THE PROBLEMS OF REPRESENTING RESEARCH AND DEVELOPMENT IN

FINANCIAL ACCOUNTING

István Deák
Senior Lecturer, Division of Accounting,
Faculty of Economics and Business Administration, University of Szeged
P.O. Box 914, H-6701 Szeged
Phone: +36 62 544 680, E-mail: deak@eco.u-szeged.hu

Miklós Lukovics
Senior Lecturer, Division of Regional Economic Development,
Faculty of Economics and Business Administration, University of Szeged
P.O. Box 914, H-6701 Szeged
Phone: +36 62 546 908, E-mail: miki@eco.u-szeged.hu

In today’s information society knowledge has become the governing element of

competitiveness and the driving force of economic development. Consequently, knowledge
production, research and development, innovation and other non-material resources tend to
assume an increasingly dominant role among the factors influencing companies’
competitiveness. Within the rigid frameworks of financial accounting it takes rather big
compromises and information loss to review these factors and the costs lying behind them,
what is more, it is downright impossible to quantify the uncertainty and its cost constituting
the core of R&D.
The aim of the present paper is to introduce how utilizable data can be obtained about
research and development and what the problems to be encountered are in the area of
financial accounting. Intellectual capital plays a significant role in company evaluation;
therefore, grasping it represents an especially important task for the management.
Key words: financial accounting, research and development, innovation, evaluation

1 Introduction

Today’s economic environment is characterized by an increasingly intensifying

competition and the determined efforts to hold the ground successfully. The innovation
process exercises a great influence on the success of companies, since the quick launch of a
new technology means competitive advantage. Innovation tends to be considered one of the
most important sources of the competitive advantages in modern economies (Halbrook –
Wolfe 2002). Research and development faces upvaluation, R&D expenditure keeps
increasing and companies’ information systems must also adjust to this. In the following, the
most important questions of handling R&D results in accounting will be briefly reviewed and
summarized (Lukovics – Deák 2005).

2 The occurrence of R&D in accounting

Representing R&D activities means a serious challenge difficult to solve for financial
accounting, the fundamental reasons of which are to be found in the strict prescriptions of
accounting regulations regarding financial solvency, especially restrictive in the case of R&D.
Consequently, the financial accounting settlement of research and development is basically
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limited to recording accrued payables, in the course of which at least three factors must be
taken into consideration:
1. information needs
2. relevant prescriptions of the regulation on accounting
3. relevant prescriptions on taxation
It is useful to establish all these three areas within the closed system of accounting. In
this process it is not easy to find the optimal relationship between the strictly regulated
(standardized) accounting settlement ensuring the satisfaction of external information needs
(financial accounting) and the settlement adapting to the content of internal information needs
and facilitating the observation of operative processes specifically focusing on economic
entities (management accounting).
This area may present an especially strong need to exploit the possibilities provided by
management accounting, since a given expenditure often appears in traditional accounting
settlement with considerable delay (at the point of becoming an economic event, that is
occurrence) (Boda – Szlávik 2001). Financial accounting treats cost settlement in a flexible
manner (with respect to the space provided by regulation), because it enables developing a
structure of cost centres and profit centres corresponding to information needs. For example,
the breakdown of expenditures according to functions may provide considerable support for
 potential capitalization realized within the frameworks of accounting regulations,
 the separation of activities performed for own purposes or based on orders, and
 the enforcement of allowances granted by the tax system1.
Apart from a few exceptions, accounting regulations generally exclude the
capitalization of such expenditures, since it is incompliant with the generic requirements of
financial solvency with special regard to the condition that the inflow of future economic
profit can be expected2. Despite this, the formation and administration of bills of costs, the
remittance of accrued payables, their charge on job number and the (occurrent) division of
indirect costs can follow a similar procedure as in the case of any other asset of own
production. The costs of human resources, services provided by external experts and other
used services, the value of utilized materials, the depreciation of physical assets used for the
activities, etc. as well as costs subsequently divided among the different areas are settled as
direct costs of R&D activities – in different proportions depending on the type of activity.
According to regulations on accounting, the phases of research and development must
be distinctly separated3. The Act on Accounting includes the following conceptual definitions
concerning the content of these (Section (4) of Paragraph 3 of Act C of 2000):
1. basic research: experimental and theoretical work, the primary aim of which is to gain
new knowledge and information about the basic core of phenomena and about
perceptible facts without any actual objective concerning application and utilization;
2. applied research: original research with the purpose of gaining new knowledge and
information, primarily carried out in order to reach some actual and practical goal;
3. experimental development: regular work based on already existing knowledge
(derived from former research or practical experience) that aims at creating new

