact: Innovations in military
defense, commercial aviation, and
space travel.
Examples: Boeing, Lockheed Martin,
Airbus
Electronics and
Semiconductors
Nature of R&D: Development of new
electronic components, semiconductors,
and consumer electronics.
R&D Intensity: High, driven by the need
for miniaturization, increased
performance, and energy efficiency.
Impact: Progress in semiconductor
technology, consumer electronics, and
industrial electronics.
Examples: Intel Corporation, Samsung
Electronics Ltd, Taiwan Semiconductor
Manufacturing Company
Chemical
Nature of R&D: Development of new
chemicals, materials, and industrial
processes.
R&D Intensity: High, with a focus on
creating more efficient, sustainable,
and innovative chemical products.
Impact: Development of advanced
materials, specialty chemicals, and
environmentally friendly processes.
Examples: BASF SE, Dow Inc., DuPont
de Nemours Inc.
Medical Devices
Nature of R&D: Development of new
medical instruments, diagnostic
equipment, and healthcare
technologies.
R&D Intensity: High due to the need for
innovation in medical treatments,
diagnostics, and regulatory compliance.
Impact: Introduction of advanced
medical devices, diagnostic tools, and
healthcare solutions.
Examples: Medtronic plc, Johnson &
Johnson (J&J) - Medical Devices
Segment, Siemens Healthineers AG
Medical Devices
Nature of R&D: Development of new
medical instruments, diagnostic
equipment, and healthcare
technologies.
R&D Intensity: High due to the need for
innovation in medical treatments,
diagnostics, and regulatory compliance.
Impact: Introduction of advanced
medical devices, diagnostic tools, and
healthcare solutions.
Examples: Medtronic plc, Johnson &
Johnson (J&J) - Medical Devices
Segment, Siemens Healthineers AG
Accounting for
R & D under US
GAAP and
IFRS
 Under U.S. GAAP, the accounting
for R&D expenses is governed by
the Financial Accounting
Standards Board (FASB)
Accounting Standards
Codification (ASC) Topic 730,
Research and Development.

US GAAP
Key Principles
Expense Recognition
Typically, all R&D expenditures
are recognized as expenses
when incurred. This includes
salaries, materials, overhead,
and contract services related
to R&D activities.
Costs associated with
software development
intended for sale are
treated under ASC 985-
20, where costs incurred
before technological
feasibility is established
are expensed. Costs
incurred after achieving
technological feasibility
but before the product is
ready for sale can be
capitalized.
Capitalization
Under ASC 730, there is
limited scope for the
capitalization of R&D costs.
Most R&D expenses must
be expensed as they are
incurred, reflecting the
uncertainty and risk
associated with R&D
activities.
Disclosure
Requirements

Companies are required to

disclose the total R&D
expenses incurred during the
reporting period.

Additional disclosures may

include a description of the
nature of R&D activities and
any capitalized software
development costs.
IFRS
Under IFRS, the treatment of R&D
expenses is primarily governed by
the International Accounting
Standard (IAS) 38, Intangible Assets.

Key Principles
Expense Recognition
Research costs are expensed
as incurred. These costs are
defined as activities aimed at
obtaining new knowledge
without specific commercial
objectives.

• However,
development costs can
be capitalized if specific
criteria are satisfied
Capitalization
Development costs are capitalized when
they meet specific criteria outlined in IAS
38. These criteria include:

Technical feasibility of
completing the
intangible asset.

Intention to complete
and use or sell the asset.
Capability to utilize or sell the
asset effectively.

Expected mechanisms through

which the intangible asset will
likely yield future economic
benefits.

Availability of sufficient technical,

financial, and other resources to
complete the development.
Ability to reliably
measure the expenditure
attributable to the
intangible asset during
its development.

If these criteria are not

met, development costs
must be expensed as
incurred.
Disclosure
Requirements
Companies must
disclose the total
amount of research
and development
expenditure recognized
as an expense during
the period.
 For capitalized
development costs,
companies must
disclose the
amortization methods
used, useful lives, and
other relevant details
Impact of R &D

cost on financial
statement

Income Statement
R&D costs appear as
an operating
expense, reducing
the operating profit
and net income for
the period in which
they are incurred.
High R&D expenses
can lead to lower
short-term
profitability but
may signal the
potential for long-
term growth
Let us have a look at
how two of the most
prominent companies
in the pharmaceutical
industry and the
Information
Technology industry
present R&D costs in
their Income
Statements.
 From the Consolidated Income
Statement of Merck & Co. Inc., we can
see that the total research and
development cost incurred by the
company in fiscal year 2023 is $30,531
million, and in 2022 is $13,548 million.

Pharmaceutical
Company: Merck
& Co. Inc
 Technology Company:
NVIDIA Corporation

From the Consolidated

Income Statement of
NVIDIA Corporation, we
can see that the total
research and
development cost
incurred by the company
in the fiscal year 2023 is $
7.3 billion and in 2022 is $
5.3 billion.
Balance Sheet

If development costs are

capitalized, they are
recorded as intangible
assets on the balance sheet.

