Research vs Development: Accounting Rules for Biotech and Deeptech Startups

Research vs Development: Understanding the Critical Accounting Difference

For many early-stage startups, the R&D line item in QuickBooks or Xero is a simple catch-all for the entire technical team's spend. While practical at first, this simplification can create significant friction as your company matures. The distinction between capitalizing development costs vs research expenses becomes a critical measure of financial discipline when you engage with sophisticated investors or prepare for an audit. Misclassifying this spend can misstate your financials, erode investor confidence, cause you to miss valuable tax credits, and dangerously skew cash-burn forecasts, risking surprise liquidity gaps when you can least afford them. For a broader look at this topic, see our hub on Capex, Depreciation, and Intangibles.

Incorrectly expensing all technical spend can make a promising deeptech or biotech venture appear unprofitable, while improperly capitalizing uncertain research can inflate your balance sheet with assets that have no probable future. Getting this right is fundamental to building a credible and fundable company.

Foundational Concepts: Research vs. Development in Plain English

At its core, the distinction is about intent and certainty. Research is the act of discovery. It is the original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge. Think of early-stage lab experiments, theoretical brainstorming, or evaluating alternative technologies. The outcome is fundamentally uncertain.

Development, on the other hand, is the act of construction. It is the application of research findings to a plan or design for producing new or substantially improved materials, devices, products, or processes before the start of commercial production. This is when you are building the Minimum Viable Product, not just sketching it on a whiteboard.

From an accounting perspective, the rule is unambiguous. Under both International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP), all pure research costs must be expensed as incurred. This means they hit your Profit & Loss (P&L) statement immediately, reducing profitability in that period. The logic here is to prevent companies from filling their balance sheets with speculative assets that may never generate revenue. Development costs, if they meet strict criteria, can be capitalized. Capitalization converts an expense into an intangible asset on your balance sheet, whose cost is then gradually expensed over its useful life through amortization, typically over 3-5 years for software.

Defining the Milestone: When Exploration Becomes Construction

How do you know when you have officially moved from the research phase to the development phase? This transition isn't just a shift in team meetings; it's a formal accounting milestone that must be justified and documented. This is the point where uncertain exploration solidifies into a defined plan for construction with a probable commercial outcome. While an early-stage startup will not have a complex system for this, you must be able to prove why costs after a certain date are treated differently.

This process is governed by specific R&D accounting rules. For many global and UK-based companies, this is guided by International Financial Reporting Standards, specifically IAS 38 on intangible assets. For US companies, US Generally Accepted Accounting Principles, specifically ASC 730, governs research and development costs. While the principles are similar, the application differs, making it crucial to know which rules you need to follow.

The Litmus Test: 6 Criteria for Capitalizing Development Costs Under IFRS

For companies following IFRS, IAS 38 provides a clear checklist before you can begin capitalizing development costs. A helpful mnemonic is PIRATE. If you can confidently provide evidence for all six of these criteria, you can start treating eligible costs as an intangible asset.

1. Probable future economic benefits: You must demonstrate how the asset will generate revenue or reduce costs. A documented business case, market analysis, or revenue forecast would support this.
2. Intention to complete the asset: You must be committed to finishing the project for its intended use or sale. Evidence includes board meeting minutes approving the project, detailed project plans, and allocated budgets.
3. Resources are adequate to complete it: You need the technical, financial, and other resources to finish the project and bring it to market. This means having the cash, the right team members, and the necessary infrastructure available.
4. Ability to use or sell the asset: There must be a clear path to either using the technology internally to improve operations or selling it to customers. A project that is a purely academic exercise cannot be capitalized.
5. Technical feasibility is established: This is the critical trigger point. You must have reached a stage where you are confident the project can be completed successfully from a technical standpoint. This moves the project from uncertain to probable.
6. Expenditure can be measured reliably: You must be able to accurately track the costs directly attributable to the development project. This includes the salaries of engineers working on it, contractor invoices, and specific materials used.

For US companies, the rules under US GAAP are generally stricter. Capitalization of internal-use software costs begins only after technological feasibility is established, a higher bar than under IFRS. For software, technological feasibility is often defined as having a working model or a completed detailed program design. For more detail on these specific US GAAP rules, see this guidance from PwC on R&D expensing.

Bringing It to Life: Capitalizing Development Costs in SaaS vs. Deeptech

A scenario we repeatedly see is confusion around what "technical feasibility" actually looks like across different industries. The trigger point for capitalizing development costs is not universal; it is highly specific to your business model and technology.

For a B2B SaaS Startup

• Research Phase (Expensed): This phase includes all initial exploratory work. Costs here are always expensed as incurred. Activities include conducting customer discovery interviews, analyzing competitor products, evaluating different programming languages or cloud architectures, and creating initial wireframes and mockups. The salaries of product managers, UX designers, and engineers involved in this work are treated as operating expenses in your QuickBooks or Xero.
• The Trigger Point: Feasibility is typically established once the company approves a detailed product roadmap, completes the architectural and program design, and formally allocates a budget to build the platform. For a US company under ASC 730, this milestone is key for justifying the start of capitalization.
• Development Phase (Capitalized): Now, capitalization can begin. Directly attributable costs can be bundled into an intangible asset. This includes the salaries of software engineers writing production code, QA testers debugging the platform, and the specific cloud-hosting costs for the development environment. For detailed guidance on software-specific accounting, see our guide on Software Capitalization Under ASC 350-40.