1
Not questioning the solution when (using the opportunities deriving from informatics support) all this is handled within the
types of costs.
2
A great degree of uncertainty is one of the most important distinctive characteristics of research and development activities
(Inzelt 1998).
3
Let us note that this distinction moves on a rather theoretical level, since in practice these phases are usually inseparable.
 3

materials, products or structures, introducing new methods, systems or services or

improving the already created or introduced ones significantly.
In judging the accounting settlement of (basic and applied) research activities
performed for own purpose the different accounting regulation systems (including Hungarian)
share the same standpoint, in so far as not allowing the redeployment of such costs over years
either with the help of capitalization or accruals (figure 1). The reason for this is that in the
period of cost accounting the secure inflow of future economic profits cannot be duly attested
(usually) (what is, in fact, one of the determining criteria of financial solvency), making
comparison with future revenues uncertain. Therefore, R&D mostly occurs as invisible assets4
in the statements of economic entities (Hollender – Deák 2004). Associating costs with the
year of occurrence may cause a considerable fluctuation in profit and loss (since in the
majority of cases these costs do not occur with steady distribution), what makes the direct
comparison of the profit and loss of the different years uncertain. This statement may be
significantly modified by the recognition of non-refundable subsidies partially or entirely
financing R&D activities as income5. The sum of subsidies credited before the date of balance
sheet preparation must also be enforced (with the help of accruals) in the base year settlement.
Special attention must be paid to the settlement of physical assets serving R&D activities (see,
for example, the more favourable regulations on depreciation) and final subsidies received for
these. The situation is different in the case of settling R&D activities performed for orders,
since in this case the invoiced sales revenue of the performed activity creates a secure
coverage for accrued payables, the influence of which covering more business years can be
handled by recognizing services in progress (as assets of own production).
Although based on strict criteria, in the case of projects in the phase of experimental
development it is already possible to capitalize these costs as assets (usually among intangible
assets), and this way level off the expenditure charge of the different years (figure 1).
Similarly to the research phase, here it is also valid that associating costs with the year of
occurrence may cause significant variability in profit and loss, making this way the
comparison of figures associated with different years uncertain 6. The requirement of
capitalization is the properly documented statement of future income surplus or cost saving
occurring as a result of experimental development and ensuring the coverage of returns. The
relevant prescriptions of the Act on Accounting must be followed also when determining the
market value of the asset recognized this way, which means that only those expenditures can
be taken into account that were directly remitted for the development to be capitalized and
settled with the content defined in the internal regulations concerning the cost accounting
system of the enterprise (Nagy 2004).

4
By the common expression ’intangible assets’ widely used in international literature the authors of the present article –
similarly to the ones cited – also mean intangible assets together with the invisible assets introduced in the main text.
5
The sum of fiancially settled subsidies received for covering costs based on contracts and legislation must be settled as other
income.
6
The typical product development process in the electronics industry involves two years of product development followed by
a five-year long evaluation phase. This way it takes companies three years to receive the first feedback about the success of
the product development process (Kaplan – Norton 1999).
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Figure 1 Decision tree for the accounting settlement of (own) R&D activities
RESEARCH AND DEVELOPMENT

Research Experimental
development

No capitalization (not allowed) Capitalization

Settlement in the year of occurrance Settlement during service life

IN PROGRESS COMPLETED

(probably) (probably)
SUCCESSFUL UNSUCCESSFUL

WRITING OFF

UTILIZABLE NOT UTILIZABLE

Cannot be taken into account Can be taken into account as

as the value of anoher asset the value of another asset WRITING OFF
(reclassification)

ACCOUNTABLE AMONG
INTANGIBLE ASSETS

Source: Deák – Lukovics (2006), Lukovics – Deák (2005)