The amortization of these

capitalized costs affects future
periods' earnings, spreading the
expense over the asset's useful life.
Cash Flow
Statement

R&D costs are included

in operating activities in
the cash flow statement,
impacting the cash flow
from operations.
Capitalized
development costs
appear as investing
activities, reflecting

cash outflows for the

acquisition of
intangible assets.
Impact of R & D
costs on key
financial
metrics

Profitability Ratios
Gross Profit Margin:

High R&D costs can reduce the gross

profit margin in the short term but
may lead to higher margins in the
future if the investments result in
successful products.
Operating Profit Margin:

R&D expenses are typically

included in operating
expenses, affecting the
operating profit margin. A
higher R&D expense can
lower the margin initially,
but successful innovation
can improve profitability
over time.
Return Ratios
Return on Assets (ROA)

Significant R&D investments

can lower ROA in the short
term as these costs are
expensed immediately.
However, successful R&D
projects can enhance asset
utilization and improve ROA
in the long run
Return on Equity (ROE)

R&D costs can impact

ROE by affecting net
income. While high R&D
spending may decrease
ROE initially, the long-
term returns from
successful innovations
can enhance
shareholder value
Cash Flow Analysis
Operating Cash Flow

Research and development

(R&D) expenditures typically
decrease short-term
operating cash flow. Analysts
assess the adequacy of cash
flows to support ongoing R&D
investments.
Free Cash Flow

High R&D spending can

impact free cash flow,
which is crucial for
evaluating a company's
ability to fund future
projects, pay dividends, and
meet other obligations.
How Analysts
Interpret R D
&
costs
Comparative Analysis
Higher-than-average R&D
expenses may indicate a
more aggressive innovation
strategy, while lower-than-
average spending could
signal a potential risk of
falling behind competitors.
Analysts compare
R&D spending with
industry peers to
evaluate a
company's relative
investment in
innovation.
Trend Analysis
Examining trends in
R&D spending over
time helps analysts
understand a
company's strategic
focus and
commitment to
innovation.
Consistent or increasing
R&D investment is
generally viewed
positively, suggesting a
long-term growth
strategy.
Efficiency Metrics
Analysts use metrics
like R&D intensity
(where R&D
expenditures are
expressed as a
percentage of sales) to
evaluate the
effectiveness of R&D
investments.
Merck & Co. Inc.
calculate the R&D
cost as a percentage
of sales for the fiscal
years 2023 and 2022
as follows from the
above income
statement.
We can note that in the year 2022, the
R&D cost is 23% of the Sales while in
the year 2023, it almost rose to 50%.
As the company mentions below in
2023, R&D expenses rose to $30.5
billion from $13.5 billion in 2022,
driven by significant business
development activities including
acquisitions and collaborations, as
well as increased spending on new
programs and higher employee
costs. This increase was slightly
offset by reduced intangible asset
impairment charges.
NVIDIA Corporation calculates the R&D
cost as a percentage of sales for the
fiscal years 2023 and 2022 as follows
from the above income statement.
The ratio is 27.2% for 2023 and 19.6% for 2022.
The ratio has increased from 2022 to 2023. In
2023, NVIDIA's rise in R&D expenses as a
percentage of sales can be attributed to
several factors.
The increase in research
and development
expenses for the fiscal
year 2023 was primarily
driven by increased
compensation, employee
growth, engineering
development costs, and
data center infrastructure
Primarily, the company
increased its overall investment
in new technologies, such as AI,
data centers, and automotive
platforms, which led to a
significant uptick in R&D costs.
Despite a slight revenue
increase, the substantial growth
in R&D expenditures resulted in
a larger proportion of sales
being dedicated to research
and development.
This strategic approach
underscores NVIDIA's
dedication to innovation
and sustaining its
competitive advantage
in dynamic technology
sectors
Evaluating the return on
R&D investment
involves looking at the
outcomes of R&D
efforts, such as new
product launches,
patents filed, and
revenue generated
from new products.
Impact on Valuation
Models

R&D costs are factored

into valuation models,
such as discounted cash
flow (DCF) analysis, to
project future cash flows
and earnings.
The potential
future benefits of
R&D investments
are considered
when estimating
the company's
intrinsic value.
Importance of
R & D costs in
financial
analysis
Some of the importance of
R&D Costs in Financial
Analysis are as follows:
Indicator of
Innovation Capability

R&D expenses are

a direct measure
of a company's
investment in
innovation and
new product
development.
High R&D spending
can indicate a
strong pipeline of
future products and
technologies,
enhancing the
company's growth
potential.
Competitive
Advantage

Companies with
substantial R&D
investments are often
better positioned to
maintain and enhance
their market position.
R&D efforts can lead to
unique products,
technological advancements,
and improved processes,
providing a competitive edge.

Long-term Growth
Potential
 R&D spending is a signal of
a company's commitment
to long-term growth and
sustainability.

Analysts look at R&D

expenses to assess whether
a company is investing
adequately in future growth
opportunities.
 R&D costs are a vital element of
financial reporting, offering insights
into a company's innovation efforts
and long-term growth potential.
Proper accounting and disclosure of
these costs enable stakeholders to
make informed decisions, assess the
company's strategic direction, and
evaluate its financial health.
Understanding the relevance of R&D
costs in financial reporting helps
companies maintain transparency,
attract investment, and drive
sustainable innovation.
 Ashish Agarwal

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