The steps to capitalize software development costs are technical to accounting and specifics would not be covered in this article.
However, this article should serve as a guide to familiarize you with the concept and examples of how companies use capitalization to an advantage.
If you are a business owner curious to know one of the many concepts that could help in the day-to-day running of your startup, continue with this article in the next section.
What software capitalization mean
To capitalize is to record the cost of developing a custom software as an expenditure spread over the lifetime of the software instead of being recorded as only a cost in the year that it was created.
Startups accountants consider internally developed software as fixed assets. They are recorded in a company’s financial statement as the original value of the software minus accumulated depreciation and any impairment charges.
Capitalization is mostly encouraged because it allows for an accurate reflection of a company’s asset’s financial performance.
In Hakan Altintepe’s words — The founder of Technology for Alpha LLC and a technology strategy and digital transformation advisor, most IT organizations capitalize software development expenses to minimize the impact on their current year’s profit and loss, which is the basis for core business planning
Typically, capitalization works like this according to CIO:
A company spends $10 million on software development. The finance department determines that 40% of project expenses can be capitalized over a five-year period, which results in $6MM operating expenses and $4 million capital expenditures. The current year P&L impact of this project then becomes $6.8MM, and the remaining $3.2 million is depreciated over the next four years.
As a startup founder, familiarizing yourself with how software capitalization works can be crucial to accurately model your company’s finances.
Should software costs be capitalized?
Historically, there have been oppositions to capitalizing software cost since software does not meet the traditional definition of an asset class. Opponents believed that the cost associated with the development of software should be considered as the cost of conducting business.
In the following table, we give a proper overview of the advantages and disadvantages of capitalizing software development costs.
Pros
Cons
| Savings on taxes: Capitalization allows companies to save on taxes through the lifespan of the software. Since the development cost is spread out over years, companies can take advantage of the tax-saving to hire more and accelerate internal projects. | Increases overhead expenses: Software capitalization can sometimes be laborious without any real benefit to it and as a result increase indirect business costs. |
| Company’s profitability ratio increases: Capitalizing software development costs often lead to a short-term profit for companies. | It can sometimes lead to prioritization problems. Hakan Altintepe believes software capitalization leads to suboptimal prioritization where projects with a higher capitalization ratio are prioritized over other more important projects. |
| Increase of total assets. The idea behind capitalizing software costs is to not hide its true value by treating it as an operational expense. As such, software capitalizing benefits a company’s assets value. | |
| Reduced impact on cashflow Capitalizing software development costs takes away the heavy toll of full business expense from a company’s balance sheet. |
When to capitalize software costs
Generally speaking, software is only capitalized if it is perceived to be revenue-driving for a startup. And even then, only parts of the cost that makes up the total cost of the software can be capitalized according to the accepted accounting principle.
Some of the costs that could be capitalized includes:
- Core software development costs or developer compensation
- Indirect overheads
- Software testing and other direct costs
Deciding which cost to capitalize and which one to record as a business expense can be known mainly by deciding if the cost falls into any of those categories.
In one reputable finance website’s article on capitalizing software cost, the contributor highlighted two stages of software development during which a company can capitalize costs:
- The application development (i.e. coding) stage for software intended for a company’s internal use.
- The stage when “technological feasibility” is achieved for software that will be sold or marketed to the public
According to a contributor on Accounting Tools, any allowable capitalization of costs based on the three categories mentioned above should begin after:
- The preliminary stage has been completed. That is, all costs incurred before coding starts should be recorded as expenses and not capitalized.
- Funding has been committed to the project
- It is certain that the project will be completed
- The software will be used for its intended function.
Proceeding further, the contributor noted:
The capitalization of costs should end when all substantial testing has been completed. If it is no longer probable that a project will be completed, stop capitalizing the costs associated with it, and conduct impairment testing on the costs already capitalized.
An example of capitalizing software
AthenaHealth, providers of cloud-based practice management and electronic health record (EHR) systems, disclosed that it capitalizes a significant chunk of the development cost for its internally used software in a 2017 report:
We capitalize certain costs related to the development of athenaNet services and other internal-use software. Costs incurred during the application development phase are capitalized only when we believe it is probable the development will result in new or additional functionality. The types of costs capitalized during the application development phase include employee compensation, as well as consulting fees for third-party developers working on these projects. Costs related to the preliminary project stage and post-implementation activities are expensed as incurred.
Final note
The reason for this article on capitalizing software costs for startup founders is educational. It is to familiarize you as an entrepreneur with the concept.
For the most part, as a business owner who wants to take advantage of the benefits of capitalizing costs, you will need to employ an expert accounting firm to handle the granular details not covered here.
P.S: The following section was added to further explain the concept of capitalizing software costs from the questions gotten from readers of the main article.
Capitalized Software Costs: A Clear Overview
Capitalized software costs are a fundamental aspect of financial management within the realm of software development. These costs encompass specific expenses that meet the criteria established by Generally Accepted Accounting Principles (GAAP) for capitalization. In essence, these expenditures are recorded as assets on a company’s balance sheet and are subsequently amortized over time through the income statement.
Eligible Costs and Stages for Capitalization
The eligible costs for capitalization vary based on the specific stage of software development. During the coding stage, costs such as programmer compensation can be capitalized, particularly for software intended for internal use. Similarly, for software designed for public use, these costs can be capitalized until the threshold of “technological feasibility” is achieved. Beyond this stage, any further costs must be treated as immediate expenses
Examples of Capitalizable Costs
Numerous types of expenses can be capitalized, including compensation for programmers and development teams, fees associated with third-party services, travel expenses linked to software development, and even interest costs tied to project funding. These capitalized costs are considered intangible assets and are subject to gradual amortization over time, which can lead to a reduction in expenditure and potentially an increase in income.
Distinguishing Internal and External Software Costs
It is vital to differentiate between software created for internal use and software intended for external sale or lease. Costs associated with internal use software can be capitalized during the coding stage. In contrast, for software intended for external use, capitalization is only allowed until the milestone of “technological feasibility” is met. Once the software is introduced to the public through marketing or sales, any subsequent development costs must be treated as immediate expenses.
In Conclusion
Mastering the intricacies of capitalized software costs is pivotal for maintaining precise financial records and accurate asset valuation within software development ventures. Adhering to GAAP guidelines and thoughtfully considering the permissible stages for capitalization enable effective financial management and reporting of software-related expenses, ultimately contributing to better decision-making and successful project outcomes.
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