Most companies treat software development costs as just another expense and are unsure how certain costs can be capitalized.
Recording the actual value of any software development process must involve recognizing the development process as a high-return asset.
That’s what software capitalization is for.
This article will answer all the what’s, why’s, and when’s of software capitalization.
Software capitalization is an accounting process that recognizes the incurred software development costs and treats them as long-term assets rather than immediate expenses.
Typical costs include employee wages, third-party app expenses, consultation fees, and license purchases.
The idea is to amortize these costs over the software’s lifetime, thus aligning expenses with future revenues generated by the software.
Shifting a developed software’s narrative from being an expense to a revenue-generating asset comes with some key advantages:
Capitalization helps preserve profitability for the longer term by reducing the impact on the company’s expenses. That’s because you amortize intangible and tangible asset expenses, thus minimizing cash flow impact.
Capitalizing software development costs results in higher reported asset value and reduces short-term expenses, which ultimately improves your profitability metrics like net profit margin, ARR growth, and ROA (return on assets).
Software capitalization complies with the rules set by major accounting standards like ASC 350-40, U.S. GAAP, and IFRS and makes it easier for companies to undergo audits.
Here’s when it’s acceptable to capitalize software costs:
The software development stage starts when you receive funding and are in an active development phase. Here, you can capitalize on any cost directly related to development, considering the software is for internal use.
Example costs include interface designing, coding, configuring, installation, and testing.
If the software is intended for external use, then your costs can be capitalized when the software reaches the technical feasibility stage, i.e., when it’s viable. Example costs include coding, testing, and employee wages.
The software must be a probable candidate to generate consistent revenue for your company in the long run and considered an “asset”. For external use software, this can mean it possesses a selling and leasing expectation.
The overall software development costs must be accurately measurable. This way, you ensure that the capitalized amount reflects the software’s exact invested amount.
The five main costs you can capitalize for software are:
Direct costs that go into your active development phase can be capitalized. These include payroll costs of employees who were directly part of the software development, additional software purchase fees, and travel costs.
These costs include the ones incurred by the developers when working with external service providers. Examples include travel costs, technical support, outsourcing expenses, and more.
License fees can be capitalized instead of being treated as an expense. However, this can depend on the type of accounting standard. For example, GAAP’s terms state capitalization is feasible for one-time software license purchases where it provides long-term benefits.
Acquisition costs can be capitalized as assets, provided your software is intended for internal use.
Training and documentation costs are considered assets only if you’re investing in them during the development phase. Post-implementation, these costs turn into operating expenses and cannot be amortized.
Here are a few costs that do not qualify for software capitalization and are expensed:
Research and planning stages are categorized under the preliminary software development stage. These incurred costs are expensed and cannot be capitalized. The GAAP accounting standard, for example, states that an organization can begin to capitalize on costs only after completing these stages.
Post-implementation or the operational stage is the maintenance period after the software is fully deployed. Any costs, be it training, support, or other operational charges during this time are expensed as incurred.
Any costs related to software upgrades, modernization, or enhancements cannot be capitalized. For example, money spent on bug fixes, future modifications, and routine maintenance activities.
Below are the two most common accounting standards that state the eligibility criteria for software capitalization:
GAAP is a set of rules and procedures that organizations must follow while preparing their financial statements. These standards ensure accuracy and transparency in reporting across industries, including software.
IFRS is an alternative to GAAP and is used worldwide. Compared to GAAP, IFRS allows better capitalization of development costs, considering you meet every criterion, naturally making the standard more complex.
Software capitalization, from a financial perspective, can have the following aftereffects:
A company’s profit and loss (P&L) statement is an income report that shows the company’s overall expenses and revenues. So, if your company wishes to capitalize some of the software’s R&D costs, they are recognized as “profitable assets” instead of “losses,” so development can be amortized over a time period.
Software capitalization treats your development-related costs as long-term assets rather than incurred expenses. This means putting these costs on a balance sheet without recognizing the initial costs until you have a viable finished product that generates revenue.
As a result, it delays paying taxes on those costs and leads to a bigger net income over that period.
Although tax implications can be complex, capitalizing on software can often lead to tax deferral. That’s because amortization deductions are spread across multiple periods, reducing your company’s tax burden for the time being.
✓ Specific identifiable project
✓ Intent to complete and use the software
✓ Technical feasibility demonstrated
✓ Expected future economic benefits
✓ Sufficient resources to complete project
✓ Ability to reliably measure development costs
Capitalize the entire $464,145 as an intangible asset, amortizing over 4 years.
Tracking R&D investments is a major part of streamlining software capitalization while leaving no room for manual errors. With Typo, you streamline this entire process by automating the reporting and management of R&D costs.
Typo’s best features and benefits for software capitalization include:
Typo transforms R&D from a cost center into a revenue-generating function by optimizing financial workflows and improving engineering efficiency, thus maximizing your returns on software development investments.
Capitalizing software costs allows tech companies to secure better investment opportunities by increasing profits legitimately.
Although software capitalization can be quite challenging, it presents massive future revenue potential.
With a tool like Typo, you rapidly maximize returns on software development investments with its automated capitalized asset reporting and real-time effort tracking.
Implement engineering metrics, gather SDLC insights & set continuous improvement goals in your dev teams.
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