How to Set R&D Capitalization Thresholds: Materiality Limits and Practical Tracking

R&D Capitalization: Understanding the Core Concepts

For an early-stage SaaS, Biotech, or Deeptech company, every dollar of R&D spend feels critical. But tracking it often creates a dilemma: what is a simple project expense, and what is a long-term asset? This is not just an academic accounting question. Mis-classifying R&D costs can distort your burn rate, create challenges during fundraising due diligence, and even jeopardize valuable tax credits. Establishing a clear policy on the minimum amount to capitalize R&D costs provides the consistency that investors and auditors look for.

Defining this threshold removes guesswork, ensuring your financial statements accurately reflect the value being built. The goal is a defensible process that aligns with your operational reality, not a complex system that your small team cannot maintain. Here’s how to approach it practically.

At its core, the choice is between expensing vs capitalizing R&D costs. Expensing a cost means it immediately hits your income statement, increasing your net loss for that period. Think of it as a one-time operational cost, like paying for electricity. Capitalizing a cost, on the other hand, turns it into an asset on your balance sheet. This asset is then gradually expensed over its useful life through a process called amortization, which smooths out the impact on your profitability and can present a healthier view of your company's financial position.

For US companies, the primary guidance comes from US GAAP (ASC 985-20), which governs software costs. It outlines a clear framework based on when “technological feasibility” is reached. In the UK, companies typically follow UK GAAP (FRS 102), which has different criteria. For companies under International Financial Reporting Standards, IAS 38 provides the guidance. The key takeaway is that not all R&D spending is created equal, and the rules vary by jurisdiction.

Think of it like building a new facility. The initial brainstorming, architectural sketches, and feasibility studies are expensed as they are part of the discovery process. However, once the decision to build is made and blueprints are approved, the actual construction costs for bricks, steel, and labor are capitalized because they create a tangible asset. Software and other R&D projects follow a similar logic.

How to Set a Defensible R&D Capitalization Threshold

Unclear R&D thresholds expose companies to inconsistent treatment and audit challenges. The key is to establish and document a formal policy around materiality in R&D accounting. Your policy doesn't need to be complex; a simple one-page document is often sufficient. For most pre-seed to Series B startups, the operational reality is that consistency is valued more than perfection.

Step 1: Establish a De Minimis Threshold for Minor Expenses

Your policy should first define a de minimis threshold, which acts as a floor for small-ticket items. A common range for this is $5,000 to $10,000 per project. The purpose is clear: automatically expense all costs below this value. This reduces administrative overhead and saves valuable bookkeeping time by preventing analysis paralysis over minor expenditures.

If a small research project or minor feature update costs $4,000, it’s expensed without further analysis. This pragmatic approach allows your team to focus its accounting efforts on projects with a material impact on the company’s financial standing.

Step 2: Define a Project-Level Materiality Threshold

Next, you need a project-level materiality threshold. This figure is the trigger for serious consideration of capitalization. A typical range is $25,000 to $50,000+ per project. Its purpose is to identify significant development efforts that warrant evaluation against formal capitalization criteria. When a project's anticipated development-phase costs exceed this amount, you apply the criteria. Projects below this amount are expensed by default.

Choosing Your Thresholds: A Practical Guide

How do you pick a number? There is no single magic figure. It depends entirely on your company's scale and R&D budget. A startup with a $5 million R&D budget might set a higher project threshold than one with a $500,000 budget. A good starting point is to set the project threshold at a level that feels significant relative to your monthly or quarterly R&D spend.

What founders find actually works is choosing a reasonable number, documenting the logic, and applying it consistently to all projects. For example, your logic could state that any project representing more than 5% of the quarterly R&D budget will be evaluated for capitalization. This defensible approach is what auditors and investors want to see. The key is to document your logic and stick to it.

Example of a Simple R&D Capitalization Policy

Use our policy template as a starting point. Your one-page document could include:

• Policy Objective: To ensure consistent and accurate accounting for all Research and Development (R&D) expenditures in accordance with US GAAP / FRS 102.
• De Minimis Threshold: All projects with total estimated costs under $5,000 will be expensed as incurred.
• Project Capitalization Threshold: Projects with anticipated development stage costs exceeding $25,000 will be evaluated for capitalization.
• Capitalization Criteria: Costs will be capitalized starting when technological feasibility is established and management has committed to funding the project, and ending when the product is ready for general market release.
• Trackable Costs: Includes direct labor (at a loaded rate), third-party contractor fees, and software licenses used directly for development. General and administrative overhead is excluded.
• Phases: Defines the Preliminary, Application Development, and Post-Implementation stages clearly.

Tracking Eligible Costs: A Phased Approach to R&D Accounting

Once you have a threshold, the next challenge is tracking costs accurately. Lacking robust time and cost tracking by project phase makes it difficult to substantiate capitalized amounts. For US companies, ASC 985-20 provides a helpful framework by breaking software development into three phases. While UK FRS 102 has different specific rules, this phased approach is a universally practical way to organize cost tracking.

Phase 1: Preliminary Project Stage (Always Expense)

This phase includes all activities before technological feasibility is established. Think of it as the “what if” stage where ideas are explored and vetted. Costs incurred here are always expensed as incurred.

• Conceptual formulation and evaluation of alternatives.
• Requirements definition and high-level planning.
• Prototyping and feasibility studies.
• Determining system requirements and selecting vendors.

Phase 2: Application Development Stage (Potentially Capitalize)

This phase begins once you have committed to the project, confirmed it is technologically feasible, and have a detailed plan for creating the asset. These are the costs eligible for capitalization if they exceed your project-level threshold. Eligible costs are typically limited to direct labor and contractor fees associated with building the software.

