The tech industry is growing at an exponential rate. As tech companies grow and other businesses and industries seek out software development to help their companies grow, it is important to take the time to understand capitalized software costs.
What is Software Capitalization?
Simply put, planning, developing, testing, and maintaining software costs money. Capitalized software costs take the overhead associated with software development and capitalize them on a business’s balance sheet rather than expensing the costs as they are incurred.
Should Software Costs be Capitalized?
There are a few things to consider when determining if your software costs should be capitalized in accordance with accounting guidance. There are two main stages of software development during which costs are eligible for capitalization.
Software Development Costs
Software capitalization is permitted during the application development stage. However, the costs can only be capitalized if it is software for internal use. You are not able to capitalize on software development costs when the software is intended for the market until it reaches the point of technological feasibility.
Technological Feasibility
If the software is intended for the public market, software costs can also be capitalized on when it reaches the technical feasibility stage. Essentially, when software is considered viable, and there is a certainty it will be produced for its intended purpose, it is considered technologically feasible.
Software development costs, while entirely worthwhile, do add up. Consider ways to capitalize on software development costs to reduce costs incurred.
Software Capitalization Term
Software capitalization can be complicated. So, let’s take a moment and break it down.
Capital and Capital Expense
Capital is anything that accrues value or revenue to your business. A capital expense is the money it takes to create or acquire a new asset or to enhance an existing one. In software, adding new or additional functionality to the software, software development costs, and purchased software are considered capital expenses.
Assets: Fixed and Intangible
Assets are the things of value that a company owns and can convert to cash in some way. A fixed asset is one that a company intends to use for the long term, such as a physical building, whereas software is considered an intangible asset that has no physical form but still holds monetary value.
Amortization
Amortization is when an intangible asset, such as software, is gradually expensed rather than incurred at once. Amortization reduces your taxable income by associating the cost of the software with the revenue it generates.
Since the software is used to generate revenue and has value, it can and should be capitalized so long as it follows standard accounting principles.
Where Can You Capitalize Software?
Software development costs and other costs incurred may be capitalized at different stages. During the preliminary project stage, costs are treated as an expense and may be amortized to reduce costs. Consulting fees are a prime example of expenses incurred during the preliminary phase.
What are the Primary Challenges to Tracking Development Costs?
The nature and approach of your company determine what and when to capitalize on software costs. Deciding when software is technological feasibility is subjective. As such, we recommend consulting with a professional accounting specialist who can help you determine which route is best for you and your company.
Subjectivity
Some may consider a project technologically feasible far before it is available for sale. This company may capitalize costs during the application development phase if they believe that the software will include additional functionality to an existing asset.
Another company may develop software and determine that the software is not technologically feasible until much closer to a launch. In this example, the company may not capitalize on any development costs and may choose instead to only capitalize on software intended for internal use.
As such, we recommend consulting with a professional accounting specialist who can help you determine which route is best for you and your company.
Capitalizing Software Examples
Some general examples of capitalized software development costs include the software license, internal use software, conduct impairment testing, maintenance costs, implementation costs, and costs to compensate development teams.
There are different stages and best practices for different types of software as well.
Internal Use Software
Internal use software such as accounting and payroll or CMS software may be capitalized. However, internal use software is typically capitalized during the application development stage alone. Expenses for coding computer software, testing, and adjustments may be capitalized.
External Use Software
External use software is software that is to be sold or marketed to external users and is more subjective when it comes to capitalized software. Costs may generally be capitalized once the software is considered feasible. Since this point is so subjective, we recommend consulting with accounting personnel to determine the best route for your external use software.
Understanding capitalizing software development costs is not only necessary but can save you in the long run. Reach out to our team to see how Geneca can help you on your next development project and save you time and money along the way!
About Geneca & Capitalized Software
What parts of software development can be capitalized?
In short, it depends! Generally speaking, development costs, testing, requirement writing, and consulting fees may be capitalized.
Why do we capitalize software development costs?
Capitalizing software development costs allows you to expense costs incrementally rather than as they are incurred. Capitalized costs can then be amortized to depreciate costs.
What kind of software can be capitalized?
Both internal and external use software can be capitalized! However, there are different standards and requirements of reach, which are broken down in this article.