Capitalising Research and Development for Early Stage Tech Founders Explained
I was asked very recently by a company to explain how I would approach their projected Intellectual Property (trademarks, patents, code of the platform) concerning their Balance Sheet or Statement of Financial Position.
To make it even more complicated and they have asked me to consider both UK accounting rules as well as the US.
I like a challenge and think there is an approach we can adopt to reach a response and help founders understand how to treat Research and Development costs without much difficulty.
In accounting terms, you can only value the patents, trademarks, and code, when you have a product that can be sold and you’re able to understand the future economic benefits. It is another way of saying that you should be able to understand what the product will do, who you will sell it to and how much you’re going to price the usage of your product.
An example can help clarify what this means.
Assume Company XYZ has built an e-health platform and app, having spent £3m pre-launch on the product. Until the platform and app are ready to be launched, they can only expense the cost of this technology.
Now the company has closed another round and is ready to push this to the market, and they think they will get 10k users in Year 1 so approx. £500k in Revenues. Now they can have an option to capitalise.
Expensing and Capitalising
For company XYZ the cost of Research and Development was expensed, so £3m have been channelled through their income statement and no entry in the Non-Current Intangible Assets.
Current Assets. (cash at bank, receivables, assets that convert to cash in 12 months)
Non-current (assets that convert to cash in more than 12 months, IP, intangible assets — code trademarks)
Liabilities Current/Non-Current (the claims of creditors against the assets of the business)
Equity (Share Capital, Premium, Retained Earnings/Loss)
When you can understand the future benefits of the product that results from research and development activity, and only then, you can capitalise the costs that have gone into producing that asset.
If you invest £3m to produce a platform and app until you are ready to sell and can understand its potential as a marketable product, you will not have a £3m Intangible Assets on your Balance Sheet. You will have to expense it in your Income Statement, which results is a negative figure for most early-stage technology companies.
This figure enters the Balance Sheet through Retained Income/Loss under Equity. It is essential to understand the way it should look when we expense while building the product.
Many founders have the temptation to capitalise the value of your code and patents as your building them; however, this is not allowed under most accounting rules. It distorts the value of the company, and it will not be a fair representation of the business.
A Forecasting Problem
As best practice when forecasting, it is essential to delimit your Research & Development period when product built stage is implemented, and roughly when the product will be ready for sale. Of course, this is still a scenario that is used for internal assessments and to provide more clarity of company book value which for many companies is not a great guide especially as you plan for next funding rounds.
The rules for capitalisation as rather strict and you need to prove the future economic benefits. Furthermore, it creates a lot of complexity in accounting terms as the company will be required to test for impairments the intangible assets every year.
As always, when thinking about accounting policies, it is best to work with a chartered accountant to help define the best policies for capitalising intellectual property.