How do you capitalize R&D expenses?

The portion of R&D spend that is capitalized is usually only a small part of R&D. However, most companies benefit from R&D spending in the form of acquired know-how. This acquired know-how is a valuable asset that produces cash flow in the future. Analysts and investors should want the value of R&D spending in the balance sheet. So R&D should be treated like another investment and the R&D spending capitalized like other assets such as an investment in a building. But how do you capitalize R&D expenses? What are the steps involved in capitalizing R&D expenses?

You can capitalize R&D expenses by following the following steps.

1. Estimate the number of years it takes to build a commercially feasible product.
2. Add the R&D spending over the number of years it takes to build a commercially feasible product.
3. Treat the value arrived at above as a capital asset.
4. Estimate the number of years the R&D asset will provide value to the business. For example the patent validity in the case of a pharma drug.
5. Amortize the asset over the number of years of the R&D asset will provide value to the business.
6. Reduce the gross value of the capitalized asset by the accumulated amortization to arrive at the net book value of the capitalized R&D assets.
7. Add the R&D expense shown in the income statement back to the operating income.
8. Reduce the annual amortization of R&D assets from the operating income.

Here is a great video on capitalizing R&D from Professor. Damodharan.