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.
What are capitalized software costs?
Capitalized software costs are GAAP-qualified software development costs that have been amortized through a company’s income statement.
According to GAAP or Generally accepted accounting principles only costs associated with the coding stage (i.e. programmer compensation) for software intended for a company’s internal use, or the cost associated with the stage where “technological feasibility” is achieved for software that will be for public use, can be capitalized.
Examples of software whose costs can be capitalized include accounting and customer management systems, cash management tracking systems, membership tracking systems, production automation systems, etc. that are unlikely to be for public use.
For an example of core software development costs that can be capitalized, see the following sections.
Why do companies capitalize software development costs?
One reason is that it provides a way to spread the cost of software development across the duration of its usage.
Companies capitalize software costs this way based on the recognition that softwares are assets whose value as recorded in the company’s balance sheet can be reduced gradually until its development costs are fully expensed.
Amortizing software costs as described in the previous paragraph is done through a company’s income statement and as such reduces expenditure and increases income.
Should I capitalize or expense the costs of software designed to be sold?
In many cases software is typically available to be sold or leased to the public as they reach the stage of “technological feasibility” and as such any costs accumulated from this point onward must be expensed as incurred.
What software costs can be capitalized?
According to a contributor on Accounting Tools, the following costs can be capitalized:
- Materials and services costs such as third-party development fees, and travel costs related to development work.
- The compensation of those directly associated with the development of the software
- The capitalization of interest costs incurred to fund the project.
Where do capitalized software costs go on the balance sheet?
The cost of software is written off over time from the total value of the software asset as recorded in the balance sheet. See amortization of Intangibles in Investopedia.
Is capitalized software a capital expenditure?
Yes. Custom software is an intangible asset that generates value for companies and as a result, the amount spent on their development can be considered capital expenditure.
Capitalized costs for internal vs external use software
Software costs capitalization differs between softwares made solely for internal use and ones made to be marketed for profit in that, the rule surrounding the capitalization of costs applies to the latter only at the stage of software development where feasibility has been achieved but the software product is yet to begin to be sold to the public.
Once the software has begun to be sold, it becomes illegal for its associated development costs to be capitalized according to the GAAP principle.
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