Research and development costs can be expensed or capitalised. Their treatment significantly affects EBITDA and requires careful analysis in FDD.
Research and development costs create some of the most nuanced accounting judgments in financial due diligence. How they are classified — expensed through the P&L or capitalised on the balance sheet — has a direct and significant impact on reported EBITDA, and inconsistent treatment across periods can make earnings appear more or less stable than they really are.
Under IAS 38, research costs must be expensed as incurred, while development costs may be capitalised if specific criteria are met:
In practice, the boundary between research and development — and between development costs that meet the IAS 38 criteria and those that do not — involves significant judgment. Different companies apply the threshold very differently, even within the same industry.
Under US GAAP (ASC 730), all R&D costs are generally expensed as incurred, which creates a systematic difference between IFRS and US GAAP comparisons.
Whether R&D costs are expensed or capitalised has a direct impact on reported EBITDA:
A company that capitalises more R&D than its peers will report a higher EBITDA, all else equal. This is not necessarily improper, but it must be understood when making cross-company comparisons or assessing run-rate earnings.
Request and review the company's R&D accounting policy. Understand:
A policy change that increases capitalisation rates between periods will inflate EBITDA trends. This is a red flag for earnings quality.
Look at the balance sheet and P&L together:
In businesses with a mix of product development cycles, some projects may be at early research stage and others at late development stage. If the company has reclassified projects or changed their stage assessment, EBITDA may not be comparable across periods.
In some cases, FDD teams present an EBITDA figure that adds back all capitalised R&D amortisation and subtracts total R&D spend (effectively putting all R&D costs on a cash/expensed basis). This produces a more conservative view of underlying earnings and is used when capitalisation policies are aggressive or inconsistent.
In software, biotech, pharmaceutical, and clean technology businesses, R&D can represent a very large proportion of total costs. The difference between a capitalising and an expensing business can be 5 to 15 percentage points of EBITDA margin. Buyers need to understand this before applying a multiple.
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