• Detailed software design, coding, and configuration.
• Installation of hardware and development software.
• Testing activities, including quality assurance and integration testing (prior to release).
• Producing product masters for training materials.

Phase 3: Post-Implementation Stage (Always Expense)

This phase starts once the software or product is released and available for use. These are considered ongoing operational costs necessary to maintain the product, and they are always expensed.

• Customer support and user training.
• Routine maintenance and minor bug fixes that do not add new functionality.
• Data conversion and ongoing performance monitoring.
• Marketing and promotional activities.

Practical Cost Tracking for Early-Stage Companies

To track these costs, you do not need a complex ERP system. Tools you may already use, like Jira for project management and Clockify or Harvest for time tracking, are often sufficient. The key is to tag tasks or tickets with a project name and phase. This allows you to run reports showing how many hours were spent on “Project X - Development Phase.”

To convert hours into dollars, you need a loaded labor cost rate. A common starting point is 1.25x salary. This benchmark helps estimate the full cost of an employee, including not just salary but also payroll taxes and benefits. For example, an engineer with a $120,000 salary has an hourly rate of about $60 ($120,000 / 2,080 work hours). Their loaded hourly rate would be approximately $60 * 1.25 = $75.

Example of a Capitalization Decision

Consider a SaaS startup building a new “AI Analytics Module.” Their project materiality threshold is $25,000.

• Phase 1 (Preliminary): The product manager and a lead engineer spend 80 hours total on planning and feasibility. At a loaded rate of $100/hour, this is $8,000. This amount is expensed.
• Phase 2 (Development): Two developers spend a combined 500 hours coding and testing the module. At a loaded rate of $75/hour, the total cost is $37,500.
• Decision: Since $37,500 is greater than the $25,000 threshold, the full $37,500 is capitalized as an intangible asset on the balance sheet.
• Phase 3 (Post-Implementation): After launch, 10 hours per month are spent on minor bug fixes. These ongoing costs are expensed as they occur.

Common Pitfalls in R&D Accounting and How to Avoid Them

Mis-classifying R&D costs can distort burn forecasts and raise red flags during due diligence. Avoiding a few common mistakes can save significant headaches later.

Pitfall 1: Confusing Accounting Rules with Tax Rules

This distinction is crucial. For US companies, the accounting rules under US GAAP for financial statements are separate from the tax treatment specified by the US Tax Code (Section 174), which has its own requirements for capitalization and amortization for tax purposes. An activity might be expensed on your books but need to be capitalized for your tax return. Similarly, in the UK, the criteria for capitalization under FRS 102 may differ from what qualifies for R&D tax relief under HMRC guidance. In practice, we see that maintaining separate, clear workpapers for book versus tax reporting is the most effective approach.

Pitfall 2: Inconsistent Application of Your Policy

The biggest red flag for an auditor or investor is inconsistency. If you capitalize costs for one project but expense similar costs for another without a clear reason documented in your policy, it undermines the credibility of your financials. It suggests that accounting decisions may be driven by a desired financial outcome rather than a consistent application of principles. The solution is your documented, one-page policy. Stick to it rigorously.

Pitfall 3: Capitalizing the Wrong Types of Costs

A frequent error is capitalizing costs from the preliminary or post-implementation phases. Another is including indirect overhead costs, such as rent or administrative salaries, in the capitalized amount. Remember, only direct costs incurred during the specific application development stage are eligible. Strong project and time tracking, with tasks clearly marked by phase, helps prevent this.

Putting Your R&D Capitalization Policy into Action

For an early-stage company, establishing accounting policies for R&D spend should not be an exercise in perfection. It is about creating a practical, defensible framework that supports your growth and provides clarity to stakeholders.

Here are your key actions:

• Document a Simple Policy: Choose your de minimis ($5k-$10k) and project-level ($25k-$50k+) thresholds. Write them down, define your phases, and state your logic. In your accounting software like QuickBooks or Xero, you can set up specific accounts for “Capitalized Software Development” to keep these costs separate.
• Implement “Good Enough” Tracking: Enforce basic project and phase tagging in your existing project management tools. Ensure your team logs time against these tasks. It does not need to be perfect, just consistent and auditable.
• Use a Loaded Labor Rate: To get a true sense of project costs, apply a simple multiplier like 1.25x to employee salaries. This gives you a more accurate basis for your capitalization decisions and is more defensible under scrutiny.
• Remember the Book vs. Tax Difference: Work closely with your accountant to ensure you are complying with accounting standards for your financial statements (US GAAP/FRS 102) and tax law for your returns (Section 174/HMRC). They serve different purposes and require separate calculations.

The goal is not to achieve a flawless accounting outcome but to implement a reasonable and consistently applied process. This level of diligence provides the clarity that both you and your stakeholders need to make informed decisions. For more on this topic, see our guide to R&D Project Accounting & Capitalisation.

Frequently Asked Questions

Q: What happens if a capitalized R&D project is abandoned?
A: If a project that has capitalized costs is abandoned before completion, the capitalized amount must be written off. This means it is recognized as an expense on the income statement in the period the decision to abandon is made. This is known as an impairment loss.

Q: Can we capitalize costs for internal-use software?
A: Yes, the accounting guidance (under ASC 350-40 in US GAAP) for internal-use software is similar. Costs in the application development stage can be capitalized, while preliminary and post-implementation costs are expensed. The same principles of establishing a threshold and tracking costs by phase apply.

Q: How does R&D capitalization affect EBITDA?
A: Capitalizing R&D costs instead of expensing them will increase your reported EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). This is because the expensed cost is replaced by an asset that is amortized over time, and amortization is typically excluded from EBITDA calculations. This can make profitability metrics appear stronger.