What is Software Capitalization?

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.

What is 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.

This process illustrates how IT development and accounting can seamlessly integrate. As more businesses seek to enhance operational efficiency, automating systems with custom software applications becomes essential. By capitalizing software, companies can select systems that not only meet their operational needs but also align accounting practices with strategic IT development goals.

In this way, software capitalization serves as a bridge between the tech and financial realms, ensuring that both departments work hand in hand to support the organization’s long-term objectives. This synergy reinforces the importance of choosing compatible systems that optimize both technological advancements and financial reporting.

Why is Software Capitalization Important?

Shifting a developed software’s narrative from being an expense to a revenue-generating asset comes with some key advantages:

1. Preserves profitability

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.   

2. Reflects asset value

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).

3. Complies with accounting standards

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.

When is Software Capitalization Applicable?

Here’s when it’s acceptable to capitalize software costs:

1. Development stage

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.

For internal-use software like CRM, production automation, and accounting systems, consider the following:

• Preliminary Stage: Record expenses as they’re incurred during the initial phase of the project.
• Application Development Stage: Capitalize costs related to activities like testing, programming, and installation. Administrative costs, such as user training or overhead, should be expensed.
• Implementation Stage: Record any associated costs of the roll-out, like software maintenance and user training, as expenses.

2. Technical feasibility

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.

3. Future economic benefits

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.

4. Measurable costs

The overall software development costs must be accurately measurable. This way, you ensure that the capitalized amount reflects the software’s exact invested amount.

Regulatory Compliance

Ensure that all accounting procedures adhere to GAAP regulations, which provide the framework for accurately reporting and capitalizing software costs. This compliance underscores the financial integrity of your capitalization efforts.

By combining these criteria with a structured approach to expense and capital cost management, companies can effectively navigate the complexities of software capitalization, ensuring both compliance and financial clarity.

Key Costs that can be Capitalized

The five main costs you can capitalize for software are:

1. Direct development costs

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.

2. External development 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.

3. Software Licensing Fees

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.

When deciding whether to capitalize or expense software licenses, timing and the stage of the project play crucial roles. Generally, costs incurred during the preliminary and implementation stages are recorded as expenses. These stages include the initial planning and setup, where the financial outlay does not yet contribute directly to the creation of a tangible asset.

In contrast, during the development stage, many costs can be capitalized. This includes expenditures directly contributing to building and testing the software, as this stage is where the asset truly begins to take shape. Capitalization should continue until the project reaches completion and the software is either used internally or marketed externally.

Understanding these stages and criteria allows businesses to make informed decisions about their software investments, ensuring they align with accounting principles and maximize financial benefits.

4. Acquisition costs

Acquisition costs can be capitalized as assets, provided your software is intended for internal use. 

5. Training and documentation costs

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. 

Costs that should NOT be Capitalized

Here are a few costs that do not qualify for software capitalization and are expensed:

1. Research and planning costs 

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. 

2. Post-implementation costs 

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. 

3. Costs for upgrades and enhancements

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. 

Accounting Standards you should know for Software Capitalization

Below are the two most common accounting standards that state the eligibility criteria for software capitalization: 

1. U.S. GAAP (Generally Accepted Accounting Principles)

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. 

Understanding GAAP and key takeaways for software capitalization:

• GAAP allows capitalization for internal and external costs directly related to the software development process. Examples of costs include licensing fees, third-party development costs, and wages of employees who are part of the project.

• Costs incurred after the software is deemed viable but before it is ready for use can be capitalized. Example costs can be for coding, installation, and testing. 

• Every post-implementation cost is expensed.

• A development project still in the preliminary or planning phase is too early to capitalize on. 

2. IFRS (International Financial Reporting Standards)

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.

Understanding IFRS and key takeaways for software capitalization:

• IFRS treats computer software as an intangible asset. If it’s internally developed software (for internal/external use or sale), it is charged to expense until it reaches technical feasibility.

• All research and planning costs are charged as expenses.

• Development costs are capitalized only after technical or commercial feasibility for sale if the software’s use has been established.  

Financial Implications of Software Capitalization

Software capitalization, from a financial perspective, can have the following aftereffects:

1. Impact on profit and loss statement

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. 

2. Balance sheet impact

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.

• Accounting Procedure: Software capitalization is not just a financial move but an accounting procedure that recognizes development as a fixed asset. This strategic move places your development costs on the balance sheet, transforming them from immediate expenses into long-term investments.
• Financial Impact: By delaying the recognition of these costs, businesses can spread expenses over several years, typically between two and five years. This is achieved through depreciation or amortization, often using the straight-line method, which evenly distributes the cost over the software's useful life.
• Benefits: The primary advantage here is the ability to report fewer expenses, which results in a higher net income. This not only reduces taxable income but also enhances the company's appeal to potential investors, presenting a more attractive financial position.

