Often a company will spend months or even years developing a new product. The labor and material used to develop a new product or offering is considered Research and Development (R&D). R&D is often considered an expense to the company. Expenses are deducted from Revenue in the year they are incurred and help to reduce the company’s and investors’ taxable income in the short term.
Let’s say we have a start-up company which is releasing their first product, and that the new product is a success. Even so, the company’s first year often shows no profit or a loss, since the company accounted for the R&D costs as an expense as it was accrued on the front end. Then, in subsequent years, the revenue from the new product is accounted for without the associated cost to develop it, showing that the company is making larger margins.
This is how Enron fooled investors into believing it was more profitable in some years than it actually was. Enron decoupled the R&D costs from the success of a particular project. Expensing R&D and showing higher profits in subsequent years may be a viable tactic for someone with an exit strategy.
However, a company can also Amortize a product’s R&D expenses over the expected life of the product. Spreading out the R&D cost over the life of a product more accurately measures the product’s real success over time. A business can choose to Expense or Amortize its R&D costs, thereby manipulating their taxes and profits to meet their business goals.