Capitalization is not determined by whether the final subsidy played any role in
financing the development. In such cases displaying the part of subsidies recognized as base
year income not set off against any expense (due to capitalization) as accruals is grounded,
this way associating the subsidy with the years, in which the capitalized development cost was
written off. Let us note that accounting regulations (including international standards as well)
are less strict in the case of assets purchased in the course of market transactions, therefore, in
purchased R&D projects it is easier to meet the criteria of financial solvency (identification,
measuring, advantages). Consequently, outsourcing research and development activities, then
repurchasing or ordering their results from institutions specialized in such activities may
significantly contribute to the direct recognition of these resources in the balance sheet.
Dividing the costs of R&D activities into direct and general parts is not only
indispensable for determining the cost necessary for capitalization but also for observing
certain regulations related to taxation and enforcing tax advantages. In 2004 the innovation
contribution (payable by medium size and large companies) was introduced with the intention
to establish central budgetary sources for financing R&D by direct withdrawal (Research and
Technological Innovation Fund). However, it grants an allowance for enterprises performing
R&D activities for own purposes or based on public orders by enabling them to deduct the
sum of direct expenditure applied in relation to such activities from their calculated liabilities
regardless of whether the expenditure can be capitalized from an accounting point of view.
Enterprises performing research and development are granted special allowances in
corporation taxation as well. Such allowance can be enforced in the course of calculating
corporation tax base. According to this, the sum of direct research and development
 5

expenditures performed for own purposes or public orders applied in accounting can be taken
into account once again when determining the tax base. Depending on the entrepreneur’s
decision, tax base reduction can be realized in a lump sum in the year when the expenditure
occurs (and its accounting settlement takes place) or (in the case of experimental development
that can be capitalized according to the Act on Accounting) in the sum of depreciation applied
in the different years. No allowance can be granted based on the value of R&D activities
ordered from others, this way avoiding the settlement of the same item as allowance by more
business organizations. Therefore, special emphasis must be paid on the isolated accounting
record of these. This limitation does not affect research and development ordered from
organizations operating in a budgetary system of management or public utility organizations
(provided that they do not utilize services from organizations enforcing allowances for this).
A special rule (the possibility of triple reduction) applies to enterprises that perform such
activities in collaboration with a higher education institution or research institute (based on a
written agreement). As a result of tax base reduction the tax base can also become negative
that, according to the regulations concerning loss accruals can also be set off against the
positive tax base of the subsequent years. Consequently, organizations performing research
and development activities can enforce corporation tax allowance, may be exempt from the
obligation to pay innovation contribution and can also apply for government financing for
such activities. However, R&D expenditures covered by a non-refundable subsidy (for
example received form the Fund) cannot be deducted from the innovation contribution and
corporation tax base. Based on all this it becomes obvious that special care must be paid in the
course of settling and recording expenditures related to R&D activities.

3 Conclusions

As introduced above, part of research and development activities occur in financial

reports only with a certain delay, distributed unsteadily in a manner that does not allow for
setting off against current incomes, furthermore, a significant portion of the activity often
remains hidden from analyzers of the statement based on financial accounting as an element
of invisible assets. This makes defining the company’s real value difficult (Daum 2001).
The prescriptions of the Act on Accounting include the approach according to which
the numerical parts of the statement must be accompanied by additional information, since
regulations on the introduction of R&D can also be found among the prescriptions concerning
the descriptive parts of the statement. According to the general prescription the notes to the
statement must include the data and descriptive justifications required for the most
comprehensive introduction of the entrepreneur’s real property and financial status and the
results of its operations (Paragraph 18). Among itemized supplements related to profit and
loss statements (Section (4), Paragraph 93), the Act prescribes the introduction of the base
year costs of research and experimental development. Since statements are also meant to
serve the comparison of the data of two different years, it is also useful to include similar data
deriving from the base period(s) among the base year data concerning R&D described in the
notes to the statement. There is no regulation concerning the manner and form of this,
consequently, economic entities must develop and design a form of introduction, which
enables them to enforce the implementation of the regulation in the best way (also taking into
account that the usability of the published information should be in proportion to the prime
cost of such information). The data disclosed in the notes to the statement must also be
supported by accounting data; therefore, the observation of this prescription also justifies
showing the expenditures itemized directly and indirectly in thematic categories.
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Beyond providing information in the notes to the statement, research and development
represent an emphasized area in the business report (the preparation of which is obligatory as
part of the annual statement) as well. According to the prescriptions of law, the business
report must describe operations together with the main risks and uncertainties occurring in the
course of the activity in an analyzing manner. In our opinion, R&D activity (especially
research) can also be identified as such a risk factor; therefore, it cannot be disregarded in the
course of compiling the business report either. Contrary to the factual nature of the notes to
the statement, the business report (also applying factual data) must place greater emphasis on
expected and planned factors and processes (the state of projects in progress, their expected
results, expected time of termination, future research and development plans, etc.).
It is important to note that the depth of published information must be determined
carefully. In fact, we must not forget the quite trivial fact that financial accounting provides
information for external interested parties, therefore, the core of research and development
would be lost if anyone could gain information about every element of it.

4 References

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