For a Preclinical Biotech Startup

• Research Phase (Expensed): This covers the long, uncertain discovery process. All costs associated with identifying a new biological target, screening thousands of potential compounds, and conducting early in-vitro and in-vivo experiments to understand a mechanism of action must be expensed as they occur. This period is defined by high scientific risk.
• The Trigger Point: The milestone here is the selection of a single lead candidate compound for formal preclinical development. At this point, the company has a clear development plan, sufficient grant or VC funding committed to this phase, and robust data suggesting the compound has a probable chance of success, meeting the IFRS PIRATE criteria.
• Development Phase (Capitalized): Costs that can now be capitalized are those for specific activities moving this one candidate forward. Examples include formulation studies, IND-enabling regulatory toxicology testing, and developing the scaled-up manufacturing process (CMC). These are no longer general research but targeted investments in a specific future asset with a measurable probability of success.

The Strategic Impact: Why This Accounting Rule Matters

Why go through this effort? The tangible benefit of correctly capitalizing development costs vs research expenses extends across your fundraising narrative, tax optimization, and operational discipline.

It Improves Your Financial Story

First, it significantly impacts your financial story. Expensing all R&D can make your startup appear deeply unprofitable on your P&L statement, even if you are building significant value. By capitalizing eligible development spend, you move those costs from the P&L to the balance sheet. This improves key metrics like EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), which is often a primary focus for investors and acquirers. It presents a more accurate picture of your underlying profitability by matching significant investment costs with the future revenues they will generate. The capitalized costs are then amortized, meaning the expense is recognized systematically over the asset's useful life, preventing a single large outlay from distorting your burn rate in one period.

It Enables Tax Optimization

Second, this process aligns directly with claiming valuable R&D tax credits. The meticulous documentation required to justify capitalization, such as tracking employee time against project milestones, is precisely what you need for a successful R&D tax claim. The UK offers the SME R&D tax relief scheme, which can provide a significant cash benefit for qualifying activities. Similarly, the US offers the R&D Tax Credit, a dollar-for-dollar reduction in tax liability. Proper phase-tracking and documentation are non-negotiable for securing these benefits and defending them in an audit.

It Instills Operational Discipline

Finally, this process instills financial and operational discipline. It forces you to define project phases, track resources more accurately, and make conscious, evidence-based decisions about when an idea transitions from an experiment into a core company asset. This clarity helps you manage your runway more effectively, make better resource allocation decisions, and provides your board and investors with a clearer view of how their capital is being deployed to create tangible value.

Practical Takeaways for Founders

Implementing a proper R&D accounting policy does not require enterprise-level software. For a startup in the pre-seed to Series B stage, a few pragmatic steps can establish the right foundation for growth.

1. Separate Your Chart of Accounts: In QuickBooks or Xero, stop using a single generic 'R&D' account. Create at least two distinct accounts: 'Research Expenses' and 'Capitalizable Development Costs.' This simple change is the first step toward better visibility and makes period-end accounting far easier. For UK-specific guidance, see our Capitalisation vs Expense: UK Startup Decision Guide.
2. Document the Trigger Point: When your team formally decides a project is technically feasible and commercially viable, document it. Write a simple internal memo that briefly explains how the project meets the PIRATE criteria (for IFRS) or establishes technological feasibility (for US GAAP). Have it signed by the CTO and CEO, and store it with your financial records. This is your audit trail.
3. Implement Basic Time Tracking: A significant portion of your R&D spend is salaries. Use a simple time-tracking tool to have your technical team allocate their hours to specific projects, distinguishing between research and development activities. This data is essential for accurately calculating the amount to capitalize and is invaluable for supporting R&D tax credit claims.
4. Consult Your Accountant: This is an area where professional guidance is invaluable. Discuss your R&D accounting policy with your accountant or fractional CFO early. Getting the policy right from the start prevents painful and expensive financial restatements down the line, especially as you prepare for a funding round, due diligence, or an audit.

For more on capitalisation, depreciation, and managing intangible assets across your financial model, see our hub on Capex, Depreciation, and Intangibles.

Frequently Asked Questions

Q: What happens if a capitalized development project fails?
A: If a project is abandoned or deemed no longer viable, the capitalized asset must be impaired. This means its carrying value on the balance sheet is written down to zero (or its recoverable amount), and the loss is recognized as an expense on the P&L statement in that period.

Q: Can I capitalize costs for updating or maintaining existing software?
A: Generally, no. Costs related to routine maintenance, bug fixes, or minor updates that do not add substantial new functionality must be expensed as incurred. You can only capitalize expenditures on upgrades that meet the same strict criteria as a new project, delivering significant new features or performance improvements.

Q: How do I handle salaries for staff who work on both research and development?
A: Accurate time tracking is essential. Employees who split their time between early-stage research and defined development projects should log their hours accordingly. Their salary and related costs can then be allocated proportionally between 'Research Expenses' and 'Capitalizable Development Costs' based on this data.

Q: Is it better to expense everything to be safe?
A: While conservative, expensing all R&D costs can be detrimental. It understates your profitability (or overstates your losses) on the P&L and presents a less accurate picture of the value being created in the business. For asset-intensive biotech and deeptech companies, a proper capitalization policy is crucial for reflecting economic reality to investors.