This approach allows companies to manage their financial narratives better, demonstrating profitability and stability, which are crucial for growth and investment.

3. Tax considerations 

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. 

Consequences of Canceling a Software Project in Terms of Capitalization

When a software project is canceled, one of the key financial implications revolves around capitalization. Here's what you need to know:

• Cessation of Capitalization: Once a software project is terminated, the accounting treatment changes. Costs previously capitalized as an asset must stop accumulating. This means that future expenses related to the project can no longer be deferred and must be expensed immediately.
• Impact on Financial Statements: Canceling a project leads to a direct impact on the company's financial statements. Previously capitalized costs may need reevaluation for impairment, potentially resulting in a write-off. This can affect both the balance sheet, by reducing assets, and the income statement, through increased expenses.
• Tax Implications: Depending on jurisdiction, the tax treatment of capitalized expenses could change. Some regions allow for a deduction of capitalized costs when a project is canceled, impacting the company’s taxable income.
• Resource Reallocation: Financial resources that were tied up in the project become available for redeployment. This can offer new opportunities for investment but requires strategic planning to ensure the best use of freed-up funds.
• Stakeholder Communication: It's essential to communicate effectively with stakeholders about the financial changes due to the project's cancellation. Clear, transparent explanations help maintain trust and manage expectations around the revised financial outlook.

Understanding these consequences helps businesses make informed decisions about resource allocation and financial management when considering the fate of a software project.

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Detailed Software Capitalization Financial Model

Workforce and Development Parameters

Team Composition

• Senior Software Engineers: 4
• Mid-level Software Engineers: 6
• Junior Software Engineers: 3
• Total Team: 13 engineers

Compensation Structure (Annual)

1. Senior Engineers
   • Base Salary: $180,000
   • Fully Loaded Cost: $235,000 (includes benefits, taxes, equipment)
   • Hourly Rate: $113 (2,080 working hours/year)
2. Mid-level Engineers
   • Base Salary: $130,000
   • Fully Loaded Cost: $169,000
   • Hourly Rate: $81
3. Junior Engineers
   • Base Salary: $90,000
   • Fully Loaded Cost: $117,000
   • Hourly Rate: $56

Story Point Economics

Story Point Allocation Model

• 1 Story Point = 1 hour of work
• Complexity-based hourly ratessome text
  • Junior: $56/SP
  • Mid-level: $81/SP
  • Senior: $113/SP

Project Capitalization Worksheet

Project: Enterprise Security Enhancement Module

Detailed Story Point Breakdown

Indirect Costs Allocation

1. Infrastructure Costs
   • Cloud Development Environments: $75,000
   • Security Testing Platforms: $45,000
   • Development Tools Licensing: $30,000
   • Total: $150,000
2. Overhead Allocation
   • Project Management (15%): $37,697
   • DevOps Support (10%): $25,132
   • Total Overhead: $62,829

Total Capitalization Calculation

• Direct Labor Costs: $251,316
• Infrastructure Costs: $150,000
• Overhead Costs: $62,829
• Total Capitalizable Costs: $464,145

Capitalization Eligibility Assessment

Capitalization Criteria Checklist

✓ 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

Amortization Schedule

Useful Life Estimation

• Estimated Useful Life: 4 years
• Amortization Method: Straight-line
• Annual Amortization: $116,036 ($464,145 ÷ 4)

Financial Impact Analysis

Income Statement Projection

Risk Mitigation Factors

Capitalization Risk Assessment

1. Over-capitalization probability: Low (15%)
2. Underestimation risk: Moderate (25%)
3. Compliance deviation risk: Low (10%)

Sensitivity Analysis

Cost Variation Scenarios

• Best Case: $441,938 (5% cost reduction)
• Base Case: $464,145 (current estimate)
• Worst Case: $487,352 (5% cost increase)

Compliance Considerations

• ASC 350 Accounting Standards
• GAAP Reporting Guidelines
• SOX Compliance Checks
• Annual Independent Audit Verification

Key Observations

1. Precise tracking of story points allows granular cost allocation
2. Multi-tier engineer cost model reflects skill complexity
3. Comprehensive overhead and infrastructure costs included
4. Rigorous capitalization criteria applied

Recommendation

Capitalize the entire $464,145 as an intangible asset, amortizing over 4 years.

How Typo can help 

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:

• Automated Reporting: Generates customizable reports for capitalizable and non-capitalizable work.
• Resource Allocation: Provides visibility into team investments, allowing for realignment with business objectives.
• Custom Dashboards: Offers real-time tracking of expenditures and resource allocation.
• Predictive Insights: Uses KPIs to forecast project timelines and delivery risks.
• DORA Metrics: Assesses software delivery performance, enhancing productivity.

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.

Wrapping up

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.